Q: My friend and I have been talking about starting a small business. We’re keeping our day jobs for now and assuming business won’t take off for a while. Do we need to create an LLC right away or can we wait until we actually start making money?
A: Starting a business without an entity is one of the top 10 mistakes small business entrepreneurs make. I’ll use the example of fictitious friends Tom and Jerry to talk about incorporation and nine other mistakes all small businesses and start-ups should avoid.
Imagine that Tom and Jerry, two longtime friends, have been speaking about their love of cheese. Tom likes the raw milk cheeses, aged six or more weeks and sourced from small farms, that he finds at the farmer’s market. Jerry can’t get to the farmer’s market because his kids have soccer games across town at the same time. But Jerry works as a buyer for a local supermarket, and he knows that if he could offer those cheeses at his supermarket, he’d be able to enjoy them like Tom does. Tom and Jerry decide to start buying cheese from the farmers and distributing it to grocery stores.
Only time will tell if Tom and Jerry’s idea is the best thing since sliced bread. But right now, they need to avoid a few pitfalls.
10 common mistakes to avoid when starting a small business
Mistake #1: Starting a business without an entity
In most states, securing a business license or registration is required to operate a business, but this process is different from incorporating or organizing a company. Unless you register for limited liability corporation, or LCC, protection, the partners in the business can be held liable for anything bad that happens with relation to the business.
That means that if someone gets food poisoning from the cheese Tom and Jerry sell, that sick person could sue for damages and come after Tom and Jerry’s personal assets, which they might think have nothing to do with their business. LLCs are, in almost all states, the most common form of registered entity due to their low cost and ease of operation.
Mistake #2: Inadequate capitalization
Also known as “money,” capital is what partners, shareholders or business members contribute in exchange for ownership in the business. Some businesses are capital intensive — as in a dental practice — while others are capital efficient — as in a copy editing company — but in every business, lack of money is the number one cause of failure.
Mistake #3: Planning only for success
Every entrepreneur dreams big dreams — and thank goodness — but sometimes things go awry. In order to be successful, a new business needs to remain flexible in its processes and develop easy-to-understand contingency plans in case the idea isn’t as big of a hit as expected. A line of credit from your bank, for example, need never be used but can be critical when you hit a bump in the road.
Mistake #4: Understanding the industry, but not the market
Most entrepreneurs know their industry intimately and have expertise in their product or services. But critical to their success or failure is a simple question: Will others pay for the product or service? This product market fit can sometimes be tested in a small way; somehow you need to test to make sure you’re building a Ford Model T and not an Edsel.
Mistake #5: Doing it all yourself
Having an accountant, banker and attorney with whom you’re on a first-name basis ensures you will build a strong foundation for your business and won’t make mistakes that will cost you more to fix down the line.
Mistake #6: Working with friends instead of business partners
In our example, Tom and Jerry are good friends, but they need to treat the business seriously. Jerry has a day job, so Tom needs to ask some hard questions: Is Jerry going to keep his day job? Does he expect an equal share of equity? More on that below. To be successful, business partners cannot be afraid of hurt feelings.
Mistake #7: 50/50 partnerships
Two people starting a business naturally want to be fair to one another. But who makes a decision if the partners disagree? There are ways to address this in the legal documents, but it typically makes things easier if partners agree that one is the 51 percent partner.
Mistake #8: Ignoring intellectual property
Intellectual property, or IP, describes almost all the intangibles in your business, including trademarks, copyrights, trade secrets, et cetera. If you don’t pay attention to your IP, others can copy your business. If you don’t pay attention to the IP of others, they can sue you for infringing on their protected property.
Mistake #9: Counting your eggs before they hatch
Let’s say that in year three, Tom and Jerry are making good money and selling a lot of cheese. They now have dedicated employees, a recognizable brand, and good relationships with farmers and grocery stores. But, somehow, they didn’t realize they needed to comply with food labeling regulations.
As a result, they may face legal action or penalties from the U.S. Food and Drug Administration, paying fines and destroying inventory or issuing recalls (this would be a good time to have an LLC).
Mistake #10: Falling in love with the idea
Successful businesses are run by people who understand that things don’t always go according to plan. Being able to change your approach, in small and large ways — a move sometimes called a pivot — allows the product or service to find its market and, eventually, success.
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