Choose the right legal entity to secure funding
A company’s business structure may be one factor that weighs into a lender’s or investor’s decision-making regarding investment funding.
According to a report in Forbes, the 2021 State of Latino Entrepreneurship Report shows that Latino-owned businesses are growing faster than other businesses in the U.S. However, this good news is tempered by a disparity in how Latino-owned firms were able to raise capital. According to the report, Latino-owned businesses are more likely to encounter obstacles while obtaining the funding needed to start and grow their businesses, despite Latino-owned and white-owned businesses posing a similar credit risk.
Nellie Akalp, one of SCORE’s content partners, is a passionate entrepreneur, business expert, professional speaker, author, and mother of four. She is also the CEO of CorpNet and wrote a piece that explores the reason that results in this situation. I will share some of her findings.
A company’s business structure may be one factor that weighs into a lender’s or investor’s decision-making regarding investment funding. So choosing the correct legal entity from the beginning may make it easier for Latino-owned businesses to raise money and grow. Here’s what to know about how each legal structure can raise capital and how to change your business structure if needed.
Sole Proprietorships. Although a sole proprietorship is the easiest and least costly business structure to establish, it may be the least attractive to investors for funding purposes. Here’s why:
In a sole proprietorship, the business has no legal separation from the business owner. In other words, the business’s assets, profits, losses, and debts belong to the owner, not the company.
Lenders and investors use the owner’s personal credit profile to assess the borrower’s ability to be financed.
Most owners of sole proprietorships need to provide a personal guarantee, some collateral, or both, for loan and investment approval.
Business credit card approval also relies on the strength of the business owner’s personal credit score.
Sole proprietorships cannot offer shares in the business, making investment funding impossible. To provide a piece of the company as an incentive, business owners can structure their business as a partnership.
Partnerships. In a partnership business, the legal and money responsibilities are divided among the partners, which may or may not help secure funding.
Lenders with two or more partners have more credit history on which to base their funding decisions. Strong credit profiles could mean a better chance for loan approval; however, even one bad credit score or delinquency could mean rejection.
One partnership funding option is equity financing, which allows existing or new partners to invest in the business.
Unless otherwise documented in the partnership agreement, all partners share equally in the company’s profits, losses, and responsibilities. Before bringing on new partners, it’s vital to decide whether that person will have an active role in the business’s operations or if they’ll be a silent partner. Typically, each partner receives shares in the company in proportion to the money they’ve invested.
Investors in a partnership also take on the partnership’s profits, debts, and responsibilities—something not all investors want to risk.
A Limited Partnership allows silent partners to invest in the company without having personal liability for the business’s debts and legal responsibilities. Be aware that the rules for Limited Partnerships vary by state.
Corporations. Unlike sole proprietorships and partnerships, forming a corporation will legally separate the business from the business owner(s), which provides owners and investors personal protection against the company’s liabilities. In addition, corporations are the preferred legal structure for lenders and investors.
Corporations build a separate credit profile from their owners, which allows the company to obtain corporate credit cards and loans based on the business’s credit history.
Private investors, such as venture capitalists and angel investors, may only want to fund a C Corp for the protection from personal liability it provides.
Lenders, such as banks or alternative lenders, also prefer that the business bear the burden of a loan, not the owner.
Corporations can sell stock in the business, allowing the owners to raise capital without necessarily bringing active partners into the company.
Corporations can offer an unlimited number of shares to raise money.
Shareholders only pay taxes on distributed dividends, not the corporation’s profits.
Shareholders can be businesses or individuals, foreign or domestic.
Shares in a corporation can be easily transferred.
Limited Liability Companies (LLCs). A limited liability company, or LLC, has the most flexible legal structure regarding personal liability and tax benefits. Like a C Corp, LLC owners (called members) also have limited liability protection which primarily shields their personal assets in case of a legal or money dispute. Regarding raising capital, the LLC has several funding options to pursue.
Although LLCs cannot sell shares, they can bring in new members to infuse money into the business.
LLCs can structure new members’ ownership rights to meet the business’s needs. For example, the primary members can specify in the LLC’s operating agreement how much or little responsibility new members have in the company’s daily management. Also, the number of shares the new members have is determined by the amount of money invested and how much work the member contributes.
Members can only lose up to the amount of money they have invested in the company.
LLCs are a “pass-through entity,” which means members are taxed on the profits and losses of the company.
Traditional lenders, such as banks, may ask LLC members for personal guarantees on loans, especially if the LLC has been in business for less than three years.
Dean Swanson is a volunteer Certified SCORE Mentor and former SCORE chapter chairman, district director and regional vice president for the North West Region.