A startup’s entity choice and financing options affect other aspects of the business, including its long-term fate. Familiarizing yourself with some differences among various entities should help when talking with your professional advisor about how to set up and finance your business.
Financing for startups generally comes in two types: debt and equity. Debt financing involves obtaining loans. Equity involves receiving funds from investors in exchange for a portion of business ownership.
The choice of entity and differences in these types of financing affect other aspects of your business. These aspects include control over the business, allocation of ownership interests, exit options for the various people involved, and, ultimately, the fate of your business in the long run.
Many business owners are trying to cut costs, especially when starting out. Often, they try to “do it themselves” instead of paying a lawyer or accountant or both. However, this can turn out to be extremely costly, both monetarily and non-monetarily.
When selecting a business entity form and financing a business, it is worthwhile to obtain proper counsel as early as possible in the process. The right professional advice can help avoid early pitfalls that could, unfortunately, become prohibitive black holes if not addressed early and properly.
An advantage of pure debt financing is that an appropriately paid lender does not end up with any ownership in the business. However, for startups, debt financing is almost impossible to obtain without a personal guarantee that puts your family assets on the line.
The impact of equity financing depends on the terms of the deal and how it is structured.
Warning: The Securities and Exchange Commission (SEC) and certain other laws govern financial offerings and sales. Failing to comply involves serious sanctions. Consider consulting a well-versed lawyer before taking any action.
An important factor in obtaining seed financing is the exit strategy of your investors and anyone else you’re working with. Do the long-term plans of each party involved match up? For example, does one party expect to build and then sell the business, while another party expects to hold on to the business for life? Evaluating your accord early helps prevent discord later.
A sole proprietor owns all of the business and makes all of the decisions. A “downside” to sole proprietorship is personal liability for business debts. Creditors of the business may be able to satisfy business debts with the sole proprietor’s personal assets, including those that have nothing at all to do with the business (e.g., wages from another job, the family vacation funds, home computers, your personal savings account, etc).
Financing for sole proprietorships is basically limited by the amount of the sole proprietor’s personal assets. The equity financing is generally whatever assets you are able to contribute to the business. Debt financing is limited by the personal assets available to pledge as security for the loan.
Tip: A sole proprietorship is limited to one person. If another person will be introduced into the business, another business entity is used, such as a partnership or an LLC.
For startups, sole proprietorships are popular because they are simple. However, as the business progresses and financing needs become more complicated, sole proprietorships typically evolve into another form.
Corporations offer tremendous flexibility when it comes to financing. In contrast to the sole proprietorship, a corporation is a separate legal entity – it could be thought of as another person. A corporation is created by complying with state corporation statutes and is governed by state-specific corporation laws.
Tip: The owners of a corporation, its shareholders, enjoy limited liability for corporate debts. This helps to protect their personal assets from business debts.
Corporations may obtain equity financing by selling stock in exchange for a capital contribution. The rights of the shareholders are governed by the state statute on corporations and related law. Financing possibilities include common stock, preferred stock, and a variety of debt-equity hybrids.
The corporation has traditionally been a good entity choice for a capital-intensive businesses because it works well for receiving a lot of funding from many different owners. It is also a good candidate if you plan on doing an initial public offering (IPO) in the future.
In a closely held corporation, there’s not much of a market for selling shares and any transfer of shares is typically subject to a buy-sell agreement. Also, the people involved often wear “multiple hats,” with the same individual serving as director, officer, employee and shareholder. Observing corporate formalities is especially important when it comes to closely held corporations.
For federal income tax purposes, a corporation may be and a “C Corporation" or an "S corporation.” The income of a C corporation is subject to tax twice – once at the corporate level and a second time at the shareholder lever. S corporations enjoy flow-through tax treatment – the income “flows through” the corporation and is taxed at the shareholder level.
In either case, the corporation is a separate entity under state law. If a qualifying corporation wants to be taxed as an “S corporation” instead of as a “C corporation,” it elects “S corporation” tax status with the IRS.
Unlike the C corporation, the S corporation is limited to one class of stock and the number and type of shareholders is limited.
Partnerships come in different varieties. A “general partnership” is loosely defined as an association of two or more co-owners operating a business for a profit.
In contrast to corporations, partnerships are generally governed by a partnership agreement which specifies the rights and obligations of the parties involved. In other words, they are primarily governed by contract instead of a state corporation statute.
Partnerships raise capital via capital contributions of the various partners. The partnership agreement typically states each partner’s share of profits, entitlement to distributions, responsibilities and duties, and so forth. If any partner will receive a salary (e.g. in a money-talent deal), the salary terms are also generally included in the agreement.
Think ahead: It’s a good idea for the partnership agreement to address whether any salary will be paid and the terms of the salary from year to year.
If the partnership agreement fails to address certain issues, a state partnership statute may fill in the gaps. Some may describe this as, “If you fail to draft your own agreement, the state will do it for you.” However, the government’s default rules are not always the best provisions for a given situation.
Tip: Partnerships offer a great amount of flexibility in determining the rights and obligations of the various partners.
The disadvantage in using a general partnership is that the general partners are personally liable for business debts. Usually a different form of business is used which offers limited liability.
Tip: An LLC, or a limited partnership or limited liability partnership, is often used instead of a general partnership. These require a filing with the state.
Limited liability partnership
In contrast to a general partnership, a limited liability partnership (LLP) permits some limited liability for the partners. This form of business may be available only for certain professions (e.g., lawyers, accountants, architects).
A limited partnership (LP) has at least one general partner and at least one limited partner. The general partner manages the business and is liable for partnership debts (the general partner is typically a limited-liability entity). Limited partners invest in the business but do not participate in managing the business. Limited partners have limited liability.
Limited Liability Companies
An LLC is a hybrid-type of entity that provides limited liability while allowing for flexibility in structure. It is a separate entity that is created by complying with state statute. LLCs generally enjoy flow-through tax treatment, although they may elect corporate tax treatment.
Tip: Many say the LLC offers the “best of both worlds” – flexibility and pass-through tax treatment (similar to partnerships) plus limited liability (similar to corporations). Accordingly, it has become a very popular entity choice.
Nevertheless, it is still a good idea to consult your advisor about the best entity structure for your particular business. As they say, “there are exceptions to every rule,” including whether an LLC will best serve your needs in the long run.
The LLC and its members are generally governed by an operating agreement, similar to the partnership agreement of a partnership. The operating agreement generally specifies the rights and obligations of the parties involved. If the operating agreement does not address certain issues, the state LLC law may fill in the gaps.
LLCs, like partnerships, may raise capital via capital contributions. Also, they offer a great amount of flexibility.
Tip: The flexibility of LLCs means that the parties – the entrepreneur and investors – may specify the terms that govern the bulk of the business aspects. This gives each party the freedom to include provisions favorable to itself.
Many states have had an LLC act since the 1980s and 1990s. Although LLCs have been around for some time, they are a relatively “new” entity form when compared to the corporation or partnership.
Unlike a limited partner in an LP, an LLC member may manage the business. Further, with an LLC, a managing member does not have the personal liability that a general partner has with an LP or a general partnership.
Warning: A defectively formed LLC could expose you to personal liability for business debts.
When considering the terms of any seed financing, keep in mind the possibility and effects of additional financing down the road.
Tip: The most advantageous choice of entity, or combination of entities, will depend on your particular business, your tax situation, the nature of your current and future financing needs, and other factors.
Given the similarities of some entities, more than one type of entity may be a viable choice for your business. Make sure you consult appropriate professionals and obtain legal advice as early as possible.