This is a super basic article for the person who really doesn’t understand how businesses work. It’s written mostly for teenagers who haven’t been taught anything about business (except maybe that businesses are terrible).
The first thing I need to say is that businesses, on the whole, are NOT terrible.
The second thing I need to say is that there is a BIG difference between small (and medium) businesses and very large businesses. This isn’t true in all cases – there are actually some pretty OK large businesses – but they are rare. It’s like the difference between Southwest Airlines, which is filled with friendly workers, and United, which I walked away from forever even though I had 100,000 frequent flyer miles I could be using.
The problem is, once a business gets to a certain size, it starts to lose track of “helping people” and starts to become an entity onto itself, mostly concerned with its own self-preservation.
So let’s just say that for the purposes of this article, I’m going to focus on small and medium-sized businesses.
You should know that most of the businesses in the world are small. I did an analysis of the last U.S. census once, and determined that something like about 90% of all businesses in the U.S. employ 1 – 9 employees. So most of the businesses you encounter in your daily life, and will probably work in, are on the smaller side of the spectrum.
Now to the basics.
Money in, money out.
Businesses take money in and pay money out.
Successful businesses take in more than they pay out.
That’s pretty much it, honestly. You can’t continue to keep the business open if you are spending more than you are bringing in. Seems pretty simple, but it can get complicated. For example, you may need to spend a lot up front in order to the the business started, before you even have any money coming in.
That’s why it’s good to think first about starting a business where there are very few “startup costs,” where you can start selling a product or a service with the minimum of money going out.
How investments work
If you want to start a company where you will need to get some additional money to get started, you will either need a loan, where the money is paid back with interest, or an investment where the investor is willing to risk a certain amount of money in the hopes that he will get all that money back, plus more, if the business succeeds.
If you go the loan route, you will either go to someone you know personally, or a loan institution. In both cases, you will need to “qualify” – the lender will want to make sure you are a safe bet and that you will be able to pay back the loan.
This is why it literally pays to be a responsible person, who works hard and keeps his or her word. In some ways, it seems like that would make life harder, but it’s better than the alternative, where every new step is difficult because you have to overcome your past.
If you go the investment route, you and the investor will need to agree on how you will structure the investment.
Let’s use a real basic example.
A friend of yours wants to start mowing lawns in the neighborhood. The friend doesn’t have enough money to pay the full price of a commercial mower.
The friend comes to you and says, “If you give me $1200 to help buy this mower, I will give you 5% of the revenue that comes in, for the next two years.” (By the way, “revenue” is the total amount that comes in from sales; “profit” is the money that remains after you pay expenses).
Back to our story. You think that’s a pretty good deal, because you know how hard-working and reliable she is, and she has proven to you that she can make money doing this. So you say yes to her offer. You give her the money and she buys a commercial mower.
She does a great job of going around the neighborhood, and within a week or two, picks up 25 clients, paying $100 each, for a total revenue of $2500 a month.
That’s all she can handle in a given month, because she’s also going to college. So that number stays the same for two years. At the end of two years, assuming she brought in $2500 starting in the first month, you would end up with $2500 a month, times 12 months, times 2 years, times 5%, or:
$2500 a month x 12 months x 2 year x .05 = $3000.
Obviously, this is a very good investment for you. You paid $1200 initially and you got $3000 back, for a gain of $1800.
And, if your friend was paying you your 5% each month, rather than all at once at the end of two years (better for both of you, frankly), she’d only be paying 5% of the $2500 a month, or $125 a month. That’s not bad, considering her only other expenses would be gasoline and maintenance for the mower (assuming she already had a way to transport the mower to each job, perhaps on the back of her pickup truck).
How accounting works
As you can see by this example, it helps to be able to think through this stuff, using basic arithmetic. It’s important to think through these types of formulas carefully, and double-check them, so you don’t miss anything.
And if you are really smart, you will start doing all that with the help of spreadsheets. No matter which applications you end up using to keep track of your money, you should definitely be able to use spreadsheets for basic “money in/money out” tracking, and to think through problems like this.
You should get good enough with spreadsheets where you can set up basic formulas and play “what if” with those formulas. As in, what if her business starts to fail after one year and she only makes $800 a month? 5% of $800 is a lot less than $125 a month; it’s only $40. Spreadsheets can help you determine your risk.
In this case you could set up a spreadsheet like this, with columns for:
- $ of money each month
- 5% of that money
- x number of months =
- total repayment
Then you would set up formulas in the 5% and total repayment columns. I think you get the idea.
Keeping track of money in, money out
It’s easy to lose track of how much you’re spending, and suddenly find yourself in a very uncomfortable “I have less than I thought I did” situation.
It pays, big time, to keep track of everything and to be very cautious about spending. You WILL be surprised by costs you hadn’t anticipated, especially where taxes and other regulatory costs are concerned. And, you can need resources you hadn’t anticipated at first.
But bad stuff can happen, too. Your biggest customer can leave the country unexpectedly, taking the rest of the bank loan with him, leaving the employees in the parking lot with no way to get inside the building, and leaving you with thousands of dollars in expenses you racked up while doing the work (been there, done that).
I don’t believe I’ve ever met a single business owner who hasn’t been negatively surprised in some way, especially in the first two years. Which is why, if you can survive your first two years, you will be more likely to survive for another 20, if you want to.
For accounting, you will need:
- To be able to send invoices or provide receipts
- To be able to keep track of what was sold and delivered to whom
- An Employer Identification Number associated with the business for filing your taxes (I don’t recommend using your social security number, you want to keep that as private as possible, and you can get an EIN even if you don’t have employees and are a sole proprietor)
- A business bank account
- An accountant to help you file your taxes, or learn to be proficient with one of the online filing applications (however, tax law is very complicated, and best left to experts)
- To keep business and personal expenses separate
This is enough to get you started, but there’s one more thing I need to say.
Don’t cheat anyone, ever. Not even the government. Don’t lie, don’t hide, don’t pay “under the table.” Do everything aboveboard, for several reasons.
One, you’ll be able to sleep without worrying about getting caught, two, people will respect you more and want to work with you, and three, if you ever are audited, you can go through the process knowing that you did the right thing and have nothing to hide. There is a lot to be said for living your life with a clean conscience.
Also, get everything in writing, especially if you are getting advice from a government body of some type, or making any kind of business agreement. If something goes wrong, or the situation changes somehow, you need proof of what was said or agreed to.