Did you know that the business structure you choose for your small business may make it difficult for you to secure funding to start or grow your company?
Some investors will feel less confident about investing their dollars in your business if you haven’t formed an entity that they consider preferable.
What to Consider When Selecting a Business Structure
1. Do I have enough money, and will my anticipated sales be enough to start and sustain my business on my own?
Business owners that answer “no” to this question will need to raise money from outside sources to get started or expand. They will have to consider how a business structure will impact not only their own legal and tax situation but also the implications for their investors.
2. What kind of investors am I going to ask for funding?
A business’s financing needs will determine who ideal investors might be. Some of the types of investors include:
- Friends, family, acquaintances, and employees – individuals who know the business owner and are willing to invest their personal funds to help start or grow the business
- Partners in the company – owners who invest their own funds into the business
- Banks and credit unions – institutions providing business loans
- Angel investors – individuals with a significant net worth and considerable earned income that enable them to invest some of their wealth into promising business ventures
- Venture capitalists – individuals with the financial resources to make a substantial investment (often in the millions of dollars), usually investing after a business has begun to bring in a significant amount of revenue
These investor types will have different expectations when providing funding.
- An employee may want a share in the profits but not be involved in management activities.
- Angel investors may want a significant ownership share of the business and control over how the business is run.
- Venture capitalists usually want to see high growth quickly and expect to have some control over business decisions.
By understanding what investors want and expect, entrepreneurs can make an informed decision about the business entity type necessary to attract the kind of investor they want.
How Different Business Entity Types Compare for Attracting Investors
Investors want to minimize their risk while maximizing their returns. So, they prefer to fund business entity types that shield them from liability. Also, different business structures allow for varying levels of control of strategic direction and management of a company.
Aside from friends, family, and colleagues, other lenders may pass on giving financing to a business that's run as a sole proprietorship. A sole proprietorship is not an official business entity that's independent of its owner (either an individual or a husband and wife pair). So, the business owner is both legally and financially responsible for the debts of the business. Most investors consider giving money to sole proprietorships risky business!
When an investor contributes capital to a partnership, that investor becomes a partner and shares in the right to manage and receive profits from the company.
Owners (general partners) in a general partnership receive no personal liability protection because a general partnership is considered the same legal entity as its owners. Most investors will consider investing in a general partnership a less-than-ideal opportunity.
In limited partnerships (LPs) and limited liability partnerships (LLPs), a limited partner is only liable for the debts of the business to the extent of that individual’s investment. So, while the general partner(s) are involved in running the business and bear the lion’s share of liability risks, limited partners can isolate their involvement to a financial stake. Still, some investors (especially angel investors and venture capitalists) may not have an interest in funding partnerships
An LLC (limited liability company) is considered a separate legal and tax entity from its owners. Owners (called “members”) enjoy limited personal liability for the debts of the business. Members typically finance the business with their contributions. An LLC can have an unlimited number of members. LLCs may also qualify for business loans from banks and credit unions.
Typically, venture capitalists (and sometimes angel investors) will not fund LLCs. There are several reasons for this. One is because an LLC is taxed as a partnership (pass-through taxation) and will complicate an investor’s personal tax situation. By becoming a member of the LLC to invest in it, the investor will be taxed on the LLC’s profits even if receiving no cash distribution personally. Another reason that prevents some investors from funding LLCs is that they may not be allowed to do so. Venture capital funds, for example, cannot invest in companies organized as pass-through entities if the fund has partners with tax-exempt status. Doing so and receiving active business income would violate that tax-exempt status.
A corporation is a separate legal and tax entity from its owners. It provides the most personal liability protection for owners/investors (shareholders), directors, officers, and employees.
C Corporations can issue several types of stock to raise capital, and they may have an unlimited number of shareholders. Voting shares give shareholders a say in how the corporation should be run, and non-voting shares provide ownership without decision-making power.
S Corporations may issue only one class of stock and are limited to 100 or fewer shareholders.
Usually, angel investors and venture capitalists will only consider giving a company funds if it’s structured as a corporation.
What to Do If Your Business Structure Is a Bad Fit for Your Growth Goals?
If your business structure isn’t a good match for the sources of funding you want to approach, you may want to consider converting to a different entity type. The process, legal requirements, and tax impact involved are different from state to state, so it’s wise to research the requirements and talk with your attorney and tax advisor for guidance. Also, talk with your SCORE mentor for information about funding opportunities through the SBA and in your local area.
Copyright © 2023 SCORE Association, SCORE.org
Funded, in part, through a Cooperative Agreement with the U.S. Small Business Administration. All opinions, and/or recommendations expressed herein are those of the author(s) and do not necessarily reflect the views of the SBA.