Equity financing for small businesses

This organizational structure can entice financiers who would normally be reluctant to invest due to the personal liability associated with a general partnership. Under the limited partnership structure, they invest and become limited partners, supplying the capital but abstaining from the day-to-day management of the business.

In fact, limited partners are prohibited from becoming actively involved in the ongoing management of the business, or they forfeit their limited liability. Although all general partners assume personal liability for the business's liabilities, only one general partner must take responsibility for overseeing operations and making daily management decisions.

Tip

Sale of ownership interests in a limited partnership may be treated as a sale of securities. Always consult state and federal securities laws before selling ownership interests.

Limited Partnership advantages

For purposes of equity investing, a limited partnership is appealing for two important reasons:

• An investor has limited personal exposure
• A limited partner does not need to be actively involved in management responsibilities

In the past, limited partnerships were especially popular in certain industries, such as real estate, because of the generous passive loss (a loss in a business in which you are not actively involved) rules of prior tax laws.

Limited partnership disadvantages

The current tax code reduces the appeal of limited partnerships to many investors by restricting passive loss deductions.

The limited partnership's feature of limited liability is also available through other entity forms (a corporation, a limited liability company or a limited liability partnership), and unlike a limited partnership, these alternative entities also allow each participant the option of being actively involved in the business without forgoing their limited liability.

While establishing a limited partnership may be your best bet, exploring corporations and limited liability partnerships can potentially provide more protection and financing options.

Equity financing: Corporations and limited liability entities

The word "corporate" is bandied about everywhere from the evening news to the conversations of convenience store loiterers complaining about authority. But what exactly makes something corporate—and how does it apply to small business owners seeking financing?

A corporation isn't necessarily (and isn't often) a large multinational business with tens of thousands of employees. In its most basic form, a corporation is created under state law and is a legally recognized entity that exists independently of its shareholders or directors. The corporation enters into a corporate charter with the state in which the business agrees to abide by the governing state regulations in return for the state's agreement to treat the business as a separate legal entity for legal liability and tax purposes.

Corporation advantages

For many small businesses, incorporation provides:

• Ease in raising capital from multiple investors. The corporation structure accommodates widespread ownership of your business. It offers the easiest method for raising capital from multiple investors, particularly investors not necessarily interested in actively participating in the business. It may be easier to persuade 15 people to invest $5,000 than to convince one person to contribute $75,000.
• Alternative types of corporations. Small businesses may have a variety of corporate structures to choose from, including S corporations, close corporations, and C corporations. Each carries different requirements, but they all permit equity financing through the sale of stock in exchange for a capital contribution of money or property. Stock comes in a variety of different types and, depending upon your negotiating strength and the interests of your investors, a small business can limit the extent of ownership control being sold by limiting the number of shares for sale and/or the rights associated with each class of stock. Nonvoting shares, preferred shares, redeemable shares and a variety of hybrid shares are possible.

Example

The sale of either nonvoting shares or a minority percentage of voting shares could be considered an acceptable investment to a family member who doesn't want to be actively involved in your business and trusts your judgment.

• Limited personal liability for the investors. Because a corporation is a separate legal entity, investors aren't personally liable like they would be in less formal structures.
• Flexibility in structuring ownership. With the ability to separate ownership from management, you and several members can run the ship without too much interference from investors.

Corporations have their clear advantages, but as your business entity becomes more complex, so do the disadvantages.

Corporation disadvantages

Before you commit to corporate, consider these concerns:

Other prospective shareholders, such as venture capitalists and investment "angels," may demand a more active role in exchange for their capital contribution. As a condition of investing, they may even require a public sale of the business within a certain time period in order to ensure a quick return on their investment.

• Expensive and burdensome administration. State laws and regulations change. And even when they don't, you (or an employee or service provider) have a sizable amount of paperwork to complete just to maintain your good standing as a corporation.
• Double taxation of profits while operating. Because your shareholders and your business are considered separate entities, Uncle Sam likes to collect taxes on each.

For more information on the pros and cons of incorporation, see our discussion of establishing a corporation.

Financing LLCs

The LLC is a hybrid between a corporation and a partnership that offers the best of both worlds for many businesses. As with a corporation, the entity can only be created via compliance with state law formalities.

You and any other owners (aka, "members") will enjoy limited personal liability for the company's liabilities. And as with partnership business structures we've discussed in other articles, members benefit from pass-through (individual) tax treatment, meaning there's no taxation at the business-level, but all income, deductions, credits etc., "pass through" to the individual members and must be reported on their individual returns.

As tax laws currently stand, the LLC is one of the most popular entity choices among small business owners.

LLC advantages

As entrepreneurs transform their ideas into business, they're opting to incorporate their companies as LLCs for a host of good reasons. The benefits of LLCs include:

• Pass-through taxation. Unlike corporations, LLCs are not subject to double taxation. This maximizes profits for you and any other members.
• Equity financing and broad experience through multiple members. While you won't be able to attract as many equity investors as you would through a corporation, you can still have multiple owners, who can bring with them a variety of skills.
• Limited personal liability. Because the LLC is not, in the eyes of the government, interchangeable with the members, you and other owners will have limited personal liability for business decisions.

For an entity structure with so many advantages, there are relatively few drawbacks.

LLC disadvantages

While the benefits of LLCs have persuaded many small business owners to opt for this business organization structure, it may not be the best option for your organization if any of these concerns raise a red flag:

• Potentially expensive and time-consuming statutory formalities. Creating and maintaining an LLC involves a certain amount of paperwork. Because LLCs are formed at the state level, the statutory formalities can vary widely. Regardless, you, an employee or a service bureau will need to spend time every year ensuring compliance with your state's laws.
• Complicated legal and tax issues. Conducting business as an LLC can be relatively straight forward if you remain small and local. But as your business expands, you'll likely run into some hairy legal issues. Common legal and tax problems LLCs face include multi-state transactions, whether single-member LLCs are allowed and conflicts between state LLC laws.

If you like the overall structure and are seriously considering establishing an LLC but would like to retain some characteristics of a partnership, a limited liability partnership may be a better fit.

Financing LLPs

A limited liability partnership (LLP) is like an LLC's cousin. They're clearly family, but there's enough difference to tell them apart.

Just like an LLC, an LLP affords limited liability for partners while providing partnership tax treatment. But an LLP is fairly exclusive, often available only for certain occupations (e.g., professional groups such as attorneys or physicians). Professionals in these fields often find the LLP an attractive choice because one partner does not assume any liability for another partner's malpractice, misconduct or negligence. The only "punishment" you incur from a partner's wrongdoing is reputation damage to your practice.

You can form an LLP using a simple registration indicating the partnership elects to be treated as an LLP. General partnership law—with the important exception of no personal liability for business liabilities—will govern the entity. If a partnership can qualify as an LLP, it's almost always an opportunity you should capitalize on.

LLP advantages

For those businesses that qualify, forming as an LLP is a good business:

• Reduced risk for financiers. The limited liability feature of LLPs attracts investors who might otherwise balk at investing in a general partnership. Some are also interested in the opportunity to be actively involved in the management of the business.
• Pass-through taxation. Just like LLCs, LLPs are not subject to double taxation. This maximizes profits for you and your partners.
• Limited personal liability. In addition to you and other partners bearing limited personal liability for business decisions, the limited liability for a partner's professional misconduct makes the LLP all that more safe.

Of course, like an LLC, you'll want to verify the downsides are nothing to deter you from choosing this organizational structure.

LLP disadvantages

It's unlikely the disadvantages will sway you, but be sure to verify that none of these are roadblocks to establish your LLP:

• Restrictive access. LLPs are only available to certain professionals, primarily doctors and attorneys. You'll need to consult your state laws to determine if an LLP could work for your business, but odds are if you don't have the initial "JD" or "MD" after your name, an LLP isn't happening.
• Potentially expensive and time-consuming statutory formalities. Just like an LLC, creating and maintaining an LLP demands a certain level of paperwork at the state level, meaning statutory formalities can vary widely.
• Complicated legal and tax issues. Like an LLC, conducting business as an LLP can get onerous if your business expands. The good news is that most doctors and attorneys practice in the same area. But if you start opening new offices in different states, get ready to encounter difficulties with multi-state transactions, whether single-member LLPs are allowed and conflicts between state LLP laws.

Now that you're familiar with your entity options and what role they play in financing, you're ready to delve into the business combinations and venture capital that can help you secure the financing you need (that is, if you still need it).

Equity financing: Selecting a form of organization for your small business

Choosing the right business organization structure before you seek equity financing—and in general—is essential to your future business prosperity.

Throughout this article, you'll learn the main advantages and disadvantages of different organizational forms when it comes to financing. But before delving into these topics, we have one crucial piece of advice to share: No formula exists for making the determination of which organization structure is best for your business.

Equity financing considerations for any entity

No matter what entity you choose, before you obtain financing you should address important considerations relating to:

• Taxes
• Personnel
• Marketing and business strategies
• A variety of other factors

Of course, we've identified certain general principles that will help guide your selection of an organizational form for your small business.

For example, many startup businesses follow a progression of organizational forms. They begin as sole proprietorships into some form of corporate entities as the businesses' financing needs and options become more complicated.

The sole proprietorship is popular for startups because it requires:

• Virtually no formalities
• Little to no cost to create and maintain
• Minimal tax treatment

As less formality requires less commitment, many entrepreneurs will start a side business sole proprietorship before testing the waters and becoming full-time small business owners.

A sole proprietorship, however, may not be the ideal starting point if your business will:

• Include employees (creating potential personal tort liability for owners)
• Pose relatively high risks and/or
• Needs to attract equity financing

Your enterprise may benefit from the beginning as a corporation. The LLC entity may also be worth considering for a startup business if you want the pass-through tax benefits of a partnership but also want to limit your personal liability.

While we'll delve into each entity in this series of articles, you'll want to consider these general guidelines before you start working on your incorporation paperwork.

Properly using equity financing

The most important consideration when investigating equity financing is determining how many ownership interests you need to sell in order to raise the capital you need.

The number and type of equity investors in several of the entity forms varies significantly:

• The C corporation allows the greatest flexibility in terms of manipulating ownership interests through the type and number of ownership shares that you sell.
• S corporations and close corporations limit the number and type of shareholders.
• A sole proprietorship obviously precludes equity financing from anyone other than yourself.
• A general partnership may have problems raising equity capital because adding a new partner requires the unanimous consent of all existing partners. Plus, numerous partners in a general partnership can create cumbersome management decision-making.
• LLCs and LLPs are similar to partnerships in this context.

Of course, most small businesses do not begin with a large number of owners (e.g., more than ten); consequently, you can usually convert a more simple organizational form, such as a partnership, into a corporation if and when the need for greater equity financing arises.

Assessing investment risk

If the business has employees, or if several owners will participate actively in the business, the potential personal liability can (and should) influence your choice of organizational form.

High-risk businesses like construction contracting may favor an entity that limits the personal liability of the owners, such as a:

• Corporation
• Limited liability company
• Limited liability partnership
• Limited partnership

In contrast, a sole proprietor and a partner in a general partnership have unlimited personal liability for the conduct of associates and employees.

Reaping tax advantages

One of the best benefits of striking it on your own? Startups typically experience tax losses during their initial period.

You can usually "pass through" a greater amount of these losses to your individual tax return if you incorporate as a:

• Sole proprietorship
• A general or limited partnership
• An S corporations
• An LLC or LLP

Warning

If your interest in the partnership or S corporation is considered a passive activity, your loss deductions are consequently limited.

A C corporation would limit the amount of loss you could deduct in any one year to the amount of corporate income for that year (plus any carry-over losses from prior years). In addition, the owners of a C corporation pay a second tax on earnings when corporate revenues are distributed to shareholders.

Creating a high-profile image

To some investors, the more formal organizational entity you can create the better. It can add to the intangible appeal of your business that leads to more funding. A corporate name may create an image of credibility and business sophistication for some investors.

Maintaining control with multiple owners

Any entity with more than one owner involves compromising your exclusive control over the business.

In some cases, your dream may be to call all the shots, and financing that requires more owners may not be the best fit. Finding investors who complement your weaknesses, however, can allow you to focus on your strengths and outsource your weaknesses.

Your willingness to dilute your ownership control, and the need to obtain outside equity financing, will ultimately govern the level of control you want to maintain.

Considering transferability and marketability

All organizational forms, other than sole proprietorships and C corporations, usually have restrictions on the transfer of ownership interests. 

Although these restrictions allow the owners a greater degree of ownership control, the constraints are also likely to limit the marketability and liquidity of the equity interests.

Think ahead

For reasons relating to investor relations and financing, keep investors informed of developments within the business, regardless of the form of entity you elect to use.

Simply mail a shareholder newsletter or periodic correspondence to investors who aren't involved in day-to-day operations. Include what's going on and when the company is planning to seek another round of financing. Investors not only appreciate the information but also want to participate in further investing—and receiving more financing from the same investors is infinitely easier than soliciting new potential financiers.

With these general guidelines taken into account, addressing each entity will better help you determine the right fit for your financing needs.