USA TODAY

Avoiding the Black Hole of Business Start-ups

By Kenneth Sweet

It is the great American dream to start your own business and become your own boss. It is not that complicated, either. Simply invest everything you own and as much as you can borrow, paint a rosy picture of how successful your product or service will be, grossly underestimate the cost in time and money, then sit back and watch the business fold in less than a year. Oh, and do not forget to ruin your credit rating, personal relationships, and health along the way.

You say no one deliberately sets out to fail in business. Perhaps not, but four out of every 10 start-ups will go under within the first year, six within the first five years. It seems that nothing succeeds like failure. Yet, many of the missteps and disasters that befall a new business are avoidable.

It is an idea that has been simmering in the mind of Carla, a pastry and dessert chef, who has been told her cupcakes are second to none. At the urging of friends and coworkers, and with some credibility and success under her belt working at reputable restaurants, she finally feels she has the resources to follow her dream. The idea is to open a small shop a bakery boutique that will feature her singular cupcakes. The real business, however, will be in supplying stores and retail outlets and establishing a name brand à la "Famous Amos " chocolate chip cookies.

A viable idea, sound financial management, and hard work all are important, but first and foremost is the need for a well thought out strategic plan, the big picture of the business. It starts with the vision, mission, values, and operating principles. In addition to these basics, the plan will include financial data, market research, positioning information, competition reviews, and market description. This plan addresses the nuts-and-bolts issues of how to grow the business-it is a map for traversing the business jungle.

As part of this process, it is important to decide exactly what it is the company will be selling, whether it is a product or a service and, more importantly, to whom it will be sold. In other words: identify the market. A company can offer the finest, most affordable and efficient air-conditioning system known to man, but if the target market is only north of Alaska, the company will not last the summer.

Define the market and the market will help to define the product or service. As such, it is critical to ask and answer these basic questions: Where are the prospective customers located? Who are they? What is their demographic? What are they looking for and what is missing in the marketplace? What is the company’s unique selling proposition?

The factors that will set a new company, product, or service apart from the competition not only will help determine the future marketing approach, but will act as a barrier to entry for future competition. Without this kind of thought process and planning, a new venture is vulnerable to being co-opted and imitated by the more established competition, thereby diluting its place in the market.

In Carla’s case, the upswing in cupcake sales indicating something of a trend is what helped her decide this might be the right time to start her business. In her mind, the market already is defined. One of the challenges or opportunities is to build a brand that cannot be imitated and takes on a certain cache in the marketplace. (Using the Famous Amos model, a cookie is a cookie, except when branded as "the" cookie.)

"We will not be undersold" is a popular war cry, but if the company’s pricing is not sustainable, this statement will only apply because the company will not be in business. If the sole competitive advantage is lower pricing, a competitor with deeper pockets may price you down and eventually out of the market.

A common mistake start-ups make is setting prices according to the competition. It is better to start by calculating the profit margin needed to stay in business. What will the operating costs be? It is particularly important to shop for the best prices on equipment and materials and estimate labor costs by surveying what the competition pays or by checking regional and industry averages.

Once costs have been determined, decide if pricing is where the new company will make its stand. Perhaps not. Quality of service or product may be the unique selling proposition that sets the company apart from the pack. If so, though costs may prevent the company from being the lowest priced offering, there still may be a niche that will attract the desired target market. In some cases, where prestige and status are the qualifying factors, a price that is too low may send the wrong message and actually lower market appeal. While the mantra "location, location, location" is what drives real estate, it also could apply to any new start-up. After defining the target market, take into consideration where the business will be located. For example, if the intent is to open an overnight shipping service, an airport, rail station, or industrial area locale, where large space is available for lower costs, would be important. On the other hand, selling high- end furniture or designer fashion might be easier in an upscale mall or boutique shipping area despite the higher cost per square foot. Perhaps the business entity needs little or no square footage at all. Is the business better suited for ecommerce, or does the target market require the old bricks- and-mortar, or a combination of both? Other considerations as to the where and how large physical operations depend on how much the company plans to do in-house and how much the business will rely on strategic alliances and outsourcing for support operations such as shipping, printing, manufacturing, accounting, communications, etc.

The strategic plan also should include something few bother to consider when entering a business–an exit plan. The excitement and energy of starting a business leaves little room for looking many years down the road. Most may have some vague idea that once the business is successful, they will sell it and retire to their own private island. If the business should happen to beat the odds and succeed to the point where retirement or selling becomes a real issue, it may be very late in the game to take the needed steps crucial to a positive outcome.

The sell-the-business’ exit strategy contains the basic assumption that someone will want to buy it. Buyers look for more in a business than the mere fact of survival. They look for a sustainable income stream, verifiable assets, and an experienced management team or key employees who will guarantee that survivability. These all are considerations to be aware of right from the start.

With every "can’t miss" business idea, there are a few more nagging questions that may arise between the first blush of inspiration and successful retirement on that private island. Questions such as: What form should the business be set up as–a corporation, sole proprietorship, or partnership? Will you need to establish merchant accounts and banking services? What about insurance, payroll, tax liabilities, workmen’s compensation, etc? These are areas where expert advice from outside professionals is vital before the business opens its doors. Thinking that you will be able to "figure it out as you go along" is akin to inventing the parachute after you have jumped from the plane.

Carla may dream of opening the doors on her first day of business to a cheering throng of eager customers climbing all over themselves to buy her cupcakes. Her smartest business decision here would be to wake up. Even if her product does sell well initially, this is by no means an assurance of long-term success. Many popular products and services fail to make it, not because there is anything wrong with the idea, manufacturing, or marketing, but simply because the business did not have the resources to support its own success.

Another way to guarantee failure is to undercapitalize. The fixed costs and working capital needed usually are quite apparent. There is rent or a lease to pay, equipment costs, payroll, insurance, etc. Some costs, however, are not apparent at first and allowing for them might be the difference between a new venture having the chance to find its footing or falling immediately into financial quicksand.

Under the best of circumstances, it takes time to develop and build a customer base. During this period, the fixed costs and working capital needs remain the same. Put another way, money starts leaving the moment you open those doors, and it will be some time before any of it makes the return trip.

It is, of course, a relief when the theoretical finally becomes real and orders start coming in, but it is a trap to mistake orders for cash flow and a stronger than anticipated initial response may have a dangerously negative effect. In addition to that steady stream of cash going out the door from day one, suppliers must be paid and, if orders are strong, there may be overtime and other added labor costs.

Add to this shortfall the fact that, with some exception, these accounts receivable will remain outstanding until work is complete, invoices are sent, and payment is returned. A new start-up probably has no established credit with suppliers and must pay as it goes. Customers, on the other hand, particularly larger companies, have payment schedules and procedures that may delay the actual payment for weeks, perhaps months. Even in retail or food service there may be a lag between the time a credit card is charged and funds are released to the account. If there is any kind of dispute, even a month later, those funds may be held, or charged back, until the matter is resolved. For these reasons, it is a good rule of thumb to have a set-aside of at least three to six months of total operating costs before starting any new business.

Carla’s Classic Cupcakes starts off well, with good word-of-mouth buzz and interest from a local chain of food stores. The first supplies to the food stores sell out, and they double the next order. Carla had not anticipated this rapid growth and now not only must order twice as many supplies, but add labor and transportation costs. In addition to finding help, her costs for workmen’s compensation, insurance, payroll tax, and office support increase. If she takes too long to adjust and cannot re-supply the stores on time, she runs the risk of destroying her credibility and brand from the outset.

Most entrepreneurs who start a new business are not driven simply by the desire to make money. If they were, there certainly are easier ways. Divide the financial return by the amount of hours needed to get a business off the ground, and working behind a fast-food counter probably pays more–especially when many would-be Donald Trumps neglect to take into account their own living expenses or forget to add themselves to the payroll.

The lure of financial independence is there of course, but only as a function of the desire for self-management. Sometimes it is the wish for creative freedom, for finding a full use of personal skills and knowledge that fuels this drive. Ironically, the same skill and expertise in a particular field that leads someone to the conclusion they can and should do better on their own may limit their success in a start-up.

A case in point can be found in the construction industry. A skilled general contractor most likely will have knowledge and expertise in every area of construction he oversees. The reverse is not necessarily true. An excellent plumber, carpenter, or electrician may have the technical skills to master any or all of these areas, but lack the business savvy necessary to make a profit.

Though Carla has had to eat, sleep, and breathe cupcakes, she has managed to take her business to the next level. Now the retail boutique has a steady stream of regulars, and the food chain has decided to expand her product to stores citywide. However, to handle the increased orders, she has had to rapidly increase her capacity (and overhead), and now needs to spend more and more time finding new customers and selling the product and less time doing the actual baking (which is what the product is known for, after all). Carla has hit the classic start-up glass ceiling. "When I am selling, I do not have time to do the work, and when I am working, I cannot go out and find new business."

Whether it is because delegating is difficult or there is a need to keep labor costs to a minimum, many small business owners end up trying to do it all themselves, and the burn out factor is high.

While Carla, and her cupcakes, may be fictional, the problems of starting and growing a new business are all too real. A common trait of most, if not all, self-made success stories is the willingness to take a risk. The upside can be financially and personally rewarding if it succeeds, but the cold facts are that only a small fraction actually will survive. Even when an individual has done all the homework, is an expert in the field, has researched the marketplace, and understands the strengths and weaknesses, the resources required–in time and money–almost always are much greater than first imagined. A hard and realistic look at what is needed, along with a solid strategic plan, can help a start-up avoid early catastrophe and literally beat the odds.

Kenneth Sweet is executive director of consulting services at International Profit Associates, Inc., Buffalo Grove, Ill. IPA and its combined family of consulting firms provide comprehensive business consulting, tax planning and business valuation services to companies in the United States and Canada. For further information, call (800)531-7100 or visit www.ipa-iba.com.