Prospective entrepreneurs usually do a good job of identifying their potential costs of doing business, with one exception. They’ll get an idea of most of the major legitimate business expenses — space and rent, materials and supplies, travel and entertainment — but they’ll often miss one of a new business’ biggest costs: the wages of the owner. As a business owner, you, too, are an expense.
There are many reasons people become entrepreneurs: They may want the freedom of time, whether that actually exists or not; they may want creative control; they may have a unique idea or a unique twist on an existing idea. Often, their reason is coupled with a desire to make money. After all, a business that is designed to not make money isn’t a business — it’s a hobby.
If you make a product or service and sell it to family or friends with intent to break even financially, you are not in business. A business exists to make money. A hobby is recreation. Recreation is important, and your business may even feel like recreation, but a hobby doesn’t pay the bills; a business does.
Some entrepreneurs plan on simply keeping what’s “left over” for themselves: the table scraps approach; anything not consumed by the business is available for consumption by the owner.
In a new business, leaving what’s left over may not leave enough.
Business v Business Owner
One source of confusion is failing to differentiate between income to the business and income to the owner of the business. They’re not the same thing. The business makes sales or otherwise generates revenue through its activities. This is income to the business, which then has expenses to pay.
Here is where consideration needs to be given to the business owner as an expense.
The income to the business owner is one of the things, in addition to all the other costs, that needs to be covered out of the funds that make up the revenue of the business — the owner is an expense. If the business doesn’t have enough revenue, it can’t pay all of its expenses, and the owner usually comes last on the list.
Prospective entrepreneurs need to prepare for themselves as an expense to the business in two ways. They need to know when they will want to, or need to, take money from the business. And they’ll need to know how much they want to take, or need to take, when they take it. These are questions they should address in their business plan.
Note that there are two separate scenarios in each question. The time you would like to take money from the business, and the time you would need to take money from the business are not necessarily the same; they’re more likely different situations.
You may, for example, want to go not more than three months before beginning to draw income from the business, allowing yourself this time to build the business up and use any income to get whatever else you might need. You might need to take income by the end of six months, for example, depending on the size of the cash buffer you have when you start the business. And hopefully you do have a buffer.
Similarly, you may have an income target you want to achieve from the business, something that will at least allow you to live comfortably, pay your bills on time, and invest for your future. There is a lower number, the minimum you need to get by, once the buffer has run out.
This would allow you to live moderately well and pay your bills on time.
In creating a business plan, it’s a good idea to think about what you expect the business to do, and also how you would handle a worst case scenario. What will you do if our teetering economy falls into recession shortly after you open the doors? What are additional ways you might generate revenue for the business? How much can you or will you invest before you would pull the plug?
The Bottom Line
Many businesses fail within the first couple years. Not having sufficient capital is one of the major obstacles to success. By planning in advance, an entrepreneur can consider how they will generate the business revenue necessary to meet all of their obligations — including their obligations to themselves.