How the Legal Structure of Your Business Affects Financing

How the Legal Structure of Your Business Affects Financing

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The decision about how you legally structure your business can have a wide-ranging impact, affecting not just taxation and liability but also financing options. For example, if you start an LLC in California, your options for financing will be quite different than if you run your business as a Sole Proprietorship. But what are the different options for structuring your business? And how do they affect financing?

How Different Business Structures Impact Financing

Running your business as a Sole Proprietorship is probably the simplest way to go. Basically, a Sole Proprietorship means that, for both legal and tax purposes, the business and the business owner are one and the same. Any assets or income generated by the business are the property of the business owner. Conversely, if the business has any liabilities or debts, those become the business owner’s personal liabilities and debts.

When it comes to financing, operating your business as a Sole Proprietorship likely means a limited set of options. That’s because, when seeking to determine your creditworthiness for a business loan, lenders will look at your personal credit history. In practical terms, this means that taking out any kind of business loan or line of credit will likely require you to sign a personal guarantee or offer personal assets as collateral.

This also means that securing financing will be easier if you happen to have a high personal credit score and a clean personal credit history. By the same token, if your personal credit history is fraught, it could really limit the financing opportunities available for your business.

Instead of running your business as a Sole Proprietorship, you could operate it as a Partnership. This structure signifies that two or more individuals share ownership of the business. Each partner shares in the profits and losses, and in management responsibilities for the company.

Compared to Sole Proprietorships, Partnerships usually make it a bit easier to pursue flexible financing options. That’s because lenders can often check the business credit history, as opposed to just checking your personal credit. Having said that, for less established businesses, there’s still a high chance that lenders will want to run a credit check on each partner. It’s also possible that one partner’s bad credit could limit the financing opportunities for the business as a whole.

A potential workaround is equity financing. This involves having a couple of partners invest money in the business in exchange for a larger share of ownership, or else new partners are being brought into the fold. These new partners may be brought in to play an active role in managing the company, or they may be “silent partners,” simply investing capital in exchange for a share of profits.

When you choose to incorporate, you are establishing the company as a totally separate business entity, providing a level of protection for the partners and management team. Not only are there some key legal safeguards, but there are also some advantages when it comes to financing.

For one thing, Corporations can get corporate credit cards, as opposed to small business credit cards. This means greater spending power, and it also means that the personal credit history of the founders/managers does not come under scrutiny. Creditworthiness is determined based on the business alone, not the individuals.

There are several other options for financing your Corporation. Venture capital funds and angel investors are both possibilities, providing you with ways to bring in private investors to help seed your business. These can be excellent ways to bring in serious funding for a promising business venture, but of course, if the business really takes off, the investors will be entitled to their fair share of the profits.

The final option worth mentioning is the LLC structure. This option combines some of the legal protections you’d get from a Corporation, with the tax advantages you’d expect from a Partnership. LLCs can be operated “solo,”  or in partnership with other owners.

The kinds of financing options you’d get with a Sole Proprietorship or a Partnership are also available to LLCs. Venture capital, on the other hand, usually isn’t an option. LLCs cannot issue “shares” the way a Corporation can, and the pass-through tax structure means that investors would be subject to taxation on the LLC’s income. This is true even for investors who receive no tax distributions.

When Choosing a Legal Structure, Choose Wisely

The bottom line: Choosing the right business structure matters for a number of reasons, not least the wide-ranging implications for financing. When deciding on the right legal structure for your business, make sure you consider your short-term and long-term needs for funding, investors, and business credit.

Author Bio

Amanda E. Clark is a contributing writer to LLC University. She is a graduate of Eastern Michigan University and holds degrees in Journalism, Political Science, and English. She became a professional writer in 2008 and has led marketing and advertising initiatives for several Fortune 500 companies. She has appeared as a subject matter expert on panels about content and social media marketing. She regularly leads seminars and training sessions on trends and tactics in professional writing.

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