6 Tips For Avoiding Financial Disaster When Starting a Business

You have to make sure you are personally on a strong financial footing before you start your company.

By Jennifer Woods • Apr 4, 2015 Originally published Apr 4, 2015

Opinions expressed by Entrepreneur contributors are their own.

Starting your own business could be the ticket to the personal autonomy and financial independence you've always wanted. If it doesn't work out as planned, though, it may feel more like a nightmare--particularly if it's made a mess of your personal finances.

That's why, before embarking on a new venture, it's important to be on solid financial footing and have a plan in place to ensure that your personal wealth will be protected, regardless of how your business fares in the future.

1. Don't Put All of Your Eggs in One Basket

The only thing worse than having a business fail is having a business fail after you've invested all of your money in it.

"Entrepreneurs tend to be serial optimists," says Nate Wenner, principal and regional director of financial advisory firm Wipfli Hewins Investment Advisors. "But you need to be prepared for the potential downside of different scenarios."

"I've had clients liquidate their IRAs to start a business, take every dollar out of their checking accounts or max out their credit cards to fund their businesses and keep them operational," he says. "Sometimes it works but sometimes it doesn't. f things don't go well and you've cashed in everything, or you're thin on your own personal financial assets, what's your fallback?"

2. Maintain A Good Emergency Cash Cushion

The standard rule of thumb is to have three to six months of emergency cash on hand. However, Eric Roberge, a certified financial planner and founder of investment-advisory firm Beyond Your Hammock, says entrepreneurs need a much bigger cushion – especially if they have no other income stream.

"I'd keep two years of expenses held back that you can live on," he says. "You don't want to be stressed out about your finances while you're starting a business."

Having a strong financial foundation in place was key for Manpreet Singh when he co-founded TalkLocal, a home-services marketplace that connects consumers to local pros. Singh, who also happens to be a chartered financial analyst, says, "One thing people don't realize is that, at the onset, the entrepreneur is a company's only asset. So, if the entrepreneur is failing financially, the business doesn't stand a chance."

Related: Tony Robbins: The Best Financial Decision Every Entrepreneur Must Make

"My fate and the fate of our business was so intertwined that I initially treated myself like the business itself. I moved back to my parent's home and we even launched the business from the basement," he says. "Cohabitation was a simple way for me to cut my largest personal expense. Meanwhile, holding onto my day job held greater benefits than costs for the year or so that we spent refining our product and business model."

3. Don't Co-Mingle Your Assets

Keeping business and personal expenses separate is a must when starting a business, whether you're shelling out small sums of money or making a significant financial investment.

Any money you spend on valid business-related expenses – anything from consulting fees to office supplies -- is deductible from the business income. The more deductions you have, the less you'll owe Uncle Sam.

Experts recommend opening a separate business credit card and business bank account as well as putting an accounting system in place to track your expenses. Accounting software such as QuickBooks is a good low-cost option but if the business requires more extensive expense tracking it might be prudent to hire a bookkeeper.

4. Diversify Your Investments

Most people understand the benefits of having a well-diversified investment portfolio, yet business investments are often excluded from the group.

"If you're taking on the high risk of starting a business, your other investments need to be much more conservative," Roberge says. He believes in diversifying between a range of asset classes, including stocks, real estate, commodities, bonds and cash to reduce overall risk.

In addition, he says, entrepreneurs need to be mindful about loading up on investments in their area of expertise. For example, if you own a lot of tech stocks and then start a tech company, you are overloaded in the sector, which "completely shifts the allocation…you have to make sure you understand what that means for your risk going forward."

Related: 3 of the Worst Millennial Money Habits

5. Make Sure You're Adequately Insured

There are a lot of things that could go wrong when starting a new business, so it's a good idea to speak with a financial professional to determine where insurance policies may be helpful in mitigating certain risks.

Marguerita Cheng, chief executive of Blue Ocean Global Wealth, says disability insurance is one of the most important (though often neglected) forms of insurance for business owners.

"Disability insurance protects your greatest asset: your ability to make income," she says. "If you are the sole breadwinner, that is really important."

Additionally she says there are other options depending on the type of business you're running. There are certain policies if you're working from home, purchasing expensive equipment or even using your car for business purposes. There are also policies to protect people in the business, such as errors-and-omissions policies, which cover damages related to professional advice; directors-and-officers insurance to protect against legal action brought against a company director or officer, and key person insurance, which pays out if your partner or a key employee dies.

6. Don't Forget The IRS

Speaking with a tax expert is one of the most valuable things you can do to ensure you're setting up your business structure properly and maximizing your deductions.

It's also important to make sure you don't make any costly mistakes, which is easy to do since IRS rules can be tricky to understand. For instance, one common tax misstep that entrepreneurs make is failing to pay themselves a salary.

"A lot of people are running so thin that they don't pay themselves a salary for a long time, either trying to get the business cash flowing or to avoid going further into debt," says Wenner.

However, if the business is audited and the IRS sees that the business is not paying you and therefore the government is losing out on those tax dollars, it could be an issue.

Related: Richest Americans Prefer This Type of Credit Card

Jennifer Woods

Financial Writer

Jennifer Ryan Woods is a financial writer with extensive experience writing about ETFs, mutual funds and personal finance for leading business news organization including Dow Jones Newswires, TheStreet.com and CNBC. She is also the author of "The Asset Allocator: How ETFs Can Supercharge Your Portfolio," an instructional financial book that highlights the benefits of using ETFs to construct a well- allocated portfolio.

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