This article has been excerpted from Ultimate Guide to Personal Finance for Entrepreneurs by Peter Sander with J. Jeffrey Lambert, available from Entrepreneur Press.
Business operations, business finances and personal finances are inexorably linked in the triangle of entrepreneurial finance. Decisions and actions at one point in the triangle will most likely--in at least some way--affect a decision made in another. Some of these influences are obvious; others are more subtle. But like a balance equation in chemistry or physics, there will always be an effect. The question is how large an effect?
For example, the effect of an operational decision to hire employees has an obvious effect on business finances--wages or salaries paid, benefits paid, insurance covered, facilities required. But does this decision affect your personal finances as an entrepreneur? Obviously it might affect the cash flow you take from the business, but hopefully not much, as the ROI of these new employees should be positive. But more subtly, the number and kind of employees you have can affect the choice of retirement plans and employment benefits and, in many cases, open up options and alternatives for your own personal retirement plan. The employees may also help you qualify for group insurance plans or for better plans than you have already. That's the kind of effect we're considering.
Let's take a moment to examine the points of the triangle and how the pieces fit together.
As an entrepreneur you will make hundreds to thousands of operational decisions in setting up an infrastructure and producing your product or service. All decisions that involve money involve the finances of the business, of course, and many, like employment and facility decisions, will affect your personal finances as an owner. And these decisions are never finished: They will adjust and evolve as your business evolves--and so will your business and personal finances. Business operational decisions include the following:
- Employment and employees. Whether to have employees, how many, and what kind of compensation to provide are decisions that affect business finances in obvious ways. Decisions about employee benefits and retirement plans will affect you, for whatever you decide to do for them may have consequences for you: You can participate in benefit and retirement plans, often to your advantage. Also, your decision on how to use yourself and your spouse and/or family members as employees can impact your finances.
- Facilities and location. Early on, you'll have to decide what kind of location and building your business needs. That decision will likely have to be modified as the business grows and evolves. Naturally, like employee costs, facility costs are a major factor in the finances of most businesses. But key decisions on building ownership--buy vs. lease, owner buys and leases to business--are important to personal finances. Depending on the business, many entrepreneurs look to buy their facilities to build the asset base as part of a retirement or other exit strategy for the business. In addition, the use of a home or other personal space in a business has important personal finance consequences.
- Growth strategy and plans. Every viable business has a strategy and a plan to grow and evolve. Decisions on how to evolve and how fast must be made in the context of both business and personal finances. Many good businesses fail because they grow beyond the asset base and working capital required to support them.
- Organization. Every entrepreneur must decide how to organize his or her business. Not only are we talking about organizing facilities and human resources, but also the basic legal structure of the business. The decision of whether or not to incorporate is important. If the decision is not to incorporate, important decisions must be made between or among partners, if there are partners, and contingency plans must be in place in case things change. Like most operational decisions, the organization decision is never finished.
- Risk. Every business has risk and there are several kinds of risk. Operational risks--the risk of accident, mistake, or omission--produce potential liability for the business and can produce liability for the owners, depending on how the business is structured. Continuation risks concern the ability of the business to function in the case of unexpected catastrophe or unavailability of a key employee or owner. Financial risks concern the capital structure and the availability of capital and are covered below. Many of these risks are assumed and covered at the business level, but the owner must consider the risks at the personal level as well.
The term business finances refers to the assets, liabilities, capital, revenue and expenses of the business. For you, "expenses" may or may not literally include taxes, but however you want to slice it, taxes and tax considerations obviously have a big impact on how businesses are organized and run. These financial components are tightly intertwined with each other and with the operational decisions made by the business.
- Capital purchases and assets. Almost all businesses need to acquire and use fixed assets. That acquisition, of course, can be through purchasing or through renting or leasing. Purchase and lease decisions in turn require ROI analysis and financing decisions. Then, once an asset is acquired, it must be recovered, or expensed, over time to reflect its depreciation and plan for its replacement. The financing and cash flow decisions involved in acquiring assets will affect both business operations and owner finances, especially in proprietorships, partnerships and closely held corporations.
- Capital structure.Capital structure refers to how much of the business financing is through owner equity and how much is through debt or other liabilities and how it is done, that is, the mix of financial instruments and ownership vehicles. Business capital requirements and owner decisions influence the capital structure, which in turn influences the owner's personal finances. Entrepreneurs must decide how much of their own capital to invest in the business, how they will be "paid" for that capital (in profits, wages, interest, or other ways) and how procuring capital through loans will affect their own financial well-being.
- Working capital. This is a tough concept for many entrepreneurs to grasp. It is capital used to finance the flow-through, what goes into the business and what goes out of the business--not the fixed or tangible assets of the business. It is used to pay for inventory and to provide cash for other items necessary to the day-to-day running of the business. Any business that must pay a supplier or an employee before providing a product or a service to its customers or must provide a product or a service to customers before receiving payment needs working capital to make this happen. Working capital is part of the total capital required to run a business--and the most dynamic part. Insufficient working capital can choke business operations--insufficient inventory, inability to offer satisfactory customer purchase terms, inability to pay employees or suppliers. It is very common for a business and its entrepreneurs to underestimate its need for working capital. The usual result is that the owner must kick in more capital from personal finances--or accumulate more debt. Working capital mismanagement is a common cause of personal financial failure for entrepreneurs.
- Cash flow. This is the bigger picture for working capital. Does the business have enough cash to meet its ongoing business needs? Does it generate enough cash through operations to replace assets, pay its owners, and fund its growth? Poor cash flow leads to inadequate business resources. It can cause an assortment of financial problems, from decreases in owner returns to severe shortages of capital that must be met eventually by the owners. Cash flow becomes especially critical when the owners must replace key assets or as they're implementing important growth and competitive strategies. Many a business has declined or failed because of inadequate cash flow to replace assets or to execute key competitive strategies--and these problems almost always come back to the doorstep of the entrepreneur.
- Risk management. We mentioned risk under Business Operations, but needless to say, any business faces various financial risks. Customers don't always pay, interest rates don't always stay the same, tax rules change, sources of funds don't always come through as expected, owners or investors can leave and the list goes on--all with obvious personal financial consequences.
For now it's sufficient to say that personal finances include the income and expenses and the assets and liabilities of the individual entrepreneur and his household. Within those parameters, individual personal finance includes managing cash and money, setting short- and long-term goals, and putting plans in place to achieve those goals. Here are some important pieces to the personal financial puzzle and how they relate to the operations and especially the finances of the business:
- Cash and money management. Just as in the business, the key to a financially healthy and secure household lies in managing day-to-day money flows--income and expenses. Here we talk about the use of personal budgets and banking and credit to manage family finances and lay bricks in place to achieve longer-term goals.
- Income from business. Every entrepreneur has to decide when, how, and how much to be paid from the business. This key decision obviously impacts personal finances, but it is also important to the financial health of the business. The amount and timing of such payments should be right for both the entrepreneur and the business. Also, it should generally--but not always--be done in a way to minimize tax impact. The amount and regularity of income from the business must, of course, be accounted for in the personal financial budget. "Payment" may be in forms besides cash--benefits, retirement savings, or use of assets. However entrepreneurial compensation is structured, it must be thought through carefully.
- Management and growth of personal wealth. We mentioned income, but income most surely doesn't translate directly to wealth. Just ask the thousands (millions?) of entrepreneurs and other individuals with substantial incomes but little to show for them. The slogan is "Make it, keep it, grow it"--but many never get past "make it." Why? Poor money management--lack of awareness, commitment and control--gets in the way of keeping it, and poor or inattentive use of investing and savings vehicles gets in the way of growing it. Now, we know that most entrepreneurs are too busy to be very active investors, but we will offer some investing basics to help savvy entrepreneurs figure out where to stash their cash.
- Risk management. Just as in business, your personal life involves risks, including loss of income, health problems, liability, and loss of property. Risk management isn't just about insurance, although insurance is an important tool used to manage risk. Entrepreneurs and their families incur the same risks as other people, but business owners may face some additional risks--and may also have some other alternatives to help manage them.
- Benefits. If you're a corporate or public service employee, your fringe benefits--insurance coverage, retirement, bonuses, discounts, use of facilities, etc.--are usually fairly well defined upfront or at least defined as a set of choices. When you're an entrepreneur, the sky's the limit, at least within the law. The business can provide your benefits; if it is large enough, it can take advantage of group plans and rates. Good entrepreneurial personal finance means choosing the right combination of benefits to get you the most personally, while not compromising the business and while minimizing total taxes.
- Retirement planning. "Retirement planning" means figuring out how much you need for retirement and how you will achieve that "number" or goal; "retirement plans" refer to the specific savings vehicles you use to move toward achieving that goal. The first is a matter of pure planning and number crunching; for the entrepreneur, it must include an exit strategy, a way out of the business. The second is really part of the "benefits" package--choosing the right retirement savings package to maximize savings and tax advantages for both you and your business. There are many choices, complex choices that depend on both the finances and the operations (specifically, number and type of employees) of the business.
- Transition and distribution planning. Sooner or later, for financial or other personal reasons, every entrepreneur needs to figure out an exit strategy from the business. Needless to say also, sooner or later, we all die. In personal finance, estate planning concerns the preparation to transfer assets and decision-making authority to others. When a business is involved, the process is first more complex and second should usually start earlier. If something happens to you, what happens to the business? If something happens to one of your partners or key employees, what happens to the business? And what happens to your personal finances as a result of these events? Should you sell your business? When and why? How do you maximize your personal wealth as you close the doors? Again, many, many choices--all begging for careful planning.