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Steering Clear of Small Business Traps

“Steering Clear of Small Business Traps”

The author, a banker, dispenses some straightforward advice for keeping your business on the straight and narrow. Several common pitfalls are pointed out, with strategies for avoidance. Includes discussion on such topics as finance, management, planning, family, and lack of focus.

According to the Small Business Administration, three out of five small businesses fold within the first five years. Sadly, few experienced lenders would find this statistic surprising, because we’ve seen all too many times the mistakes that can be fatal to a small business.

However, small business owners can dramatically increase their chances for success if they’re prepared for the problems they’ll encounter. Whether they own restaurants, professional service firms, high-tech ventures or retail outlets, all entrepreneurs face common pitfalls. The following traps have been the downfall of many businesses and should be avoided by current or prospective small business owners:

Undercapitalization. Small business owners often want to run their companies on a shoestring, and thus avoid borrowing money. But adequate capital is needed, sometimes suddenly, to invest in the materials, equipment, staff and real estate that will lead to profits and, hopefully, success. Small business owners should always allow for a safety margin when estimating their capital needs. Overcapitalization can’t kill a small business, a capital shortfall can.

Ignoring business problems. A small business doesn’t fail overnight. There are always warning signs, and entrepreneurs must recognize and respond to them. Too many small business owners ignore cash flow problems, payroll shortages and other signals. When they finally approach a lender for financing help, it’s often too late, the business is in a hole too deep to escape.

Using the wrong type of financing. The relationship between the type of financing and its purpose should follow simple logic: long-term loans should be used for long-term investments, such as equipment, while short-term loans should be used for working capital. Repayment terms should always make good business sense. For instance, the owner of a construction company shouldn’t finance a new truck over 10 years. In that industry, the truck may be replaced in as little as four years, and the owner would be paying for an asset that no longer exists.

Mixing business and personal finances. When small business owners face personal financial pressures, such as college tuition, second homes, car payments, etc., they sometimes "borrow" money from the business to cover personal obligation. Despite good intentions, this money may not be paid back, and the end result could be the failure of the business. Entrepreneurs should exercise strict discipline in this area, and remember that any money in the business is there to cover future business — not personal — obligations.

Owner’s death or health problems. People start businesses because they want to be independent, but they shouldn’t assume sole responsibility for every facet of the operation. I’ve seen many successful businesses fold because the owner dies or has long-term health problems, and no one else can sustain the momentum. Small business owners need to ensure that the company is not overly dependent on themselves and should put in place life and/or disability insurance adequate to sustain the business in the event it is turned over to heirs or sold. Someone else should know enough about the business and its finances to take over, if only temporarily.

Second- or third-generation owners lose interest. Most entrepreneurs would like to pass the "family" business on to their heirs. But they need to consider if this is the best choice. Are the children and grandchildren interested in and enthusiastic about the business? Do they have the necessary drive and skills? These are hard questions, but every entrepreneur needs to ask them and make realistic succession plans — in advance.

Side ventures. Success brings its own traps, including the lure of side ventures. The owner of a mature business may become bored and may start looking for new challenges. This could lead to a side venture, perhaps in an industry in which the owner has little experience, a significant handicap for any business. The new venture may take excessive time and resources away from the main business, effectively ending both businesses.

External economic factors. Even the most profitable small business will feel the effects of a regional or national downturn. And, for a business that’s already struggling, a recession can mean the end. While entrepreneurs have no control over the economic climate, they should prepare a contingency plan that accounts for inevitable economic swings.

Failure to plan ahead. The biggest pitfall for small business owners is short-sightedness. Owners need to prepare for periods of growth, new product development, physical expansion, etc., well in advance — and consider every possible outcome of their actions before proceeding. In addition, they need a sound financial plan that allows for variations in capital requirements, equipment and real estate needs, personnel, marketplace demand, etc.

An experienced small business lender can be an invaluable resource for information about financing options, capital need calculation, personal finances, financial and estate planning, and other issues that are critical to small business success. Entrepreneurs should sit down with their lender at annual or semi-annual intervals to discuss what’s happened in the business recently, what the future holds, and what resources are available to manage the challenges of owning a small business.

About the Writer: James V. Schermerhorn is a former Senior Vice President and Regional Manager of the Mellon PSFS Business Banking Division.

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