Introduction

Why do people start a small business? Some want to spend more time with family, and starting a business allows them to do that. Some find it exhausting to be outside the house all day, dealing with traffic, co-workers, meetings and interruptions. Some people hate answering to a boss all the time- needing permission to schedule a dentist appointment or take the day off when they're sick. Some people are unmotivated by the security of a regular paycheck and prefer the challenge of the direct rewards or losses that entrepreneurs see from their efforts.

Maybe you want to build an empire and become famous, or create a wealth-generation machine that you can pass on to your children. Or perhaps you can't convince anyone to recognize your unique vision and you've decided that it will never come to fruition unless you strike out on your own. Or maybe you're thinking of self-employment because you've been unemployed for so long that you feel that you've exhausted all the other options.

Becoming a small business owner has unique challenges and rewards that aren't right for everyone. You must be driven, disciplined and able to identify a product or service that people need - one that they will pay enough for to allow you to live comfortably. You have to develop marketing skills and be able to find your own work, because it won't fall into your lap until after you're well established. Business owners need to understand how to budget, keep records and handle small business taxes. They must familiarize themselves with employment laws if they want to hire staff. They also need a plan for protecting their business and everything that's tied to it if something goes wrong. (For more, see Are You An Entrepreneur?)

In this tutorial on starting a small business, we'll address all these issues and more.

1. Choosing Your Business

One of the most difficult decisions in starting a small business can be what line of work to pursue. You might not be sure what talents you have that will allow you to succeed without an established company's name behind you. Or you might excel in so many areas that you're not sure which one or two to hone in on. Whatever your situation, you should consider the following factors before you settle on a business concept.

Play to Your Strengths and Interests
If you thrive on interaction with others, working alone from your desk as a manuscript editor will make you restless. If you'd rather have the flu than pick up the phone and call a stranger, don't start selling insurance. You're going to be spending a lot of time on your business - probably more than the 40 hours a week you're giving to your current employer. Ideally, you should wake up every morning feeling energetic and passionate about the work that lies ahead of you. At the very least, your small business idea should be something that you're interested in and that plays to your strengths.

The process of figuring out what line of business to go into is not that different from figuring out what you want when you're looking for any other new job. It seems daunting because the possibilities are wide open, but that's also the main attraction of working for yourself. You don't have to limit yourself to what your resume says you're good at. What gets you excited? Don't be afraid to consider every possibility. Even the ones that don't initially seem to have any money-making potential - like dining in restaurants, vacationing in Jamaica, or playing with your dogs - can work if you are motivated enough. There are, after all, plenty of successful food critics, travel writers and pet sitters. (To learn more, see In Small Business, Success Is Spelled With 5 "C"s.)

Potential Demand
Is there market demand for the product or service you want to offer? Before you quit your day job, you need to do some research to see if your idea has the potential to succeed. If you want to work independently as a financial planner, see if you can attract clients based on your existing credentials and experience. If you want to offer a product, then you will want to start doing market research, product testing and surveys. It can be hard to find the time to pursue your own business while you're still working for someone else, but it's the most secure way to test your idea without taking a big financial risk. And if you're not motivated enough to find the time for it, maybe you're not really that interested in becoming a small business owner.

Potential Earnings
How much do you need to earn? We'll talk more about developing a business budget in a later section, but for now it's enough to say that you need to weigh the earning potential of any business you want to start against your monthly expenses. If you have to make a $2,500 mortgage payment every month, sign private school tuition checks and pay off your Lexus, it might be a bad idea to open a brick-and-mortar bookstore unless someone else in your household can comfortably cover all the expenses with their paycheck.

How much do you want to earn? Some of us want to be rich. Others find comfort in getting by on as little as possible. When choosing your line of business, consider what kind of earning potential it offers not just in the first couple of years, but down the road. Does your idea offer possibilities for expansion, growth and career advancement? Do you know what those possibilities are and how you can exploit them? (Learn more in 10 Breakout Ideas For Small Business.)

Customer Interaction
Do you like to interact with others? Some small business occupations lend themselves to solitude, while others require you to be out in the world, constantly schmoozing and selling yourself to people. If you just want to be left alone, don't open up shop as a publicist. If you feel compelled to call your mom for a chat anytime you're alone for more than 15 minutes, don't start a tax preparation business.

Lifestyle
What hours and days do you want to work? If you don't like working from nine to five, you don't have to when you're self-employed. You can choose a line of work that suits whatever hours you prefer. That said, many businesses require that you work according to your clients' schedules. This means arranging your life to fit your customers' needs.

How many hours a week do you want to work? Some small businesses lend themselves to longer hours than others. If you decide to open a restaurant, you might as well make space for a twin bed in your office - if you have any hope of ever sleeping again. A sales-based business that involves large commissions, on the other hand, could leave you with more free time if you're skilled enough.

How much time are you willing to spend away from home? For some people, the ability to stay home all day is a major draw of becoming a small business owner, but not all small businesses are home businesses. Becoming a consultant might require you to attend lots of meetings and travel frequently. Open a boutique and you'll spend most of your waking hours at your store, at least initially. (For more, read Start Your Own Small Business.)

Once you figure out want you want to do for a business, it's time to figure out how you will afford it.

2. Financing Your Business

No matter what line of business you go into, you will need startup capital to get your business going. Some typical startup costs facing new business owners include:

Electronic equipment: computer, printer, scanner, fax machine, photocopier, etc.
Vehicle
Furniture and fixtures: desk, lamps, bookshelves
Office supplies
Reference books
Supplies/inventory
Manufacturing machinery and equipment
Advertising: domain name, domain hosting, mailers, website design, etc.
Operating Space
Licenses
Permits
Corporation fees
Legal fees
Security deposit for renting a business location

What you need to buy can also depend on the degree to which you want to separate your business from your personal life. Many people will use their personal vehicle, cell phone and a room in their home to meet these needs inexpensively. Incorporating to separate your business assets and liabilities from your personal ones also costs money, but it offers an extra layer of protection if your business fails.

You should also consider operating costs that you'll pay regularly in the course of running your business. Some of these may be required before you set up shop and on an ongoing basis thereafter, like insurance, membership fees and dues, loan payments and employee wages.

Sources of Startup Capital
How much money you can afford to risk on your business from your personal savings and how much money you need to open for business will determine whether you need to look elsewhere to raise startup capital. Let's consider the pros and cons of each potential money source.

Personal Savings
Personal savings are commonly used by business owners to help pay for startup costs. You won't incur any interest expense when you use your own money to finance your business. You also won't have any creditors to pay back, and no one will come after you for money if your business fails or isn't successful right away. On the other hand, most people have already earmarked their personal savings for other uses, like retirement and a rainy day fund. Unless you already have plenty of extra money lying around, you might want to start setting aside some of your savings each month to put toward your business. You might also be able to tap your home equity, but it's a big risk to tie the success of your business up with having a place to live.

Business Loans
Banks provide business loans to finance vehicles, equipment, real estate and other expenses. These loans are generally for a short term, such as six to seven years, but the duration can often vary based on the type of financing required. Some type of collateral generally must be used to secure the loan - usually the vehicle, equipment or real estate being purchased with the loan, or a blanket lien on other assets. Expect to pay a loan origination fee and, of course, interest. Business loans can offer the security of a fixed monthly payment and a fixed interest rate, although variable rate loans may also be available. (Not sure what sort of loan you should get? Read Which is better, a fixed or variable rate loan?)

Some banks may only offer loans on large amounts; if you need to borrow less than the minimum requirement, seek other financial institutions to provide a more accommodating loan or dip into your personal finances. You might also want to finance your equipment and vehicle needs with a line of credit or a conditional sales agreement.

If you plan to seek a loan from a bank, be prepared to provide a detailed explanation of how much money you need and for what purposes, as well as a detailed explanation of how you will be able to repay the loan. The bank may want to see recent personal income tax returns, bank statements, credit history and other personal financial information.

Small Business Administration Loans
Small Business Administration (SBA) loans are an option if you don't qualify for a regular business loan. Your business must be owner-operated, for profit, organized as a sole proprietorship, corporation or professional partnership, and fall within the size guidelines set by the SBA. Because these loans are guaranteed by the government, they can be easier to qualify for than conventional business loans. They also allow you to make lower payments over a longer period of time. Although SBA loans are provided through regular banks, the government simply acts as the guarantor. Special SBA loans are available for veterans, active duty military, reservists, National Guard members and the spouses of people in these groups.

Credit Cards
You can always use a business and/or personal credit card to pay your business startup costs, assuming you already have or can qualify for a credit card. However, unless you have a card with the required limit and a low interest rate that you will be able to make regular payments on, credit card financing can quickly get you in trouble. You don't want to borrow money for your business at a 20% interest rate because the balance will grow each month and it can become very difficult to pay off the debt. Sometimes it is possible to get a card with an introductory interest rate as low as 0%. If you take advantage of an offer like this, make sure you have a plan for paying off the money you borrow before the card's interest rate goes up. (To learn more, see The Pros And Cons Of Small Business Credit Cards.)

Business Line of Credit
A business line of credit should have less rigorous qualification requirements than a business loan. It is similar to a business credit card in that it is an unsecured loan and you can use it as you need rather than borrowing a lump sum all at once. It can be used to refinance debt as well as to finance working capital, payroll and all the same types of expenses as a credit card financing. It is typically designed to be a short-term loan and may have a variable interest rate and an annual fee. Some banks may only offer large business lines of credit, such as $25,000 and up, so this may not be the right option for you if you only need access to a small amount of credit.

Family and Friends
Are you willing to risk your personal relationships by mingling them with money? Only you know the nature of your relationships with friends and family, and whether any of these people are a viable source of financing. But if your business goes under, would you rather have to explain to a stranger or to your best friend that you're not sure when you'll be able to pay them back? Mixing friends and family with finances adds yet another risk to your business endeavor - the risk that you'll ruin a close relationship. (For more on mixing your personal and business relationships, see 8 Ways To Help Family Members In Financial Trouble.)

Nothing can strain a relationship like money. Merely asking for it can be enough to introduce awkwardness into an otherwise sound relationship. If your dad won't lend you startup capital, you might find yourself thinking, "How can my own father not believe that I have what it takes to succeed?" It's much easier to be rejected for a loan by someone who doesn't know you because you'll know it's purely a business decision, not a personal one.

Venture Capital
Pursuing venture capital means bringing someone else, generally a stranger, into your business as a partial owner. If retaining control of your business is important, you shouldn't consider this financing option. Usually, you will not receive any profit yourself until your investors have profited from your business. Additionally, this type of financing limits the entrepreneur's upside potential since venture capitalists will often require majority ownership of the business. On the other hand, the majority of the downside risks are also assumed by the lending party. (For more insight, read When Your Business Needs Money: Angel Investors.)

How Much Capital Do You Need?
There is no one-size-fits-all method for determining startup capital needs because each business has unique requirements. Basically, you need to make a list of the startup items specific to your business and research each one to determine its cost. It's important to actually do the research, and not just guess - especially if you are doing this for the first time. If you rely on hunches, you may grossly under- or overestimate your expenses. Also, if you're seeking financing, the lender will be hesitant and may not take you seriously if your numbers aren't realistic and well-researched.

When you're starting a business, there are a couple of ways to get carried away with spending money. First, you may be overemphasizing about the tax deductibility of business expenses. While tax breaks will reduce your costs, they won't make your purchases free. You'll still be paying for the bulk of everything yourself, so you shouldn't buy it if it isn't necessary. Second, you may be so excited about starting a business that you have trouble differentiating necessary expenses from optional ones. Do you really need a brand-new, solid wood desk, or will that card table in the garage get the job done just as well?

Remember, initially the most important thing is keeping your business afloat so you can earn a profit. Every purchase you make should be directly related to this goal. Minimizing what you need to buy and how much each item costs will help you meet this goal. You want to get by on as little startup capital as possible. (Don't overlook the details when starting up a business. It's the small expenses that have the potential to make or break a great idea. For more information, refer to Business Startup Costs: It's In The Details.)

3. Business Structures

When you start your business, you have several options for structuring it that will affect your income tax situation and your potential liability if something goes wrong.

Sole Proprietorship
The default option is to be a sole proprietor. There are fewer forms to file to become a sole proprietor. The business is structured in such a manner that legal documents are not required determine how profit-sharing from business operations will be determined.

This structure is acceptable if you are the business's sole owner and you don't need to distinguish the business from yourself. Being a sole proprietor does not preclude you from using a business name that is different from your own name, however. In a sole proprietorship, all profits, losses, assets and liabilities are the direct and sole responsibility of the owner. Also, the sole proprietor will pay self-employment tax on his or her income.

Sole proprietorships are not ideal for high-risk businesses because they put your personal assets at risk. If you are taking on significant amounts of debt to start your business, if you've gotten into trouble with personal debt in the past or if your business involves an activity for which you might potentially be sued, then you should choose a legal structure that will better protect your personal assets. Nolo, a company whose educational books make legal information accessible to the average person, gives several examples of risky businesses, including businesses that involve child care, animal care, manufacturing or selling edible goods, repairing items of value, and providing alcohol. These are just a few examples. There are many other activities that can make your business high-risk.

If the risks in your line of work are not very high, a good business insurance policy can provide protection and peace of mind while allowing you to remain a sole proprietor. One of the biggest advantages of a sole proprietorship is the ease with which business decisions are made.

LLC
An LLC is a limited liability company. This business structure protects the owner's personal assets from financial liability and provides some protection against personal liability. There are situations where an LLC owner can still be held personally responsible, such as if he intentionally does something fraudulent, reckless or illegal, or if she fails to adequately separate the activities of the LLC from her personal affairs.

This structure is established under state law, so the rules governing LLCs vary depending on where your business is located. According to the IRS, most states do not allow banks, insurance companies or nonprofits to be LLCs.

Because an LLC is a state structure, there are no special federal tax forms for LLCs. An LLC must elect to be taxed as an individual, partnership or corporation. You will need to file paperwork with the state if you want to adopt this business structure and pay fees that usually range from $100 to $800. In some states, there is an annual fee for being an LLC.

You will also need to name your LLC and file some simple documents, called articles of organization, with your state. Depending on your state's laws and your business's needs, you may also need to create an LLC operating agreement that spells out each owner's percentage interest in the business, responsibilities and voting power, as well as how profits and losses will be shared and what happens if an owner wants to sell her interest in the business. You may also have to publish a notice in your local newspaper stating that you are forming an LLC.

Corporation
Like the LLC, the corporate structure distinguishes the business entity from its owner and can reduce liability. However, it is considered more complicated to run a corporation because of tax, accounting, record keeping and paperwork requirements. Unless you want to have shareholders or your potential clients will only do business with a corporation, it may not be logical to establish your business as a corporation from the start - an LLC may be a better choice.

The steps for establishing a corporation are very similar to the steps for establishing an LLC. You will need to choose a business name, appoint directors, file paperwork (articles of incorporation), pay filing fees and follow any other specific state/national requirements. (Find out how becoming a corporation can protect and further your finances. See Should You Incorporate Your Business?)

There are two types of corporations: C corporations and S corporations. C corporations are considered separate taxpaying entities. They file their own income tax returns, and income earned remains in the corporation until it is paid as a salary or wages to the corporation's officers and employees. Corporate income is often taxed at lower rates than personal income, so you can save money on taxes by leaving money in the corporation.

If you're only making enough to get by, however, this won't help you because you'll need to pay almost all of the corporation's earnings to yourself. If the corporation has shareholders, corporate earnings become subject to double taxation in the sense that income earned by the corporation is taxed, and dividends distributed to shareholders are also taxed. However, if you are a one-person corporation, you don't have to worry about double taxation.

S corporations are pass-through entities, meaning that their income, losses, deductions and credit pass through the company and become the direct responsibility of the company's shareholders. The shareholders report these items on their personal income tax returns. S corps thus avoid the double taxation on income that is associated with C corps.

All shareholders must sign IRS form 2553 to make the business an S corp for tax purposes. The IRS also requires S corps to meet the following requirements:

Be a domestic corporation
Have only allowable shareholders, including individuals, certain trusts and estates
Not include partnerships, corporations or non-resident alien shareholders
Have no more than 100 shareholders
Have one class of stock
Not be an ineligible corporation (i.e., certain financial institutions, insurance companies and domestic international sales corporations)

General Partnerships, Limited Partnerships (LP) and Limited Liability Partnerships (LLP)
A partnership is a structure you can use if you are not going to be the sole owner of your new business.

In a general partnership, all partners are personally liable for business debts, any partner can be held totally responsible for the business and any partner can make decisions that affect the whole business.

In a limited partnership, one partner is responsible for decision-making and can be held personally liable for business debts. The other partner merely invests in the business. Although the general structure of limited partnerships can vary, each individual is liable only to the extent of their invested capital.

LLPs are most commonly used by professionals such as doctors and lawyers. The LLP structure protects each partner's personal assets and also protects each partner from debts or liability incurred by the other partners. Different states have varying regulations regarding these establishments that business owners must take note of.

Partnerships must file information returns with the IRS, but they do not file separate tax returns. For tax purposes, the partnership's profits or losses pass through to its owners, so a partnership's income is taxed at the individual level. LPs and LLPs are also state entities and must file paperwork and pay fees similar to those involved in establishing an LLC.

You don't have to choose a business structure right now if you're operating alone. If you're unsure, you can remain a sole proprietor and see if it makes sense to incorporate or become an LLC later. If your business will have more than one owner from the start, then it can't be a sole proprietorship. In this case you will have to choose another structure before you start doing business. Regardless of your structure, business liability insurance is probably a good idea.

Business Liability Insurance
You shouldn't rely entirely on the legal structure of your business to protect you. Business insurance offers a second and often essential layer of protection. It shields you from legal fees and judgments if your business is sued. Here are some of the basic policies and their purpose:

General liability insurance protects you from injury claims, property damage claims and advertising claims.
Professionals such as doctors, lawyers and consultants need professional liability insurance to protect them from errors and omissions, including malpractice and negligence.
If you are going to manufacture or sell products, you will want product liability insurance in case someone is injured by your product.
If you will have a business location that customers or clients will be visiting, you will certainly want to make sure you are covered for claims of personal injury on your property.
If your business has employees, you can purchase employment practices liability insurance to protect yourself against claims of harassment, discrimination and wrongful termination. You will also want insurance that protects your business from any liability your employees may incur.

Whatever line of business you are entering, there is probably an insurance product that will cover you. For example, there are specialty business insurance products designed for architects, engineers, accountants, dentists and technology service providers (among others). (For further reading, check out Insurance Coverage: A Business Necessity.)

Next, we'll discuss how to transition from your current job to self-employment.