Why should you consider your business structure before seeking financing?
If you are seeking financing, you are serious about running a business. If you are serious about running a business, you need to think through the various ways to structure it. Will you run it alone or with a partner? Will a partner be active or not? The type of structure you select will have an impact on the financing, said David H. Fater, a financial executive with more than 40 years’ experience working with entrepreneurs and small businesses, because it all starts with how much personal risk you’re willing to take.
Setting up your business as a sole proprietorship is the simplest structure and requires no filing of papers. But if the business goes bankrupt and a creditor puts a lien on the assets of the business, the creditor can also put a lien on the business owner’s personal assets.
“If David Fater operates something called Sam’s Sausage Shop as a proprietorship, while the business operates under a different name, it gets treated as if it’s part of David Fater, and it’s reported as part of David Fater’s individual tax return,” Fater explained. “If I borrow money in the name of Sam’s, I will have to sign for it as David Fater the individual.”
Other types of business structures—LLCs, limited partnerships, S corporations or C corporations—are designed to protect personal assets.
If you choose to operate your business as a proprietorship, you may be able to get a bank loan to finance your business, but Fater recommends against it in this business structure.
“The last thing you want to do is be on the hook for any funding,” Fater said. “In which case, you may look to family and friends and/or angel investors for capital.”
Fater’s rule of thumb is, “Anything under $3 million may be raised from family, friends and angel investors. For financing in excess of $3 million, you need to go to real capital sources for which you need a corporate structure.”
He’s not saying that this simplest way of forming a company isn’t useful.
“I think there are a number of things that can be done very appropriately in a proprietorship,” he said.
Fater cautions that you need to consider risk and anticipate tough junctures for your business. Ask yourself, “Do I anticipate that any of my customers may be dissatisfied sufficiently that they’re going to get back more than the fees they paid me?”
Partnerships, LLCs, and Corporations
A partnership is also simple to set up and—like a proprietorship—provides little protection against risk. You don’t have to sign any papers. Each partner claims a share of business income on his personal income tax return, and each is liable for the entire amount of any business debts or claims against the business.
An LLC (limited-liability company) offers less risk but is more costly to set up and run. There is a general partner as well as one or more limited partners who invest in the business. LLCs do provide limited personal liability for business debts. In most LLCs, owners pay taxes on their shares of business income in their personal tax returns, but there is an option to be taxed as a corporation. If there is a lawsuit or a collection on a debt, only the assets of the business itself are at risk. The Small Business Authority advises, however, that although an LLC or other structure may provide some more protections than a sole proprietorship or partnership would, the borrower will still be on the line personally, along with all personal assets, if the borrower took out a government-backed loan (via the U.S. Small Business Administration). Although these loans are small-business friendly, they have strict requirements. A personal guarantee and a lien on all business assets are required to secure the loan.
“If someone goes to the trouble of forming a limited-liability company and then personally guarantees debt, he or she has defeated the whole purpose of creating the structure in the first place,” Fater warned. He admits he was guilty of making such a decision at a time when cash was critical for a public company in which he was an officer.
It may be more difficult to raise money for an LLC than a corporation, simply because the corporate structure tends to make investors more comfortable.
“One possible solution may be to form a new corporation and merge into it, dissolving the LLC and converting into a corporation,” Fater wrote in his book, “Essentials of Corporate and Capital Formation.”
The best protection from risk is found under a corporate structure in which the legal entity exists separately from the persons who form it. An S corporation provides the limited-liability protection of a corporation, but its revenues are taxed the way a partnership or sole proprietorship would be: It pays no taxes as an entity, but its earnings or losses flow through to the owners’ individual tax returns. A C corporation is the best way to minimize personal risk. It is the structure under which business owners can most easily raise capital. Also, it is taxed as an entity separate from its owners.
Fater, who works with entrepreneurs regularly, said it is always his recommendation to form a C corporation to conduct meaningful business. This recommendation is especially true if you will be borrowing money or seeking investors. A C corporation is the type of business that will best protect the individual going into business, and it’s the structure lenders prefer.
“Startup business corporations generally have no real means with which to repay debt, so the initial startup capital will be some form of equity, probably common stock or a sort of preferred stock, depending on who the early investors are,” Fater said.
“Large amounts of money can be raised based on the founder’s credibility. That credibility comes from past successes [i.e., people will throw money at you if you have made money for them in the past] and evidence that you can and do accomplish what you say you can. [Achieving company milestones is how you demonstrate this kind of credibility; missing those milestones is how you destroy it.]”