What Is Needed to Start a Small Business?

Small Business

Uncovering Critical Success Factors for Starting a Small Business Venture

Small businesses have been considered the mainstay in countries around the world. In many European countries for example, the small business has been considered crucial to the success and flourishment of the country in general. Most individuals embark upon a small business venture in the hopes of realizing ownership, independent profits and personal success. Small businesses can prove extremely successful when planned properly. Studies suggest that several small businesses however, close or fail within the first few years of operation. This failure suggests that a majority of small business owners may not have as yet realized the crucial success factors necessary for successful implementation of a small business.

There are as yet, few empirical studies conducted that specifically address key factors for the success of small businesses across several industries. As such, the aim of this paper is to determine what is needed to start a small business and what the key success factors are for maintenance of a small business within the United States and abroad. This researcher assumes that for purposes of this study, the results discovered will can and will be generalized to corporations across the United States and in foreign countries. It also assumes that this research can be generalized to all small businesses, regardless of the type of business being conducted.

Thousands of new entrepreneurs attempt to start new businesses every year. A majority however do so without investigating the tasks required to form a small business successfully. There are several factors that have historically been identified as critical to the success of a small business. Among these include the ability of an owner to develop a business plan, appropriately market their business, and appropriately categorize the small business according to its entity type.

Traditionally small business has been considered only in the context of big business, and its relation to it. Big business is a concept that was popularized within the U.S. economy as early on as the late 1800s, when a "wave of corporate mergers" swept the country (Odaka, 1999:1). During the end of the nineteenth centering, mass production methods were beginning to be introduced into the economy promoting the idea of maximized profit, production and minimal costs (Odaka, 1999:1). Big Business became synonymous with economic abundance and a capitalistic society. Eventually however, individuals began to realize that opportunities might exist for other types of business.

Small businesses came into creation as individuals realized that they could have a piece of a capitalistic economy, and provide services that were worthy of note to customers within the United States and eventually throughout the world. Small firms historically have been noted for their ability to establish long-lasting and trusting relationships between customers and employers. Small businesses have been defined by numerous standards; for purposes of this study however, a small business will be considered that which is under 200 employees. Small businesses over time under certain conditions have become the mainstay of many different economies. Small business owners, equipped with the right tools, have the ability to drastically affect the outcome and efficiency of an economy.

In many countries small businesses are actually more predominant than large ones. This is evident by an international comparison of small businesses by S. Kato in 1967, which showed that manufacturing establishments in Germany with less than 100 employees comprised "98.2% of the total" businesses in West Germany (Odaka, 1999). Times have changed however, and the face of many countries has changed. Within the United States, the trend seems to be toward struggling as related to small businesses. More and more mega-corporations are seemingly pushing out small business entrepreneurs.

Thus, this study intends to examine the structure of small businesses in an attempt to ascertain what exactly is necessary, or critical success factors for small business operation within the United States. In doing so, this study will also attempt to identify common factors among businesses that have failed, in order to identify an appropriate methodology for defining what factors make a small business successful vs. unsuccessful.

PURPOSE/AIM OF STUDY

The purpose of this study is to examine critical factors for success related to small businesses within the United States. This study is intended to be explorative in nature. The intention of this study is also to identify what factors are necessary for a small business to be created. For purposes of this study a small business will be defined as that which has less than 200 employees, though businesses in general of less than 500 employees will be examined in order to obtain the most comprehensive results as possible. This study intends to be primarily exploratory in nature. At this point there are few if any relevant theories related to successful small business formation. As such it is the intention of this study to develop a framework from which new business entrepreneurs can develop a framework for development of a successful business venture.

This study aspires to investigate the following questions related to small business creation and formation:

What critical success factors are necessary for the success of a small business?

What are the leading causes for failure of a small business?

What legal steps does a small business have to follow to ensure success?

SIGNIFICANCE OF STUDY

Research suggests that four out of five new businesses fail each year despite owner's best intentions at success (Attard, 2004). The aim of this study is to identify key success factors for success, to reduce the percentage of businesses that close or fail within the first few years of operation.

There are several countries that have successfully through time supported the cause of a small business. For example, in Europe many small businesses are thought to contribute to the economy more so than large corporations. In the face of a rapidly changing society however, many small business owners are pushed out of business before they have the ability to adequately establish their business or make an impact on economic operations. A majority of small business owners fail not because they are not educated or motivated, but rather because they lack adequate knowledge of the tools necessary to ensure a businesses success. Many small business owners also realize short-term success, but find that through poor planning or improper structuring, they are subject to IRS investigation and tax liabilities.

Small business owners need to be presented with a methodology and broad scope of facts and statistics in order to successfully implement a productive strategy conducive to productivity and efficiency.

PRIOR RESEARCH:

The purpose of this study is to examine critical success factors for establishment, maintenance and productivity of today's modern business. Small business has been a popular concept for centuries. Though large businesses are traditionally credited with adding to the success of a capitalistic economy, many countries historically have recognized the significance of small businesses. Unfortunately, many small businesses fail before they have an opportunity to adequately establish themselves. The aim of this study thus, is to identify critical success factors for establishment and maintenance of small business throughout the United States. To do this, exploration of historical and current practices and recommendations from governing authorities will be examined.

For one to analyze the concept of a small business, one must first be able to define a small business. This definition has varied from state to state and country to country throughout time. The UK defines a small business as that with 200 or fewer employees for example; this compared with Japan or Korea who define a small business as less than 300 employees, or 500 in the following: France, Germany, Italy and the U.S.A. (Odaka & Sawai, 1999:4). For some what might be considered a 'small' business in one respect might be considered a medium sized venue in another. For many people a small business might consist of one person. This is often the case of the independent contractor, where business is conducted under the assumption that an independent contractor operates as a sole proprietor.

Studies suggest that a large number of small businesses exist within Western Europe and North America in particular (Odaka & Sawai, 1998). Within the United States, in 1953 the Small Business Act created the Small Business Administration (SBA) in an attempt to "aid, counsel, assist and protect, insofar as possible, the interests of small business concerns" (Kilpatrick, 2002:1). SBA provides loans for financial assistance to small business owners among other things. The SBA is known for providing loans to small business owners that might not otherwise be considered an acceptable credit risk for private lenders.

There are several steps small business owners should consider prior to starting their business. First and foremost a new business owner should determine what the local, state and federal laws might be applicable to their new business in order to ensure they do not unintentionally violate any regulatory details. There are certain common requirements that are necessary for a small business to operate. These include the following: (1) acquisition of a business license to operate legally, (2) establishment of a location from which a business will conduct business from, (3) certificate of occupancy if a business is to occupy a new or used building, (4) formation of the business organization (IRS, 2004:99065).

Of these requirements, establishing a location from which a business will operate and the attainment of a certificate of occupancy is often the easiest factors with which to deal with. More difficult and important to survey are the requirements for licensing and identification of a business entity appropriately. The requirements regarding acquisition of a business license vary from state to state. Some states require that particular forms or business such as a liquor store acquire a license before operating. They formation of a business organization is also a key decision making process. A small business might fall into any of the following categories: sole proprietorship, Limited Liability Company, corporation or partnership.

A sole proprietorship is often the simplest and most uncomplicated type of small business. Generally a sole proprietorship is owned by one individual, traditionally operating under their own name. This type of business is generally unincorporated (IRS, 2004). Generally under a sole proprietorship the liabilities of the company are the same as an individuals personal liabilities, as such the owner undertakes all of the risks associated with conducting business. Sole proprietorships make tax issues easy, as the owner can file the expenses and income of the business on their own tax return.

The Limited Liability Company or LLC and Limited Liability Partnership (LLP) are a new form of business entity much like the sole proprietorship with added personal assets protection. An LLC can actually operate as a sole proprietorship, corporation or partnership. To operate as a partnership two individuals must be designated as owners of the company. An LLC can also have an unlimited amount of members. The LLP differs from the LLC in that it gives protection from any liability that might arise from the wrongful acts of any partners involved in the company. An LLC is easily formed by filing "Articles of Organization" with the Secretary of State (Davidson, 2000). One member LLC's are generally permitted in most states though this might create IRS problems in some states. In general creation of an LLC requires an Operating Agreement be written which contains information regarding how the LLC will be managed and how it will be taxed.

A partnership can also exist as an entity in its own; a partnership is defined as a relationship that exists between two ore more persons that will conduct business related to a trade, service or skill, where both entities expect to share in the profits and losses of the business (IRS, 2004). In a partnership each partner is required to file their share of income and losses on their personal tax return. Partnerships generally require the least legality in forming; a general partnership for example can be created by verbal agreement only; no documents need be filed with the state (Davidson, 2000). Generally a limited partnership may have no more than 35 owners.

A corporation is the most commonly known form of small business entity. A corporation involves the transfer or money and property between shareholders for the corporation's capital stock (IRS, 2004). A corporation has more tax liability than most other forms of business. Generally a corporation is considered a business entity with a 'perpetual life' and is therefore a tax paying identity (Davidson, 2000). Whereas in a limited liability company the individual member or members file taxes, in a corporation the corporation in and of itself is responsible for filing taxes. A corporation is created through filing of Articles of Incorporation with the Secretary of State (IRS, 2004). Whence this happens, shares of stock can be issued to shareholders and bylaws can be adopted. A board of directors must also be appointed to manage the corporation and appoint the positions of president, secretary and treasurer to manage the daily business of the company (Davidson, 2000). Generally a corporation is required to hold shareholder meetings, and any decisions that are made must be formalized in the form of written resolutions.

There is a subchapter of a corporation entitled as's corporation, which can be formed via special IRS election on the Articles of Incorporation. This election enables "flow-through taxation treatment' which is more similar to the tax treatment that a partnership or LLC might enjoy (Davidson, 2000). Much like an LLC, a corporation can be formed by one person only. An S corporation however is limited to only 75 members (Davidson, 2000).

Generally a new business is required to obtain an Employer ID number or (EIN). In a sole proprietorship, and EIN can simply be the individuals social security or Tax ID number. An EIN for a business is a federal tax identification number utilized to identify a business entity; generally a business will need an EIN to operate. EIN's are required if any of the following situations applies: (1) the company has employees, (2) the company operates as a corporation or partnership, (3) the company files tax returns related to employment, excise, alcohol or firearms, (4) the company withholds taxes on income other than wages paid to a non-resident alien, (5) the company has a Keogh plan, (6) the company is involved in the following: trusts, estates, real estate mortgage investment conduits, non-profit organizations, farmers cooperatives (IRS, 2004).

After establishing a formal tax identification number, it is critical when starting a new business to create a business plan, which delineates the factors that will impact the start up, development, management and operation of a business. Among other things, a business plan helps define a business structure, identify goals and serves as a resume for an organization (SBA, n.d.). Some important and necessary components of a business plan include a balance sheet, income statement and cash flow analysis (SBA, n.d.). A business plan also enables a small business to allocate resources and make business decisions. Organized and specific information about the company is often included on a business plan, including how the owner or owners plan of repaying borrowed money and conducting sales or interaction with suppliers and customers. According to Robert Krummer J. Chairman of First Business Bank in LA, "The business plan is a necessity. If the person who wants to start a small business can't put a business plan together, he or she is in trouble" (SBA, n.d.). The small business administration recommends reviewing the following four questions prior to creation of a business plan:

What service or product does your business provide and what needs does it fill?"

Who are the potential customers for your product or service and why will they purchase it from you?"

How will you reach our potential customers?"

Where will you get the financial resources to start your business?"

Source: SBA, N.D.

When it comes to creation and operation of a small business, financing also becomes an important issue. Financing can be accomplished through several avenues. Small business owners should be aware of the four main types of business loan programs available to small business owners including the following: (1) 7(a) Loan Guaranty Program, (2) SBA Micro loan Program, (3) 504 Certified Development Company Loan Program and (4) Small Business Investment Company or SBIC Program (Kilpatrick, 2002:1). The first type of loan, the 7 (a) is used for most general business purposes including the purchase of property for operations, equipment, construction materials and the purchase of inventory (Kilpatrick, 2002:1). This is they type of loan most often utilized by small business owners. The SBA also can offer a guaranty for small loans up to $150,000 and large loans that exceed this amount but for no more than 2 million dollars (Kilpatrick, 2002:1).

A small business in the process of forming might also consider obtaining a copyright or patent. A copyright serves to protect the authors of any original works of ownership; this is inclusive of literary, dramatic, musical and intellectual works, and the protection is available for both published and unpublished works (IRS-ILA, 2004). A patent is a similar protection afforded small businesses, and is basically a grant of property right to an inventor. A trademark is also valued by a small business. A trademark is representative of a word, name or symbol that is used in "trade with goods to indicate the source of the goods and to distinguish them from the goods of others" (IRS-ILA, 2004).

Savage (1998) conducted a survey of small businesses and identified seventy six mistakes that small business owners make, and that are important to consider when starting a small business. He notes that small businesses are audited more often by the IRS than any other group, and also are known to get into more trouble with the IRS than any other group (Savage, 1998: XV). Small business owners have numerous considerations to consider. They are in fact, liable for a majority of the decisions that large business owners are however small business owners often do not have the resources that large corporations do to ensure they are not audited. Among the biggest mistakes that small business men make is underpaying their taxes (Savage, 1998:3). A small business owner who for example, underpays his/her taxes is liable for paying interest penalties incurred by the IRS which might substantially increase the amount owed in any given year. A small business owner may demonstrate 'good faith efforts' at paying appropriate amounts, but this does not reduce the likelihood that he/she will owe taxes with interest.

Another common area for error occurs in paying employees. There are employer-paid taxes vs. taxes that are withheld from employee paychecks. The employer-paid tax refers to the amount owed to the government for social security, which in general amounts to 7.65% of each employee's wages up to a wage base amount, then an additional 1.45% above this wage base (Savage, 1998:4). Other common areas for error include mis-classification of employees vs. independent contractors and misallocation or reimbursement of travel and entertainment expenses.

Identifying an employee vs. An independent contractor can be a complicated task for small business owners. From a financial standpoint, most small business owners would benefit by having everyone that works for them be classified as an independent contractor. Employees are subject to much legality that independent contractors are not. For example, as a small business owner, an employer is responsible for calculating and paying social security and unemployment taxes on wages collected by employees. Depending on the number of employees in a small business, an owner might also be liable for providing health insurance and pension benefits to employees, but not so for independent contractors. Independent contractors also benefit by not having income taxes withheld from their paychecks (though they will eventually be responsible for any tax liability incurred) (Savage, 1998:16).

Unfortunately for small business owners, there are no hard and fast rules regarding classification of a worker from employee to independent contractor. The owner of a small business is responsible for differentiating independent contractors from employees, and is liable for mis representation, but has only a set of guidelines available to assist him/her in choosing the appropriate title. In general there are several factors that have been identified in a bona fied employee/employer relationship. This includes the responsibility of an employer to complete the following with regard to employees: (1) instruct a worker related to where, when and how to work, (2) training a worker regarding work functions, (3) integrating a worker's services into business operations, (4) provisions for a worker to have assistants, (5) maintenance of an ongoing relationship with the worker (Savage, 1998:19). An employee is also in general provided with tools and materials from the employer with which to work. Generally an independent contractor is someone that is classified as a worker that performs work for a business owner off premises, utilizing his own office or facilities, and someone who generally works under his/her own direction and suffers his own losses as a result of any services rendered (Savage, 1998:20).

There is a safe harbor rule that protects employers from damages sought from independent contractors that should have been classified as employees in years prior. Certain conditions must be met for this rule to be applied however. This includes the following: (1) other businesses within the same industry should treat similar workers in the same manner that the business in question does, (2) there are court decisions or IRS rulings that support the business owners positions, (3) the IRS in the past has examined the independent contractor status of a worker in question and has not required a change in classification (Savage, 1998: 22). When a small business owner truly is not able to differentiate between an employee and an independent contractor, the best course of action is to ask for an IRS ruling which will help determine the status of the employee.

Small business owners under certain conditions are allowed a tax reduction for work conducted in their home; however the rules regarding this are also very restrictive. A home-office deduction is available to small business owners only under certain circumstance. Business owners seeking this deduction must make every effort to ensure that they take the steps necessary to qualify for this business deduction.

A home office deduction is allowed when a portion of the home is utilized as the principal place of business. Thus this deduction commonly would not apply to people who are working in an office location away from their home that uses their home office only sporadically (Savage, 1998:78). Principle place of business is generally considered the place where a business owner spends the majority of their time working. A home office location will be considered however in the case where a home office is utilized as a meeting or gathering place for client and customer consultations (Savage, 1998:78).

One common pitfall for business owners is the manner in which they withdraw funds from their business for personal usage. This most often presents a problem when the type of business in question is a corporation. A sole proprietorship or partnership generally affords more flexibility in this respect. This is because these forms of businesses do not in and of themselves pay taxes. However a corporation does pay taxes on its own income. In addition, an individual owner withdrawing money from his/her corporation also pays taxes on that income. Thus a small business owner must decide the manner that is most economically feasible in which to withdraw money form his/her corporation. Money can be withdrawn in several ways, including the following: as salary, dividends or loans (Savage, 1998:29). Traditionally small business owners withdraw money from their corporation in the form of a salary. This is the most logical method for withdrawing funds, as profits paid as salary by the corporation are in fact tax deductive and taxed only once on the withdrawees individual tax return. Dividends paid out are not deductible, and thus offer no benefit to the owner of a corporation who is seeking to reduce the tax implications of his/her actions. There is however a stipulation by the IRS that allows only 'reasonable" amounts of compensation to be withdrawn from a corporation as a salary; anything above this amount might be considered dividends (Savage, 1998:30). This is an important consideration when attempting to reduce the profits of a corporation by salary.

A corporations are in fact an entity of their own that require special consideration related to a small business. Under state laws an S corporation will provide an owner with all of the standards protections afforded a regular corporation; the designation also serves to protect an organization from business creditors (Savage, 1998:116). S corporations are required to comply with very stringent rules however, and their failure largely results from the inability of owners to comply 100% with these rules.

Among the nuances that must be considered in an S corporation is the requirement that all shareholders of the corporation consent to the election of a corporation as's (Savage, 1998:117). All shareholders must then, sign the form indicating consent; if the IRS discovers for example, years later, that this did not happen, an S corporation is not recognized.

In addition, generally an S corporation must be designated no later than the fifteenth day of the third month of a tax year for it to be recognized as legitimate (Savage, 1998:118).

In a majority of countries large companies and manufacturers are thought to drive business; not so in Canada, where small businesses are generally considered the countries "most important driver of employment growth" (N.A., Canadian Speeches, and 2002:1). Small businesses in 2002 accounted from more than 75% of the total employment growth in Canada during 2002, and in Ontario small business resulting in approximately one third of all new jobs (N.A., Canadian Speeches, and 2002:1). In America the small business man is said to have the on his shoulders "the hope of those who hold to the Jeffersonian ideal of a typically small and self sufficient proprietor as the mainstay of political and economic democracy" (Phillips, 1958:7).

Another important consideration for a small business is marketing. Successful marketing can mean the difference between success and failure for a small business. Marketing is contingent upon a corporation's ability to accurately and adequately assess the needs of their customers, and in turn direct their activities toward satisfying customer needs, wants and desires. The needs of customers can be ascertained through market research; According to the SBA most small business owners have acknowledged that market research enables the possibility for improved sales or products and services (SBA, n.d.).

Marketing research is defined by the American Marketing Association as the "systematic and objective approach to gathering marketing information which when processed, analyzed and interpreted will help identify problems and opportunities that allow for better informed, lower risk decisions" (Business.gov, n.d.).

Perhaps the most common failure of any small business is the lack of adequate planning and the failure of an owner or partner to structure the business properly. An example of this is a situation where one person owns two corporations; one of these corporations had large profits upon which taxes were paid regularly, however the other frequently suffered losses; unfortunately in this case the corporations were structured incorrectly. In one year the net income from the two companies combined came to $200,000 yet the tax liability also amounted to $200,000; this happened because one company had profits of $600,000 and the other losses by $400,000, but the losses could not be deducted from the more profitable company based on how the business was structured (Savage, 1998:136). This case example exemplifies the need of small business owners to carefully examine the structure and composition of their company to ensure that they are set up in a manner conducive to profit making not profit losses.

When a business owner owns more than one organization, it is critical that he/she establishes his businesses in a manner such that the profits of one business can be offset by the losses of another business (Savage, 1998). This can be established via filing of a consolidated return (Savage, 1998:137). A consolidated return may only be filed however if a holding company exists between the owner and their operating corporations, meaning that the owner will hold all of the stock of the holding company, and the holding company will hold the stock of the corporations, making a consolidated return possible (Savage, 1998).

Research legitimately suggests that starting a new business is a risky venture. There are no guarantees that a new business will result in profit, yet the studies available suggest that a great deal of risk is involved in starting a small business. Yet every year thousands of independent businessmen take a step forward and embark on a journey of ownership.

Certain factors have been universally identified as critical to the success of any new business venture. First and foremost, a new owner must be willing to acknowledge and accept the risks associated with starting a new business. There are no guarantees than any business will be successful, even if similar businesses have been formed in the past that have been successful. Research does show however that appropriate planning and preparation methods however, will increase the likelihood for success (SBA, n.d.). Among the considerations of a first time business owner include knowledge of market practices, and legalities (SBA, n.d.).

METHODOLOGY:

This research will be conducted as an observational survey of historical practices as well as a review of the literature. Specifically a review of the literature on formation and creation of a small business will be conducted. A survey approach methodology will be utilized for purposes of this research study. The purpose of this study is to ascertain what exactly is necessary for formation of a small business. Thus, a qualitative research method, which generally is designed to help researchers understand the meaning of social phenomena and explain behaviors, may be helpful in this situation. The purpose of the survey will be to examine a causal relationship between small business start up and success. The aim is to identify key factors that result in a successful small business, as opposed to a failed one.

The majority of data collected for purposes of this study will be gathered from examination of small business practices and research results from the Literature review. A survey will be conducted to determine what factors and circumstances are most critical to a small business.

Twenty small businesses will be selected from varying industries for purpose of the survey. They will be asked ten questions and asked to respond on a Likert scale. The Likert scale requires a response as follows: strongly agree, agree, strongly disagree, and disagree.

This study is qualitative in nature as no recognized theory has yet been developed relevant to the topic of creation of a small business. The study is also exploratory in nature, intending to uncover principles and methods most effective for a start up business. The survey results will also result in responses that are for the most part, at least partially subjective to the individual interpretation of the businessmen surveyed.

Studies suggest that research that takes place in a regulated laboratory like setting as opposed to a natural context is more valid however this is not the case in an examination of small business methodology (Hoshmand, 1999; McGartland & Polgar, 1994). Rather conceptualization of a small business relies upon the ability of the researcher to observe naturalistic practices and conclude the best method from those observances. No experiment could equivocally in theory, result in adequate results for purposes of investigation in this instance, outside of starting a small business for investigative purposes.