Creating Wealth with a Small Business

iUniverse, Inc.

Contents

Foreword to the 2010's Edition..........................................................................................................xiChapter One: Why Some Small Businesses Succeed..........................................................................................1Chapter Two: Ten Management Skills Found in Successful Small Business Owners............................................................49Chapter Three: The Self-Employment Trap.................................................................................................110Chapter Four: Small is Beautiful........................................................................................................129Chapter Five: Small Business Models.....................................................................................................192Addendum to Chapter Five: - Small Business Models A Case Study of the Bostrom Company: A Small Business That Failed.....................261Chapter Six: Pricing Strategies for Products and Services...............................................................................323Chapter Seven: A Pricing Strategy for Selling Your Business.............................................................................418Chapter Eight: Small Business Opportunities after the Great Recession...................................................................456Appendix: Cash Flow and Accounting During the Start-Up Phase............................................................................500

Chapter One

America leads the world in the creation of individual wealth. One reason for this is that America also leads the world in the formation of new businesses. Contrary to what we might expect, it appears that the number of new businesses being formed in the U.S. has not decreased during the recent economic slowdown. Business failure rates are extremely high, however, and so there is substantial personal risk involved in becoming an entrepreneur. What causes businesses to fail and what motivates entrepreneurs to take risks? What can entrepreneurs do to improve their chances of success in a weak economy? To answer these questions entrepreneurs need to begin by rethinking much of the conventional wisdom that has traditionally guided small business owners. In addition, it is also important for entrepreneurs to develop Core Values and General Principles as a basis for strategic planning and management decisions in a rapidly changing business environment. Chapter One explores these issues and also presents a case study of a small business that failed during the Great Recession that began in 2008. Did it fail because of the recession or were there other problems that led to the collapse? Understanding why businesses fail can help entrepreneurs understand why some small businesses succeed.

At the end of 2009, approximately 10 million individuals in the world had cash (liquid) assets of one million dollars or more. This was the most millionaires since 2007 and reflects the improving finances of HNWIs (High Net Worth Individuals) now that the Great Recession is officially over. Aggregate global GDP (Gross Domestic Product, a standard measurement of economic activity) actually contracted 2% in 2009, but HNWI financial assets grew 18.9% to $39 trillion. This represents about 35.5% of total global wealth. The U.S. had the largest number of HNWIs (2,860,000 or 28.6% of the global HNMI population). They had assets of about $10.7 trillion. Despite the slow recovery from the recession, the number of HNWIs in the U.S. increased by 406,000 in 2009. (By comparison, China, with a population six times greater than the U.S., had about 1.1 million millionaires at the end of 2010.) America has continued to generate great wealth even during the worst economic downturn since the 1930's.

How do HNWIs accumulate their wealth? Globally, approximately 14% are full-time investors with financial portfolios and real estate holdings, 16% receive inheritances, and 23% hold down a job, usually as a high-end executive or skilled professional. The rest, 47% of the total HNMI population, own private businesses. In the U.S. the percentage of business owners is even higher, approximately 66%. Add to that number those who inherit wealth or accumulate it from investments and you soon realize that only a small number of Americans become millionaires working for someone else. Most of them own businesses.

Who Wants to be a Millionaire?

Is it important to have $1M? Most Americans today probably think so although this has not always been the case. In the 1950's a popular TV drama called The Millionaire conveyed the message that having $1M was not necessarily a good thing. The show was fictional but bore a strong resemblance to present-day reality TV. Each week a philanthropist named John Beresford Tipton, Jr., selected individuals seemingly at random and gave them a cashier's check for $1M. There were no obligations and no strings attached. There weren't even any taxes due (Mr. Tipton paid them in advance). The lucky recipients were free to do as they pleased with the money. Not surprisingly, things often went badly as wealth proved to be a mixed blessing. The weekly lesson for Mr. Tipton (and the TV audience) was that coping with great wealth can change people. It undermines their sense of self-worth, destroys friendships, causes them to lose the respect of their peers and sometimes even costs them their lives. The Millionaire struck a responsive chord in American culture, airing for five years (1955-1960) and lasting two decades in syndicated re-runs.

Fast-forward to today and we would probably consider the sudden gift of $1M unbelievably good luck. One of the most popular TV game shows in recent years is Who Wants to be a Millionaire? It offers contestants a chance to win up to $1M by correctly answering a complex series of questions. Neither the audience nor the lucky winners have any misgivings about somebody becoming a millionaire. Moreover, Americans are not the only fans of wealth. "Millionaire fever" has gripped global audiences and Who Wants to be a Millionaire? has franchises in over 100 countries. In 2008 the movie Slumdog Millionaire was based on the fictional life of a contestant in the Indian version of Who Wants to be a Millionaire? As the contestant (a young boy from an unimaginably poor background) gets closer to winning the top prize, he is accused by the authorities of cheating simply because he is doing so well on the show. They cannot believe that someone of his lowly upbringing is answering the questions correctly and stands to win such a large sum of money. Of course the movie audience sides with the "slumdog," who they realize would never have the chance to lead a normal life (to say nothing of becoming a HNWI) unless he wins the top prize. The moral of the story is that everyone has it within himself to be a millionaire (even if the only way to become one is to win the top prize on a game show). Written by an Indian author and filmed in the slums of Mumbai, the movie was a huge hit globally and won eight Academy Awards in the U.S.

It is clear that attitudes toward wealth have changed since the 1950's. The cautionary tales of The Millionaire have given way to legions of Who Wants to be a Millionaire fans cheering on great wealth and hoping for their own chance to strike it rich. Although there are nagging issues concerning the growing concentration of wealth in the U.S., most Americans today would accept a gift (or a lottery prize) of $1M without a second thought. There is a sense that millionaires are an acceptable, and perhaps even inevitable, result of capitalism and a free market economy. The opportunity to become wealthy is there for anyone who sees it. "Millionaire fever" is not a disease - it is a calling.

What explains our changed attitudes toward wealth? First of all, the effect of inflation over several decades has made what used to be a large amount of money seem small. Mr. Tipton would have to give away $8M today to have the same impact that $1M had in 1955. Put differently, $1M in 1955 dollars is worth only $110,000 in 2010. Eight million dollars is serious money for most people. One hundred thousand dollars is a lot of money but hardly qualifies as the kind of wealth that alters lives forever.

Second, thanks to the magic of modern consumer credit, a person can live a millionaire's lifestyle even if they have no net assets. An American with a good credit score can enjoy a much higher standard of living than even a real HNWI living in a third-world country. Bona fide millionaires may be rare, but we see people living like millionaires all around us. All they have to do is make their monthly payments on time. Unfortunately, with the onset of high unemployment caused by the Great Recession, keeping up with payments due on mortgage and credit card debt has become difficult, if not impossible, for many Americans living on revolving credit. Personal bankruptcies have soared and foreclosures have forced millions out of their homes. The lesson learned is that one is better off actually having $1M than using easy credit to create the illusion of being a millionaire.

A third factor in changing attitudes toward wealth has been brought about by the slow but steady fraying of the economic safety net that most Americans had come to count on to sustain them during their working and retirement years. Not only has unemployment increased dramatically and job security become more tenuous, but wage growth has also stagnated. In addition, many non-wage benefits such as health insurance and retirement plans are being reduced. Many employers no longer provide health insurance and many who do require employees to shoulder more of the costs (through higher deductibles, for example). This comes at a time when health cost increases have far exceeded the rate of inflation. Retirement has also become less secure. In 1980, 66% of American workers had defined benefits pension plans. Thirty years later that number has declined to 20%. Even union contracts provide poor defense against a restructuring of wages and benefits. Worst of all, Social Security and Medicare, programs that have become the bedrock of economic security for almost all Americans, are said to be in financial trouble. Increases in worker and employer contributions are being phased in and consideration is being given to reductions in benefits. Increasingly, Americans have to face up to the fact that there may be insufficient wealth in our society to allow everyone to live like a millionaire. If you want financial security, you are on your own.

Why Own a Business?

If the HNWI numbers tell us anything it is that much more wealth is created through business ownership than through any other investment strategy or employment opportunity. This is true not just in America but around the globe. This helps explain the tremendous interest in entrepreneurship that has gripped the imagination of people everywhere over the past thirty years. Starting in the 1970's the great promise of capitalism has been the opportunity to own a business. No one has responded more enthusiastically than Americans. At the peak of the Greenspan Bubble (2006-2007) as many as 2,500 new businesses were being started every day in the U.S., between 50,000 and 60,000 each month. We might expect that the number of start-ups has declined with the onset of the Great Recession, but according to the Kauffman Foundation, a nonprofit dedicated to business education and the encouragement of entrepreneurship, this does not appear to be the case. An in-depth study undertaken to explore patterns of new business start-ups found that the number of start-ups remains steady whether the economy is expanding or contracting:

"Firm formation in the United States is remarkably constant overtime, with the number of new companies varying little from year to year. This remains true despite sharp changes in economic conditions and markets, and longer-cycle changes in population and education. Such constancy possibly reflects the nature of the United States economy, employment churn, and demographics. A steady level of firm formation implies that relatively few factors, such as entrepreneurship education and venture capital, influence the pace of startups ..."

Why do entrepreneurs continue to start new businesses even during difficult economic times? The Kauffman study suggests several possible explanations. The most obvious is that new business formation is a reaction to high unemployment. While many "nascent entrepreneurs" (those thinking about starting a business) are frightened by an economic slowdown and decide not to start a new business, higher unemployment forces more workers into self-employment and many of these self-employeds ultimately form new companies. People start businesses because they have lost their job and need an income to survive. The Kauffman study also suggests that during an economic downturn there is heightened `opportunity recognition' by under-employed or unemployed "entrepreneurial talent" (Kauffman's term) who seek greater control over their financial future, something that employers fail to provide when the economy deteriorates.

A third factor highlighted by the Kauffman study has to do with planning. Relying on a detailed business plan or a business model that has benefitted from the input of more experienced entrepreneurs plays an important role in building confidence even in times of economic uncertainty. When an opportunity is identified, having a plan already in place allows an aggressive entrepreneur to seize the `first-mover advantage' over those who are unprepared. Wannabe entrepreneurs who lack confidence because they are not thoroughly prepared are more likely to decide not to try at all. They are right to hesitate; without adequate preparation the outcome can be disastrous.

Why Do Businesses Fail?

While the Kauffman Foundation studies excel at advocating entrepreneurship, they devote less attention to the downside of starting a new business: the potential for failure (what Kauffman delicately refers to as "adverse firm outcomes"). It is one thing to start a business; it is something else altogether to make it into a success. The failure rate of start-ups is extremely high. Approximately 80% close in less than two years even during periods when the economy is growing. Although start-ups rates apparently remain constant, failure rates appear to increase during a recession. Some start-ups survive only a few months while others last for a year or so before finally shutting down. Whenever a business fails, the effects ripple throughout the economy. Employees lose their jobs. Suppliers lose a customer. Landlords lose a tenant. Consumers are hurt by reduced market competition. Outside investors suffer losses, and entrepreneurs and their families often go bankrupt. Worst of all, the wealth that might have been created by a successful small business is permanently lost.

Why do so many businesses fail? Economists and students of business history have been debating this question for decades but have yet to arrive at a unified theory. Two schools of thought have emerged, one emphasizing the impact of external events on individual businesses, the other focusing on the uniquely human aspects of entrepreneurial behavior.

External Shocks

According to the external shock theory, business failures are caused by economic forces beyond the control of individual entrepreneurs or the executives managing business enterprises. This is the reason given most oft en for the increased failure rate of businesses of all sizes over the past three years when the economy has undergone a severe contraction. The idea that business failures are caused by events external to the business itself originated with the prominent 20th century economist Joseph Schumpeter, who thought that businesses failed because of the constant increase in market competition brought about by innovation. He coined the phrase "creative destruction," which has become an integral part of almost every modern day explanation of business failure or market malfunction. Schumpeter believed that the overall economy evolves and grows stronger as less innovative businesses die out and new, more innovative businesses take their place. This occurs naturally as the more innovative businesses pressure the older businesses competitively, causing many to fail. Schumpeter concluded that widespread business failure is nothing to be concerned about. Just the opposite, it is a sign of a properly functioning market, a normal, healthy dynamic within the capitalist system.

Disciples of Schumpeter draw upon recent advances in our understanding of the biological sciences to support their case. According to mathematical models constructed by British economist Paul Ormerod, business failure cycles are similar to mass extinctions in the natural world and occur for similar reasons. Just as dinosaurs disappeared due to the destruction of their ecosystem by the impact of a meteor, businesses disappear due to the collapse of interdependent industry and market "ecosystems" caused by the impact of social, cultural, political or economic changes. Following in Schumpeter's footsteps, Ormerod postulates an "Iron Law of Failure" which can be overcome only by "passionate innovation" and/or a business environment characterized by "aggressive (macroeconomic) competition." Schumpeter would agree and point out that when a business ecosystem is altered (by a severe recession, for example), some businesses will survive by frantically innovating while others predictably fail as they are overwhelmed by competitive pressures brought on by the innovators. Whether competition and innovation save an enterprise or destroy it, however, Ormerod, like Schumpeter, argues that the fundamental forces that change an economy are largely beyond the control of individual entrepreneurs who start and run businesses.

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Excerpted from Creating Wealth with a Small Businessby Ralph Blanchard Copyright © 2011 by Ralph Blanchard. Excerpted by permission of iUniverse, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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