These days some of the most ambitious company builders are starting serious growth businesses from home. Think that gives them a credibility problem? Not to worry
You know -- and we know -- that there are misperceptions in the marketplace about home-based businesses. At an estimated 14 million strong, and with about half a million more starting up each year, this is a far more sophisticated and ambitious entrepreneurial crowd than the part-time hobbyists, stay-at-home parents, and laid-off executives that some people still consider to be the norm. As evidence, look no further than the Inc. 500 class of 1999: a whopping 48.5% reported starting their companies in their homes.
Several recent trends have combined to encourage even the most growth-minded business owners to be stay-at-homes. Thanks to technological developments, especially the Internet, home-based companies have greatly increased their capabilities. Also, recent changes in tax laws provide financial incentives to keep start-ups and young companies at home. And new resources aimed at small growing companies make it easier than ever to take care of essentials in a cost- and time-effective manner while allowing founders to focus on their chief priority: jump-starting their companies' growth.
Still, home-based-business owners face plenty of challenges, including combating the clichéd preconceptions in order to establish credibility in the marketplace. The key is to mind your p's and q's: stay abreast of technical, financial, and legal issues, and remember that the important thing isn't where your business is located -- it's how well positioned it is in the marketplace.
Complying with local and state laws
The CEO of a financial-planning firm declined to discuss her company on the record because her co-op board doesn't know that she meets clients and performs almost all business activities from her New York City apartment. Some financial planning, that! Such subterfuge can come back to haunt an entrepreneur in many ways, from financial penalties or city-government-imposed business closures to ill will within the community.
Robert Tarutis, by contrast, investigated local and state regulations before he started his company, in December 1995, out of a spare bedroom in his Waltham, Mass., home. Tarutis, the president of Tarutis Communications Group Inc., a public-relations and film- and video-production company with 1999 revenues of about $250,000, confides, "My biggest fear was that I'd be getting ready to set out from home to produce a film for a client when some guy with a truck would back up over the curb and squash a camera. Then, suddenly, someone from the city would appear and ask, 'What was a filmmaking business doing here?" Instead, he explains, "I wanted to present myself to my community as the owner of a business that was real and serious and deserving of respect. Before I even had my business stationery printed, I wanted to be sure that my company would be in compliance with all the rules."
Some cities require home-based-business owners to fill out special forms. And some of the requirements depend on the nature of the business. Tarutis, for example, learned by a call to city hall that he didn't need a business permit. If he'd had customers trooping in and out, however, he would have been required to apply for a zoning variance.
Before John W. Nelson III opened the Capital Connection, his financial- consulting firm, out of his home in Newport, R.I., he went to City Hall. He wanted to make sure that it was all right to start a home-based business and that his neighborhood's zoning regulations allowed it. Nelson found out that he needed to get a certificate of approval from the city, which involved filling out a one-page form and submitting a document (available at office-supply stores) specifying that as a business owner he formally leased office space from himself as a homeowner. "I needed this package to be approved by the city's tax and zoning offices, and then I paid $10," says Nelson. The whole procedure, he adds, took half an hour.
Deciding when to incorporate
The issue of incorporation is important for any business owner. Whether you're based at home or someplace else, you have to examine the tax, legal, and estate-planning implications. For Tarutis, that was the most complicated legal matter he faced. He decided, in the end, to incorporate at a very early stage. "After consulting my attorney and my accountant, I decided to switch from sole-proprietor status to an S corporation because I wanted to combine tax advantages with limited liability," he says. Changing to an S corporation made things tougher for Tarutis, because "suddenly there were all kinds of state requirements that I needed to worry about, like getting workers' compensation insurance."
He is convinced, though, that "it's shortsighted to skip legal measures you know you should take -- because you risk creating all kinds of potential problems for yourself down the road, especially if your company has real growth potential. If you've got a good lawyer or accountant to advise you, you can always fax any state or local paperwork that you don't know how to handle on your own."
As his business grew to 10 major clients and a payroll that sometimes includes as many as 30 full-time, part-time, and freelance staffers, Tarutis relocated from a spare bedroom to an extension built off the side of his house. Recently, he moved headquarters to a small office suite five minutes away. Don't expect him to close up his home shop anytime soon, however. "Although I'll lose the tax deduction, I'll keep it going," he says. "I still intend to be there as much as I can."
Getting the right insurance
A fair number of home-based-business owners confided -- off the record -- that they didn't have any additional insurance coverage, because they either were strapped for funds or just assumed that their homeowner's insurance policy would cover any problems that might arise.
"That's the biggest mistake a business owner can make," says Dan Peterson, manager of risk management for Larson, Allen, Weishair & Co. LLP, an accounting and business-consulting firm in St. Cloud, Minn. "Most homeowner's policies exclude business pursuits from their coverage, so insurers can easily terminate coverage or refuse to pay claims if a customer has not disclosed the operation of a business in his or her home." It's easy to imagine the tip-offs: a fire, theft, or other catastrophe might necessitate the filing of a hefty insurance claim for losses tied to suspiciously large investments in computer equipment or customized business-software products, commercial inventories, or machinery and equipment that seem excessive for home use.
Historically, it's been tough for home-based-business owners to find property-casualty, health, or disability coverage because they've had two strikes against them. For one thing, they face the same difficulties that small- or start-up-company owners do: insurers often balk unless a business has been around for three years and has at least a handful of employees. To make matters worse, many insurers have basically shunned home-based operations, fearing that they might not be stable, long-term ventures or that they might lack adequate safety and other precautions.
Jon Feld started Navigator Systems Inc., an information-technology consulting firm, in his 800-square-foot apartment in Dallas eight years ago. He recalls getting nixed by several insurers because, as he puts it now, "I didn't have a business address separate from my home address." Although his internal-management goals were right on target -- to obtain commercial and medical insurance as quickly as possible -- it took Feld and his two employees some time to achieve them. "We had a lot of misfires even though we were working with an insurance agent, which we thought would help us reach the right insurer quickly." Finally, thanks to that agent's advice and some tips from another home-based-business owner who had confronted similar hassles, Navigator, now an $8-million company, was able to purchase both medical and commercial coverage.
Fortunately, there have been recent improvements on the insurance front. Some insurers have loosened policy restrictions, and some have even started to aggressively promote their products to the growing home-business market. The best place for founders to start is with the company that already provides their homeowner's policy. Some insurers are willing to issue an endorsement that will extend home coverage to the home business. Typically, there's an additional fee, but it is usually under $600.
However, as insurance-expert Peterson warns, "Most insurance companies are pretty selective about what type of home-based business they'd be willing to cover, if they're willing to do so at all." If your ventures involve lots of visits from customers or suppliers, production operations that can be viewed as risky, or highly specialized professional skills or equipment, your insurance company will probably reject your application for an endorsement. Such decisions can best be described as quirky. What one company may deny, another may approve. It's a good idea to put together as big a list of insurers that sell in your state as possible. Also, if you're tempted to downplay or disguise certain facts in order to qualify for an endorsement, understand that the insurance company could deny your claim or even drop your homeowner's coverage.
If you don't qualify for an endorsement, apply for a commercial policy, which provides the same coverage as any basic business policy. In order to find the most cost-effective coverage from among those insurers willing to cover home-based businesses in your state, your best bet is either to work with an agent who deals with multiple insurers or to get coverage that is available through membership in a business organization.
For example, the Central Rhode Island Chamber of Commerce sponsors a "Homebased Business Association," which enables its members to purchase workers' compensation and health insurance at a group rate. "Groups like ours stay on top of state regulatory trends that might affect small-business owners," explains executive director Renée Fullerton. For example, she says, "When we learned about a new law that was going to require small-business owners in our state to have workers' compensation coverage if they employed even one person, we went out and negotiated a group rate with one of the big local carriers so that our members could get coverage at a 15% discount." Unfortunately, there's no national roster of insurance-buying pools open to home-based businesses. To find one in your region, check with your chamber of commerce, the Small Business Administration, the Service Corps of Retired Executives, or trade associations.
Other kinds of coverage, some quite new, are also worth investigating. Peterson recommends business interruption coverage, which indemnifies for the loss of profits and continuing fixed expenses when a disaster prevents business from being carried on. The coverage is a good idea for any business owner. The twist for home-based-business owners is to shop for policies that include an extra expense clause. "In the event of a catastrophic event, that clause would cover extra expenses incurred as the business owner attempts to continue to operate his business," says Peterson. For instance, a home-based-business owner might need a short-term lease for office space and equipment at a temporary location outside the home, adding new costs that could create a cash-flow crunch and perhaps even jeopardize the company.
Another sort of coverage to consider for certain types of businesses -- say, high-end consulting firms -- is intellectual-property protection. The policies come in two forms, both pricey: defense protection covers you and your employees from accusations by outsiders of infringement; pursuit protection covers you when outsiders improperly use your company's ideas. Breach-of-security coverage, also expensive, protects against losses from unauthorized electronic access, most commonly by hackers.
Sheila Lovell had already founded, grown, and sold one successful home-based business, a landscaping company in Massachusetts, when in late 1996 she purchased another. She set up the new business -- a tiny, barely afloat manufacturer of fishing charts named Captain Segull's Nautical Charts -- in her new home, in Portsmouth, R.I. "I bought the company for $40,000, even though it only had about $15,000 in annual sales, because I believed that it really had tremendous growth possibilities," she says.
To achieve that growth, Lovell needed capital. She wanted to research and create new charts -- to add to the line of 15 that the company already printed and wholesaled -- and increase marketing efforts to the world of marinas, bait-and-tackle shops, and other fishing-supply retailers. But despite her history of entrepreneurial achievement and successful banking relationships outside the state (where her last business credit line was an unsecured loan of $100,000), her loan application to one of the biggest lenders in town was met by one requirement after another. "I got a sinking feeling in my stomach and a wicked headache," she recalls. "I could see that I had some big strikes against me, including the fact that I'd bought a very small company with unproven potential, and that I planned to operate it out of my basement, which might strike some bankers as a sign of not being serious."
Although Lovell knew she needed a substantial credit line, she had no intention of relocating her headquarters just to raise cash. "Operating out of the home has always been fabulous for me. It gives a business owner a financial advantage because it really keeps your costs down, and that allows you to funnel most of your cash flow into growth activities that matter," she says.
Lovell contacted her local chamber of commerce, which put her in touch with the Capital Connection's Nelson. A former banker and a home-based professional himself, Nelson is a specialist in helping small-company owners access capital by using a rigorous approach that emphasizes credibility and creditworthiness.
Trouble is, Lovell wasn't gunning for a small loan; her business plan called for a credit infusion of about $70,000 to help her produce 10 new charts within a year, which she viewed as the easiest way to crank up sales quickly. With the higher revenue base she expected to earn from those new charts, she planned to channel excess funds into the production of even more charts.
From Nelson's perspective, there are several reasons why home-based-business owners can have a tough time attracting financing -- maybe even a tougher time than other small-business owners. "Some bankers, especially older ones, do tend to have preconceptions, which is why one needs to work very hard on a business plan that will document a company's strengths and potential," he says.
Also, bankers look for collateral. "If your company itself doesn't have anything worth collateralizing, an owner will have to put up his or her house," he notes. "For those people who are renters and lack other kinds of collateral, it may be simply impossible to get a bank loan at an early stage."
Nelson urges home-based owners to address the credibility problem by putting together a financing application that overproves their case. It might include copies of signed contracts or letters of intent from customers, which, he says, "won't count as collateral but will help a banker build up a warm-and-fuzzy feeling."
In addition to the financial statements, projections, and tax records that would typically accompany any application, Nelson recommends including such documents as a signed lease for the home-office space (ideally one that spells out some type of payment from the company to the home owner); a floor plan that clearly illustrates the business's separate work space; and relevant paperwork, such as municipal and state guidelines, required permits, insurance certificates, and documents of incorporation.
It's also important that business owners be open about the nature of their operations and not project any embarrassment or lack of confidence about being based at home, according to William A. Tanenbaum, chairman of the Computer, Internet, and E-commerce Group at law firm Kaye, Scholer, Fierman, Hays & Handler LLP in New York City. "That should be a completely neutral factor provided the entrepreneur handles it correctly," he emphasizes. "Don't be apologetic. Don't be defensive. These days, a person's office is wherever his or her modem is, and there are very few limits to what can be done at home. But the essential message that you must convey to investors or bankers is that you are every bit as serious, sophisticated, and growth minded as you would be in any other location."
With Nelson's help, Sheila Lovell accomplished her fund-raising objective, securing $70,000 from a local bank in an SBA-backed credit arrangement in 1997. "Last year the company sales were $78,000, with fixed costs of $48,000," she says. "This year in the first eight months we've sold $112,000 worth of charts, and our fixed annual costs are still $48,000 because we're still operating out of the basement!"
Deciding whether to stay home
It is often easy for entrepreneurs to see why it makes sense to start their companies at home. But figuring out if it's time to relocate is a tougher call. (See "Start a Business at Home? You've Got to Be Kidding," below.)
For Jon Feld of Navigator Systems, the push to relocate was his need to expand staffing beyond a group of close friends. "It seemed a little ridiculous to interview total strangers in the living room," he says. "It was hard enough to get people to join a company of 25-year-olds, no matter how strong our business seemed."
But the impetus to leave home may come from any number of directions. Products, not people, crowded out Terri Alpert, the founder and CEO of Professional Cutlery Direct LLC, a mail-order and E-commerce company in North Branford, Conn. Alpert spent nearly two years operating from home. "My business plan called for one year at home, since it was the only way that I would be able to bootstrap my initial $8,000 investment," she says. But after a while, her laptop computer, five phone lines, and warehouse (oops, we mean basement) full of inventory could scarcely keep up with the company's growth. "We were packed to the rafters. And then, one season, I was forced to make a decision not to add new products because there wouldn't be room for them. That was a very strong signal that it was time to move."
Alpert has advice for other home-based-business owners who might be considering the switch. "You've got to consider the financial issues," she says. "For us the question was pretty straightforward: could we afford the $700-a-month rent we'd have to pay, as well as the extra cost of utilities? When I looked at our cash flow, I was certain we could -- and that our pattern of growth was such that we wouldn't experience unexpected cash shortfalls and need to move back home." Because of her determination to remain fiscally conservative, though, she at first rented a small space, which she left only when it became evident that the company was going to keep growing.
Jeffrey S. Levine, a partner with the CPA firm Alkon & Levine PC, in Newton, Mass., suggests that home-based-business owners draw up two columns. "In one, consider all the financial advantages of being at home -- no office rent, lower telephone and utility costs, and so on," he says. "In the other, project your increased costs -- office rent, changes in insurance, extra utilities, office cleaning, real estate taxes, additional supplies or furniture, commuting, and, of course, whatever home-office deduction you'll be losing." It also makes sense to estimate the benefit of the corporate tax deductions you'll be able to earn owing to higher operating expenses. Levine warns that "an initial cash-flow hit is almost inevitable because of the costs of the move, possible requirements for deposits on utilities or office rentals, and the likelihood of needing new furniture and equipment." Setting up a credit-line arrangement in advance can be a big help.
But don't be afraid to leave home just because the decision-making process can be complicated. "Our sales were nearly $5 million last year, and I have absolutely no doubt that this kind of growth would have been impossible if we had stayed at home," says Alpert, who currently employs 44 people. "It was the right place to start, but we needed to move on."
Jill Andresky Fraser is Inc.'s finance editor.
When you're no longer home alone
Once you begin hiring people to help you out in your home business, questions will arise about taxes, insurance, and other employee-related regulations. It's a good idea to think them through ahead of time.
Q: If I hire other people, will that affect my home-office tax deduction?
A: Not at all.
Q: If my employees work out of their homes, will they be able to claim their own tax deductions for the costs of that space?
A: That's less certain. They should be able to, so long as they are independent contractors whose work operations are based primarily in their homes. (Then they need to meet the guidelines described in "Taxing Matters," page 98.) But if they are regular employees of your company, in most cases they will not qualify for their own deductions and should consult an accountant before trying.
Q: Are the general business rules regarding payroll taxes, employee benefits, and other human-resources matters different for home-based companies?
A: Not at all. So it is essential to comply with all federal and state guidelines, as well as any municipal ones that may exist. That's an area in which you should definitely rely on qualified legal and accounting advisers instead of trying to wing it.
Q: Will my insurance needs change if I hire employees?
A: Probably. Among other things, your state will likely insist that you pay for workers' compensation insurance and may even require a minimum level of liability coverage. You'll also need to inform your current insurer, who may insist that you amend your policy or seek coverage elsewhere. Seek guidance from your lawyer or accountant.
Q: How should I handle the issue of family members who get involved with the business?
A: If you hire them as employees or independent contractors, the tax, insurance, and other rules are the same as those for your other hires. But if you use them on a more informal basis, you may be setting yourself up for insurance problems if unexpected injuries or other work-related problems occur. Check with your insurance carrier to make certain that your homeowner's policy or endorsement would cover such situations.
Let's face it: the tax deduction for business use of your home may be used, abused, and fantasized about more than any other deduction in the rule books. Although most entrepreneurs agree that they'd be crazy not to claim the deduction -- if they qualify for it -- persuading them to discuss the specifics of the tax benefits they've received and the tax strategies they've relied on is almost impossible. "People don't like to draw attention to themselves on this subject," is the way one financial adviser puts it. That's probably understandable: plenty of business owners believe that they raise the risk of an audit simply by claiming the deduction.
But let's deal with reality here. For those entrepreneurs who carefully track their business expenses and keep comprehensive tax records, the home-office deduction can add up to a lucrative benefit. After all, as Jeffrey S. Levine of Alkon & Levine, in Newton, Mass., explains, "In our firm's experience, the average federal taxpayer is in the 28%-to-31% tax bracket, the average state income tax is in the 5%-to-6% range, and social-security tax for a self-employed person -- which is the way many home-based-business owners start out -- is 15%. So in many cases self-employed people are looking at a combined tax bracket of around 48%, which means, very simply, that every dollar you can document and deduct in home-business expenses will save you 48¢ in taxes."
Now for some background. For several years the home-office deduction was a dicey matter, thanks to a 1993 case in which an anesthesiologist battled his way to the Supreme Court in an effort to defend his right to deduct expenses relating to a home office. In denying his claim, the Court established a restrictive set of guidelines that basically allowed a deduction only in cases in which taxpayers earned their revenues at home. (Since the anesthesiologist performed his job at a hospital, he didn't qualify.)
Fortunately, Congress intervened with a new set of rules that went into effect this year. Those broadened the guidelines, permitting businesspeople who used their home offices exclusively and regularly for administrative and management purposes (such as paying business bills, writing marketing material, and calling clients and suppliers) to take the deduction, so long as those functions were not also performed in any other location. Two caveats: Although today's guidelines are looser, they are still specific, so check with an accountant or lawyer to make certain that your company meets the standards. Also, the home-office deduction is limited if your business's gross income is less than or equal to its expenses. (In those cases, the unclaimed expenses can be postponed for future use.)
If your company meets the current guidelines, you should be able to deduct the following expenses that are relevant to your home-based operation:
- Depreciation on business furniture and equipment. According to the IRS, you can depreciate furniture and equipment, such as computers, desks and chairs, file cabinets, copiers, and fax machines, over five to seven years.
- Depreciation on the portion of your home that is used for business purposes. You can depreciate the business part of your home over 39 years. Keep in mind that this is the one deduction that carries a cost with it, since when the home is sold, business owners may owe taxes on any depreciation costs they've deducted. For that reason, analyze the pros and cons with your accountant.
- Other real estate expenses. These would include real estate taxes and home-mortgage interest. As they do with all expenses that are shared between the personal and business parts of a home, entrepreneurs are entitled to deduct the portion of those costs that relate to the business. More on that below.
- Strictly business expenses. Included in this category are the costs of special business-insurance policies (or the cost of amending a homeowner's policy), additional utilities, home-business cleaning, and repairs on office equipment. Other home expenses that can be justified on a strictly business basis (such as the need to install a pricey security system) also qualify for a full deduction.
When you claim deductions on a prorated basis, it's essential to make careful calculations and be prepared to back them up in the event of an audit. Ron Kolquist, a partner at Larson, Allen, Weishair & Co., advises business owners to "draw up floor plans of their homes that clearly document the square footage used for personal and for business purposes. Then you can deduct home-office expenses based on the percentage of the home's total square footage used exclusively for business."
Owners can also claim business use of the home based on a room count, but unless all rooms are basically the same size, the owners may not be able to substantiate the deduction. Overstating your claim about which portions of the house you're using for business can easily backfire. So don't try to claim shared spaces like bathrooms or kitchens.
The tax deduction for business use of the home can be tricky. Ken Hawk, the founder and CEO of iGo.com, in Reno, Nev., says that when his start-up was based out of his home, he "relied on the advice of a top-quality CPA for everything related to taxes, and that person handled my personal return as well as the company's." He emphasizes that "it's really important to pay attention to the letter of the law. There's no point in creating problems for a company that otherwise has great potential."
Kolquist notes, "In 17 years of practice, I've only needed to support a home-office deduction four times. And in each case my client and I brought in a marked-up floor plan and successfully proved our case." He adds, "Of course, keeping some photos in your files that can also back up your claim probably wouldn't be a bad idea."
The best of the Web
Here's a sad reality for any home-based entrepreneur hoping to use the Internet to save time and money on essential business matters: there is so much junk floating around in cyberspace relating to so-called HBOs (home-based offices) that Web surfers are much more likely to waste both time and money than to save them.
A case in point: The Web site of the American Association of Home-Based Businesses seems promising at first glance. The trouble is, the site consists mostly of a pitch to attract members at $30 a year for benefits -- such as membership in a discount-travel association and low-cost office products that are easily found elsewhere. The advice offered by the site is along the lines of "invest in a sturdy, four-drawer file cabinet" and "limit the number of papers in each manila file folder to 20." Hmmmm.
As a general rule of thumb, home-based-business owners will find high-caliber advice -- and good bottom-line payoffs -- from the best Web sites that serve larger businesses. After all, most issues relating to finances, marketing, raising capital, and the like are relevant to all growth-oriented companies.
Still, if you are searching for specific HBO advice, try visiting these three sites:
- www.hoaa.com will bring entrepreneurs to a business organization that charges a $49 annual membership fee. But in this case membership brings a number of real advantages: low-cost health insurance, UPS discounts, hotel and car-rental savings, and -- an unusual but appealing benefit -- inexpensive rates for using a collection agency to pursue slow-paying customers. For those Web surfers who want to browse but not buy, the site also boasts a high-quality network of Internet links to legal, government, and other relevant sources.
- www.iii.org is not devoted purely to the home-based-business community but is a good source of insurance information. Visit this site to learn the basics before you comparison shop for insurance policies or brokers.
- www.homeprofessionals.com has plenty of strikes against it. Serious home-based entrepreneurs may be put off by the hokey products that the site markets, including some cutesy-poo coffee mugs and "homework" posters. But there's one good reason to check out this spot: its comprehensive list of books that address various challenges for home-based-business owners.
Start a business at home? You've got to be kidding
CEO: Ed Storey
COMPANY: Essex Builders Group Inc., Winter Park, Fla.
ANNUAL REVENUES: $65 million
I'm not sure you want to ask me about running a home-based business. Mine only lasted for two weeks.
"That was in 1991, when my wife and I founded the company. Well, before opening the business I did spend a month arranging for the insurance and checking out the zoning rules and taking care of whatever other paperwork was necessary. I arranged for separate lines for my office phone and fax, and got a copier and the other supplies and equipment the business would need.
"We have a fairly big house. The idea of running the business from home seemed to make sense. We could clearly document our work activities, deduct legitimate business expenses, and control our costs. It would even be easier to work night and day, if we needed to do that.
"The thing is, it became clear to me very quickly that there were a lot of distractions in the house. At that time, I had two sons at home -- one in high school, one in middle school. On top of that, the phone was always ringing, what with solicitations and personal calls. We had a house cleaner once a week. There were always interruptions.
"But even more than that, there was a problem of image. When you need to meet with clients, saying that you're operating out of your house doesn't work. What I soon realized was, if you're in a service-oriented business, your credibility is the quality of your production and your image, but if your company is a start-up, all you've got is your image. And being based out of your home doesn't give you an image of business stability.
"It was time-consuming to change all the phone lines and insurance in order to make the move to a corporate suite, but it was the right move. The extra expense was not significant, and there were many benefits that outweighed it, including my company's proximity to other businesspeople. I have no doubt that we could not have grown the way we did during the past eight years if we had stayed at home."