The following information is for general purposes only and is not meant to apply to any specific situation. Please consult with your certified public accountant or tax professional to discuss your personal situation
Businesses usually do not fail because of a lack of ideas. One of the key reasons businesses fail is lack of cash. If a business can survive the period where sales are slow and startup expenses are your primary outflow, it has a chance to be one of the 50% of businesses that survive the first five years of existence. Starting a business is a scary time, and managing your personal and business cash flow well can be the critical factor to achieving self-employment. Anyone aspiring to become self employed should consider three unique savings funds to manage liquidity during the transition from traditional employment to “free agency”.
The escape fund
I am stealing this term from Pamela Slim’s outstanding book “Escape From Cubicle Nation”. Any escape from traditional employment is made easier with a strong cash reserve from which you can draw before your self-employment pay equals your take-home employment pay. The escape fund is the buffer that allows you to build your business from a position of strength instead of desperately looking for the next sale for income. Before I decided to take full-time employment and build Whiteboard Business Partners as a side business, my wife and I considered using our emergency fund as our escape fund. I’m glad we did not make that decision, because the emergency fund is a key risk management tool. Even though “creating a self-employment opportunity” is important in my vocational plan, it’s not an emergency. My wife and I maintain a six-month fund of living expenses, and we did not want to increase our family’s risk by drawing on the emergency fund. Our family has always lived below its means, so saving money has never been a problem for us. We are simply reallocating a portion of our discretionary savings to our “escape fund” and keeping our emergency fund intact. When the time is right for self-employment, we will have the escape fund for any cash shortfalls before drawing on the emergency fund.
The business emergency fund
Too many young businesses operate like many American families – they live “paycheck to paycheck”. One major, unplanned expense can cause a business with no emergency savings to die. As a Financial Peace University graduate, I can almost hear Dave Ramsey’s pleas for an emergency fund in my sleep. I applied Mr. Ramsey’s emergency fund principles more for my business instead of my personal finances and started thinking about the right emergency fund for my business. Depending on the phase of your business and your available funds, there are three different amounts to consider for a business emergency fund.*Six months of operating expenses – This level is consistent with Dave Ramsey’s baby steps and is my preferred choice. If you have six months of operating expenses available, you can adjust to sales downturns without having to accept work you really do not want to take.*The amount of your largest purchase – A brand-new business or an entrepreneur running a very tight budget can consider this emergency fund. Think of the largest purchase you would have to make to keep your business running. For example, if you run a cake decorating business, how much would it cost to replace your oven? That amount would then be your emergency fund. This is not as safe as six months of operating expenses, but it does provide some level of comfort.*A year of revenue – This amount might be too conservative, but the economic recession has proven liquidity can be a good thing. Many debt-fueled companies and leveraged buyout companies learned this lesson the hard way!
The tax fund
Self-employed individuals must maintain a fund to pay taxes. Federal and state governments do not take kindly to not paying taxes, and self-employed people do not have taxes withheld like traditional W-2 employees do. Since you must pay taxes on a quarterly basis, it’s important to keep a separate fund to pay your taxes. One key point to remember is that self-employed individuals must pay BOTH the employer and employee portions of Social Security and Medicare taxes. Employees only pay 7.65% of wages, but self-employed individuals must pay 15.3% (note that the employer’s portion of taxes is a deductible business expense). You must be disciplined to put aside at least 25% of your revenues for taxes. A conservative business owner will place even more in this fund.
The hill and valley fund
You do not want to starve your business when times get rough, and you want to be disciplined enough to keep investing even if sales are down. Many business owners I know take a portion of their revenue and invest in a special account to ensure proper investment in all business conditions. Please realize this fund is different from the emergency fund. You need the emergency fund to deal with a true business emergency like the loss of a major customer or an insurance deductible. The hill and valley account allows you to make regular business investments as part of a written plan instead of spending based on your revenue.
Smart business owners plan for the future and ensure they can pay their bills and invest in their businesses regardless of economic conditions. Having these four funds will increase your chances of making the leap from employee to entrepreneur.
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