Rather than racking up debt to finance your business, you can give ownership in exchange for the money you need. Learn what forms of business and what equity financing options can work best for your business.
Understanding equity financing
Equity financing simply means selling an ownership interest in your business in exchange for capital. The most basic hurdle to obtaining equity financing is finding investors who are willing to buy into your business. But don't worry: Many small business have done this before you.
The amount of equity financing that you undertake may depend more upon your willingness to share management control than upon the investor appeal of the business. By selling equity interests in your business, you sacrifice some of your autonomy and management rights.
The effect of selling a large percentage of the ownership interest in your business may mean that your own investment will be short-term, unless you retain a majority interest in the business and control over future sale of the business. Of course, many small business operators are not necessarily interested in maintaining their business indefinitely, and your personal motives for pursuing a small business will determine the value you place upon business ownership.
The bottom line usually boils down to whether you would rather operate a successful business for several years and then sell your interest for a fair profit, or be repeatedly frustrated in attempts at financing a business that cannot achieve its potential because of insufficient capital.
The impact of choice of entity on equity financing options
The specific types of equity financing available to you are, to some extent, determined by the organizational form of your small business. Your choice of business form, or "entity," for your small business involves a wide spectrum of other important issues, such as the degree of personal risk involved in the type of business, tax considerations and the need to attract good business managers.
Each entity has its own unique characteristics:
- Sole proprietorships are the simplest businesses to form, but equity financing is limited to the owner's assets.
- General partnerships require at least two owners, so equity financing possibilities are greater than in proprietorships.
- Limited partnerships can provide limited liability to some of the owners, if they're not active participants in the business.
- Corporations provide the most flexible possibilities for investors.
- Limited liability companies and limited liability partnerships are business entities that combine favorable tax treatment with limited legal liability for the owners.
Equity Financing: Sole proprietorship
If you're the kind of entrepreneur who likes complete control over your venture and as little paperwork as possible, a sole proprietorship could be right up your alley.
Many small businesses start (and remain) sole proprietorships because of the relative ease in paperwork and taxes. When you're ready to start your business immediately and the sole owner, establishing your business as a sole proprietorship may be your best bet.
Simply defined, a sole proprietorship is a single-owner business and the simplest form of business entity.
Like many things in life, though, simplicity often means limitations. If you're interested in equity financing for your business, a sole proprietorship is the most restrictive business organization structure you can choose.
Because a sole proprietorship, by its very nature, can only maintain one owner, equity investment is limited to whatever you have in the bank—or whatever assets you're willing to post on eBay and hope will generate the cash you need.
Aside from your personal financial portfolio — from simple savings accounts at banks to ownership of commercial real estate — you may need to borrow more money and contribute those funds as an equity investment in your business.
If you're considering debt financing instead of equity financing for your sole proprietorship, the former is usually limited to the number of personal assets you can pledge as security for a loan.
All of this isn't to say sole proprietorships are to be avoided. In many cases, they offer the prefect business organization structure for entrepreneurs.
Sole proprietorship advantages
A sole proprietorship can afford you the most freedom to run your new business. You can enjoy:
- Exclusive control. You'll retain sole control over the management and development of your business.
- Affordable formation and maintenance. Creating your sole proprietorship involves almost no formalities (barring any specific licenses necessary for your type of business) and few administrative costs. Do look into your state laws if you plan to operate your business under any name that is not your personal name. You may need to file a Doing Business As (commonly called a "DBA") within the local county where you will do business. This DBA certificate will allow creditors to locate the people (in this case, just you) legally responsible for the business's affairs.
- Simple (and often favorable) tax treatment. All income and expenses of the business are included on your personal tax return, usually on Schedule C, creating much less of a filing burden. In addition, because startup businesses often operate at a loss during an initial period, the losses can be deducted on your personal tax return to offset income you earn from other sources.
While these potential advantages can be a significant boon for your business, it's important to weigh them against the potential disadvantages.
Sole proprietorship disadvantages
While the advantages are clear, operating a sole proprietorship carries its fair share of concerns.
- Full personal liability. In the eyes of Uncle Sam, you and your business are one and the same, as are your business debts and liabilities and your personal obligations. That means you are personally responsible for your business contracts and taxes as well as the misconduct of employees who create legal liabilities while acting within their employment. You can, however, mitigate some of these liabilities with the proper insurance. And personal liability for business contracts is common in any form of small business, so being a sole proprietor doesn't necessarily exacerbate the situation.
- Limited financing options. Your financing options will be limited to your credit profile. If you are unwilling—or unable—to sell off any ownership interests in your business, you are the sole source of available equity financing. You may also have a difficult time obtaining debt financing, except to the extent you can pledge personal assets on a secured loan.
If you'd like more financing options and are relatively comfortable with a reasonable level of personal liability, organizing as a general or limited partnership may provide the flexibility you're looking for.
Equity financing: General and limited partnerships
A general partnership is defined as an association of two or more parties to operate a business for profit. Unlike a sole proprietorship, all of the risk and decision-making power is not limited to a single business owner—nor is the financing.
You and your partners can raise equity funds in several common ways:
- Through your own capital contributions
- By adding new partners
- By restructuring the relative ownership interests of the existing partners to reflect new contributions.
While you do have a broader base of individuals' creditworthiness to tap into if you consider debt financing, the owners still largely determine the business's creditworthiness.
That doesn't mean there aren't other upsides to equity financing through a general partnership.
General partnership advantages
Opting for a general partnership spreads the managerial responsibilities and financial burden among several owners. You and your partners can capitalize on:
- Low-cost formation and relatively simple maintenance. Although not quite as informal as establishing sole proprietorships, partnerships can be relatively cheap and easy to form and maintain. All partnerships should adopt a written partnership agreement, but there is no legal requirement for a contract. No statutory formalities are required nor are there any fees. However, if you choose to do business under an assumed name, registration with state authorities may be required.
- Favorable tax treatment. Partners are taxed as individuals, and the partnership itself is not taxed. Each individual partner shares the income and deductions of the business according to a previously agreed-upon allocation of partnership interests (hence the written partnership agreement we mentioned earlier). Because new small businesses frequently experience temporary losses, you can take advantage of pass-through tax treatment. This simply means the taxes of your business are "passed through" to the tax return of the individual partners, enabling you to avoid the double taxation corporations must pay. By using pass-through tax treatment, a partner (hopefully you) can benefit by immediately apply any losses from the business to offset his or her (or your) income from other sources.
- Sharing expertise and risk. Many entrepreneurs immediately recognize that more owners mean financial and legal risk doesn't fall squarely on one owner's shoulder. And that's definitely a plus. But multiple owners also means partners bring different talents, experiences and educations to the business.
If you're interested in letting a few other ringmasters help run the circus, a general partnership can offer an ideal organizational structure not only for equity financing but also operations. That's not to say, though, it's always the right choice for a few sharp entrepreneurs who want to do business together.
General partnership disadvantages
Every action has its equal and opposite reaction, and the same is true for the disadvantages of general partnerships.
- Personal liability. Like a sole proprietorship, a general partner has unlimited personal liability for business liabilities. Each partner bears personal financial liability for the contract and tort debts of the business. You can, however, mitigate this financial exposure to a certain degree by purchasing liability insurance.
- Limited transferability of ownership. The majority of partnership arrangements restrict a partner's rights to withdraw from the partnership or to transfer the ownership interests. If you don't like how things are going, you likely won't have an easy time removing yourself (or another partner) from the business.
- Limited financing options. As a general rule, the smaller your partnership, the more difficulty you'll likely have in obtaining financing. New equity financing is generally limited to increased contributions from existing partners in exchange for a greater ownership percentage. You can also add a new partner, which ordinarily requires the unanimous approval of all existing partners. Debt financing is more easily available in comparison to a sole proprietorship, but obtaining it may still be difficult because your business's credit is no better than the credit of each individual partner.
You may want to read more on this business organization structure if you're seriously considering establishing a general partnership. Or you can explore a similar partnership option: the limited partnership.
Financing options for limited partnerships
A limited partnership requires only one partner (the general partner) to assume personal liability for the business's liabilities; however, you can have multiple general partners.
Other partners (limited partners) are passive investors and do not incur personal liability.
Formation of a limited partnership requires strict compliance with state law. Otherwise, most states will treat all partners as general partners for purposes of personal liability for the business' obligations. We recommend contacting your attorney if you're contemplating this business form.