What Is a Sole Proprietorship?
If you're looking to start a business but don't even know where to begin, you're not alone. There are 31.7 million businesses in the United States, and many of them are known as "sole proprietorships".
So, what is a sole proprietorship, how does it differ from other types of businesses, and which business structure is right for me? We're glad you asked!
Different Business Types
To understand how sole proprietorships differ from other business structures, we must first discuss what those other structures are. Here's a brief description of each.
Another common business practice is when two or more partners start a business together and share the liability equally. The partners involved will jointly operate the business together, each taking shares of the profits and expenses.
Corporations are publicly traded companies with boards of directors serving as a check to the president or CEO. Investors are allowed to purchase shares (equity) of the company.
Limited Liability Company (LLC)
An LLC is a business structure that allows its members to operate and manage the business. Members could be individuals, corporations, other businesses, or foreign entities.
Essentially, it combines the pass-through tax structure of a partnership or sole proprietorship with the limited liability of a corporation.
What Is a Sole Proprietorship?
A sole proprietorship is a business structure owned and operated by one individual. These are private companies, meaning they aren't publicly traded, and all the liabilities and profits are owned by one individual.
Sole proprietorships are by far one of the most common types of business in the United States. A sole proprietorship is most likely the business structure that comes to mind when you hear the term "small business".
Some common examples likely include your local pizza shop, a small plumbing business in town, or many other small businesses in your area. However, they aren't always small businesses.
While we often think of corporations when we think of big businesses, there are many reasons why business owners would choose a sole proprietor structure to grow their business. Let's talk about some reasons why.
Benefits of a Sole Proprietorship
Of course, sole proprietorships wouldn't be the most common form of business if it didn't come with some advantages. Here are just a few of them!
Easy to Establish
A key benefit of sole proprietorships is that they are very easy to establish. In most cases, you don't even need a business license. If your state does require a business license, you usually only need business documentation and a signature to file the paperwork.
The fees typically involved with establishing a sole proprietorship are to register your company name and to obtain necessary permits, but most permits are based on the nature of your business. When you establish a corporation or LLC, there are often many more moving parts and intricacies involved.
You also won't need an employer identification number (EIN) from the IRS, you'll have a pass-through tax advantage, and it will be a lot easier to set up a business bank account. Overall, sole proprietorships are one of the easiest business structures to set up.
When we think of "owning a business", most of us actually want to own the business.
Well, as the owner of a sole proprietorship, you can control all the operations of a business. With a partnership, corporation, or LLC, you will have to share some of the decision-making with board members, partners, or members.
This is one of the most common reasons people choose to start a sole proprietorship. If you don't like the trajectory a business is going in, then you have complete authority to change it.
However, this also means that you are responsible if things don't go as intended. It's important to remember that most startups fail, so it's crucial to acknowledge the downsides of having checks and balances. If you understand how business works and make sound decisions, then starting a business might be for you.
They Keep Options Open
Sole proprietorships are the most common path to incorporating your business. Even if you don’t plan to incorporate until further down the line, a sole proprietorship can help you generate initial revenue, which could ultimately lead to more investments.
Sole proprietorships can also become LLCs later on. Essentially, there's nothing tying your company down as a permanent sole proprietorship.
No Limit to Growth
In a sole proprietorship, you can have as many employees as you want without formally incorporating your business. Also, you can make decisions on your own about when to expand your business.
Risks of Sole Proprietorship
We talked about the key benefits of owning your own business, but it isn't all glamorous. There are some downsides to being a sole proprietor, so let's talk about them.
All the liability of a private company falls directly on the owner. Total control sounds nice, but total liability is a different feat.
Also, the consequences can increase as your employee count increases. Yes, you can have as many employees as you want, but you are also personally responsible for their payment, benefits, and actions. One mistake from an employee could cost you a significant portion of your revenue.
However, with the right business insurance policy, you might be able to limit much of your personal liability.
One of the most common reasons businesses incorporate themselves is to raise capital through public investment. However, a sole proprietorship has to either find investments or generate enough revenue to drive growth.
While that doesn't sound too challenging in theory, it proves a heavy burden in practice. When your company is closed to public trading and you can't generate a profit, you might have to prompt investment through direct conversations, outreach, crowdsourcing, or other options.
Every year or every quarter, you are required to pay self-employment taxes, which is a learning curve for many first-time business owners. If you're used to receiving a tax refund, then get ready to start owing taxes. You should save up to 30% of your profits to help pay for taxes.
Also, this comes with a lot of tracking. You will have to track all of your revenue and all of your expenses. If you use a business credit card for your business-related purchases, then this process won't be too challenging, as you can always look at your credit card statements.
However, if you are using various payment methods, you will need to develop the habit of saving your receipts, tracking revenue and expenses, and filing taxes. If you choose to do it every quarter, you won't owe one lump sum, but three months does go faster than you think.
Although, you can choose to put yourself on payroll and give yourself a salary. It may be another drawback itself. You will pay what you owe in taxes every paycheck but only have to file self-employment taxes for the company's leftover funds. Some business owners find this process more convenient than paying it all at the end.
Sole Proprietorship Guide
Now that we've discussed the pros and cons of owning a sole proprietorship, you might believe it's the right choice for your business! If so, here are some helpful tips on how to get started!
Start With a Solid Business Plan
As we mentioned, the vast majority of startups fail. If you're launching your own business endeavor, you should have a proper business plan ;in place beyond just the paperwork you need to file. Not only will this help you operate your business, but it can also help you attract potential investors.
While a lot more goes into a business plan, your plan should include exact dollar amounts and plenty of backup plans. You should include a strategy for marketing, recruiting, and growth.
While you can't exactly plan on revenue, you can plan on your initial funding. Let's say you have enough money for 6 months of business operations plus 10% for emergencies. Where is that money going?
The Small Business Administration recommends putting 7% to 8% of all revenue (in this case, overall capital) toward marketing, which is essential early on. How will anybody know your business exists otherwise? From there, you will need to factor in expenses for employees, distributors, vendors, rent, and more.
For example, if you are starting a coffee shop you would need to factor in the following items:
- Dairy products
- Hot water bill
- Electric bill
- Cleaning supplies
Not only that but also any liability insurance, employee benefits, taxes, and emergency funds. The list goes on, so ensure that your business is accounting for everything.
Because of the lack of options for raising capital, emphasis should be put on it immediately. Before you start spending money on your business, it's great to have reserves ready for a rainy day. Assuming you have a great business plan, you should start reaching out for investments and loans.
Through crowdfunding, private investments, or bank loans, you will want to have enough money on hand to fund your business for as long as possible. The biggest mistake you can make as the owner of a startup is to assume you will generate revenue right away. There's no guarantee that your business will.
If you're unsure about how much you need, or if you think you already have enough, it doesn't hurt to have more, especially at the beginning. Lack of capital is one of the most common reasons startups fail, so you may want to raise as much funding as possible.
How much do you need?
Let's say you crunch the numbers and determine that you need $30,000 to launch the business and stay afloat for the first 3 months. Even if you have $30,000 on hand, aiming for 6 months can be even better.
Not only are you trying to fund the business, but you're also funding yourself. What if an emergency employee injury expense comes up that you weren't ready for? It could take you more than 3 months to start generating any revenue.
In that case, you might want to have worker's comp insurance and a plan for recovery. You should always try to prepare for the worst and hope for the best!
Register Your Business
Finally, the last thing you need to do before getting started is to register your business with the state. Again, fees for this will vary based on your needs, but you'll likely only need to pay to register the company name.
Next, apply for any business licenses or permits required in your industry. For example, a business that serves food may need additional licensure. Also, a contracting business will need plenty of different licenses before they can get started, so find out what you need and register as soon as you can.
After that, try to stick as close to the business plan as possible, trust yourself, and try to make sound decisions when challenges arise.
Protect Your New Business
As we mentioned, most businesses fail. As a business owner, you should give your company every chance for success.
Well, that starts with the right insurance policies. Anything can go wrong in business, from worker injuries to theft. Having insurance might provide you with peace of mind and could help to protect your startup over the long term, so find the right business owner policy for your business today!
Aim For Growth!
Remember, you don't just want to stay afloat. Your business plan should reflect the ambitions of your company, so reach for the stars!
Now that we've answered the question "what is a sole proprietorship?" and discussed how to start one, it's important to keep educating yourself if you want to be a successful business owner. Start by keeping up to date with our latest business news and if you have any questions about business insurance, feel free to reach out!