Small businesses and entrepreneurs form the backbone of the American economy. Without one, there would not be the other. Certainly, not all small businesses are owned by entrepreneurs, but it is entrepreneurs who generate the ideas that lead to opportunities for people to begin their own companies. That has been the case since the early days of American history, and will no doubt continue to be for the foreseeable future.
By various definitions, anywhere from 70 to 99 percent of American businesses fall into the "small" category. This range places the actual count of small businesses somewhere between 15 and 20 million firms, the vast majority of which are sole proprietorships. The exact percentage is difficult to estimate, since there is no clear-cut definition of what constiutes a small business. For example, the U.S. Chamber of Commerce defines a small business as a company that employs fewer than 500 people. Another definition suggests that a small business is one that employs fewer than 100 people. Yet a third definition eschews numbers and states simply that a small business is one that is independently owned, i.e., not a subsidiary of a large company. Whatever definition applies, one thing is certain: small businesses account for the bulk of businesses in the United States. That has been the case since the first settlers set foot on American soil in the early 1600s.
Small businesses were the lifeblood of the American economy between the time the first settlers arrived in the early 1600s and the Industrial Revolution. In almost every early American community, small business owners abounded. For example, a profile of Northampton, Massachusetts, in 1773 shows that workers other than farmers were not day laborers who toiled for wages. Rather, they were skilled artisans who worked for themselves. They comprised black-smiths, goldsmiths, tanners, weavers, tailors, traders, barbers, or any other specialist whose services were needed by others. This situation continued until the Industrial Revolution.
The proliferation of machines and assembly line processing altered the way Americans did business, but, contrary to what many people predicted at the time, it did not eliminate the need for small business owners. That has never changed. Even today, when corporations are undergoing massive changes in their work structures, the need for small business owners has remained steady or even increased.
In the late 1980s, corporations began divesting themselves of large numbers of employees, particularly those in middle management. Many of these displaced workers opted to start their own businesses rather than take a chance on working for corporations and being downsized again. So, in the early 1990s, there began a trend toward more small business ownership. Many of the people who started these new businesses were merely exercising entrepreneurial skills that had either been dormant or simply never used. These were the new breed of entrepreneurs, whose presence is necessary if any economy is to flourish.
Entrepreneurs are generally innovative people who turn new ideas into thriving businesses. Often, the businesses they start based on a simple idea turn into major corporations. Their endeavors pave the way for less innovative people with shrewd business minds to run small businesses of their own. Thus, entrepreneurs and business operators feed off one another—and feed the American economy.
As is the case with the term "small business," entrepreneur is hard to define. To some people, an entrepreneur is simply an individual who starts a new enterprise. To others, the word connotes an individual who organizes and manages natural resources, labor, and capital in order to produce goods and services with the intention of making a profit—but who also runs the risk of failure. However the word is defined, entrepreneurs are the linchpin of the American economy. They make it possible for small business owners to survive, in whatever form of operation they choose.
Running a successful small business requires a tremendous amount of dedication and a variety of skills. A successful small business owner must have a wide range of entrepreneurial skills, e.g., a knowledge of financing, selling, accounting, bookkeeping, regulatory procedures—in short, just about every facet of business. But, knowledge of the various business activities alone does not guarantee an owner success. There are other factors involved, such as location and luck. The bottom line is that small business operators must be dedicated to succeed—and not all of them do. Many small business owners fall victim to the pitfalls of the economy and fail due to no fault of their own. At other times, they end up in bankruptcy because they do not adhere to the basic rules of business.
There exist several forms of small business— S corporations , sole proprietorships, general partnerships, franchises , and others. Regardless of what type of business owners choose, their goals are the same: to make provide returns on the owner's investment.
The most common form of small business is the sole proprietorship, a business owned and usually operated by one person who is personally responsible for the firm's debts. According to Census Bureau figures, approximately three-quarters of all businesses are sole proprietorships. Nonetheless, because the tend to be so small, they account for less than six percent of total business revenues in the country. Individual sole proprietorships may be small, but from them grow some major corporations. Many of today's large companies (for example, Sears, Roebuck & Co. and Ford Motor Co.), began as sole proprietorships.
One of the reasons sole proprietorships are so popular is because they offers many advantages to small business owners. The biggest advantages are they are simple to establish and offer many freedoms for the owner. Sole proprietors answer only to themselves. They alone enjoy the profits. On the other hand, they are solely responsible for debts. Another advantage is the privacy involved in running a sole proprietorship. The owner does not have to reveal information regarding the business to anyone, aside from tax reporting to the government.
Sole proprietorships are relatively simple to start up. While certain professions or trades require certification or licensure, there is otherwise no formal requirement for creating a sole proprietorship: it exists at the will of its owner. People interested in starting their own businesses often need do no more than hang out a sign. The lack of complex regulations governing the opening of a small business is extremely appealing to entrepreneurs, many of whom thrive on starting businesses and then divesting them. Perhaps the biggest advantage, though, is that owners of sole proprietorships can dissolve them as easily as they start them. That is why many sole proprietorships are designed to be short-lived.
There are people who form sole proprietorships to run a single athletic event or rock concert. As soon as the event is over, the business is terminated. Because of the ease of starting such a business, promoters can—and often do—"open" and "close" such businesses frequently. This is possible for several reasons, not the least of which is the low cost of starting such a business.
Low start-up costs encourage many people to open their own businesses. In many cases, there are no legal fees involved. Often, a person starting a sole proprietorship need only register it with a state agency as protection against another person using the business' name. There are some sole proprietorships that require the owners to have licenses, for example, hair salons or bars. Depending on the business activity, the owner may have to comply also with local zoning and business permit requirements.
Consider a writer who wishes to start a business. There are no licenses involved, thus no fees to pay. The need for legal assistance is rare—possibly only for cases where copyright infringement is involved. Generally, writers can work out of office space in their homes without worrying about zoning regulations. And, comparatively speaking, there is very little equipment for a writer to purchase—writers need little more than a computer, a fax machine, a printer, a telephone, and a modem. They also need sundry items like paper and reference books. Thus, to start a writing business, all that is needed is a pronouncement that "I am a small business owner" and a desire to succeed. Most importantly, writers enjoy the ultimate benefits of a sole proprietorship: they keep the profits and get tax breaks.
There are, of course, cases when sole proprietors (and other business owners) suffer losses in the early stages of their operations. Tax laws allow sole proprietors to treat the sales revenues and operating expenses of the business as part of their personal finances. As a result, sole proprietors can reduce their taxes by deducting allowable operating losses from income earned from sources other than the business. This can be an important means of reducing tax liabilities that an individual would otherwise incur.
The possibility of losing money is but one of the disadvantages of a sole proprietorship. One major disadvantage is the fact that sole proprietors are responsible for all debts incurred by their businesses. This unlimited liability is a deterrent to some people seeking to start their own businesses. If a business doesn't generate the projected income in its existence, owners must pay any debts incurred out of their own pockets. If they do not—or cannot—creditors can claim the owners' personal property such as cars and houses. (Laws vary from state to state. Some states do allow business owners to protect some of their personal property.)
Another disadvantage associated with sole proprietorships is the lack of continuity. If an owner dies, the business is not passed down automatically to heirs or family members. A sole proprietorship is dissolved legally when the owner dies. Of course, there is nothing to stop other people from reorganizing the business if there is a successor available who is trained and willing to take over the business. If there is not, the deceased owner's executors or heirs must liquidate the assets of the business. The effects of an owner's death indicate another major disadvantage to a sole proprietorship: it is frequently dependent on the resources of one person.
Often, sole proprietors are responsible for all of the operations involved in running a business. They alone are responsible for the firm's cash flow and finances. Often, they find it difficult to borrow money through formal channels such as banks when they need it. This applies to money for starting and expanding businesses. Banks, for example, are sometimes reluctant to lend money to sole proprietors for fear they will not recover it if the owners die or become disabled. Therefore, proprietors usually must rely on the cash generated by the business, personal savings, or family loans to finance their operations, although the Small Business Administration does help small businesses secure outside loans by guaranteeing loans and providing other support programs.
General partnerships are fairly common in the world of small business even though they are legally one of the least popular form of business organization. There are over a million U.S. partnerships in existence, which generate less than 5 percent of total U.S. sales revenues. A general partnership is a business with two or more owners who share in the operation of a firm and in financial responsibility for its debts. There is no legal limit to the number of partners allowed. The number can run from two to hundreds. Partners do not have to invest equal amounts of money. They may earn profits that bear no relationship to the amount they have invested in the business. It is up to the partners to arrange the financial dealings and other management aspects of the organization.
Sometimes partnerships are created when sole proprietors can no longer run their businesses as oneperson operations. Or, sole proprietors may simply want to expand, and taking on a partner or partners is the best way to accomplish it. A general partnership can be a start-up operation, too.
Like any other type of business, general partnerships have their advantages and disadvantages. One of the advantages is that partnerships can add talent and money as they go along. They also have an easier time borrowing money. Normally, banks and other lending institutions prefer to loan money to businesses that do not depend on one person. Another advantage is that partners in a business have access to one another's funds. This is especially important in a business that has a large number of partners.
Another advantage is that partnerships are easy to organize. There are few legal requirements involved in forming a general partnerships. Wise partners, however, will draft some type of agreement among themselves. The agreement may be written, oral, or unspoken. The important thing is that one must exist. Some of the questions that might be asked include general ones such as who invests what sums of money in the partnership, who receives what share of the partnership's profits, who does what and who reports to whom, and how the partnership may be dissolved if the need arises. What is included in the agreement is up to the individuals involved. The document is not a legal requirement; it is strictly a private document that no government agency needs to see.
A partnership is not a legal entity in the eyes of the law. It is simply an agreement between two or more people working together. From an Internal Revenue Service standpoint, partners are taxed as individuals. That, too, is an advantage for partnerships. But, there are the inevitable disadvantages, too.
Unlimited liability is a major drawback for partnerships, just as it is for sole proprietors. By law, each partner may be held personally liable for all debts occurred in the partnership's name. If any partner incurs a debt, even if the other partners do not know about it, they are all liable for it if the responsible partner cannot pay it. This legal stipulation remains even if the partnership agreement states that all notes and bills are to endorsed by the other partners.
Again, as is the case with the sole proprietorships, lack of continuity can be a disadvantage in partnerships. If one partner dies or withdraws from the business, the partnership may dissolve legally. This can happen even if the other partners agree to stay. They can, however, form a new partnership immediately if they wish, and retain the old firm's business. This arrangement prevents the loss of revenues that might otherwise affect the partners. The lack of continuity problem is closely associated with the difficulty of transferring ownership.
In a general partnership, no individual may sell out without the permission of the other partners. In addition, partners who want to retire or transfer their interests in the firm to family members cannot do so without the express permission of all the remaining partners. As a result, the continuation of a partnership may depend on the ability of retiring partners to find someone acceptable to the other partners to buy their shares. If retiring partners cannot find such a person, the partnership may have to be liquidated. As an alternative, the remaining partners may buy out a retiring partner.
Another major problem involved frequently with partnerships is the lack of conflict resolution. When sole proprietors have problems with the way their businesses are being run, they resolve the problems themselves. That is not the case with partners. If one partner or group of partners wants to expand a business, and another partner or group does not, there is a conflict. That conflict may be difficult to resolve, especially if the partners are evenly divided. Conflicts may involve virtually anything, ranging from partners' personal habits to personnel matters. The lack of resolution can lead to dissolution.
Another type of small business is the corporation, which is normally associated with large businesses. Indeed, even though only 20 percent of the nation's businesses (about 3.6 million firms) are corporations, they generate 90 percent of the revenues. Nevertheless, a corporation does not have to be a large business.
Any business owner can incorporate. In legal terms, a corporation is a legal entity separate from its owners with many of the legal rights and privileges a person has. It is a form of business organization in which the liability of the owners is limited to their investment in the firm. Corporations may sue and be sued; buy, hold, and sell property; make and sell products to consumers; and commit crimes and be punished for them. As far as small businesses go, many of the attributes associated with corporations may be inapprpriate. For example, a writer or a newsstand owner may not want to sell stock in their businesses, form boards of directors, or deal in proxy votes. Nevertheless, small business owners can incorporate to take advantage of benefits endemic to corporations.
The biggest advantages corporations experience include limited liability, continuity, greater likelihood of professional management, and easier access to money. On the other hand, there are disadvantages. For example, corporations may undergo stockholder revolts, experience high start-up costs, be subjected to excessive regulation, and pay high taxes.
A special form of corporation is the S corporation, so named because it is part of the Subchapter S of the U.S. Internal Revenue Code. Congress created the S corporation in 1958 to help small businesses compete better and to provide them with some relief from excessive taxation and regulation, both of which have increased since World War II.
The S corporation allows businesses to avoid double taxation. It is based on the premise that owners enjoy the limited liability benefits of corporate ownership but the taxation advantages of a partnership. Stockholders of an S corporation are taxed simply as if they were partners. As with other forms of small business, the corporations do not pay income taxes on earnings and the stockholders do not pay income taxes or tax on their dividends. Of course, there are limitations on the S corporation.
First, in order to qualify as an S corporation, a business must meet some stiff legal requirements. For example, it must be a domestic corporation that is independently owned and managed and not part of any other corporation. It cannot have any more than 35 stockholders. The stockholders that do exist may only be estates or individuals. They cannot be nonresident aliens. Lastly, no more than 25 percent of the firm's sales revenues may come from dividends, rent, interest, royalties, annuities, or stock sales, and no more than 80 percent of sales revenues may come from foreign markets. Despite these restrictions, S corporations do offer small business owners significant advantages.
Limited partnerships are businesses that have both active and inactive partners. They exist mainly so owners can avoid the problem of unlimited liability. The active partners run the company. The limited partners have no active role in the company's operations. (For this reason, they are sometimes called silent partners.) Should the business fail, they are liable only to the extent of their investment. They can invest their money without being held liable for the active partners' debts. There are legal stipulations that affect how a limited partnership is run. For example, each limited partnership must have at least one active partner designated as the general partner. This is primarily for liability purposes. In most cases, the general partner oversees the day-to-day operations of the company and holds the responsibility for its survival and growth.
In a master limited partnership, the business is organized much like a corporation. However, all the profits are paid out to investors. The company is run by a single "master" partner, who holds a majority of the stock. The major advantage to a master limited partnership is that it helps owners avoid double taxation. In this arrangement, the company sells shares to investors, just as a corporation does.
Corporations retain some portion of any profits for growth and expansion. They pay income taxes on these profits, and the stockholders must pay income taxes on the dividends they receive from the company. Under the master limited partnership arrangement, this double taxation is avoided. There are disadvantages, though. For instance, since more of the earnings are paid to investors than is normally the case in a corporation structure, per-share prices for stocks are higher. This dissuades potential investors from buying into the company. Nevertheless, the master limited partnership form of ownership is growing in popularity.
Generally, small business owners are on the lookout for any advantages that will help them survive in the increasingly competitive business environment. One of the most sought after advantages is security. That is why many business owners invest in franchises, which offer a reasonable amount of security. However, franchisees (the individuals who purchase franchises) give up a lot for that security. In fact, many experts do not consider franchise owners to be small business operators at all.
A franchised business may be any of the legal forms listed above; they are unique in that the basis for the business is a contract between the franchisee and the corporate franchisor. The franchising agreement is a continuing arrangement between a franchisor, the manufacturer or sole distributor of a trademarked product or service who typically has considerable experience in the line of business being franchised, and a franchisee, the local business operator. The franchisee purchases a license to operate an outlet bearing the franchisor's name and following its standard practices. In the process, the franchisee receives the opportunity to enter a new business, hopefully with an enhanced chance of success. That is not always the case, although failure rates among franchises run at less than 5 percent. By contrast, the Small Business Administration has reported that 65 percent of business start-ups fail within five years.
People who operate franchises forego independence in running their business. They cannot make major modifications to their facilities without corporate approval and they are subject to monitoring from the franchisor's office. Another disadvantage is that they may be locked into long-term contracts with suppliers that are dictated by the corporation. Whether or not franchisors can live with such restrictions is for them to decide. Restrictions, aside, however, purchasing a franchise is a good way for people to start their own businesses.
Franchising is one of the three basic ways people can start their own businesses. The other two are starting a new firm from the ground floor and buying an existing business.
A start-up firm is one that a business owner builds from scratch. The process usually takes a lot of work. Owners have to obtain financing, choose an appropriate location, hire trustworthy personnel, plan for continuity, etc. They must make major decisions regarding all aspects of the operation. For example, should they finance continuing operations through debt capital (financing that involves a loan to be repaid, usually with interest) or equity capital (financing which usually requires that the investor be given some form of ownership in the venture)? Who will manage the company if the owner dies or is disabled? These are critical questions for small business operators.
The loss of key employees hurts small business owners much more than it does large corporations. It is problems like these that differentiate between small business owners and their large corporation counterparts. That is why these problems must be addressed in the early stages of a business' existence. The solutions can mean the difference in whether a small business survives or fails. It is problems like these that often prompt small business owners to buy existing businesses, rather than starting their own.
Some people buy existing businesses with an eye toward keeping them in basically the same form and avoiding growing pains. Other owners, basically those who fall into the entrepreneurial category, may buy an existing business with the intention of changing it dramatically so they can take it in new directions. Some entrepreneurs will purchase existing businesses they know are in financial trouble just for the challenge of reviving them. This is another approach that differentiates entrepreneurs from small business owners. For whatever reason a person buys an existing business, there are several key questions that must be considered before the purchase is made.
One of the key issues is whether the product or service the business provides falls into the prospective owner's areas of expertise and interests. Another is whether the purchase price is reasonable. A third addresses the business' turnaround prospects. Then there is the question of the target firm's financial condition: is it favorable or poor? Naturally, the most salient question deals with how to finance the purchase and continuing operations.
There exist several sources through which small business owners can finance their operations. These include, but are not limited to, Small Business Administration (SBA) loan programs, commercial banks, venture capitalists, business development corporations, and stock shares.
The SBA offers a variety of loan programs for small businesses that cannot borrow from other sources on reasonable terms. The SBA normally places limits on the amount of money that can be borrowed, but interest rates are usually slightly lower than those on commercial loans. Usually SBA loans take the form of loans by participating banks that are backed by the SBA in the event of default.
Commercial banks are good sources of loans for existing small businesses, but they are often reluctant to fund start-up firms that have no track record or cannot demonstrate adequate assets. Banks generally require security and guarantees before they will make start-up loans. They sometimes impose other stringent restrictions on borrowers. Hence, commercial banks are not a major source of loans for start-up businesses.
Venture capitalists are institutional risk takers who tend to specialize in certain types of businesses. They usually have formulas for evaluating a business and prefer strong minority ownership positions, as opposed to lending money in the form of a loan or some other debt instrument. Still, venture capitalists may structure deals with both equity and debt financing. They can be lucrative sources of funds, but competition for venture capital is fierce and thus very few who seek it actually receive any.
Business development corporations are privately owned companies chartered by states to make small business loans. They can develop creative financing packages. The most attractive facet of these corportions is that their loans are generally guaranteed by the SBA.
Another way of funding a small business is by issuing shares. In order to bring in capital from outside investors, business owners sell shares in the business through private or public offerings. Usually for very small businesses selling shares is not an option, as few independent investors will be interested unless there's potential for significant growth. In addition, such offerings are highly technical and usually require expert legal help to conform to state and federal securities laws. The share process also removes a large part of business owner's independence, however, since stockholders are given a say in how the business is run and receive a portion of the profits. Thus, selling equity in a company is mostly done by aggressive businesses that are committed to growing into larger organizations, and not by the typical home-based or one-person business.
Small business owners often must also concern themselves with advertising, public relations, the legal aspects of operating a business, and other operational and management details. There are expenditures like insurance and personnel costs to be considered. There are business policies and procedures to establish. Inattention to these details can lead a small business to failure and possible bankruptcy.
It is an unfortunate fact of small business that many companies don't survive. There are several reasons. The most prominent are economic recessions, ineffective management, insufficient capital, bad-debt losses, competition, decline in the value of assets, and poor business location. Some of these are not within a small business owner's control. Most, however, are. It is essential, then, that small business owners pay strict attention to every aspect of their operations. Attention to details is the key to success in any type of business—small businesses in particular.
SEE ALSO : Entrepreneurship
[ Arthur G. Sharp ]
Hatten, Timothy S., and Mary Coulter. Small Business: Entrepreneurship and Beyond. New York: Simon & Schuster, 1996.
Longenecker, Justin G., Carlos W. Moore, and Bill Petty. Small Business Management. 10th ed. Cincinnati: South-Western, 1996.
Ray, Robert J., Gail P. Hiduke, and J.D. Ryan. Small Business: An Entrepreneur's Guide. 4th ed. Fort Worth, TX: Dryden Press, 1996.