You know that phenomenon where suddenly you hear people use some strange word two or three times over the course of a day or weekend? And, like, you can’t remember the last time you heard the word. In fact, you’re not sure you even know what the word means?
I sort of experienced that last week. In several different ways over a few days, I heard people ask the same basic question, “How large an emergency fund should a small business owner have?”
Okay, the question can seem tough to answer. But here’s my suggestion: I think if you break down the big question into two or three smaller, subsidiary questions, the answers become pretty easy to see.
Working Capital Requirements
For example, the first smaller question you want to answer is how much money you need for working capital in your small business. In other words, how much extra cash do you need in your business checking account to smooth out the ebbs and flows of your regular normal cash flows?
It turns out that, in practice, this question is pretty straight forward to answer.
A business owner wants enough cash in the business so they avoid the scurrying around and juggling that occurs when you don’t have enough cash.
That sounds circular. But if you’ve run a small business, you can always easily tell when or if you’re in scurry/juggle mode. Even employees easily spot it…
If you are in scurry/juggle mode, the way to get out of this mode is simple: You need to add cash to the business until the scurrying and the juggling stops.
And a related comment, just because I’m compulsive: the bigger you grow, the more cash you need in the business to avoid scurry/juggle mode. For example, if your small business generates a $100,000 in revenues, you may need only $5,000 of cash to stay sane. But if your small business grows and generates $2,000,000 in revenues, you could easily need a $100,000 of cash just sitting around to prevent scurrying and juggling.
You probably want to also think about another smaller though very important question, too, based on the way recent financial meltdowns affected many small business owners.
In addition to the cash you want to avoid any scurrying and juggling, you do want either emergency resources or substantial flexibility over your fixed costs so that if things go crazy (you lose a big contract or have an unexpected giant expense), you get through the storm.
I heard a smart local banker say, a year or two into the recent economic turmoil, that small business borrowers with resources were getting through the storm okay. And this was certainly my observation, too.
But even entrepreneurs with just outstanding businesses got into deep doo-doo if they didn’t have resources to cushion the firm from the economic storm. Your entrepreneurial house needs to be strong enough to withstand the occasional storm.
Thinking like An Employee
You also want to ask and answer one other smaller question, too. And that question goes like this: Thinking about yourself as an employee of your business, how long would it take you to find a new position if your business had to “lay you off” because the business ended?
In other words, if you did need to end your venture, how long would it take to find some new way to make a living, keep a roof over your head, feed your family and so on?
This is a trickier question. Who knows how long it’ll take to find a “new” job. But I think the old rules of thumb at least give you a starting point.
If your small business produces an average middle-class income (like, let’s say $30,000 to $60,000 a year?) I think you might decide to use the old, “one month for each $10,000 of salary.” Or three to six months in reserves.
If your small business produces an upper-class, executive income (let’s say $250,000 a year or more), you might want to use the rule of thumb that says it takes a year or longer to find another good executive position. Sometimes executive severance clauses even reflect this.
Putting It All Together
Putting all these factors together, I think you want your small business adequately capitalized so you’re not juggling and strong enough so it can withstand an economic storm. Further, in the worst-case-scenario situation where your small business income ends, I think you want to have enough personal resources to get you and your family through the financial tough patch.