If you're the kind of entrepreneur who likes complete control over your venture and as little paperwork as possible, a sole proprietorship could be right up your alley.
Many small businesses start (and remain) sole proprietorships because of the relative ease in paperwork and taxes. When you're:
- ready to start your business immediately and
- the sole owner
establishing your business as a sole proprietorship may be your best bet.
Simply defined, a sole proprietorship is a single-owner business and the simplest form of business entity.
Like many things in life, though, simplicity often means limitations. If you're interested in equity financing for your business, a sole proprietorship is the most restrictive business organization structure you can choose.
Because a sole proprietorship, by its very nature, can only maintain one owner, equity investment is limited to whatever you have in the bank—or whatever assets you're willing to post on eBay and hope will generate the cash you need.
Aside from your personal financial portfolio — from simple savings accounts at banks to ownership of commercial real estate — you may need to borrow more money and contribute those funds as an equity investment in your business.
If you're considering debt financing instead of equity financing for your sole proprietorship, the former is usually limited to the number of personal assets you can pledge as security for a loan.
All of this isn't to say sole proprietorships are to be avoided. In many cases, they offer the prefect business organization structure for entrepreneurs.
Sole Proprietorship Advantages
A sole proprietorship can afford you the most freedom to run your new business. You can enjoy:
- Exclusive control. You'll retain sole control over the management and development of your business.
- Affordable formation and maintenance. Creating your sole proprietorship involves almost no formalities (barring any specific licenses necessary for your type of business) and few administrative costs. Do look into your state laws if you plan to operate your business under any name that is not your personal name.You may need to file a Doing Business As (commonly called a "DBA") within the local county where you will do business. This DBA certificate will allow creditors to locate the people (in this case, just you) legally responsible for the business's affairs.
- Simple (and often favorable) tax treatment. All income and expenses of the business are included on your personal tax return, usually on Schedule C, creating much less of a filing burden. In addition, because startup businesses often operate at a loss during an initial period, the losses can be deducted on your personal tax return to offset income you earn from other sources.
While these potential advantages can be a significant boon for your business, it's important to weigh them again the potential disadvantages.
Sole Proprietorship Disadvantages
While the advantages are clear, operating a sole proprietorship carries its fair share of concerns.
- Full personal liability. In the eyes of Uncle Sam, you and your business are one in the same, as are your business debts and liabilities and your personal obligations. That means you are personally responsible for your business contracts and taxes as well as the misconduct of employees who create legal liabilities while acting within their employment. You can, however, mitigate some of these liabilities with the proper insurance. And personal liability for business contracts is common in any form of small business, so being a sole proprietor doesn't necessarily exacerbate the situation.
- Limited financing options. Your financing options will be limited to your credit profile. If you are unwilling—or unable—to sell off any ownership interests in your business, you are the sole source of available equity financing. You may also have a difficult time obtaining debt financing, except to the extent you can pledge personal assets on a secured loan.
If you'd like more financing options and are relatively comfortable with a reasonable level of personal liability, organizing as a general or limited partnerships may provide the flexibility you're looking for.
Equity Financing: General and Limited Partnerships
A general partnership is defined as an association of two or more parties to operate a business for profit. Unlike a sole proprietorship, all of the risk and decision-making power is not limited to a single business owner—nor is the financing.
You and your partners can raise equity funds in several common ways:
- through your own capital contributions
- by adding new partners
- by restructuring the relative ownership interests of the existing partners to reflect new contributions.
While you do have a broader base of individuals' creditworthiness to tap into if you consider debt financing, the owners still largely determine the business's creditworthiness.
That doesn't mean there aren't other upsides to equity financing through a general partnership.
General Partnership Advantages
Opting for a general partnership spreads the managerial responsibilities and financial burden among several owners. You and your partners can capitalize on:
- Low-cost formation and relatively simple maintenance. Although not quite as informal as establishing sole proprietorships, partnerships can be relatively cheap and easy to form and maintain. All partnerships should adopt a written partnership agreement, but there is no legal requirement for a contract. No statutory formalities are required nor are there any fees. However, if you choose to do business under an assumed name, registration with state authorities may be required.
- Favorable tax treatment. Partners are taxed as individuals, and the partnership itself is not taxed. Each individual partner shares the income and deductions of the business according to a previously agreed-upon allocation of partnership interests (hence the written partnership agreement we mentioned earlier). Because new small businesses frequently experience temporary losses, you can take advantage of pass-through tax treatment. This simply means the taxes of your business are "passed through" to the tax return of the individual partners, enabling you to avoid the double taxation corporations must pay. By using pass-through tax treatment, a partner (hopefully you) can benefit by immediately apply any losses from the business to offset his or her (or your) income from other sources.
- Sharing expertise and risk. Many entrepreneurs immediately recognize that more owners means financial and legal risk doesn't fall squarely one one owner's shoulder. And that's definitely a plus. But multiple owners also means partners bring different talents, experiences and educations to the business.
If you're interested in letting a few other ringmasters help run the circus, a general partnership can offer an ideal organization structure not only for equity financing but also operations. That's not to say, though, it's always the right choice for a few sharp entrepreneurs who want to do business together.
General Partnership Disadvantages
Ever action has its equal and opposite reaction, and the same is true for the disadvantages of general partnerships.
- Personal liability. Like a sole proprietorship, a general partner has unlimited personal liability for business liabilities. Each partner bears personal financial liability for the contract and tort debts of the business. You can, however, mitigate this financial exposure to a certain degree by purchasing liability insurance.
- Limited transferability of ownership. The majority of partnership arrangements restrict a partner's rights to withdraw from the partnership or to transfer the ownership interests. If you don't like how things are going, you likely won't have an easy time removing yourself (or another partner) from the business.
- Limited financing options. As a general rule, the smaller your partnership, the more difficulty you'll likely have in obtaining financing. New equity financing is generally limited to increased contributions from existing partners in exchange for a greater ownership percentage. You can also add a new partner, which ordinarily requires the unanimous approval of all existing partners. Debt financing is more easily available in comparison to a sole proprietorship, but obtaining it may still be difficult because your business's credit is no better than the credit of each individual partner.
You may want to read more on this business organization structure if you're seriously considering establishing a general partnership. Or you can explore a similar partnership option: the limited partnership.
Financing Options for Limited Partnerships
A limited partnership requires only one partner (the general partner) to assume personal liability for the business's liabilities; however, you can have multiple general partners.
Other partners (limited partners) are passive investors and do not incur personal liability.
Formation of a limited partnership requires strict compliance with state law. Otherwise, most states will treat all partners as general partners for purposes of personal liability for the business' obligations. We recommend contacting your attorney if you're contemplating this business form.
This organization structure can entice financiers who would normally be reluctant to invest due to the personal liability associated with a general partnership. Under the limited partners structure, they invest and become limited partners, supplying the capital but abstaining from the day-to-day management of the business.
In fact, limited partners are prohibited from becoming actively involved in the ongoing management of the business, or they forfeit their limited liability. Although all general partners assume personal liability for the business' liabilities, only one general partner must take responsibility for overseeing operations and making daily management decisions.
Sale of ownership interests in a limited partnership may be treated as a sale of securities. Always consult state and federal securities laws before selling ownership interests.
Limited Partnership Advantages
For purposes of equity investing, a limited partnership is appealing for two important reasons:
- an investor has limited personal exposure
- a limited partner does not need to be actively involved in management responsibilities
In the past, limited partnerships were especially popular in certain industries, such as real estate, because of the generous passive loss (a loss in a business in which you are not actively involved) rules of prior tax laws.
Limited Partnership Disadvantages
The current tax code reduces the appeal of limited partnerships to many investors by restricting passive loss deductions.
The limited partnership's feature of limited liability is also available through other entity forms (a corporation, a limited liability company or a limited liability partnership), and unlike a limited partnership, these alternative entities also allow each participant the option of being actively involved in the business without forgoing their limited liability.
While establishing a limited partnership may be your best bet, exploring corporations and limited liability partnerships can potentially provide more protection and financing options.
Equity Financing: Corporations and Limited Liability Entities
The word "corporate" is bandied about everywhere from the evening news to the conversations of convenience store loiterers complaining about authority. But what exactly makes something corporate—and how does it apply to small business owners seeking financing?
A corporation isn't necessarily (and isn't often) a large multinational business with tens of thousands of employees. In its most basic form, a corporation is created under state law and is a legally recognized entity that exists independently of its shareholders or directors. The corporation enters into a corporate charter with the state in which the business agrees to abide by the governing state regulations in return for the state's agreement to treat the business as a separate legal entity for legal liability and tax purposes.
For many small businesses, incorporation provides:
- Ease in raising capital from multiple investors. The corporation structure accommodates widespread ownership of your business. It offers the easiest method for raising capital from multiple investors, particularly investors not necessarily interested in actively participating in the business. It may be easier to persuade 15 people to invest $5,000 than to convince one person to contribute $75,000.
- Alternative types of corporations. Small businesses may have a variety of corporation structures to choose from, including S corporations, close corporations and C corporations. Each carries different requirements, but they all permit equity financing through the sale of stock in exchange for a capital contribution of money or property. Stock comes in a variety of different types and, depending upon your negotiating strength and the interests of your investors, a small business can limit the extent of ownership control being sold by limiting the number of shares for sale and/or the rights associated with each class of stock. Nonvoting shares, preferred shares, redeemable shares and a variety of hybrid shares are possible.
The sale of either nonvoting shares or a minority percentage of voting shares could be considered an acceptable investment to a family member who doesn't want to be actively involved in your business and trusts your judgment.
- Limited personal liability for the investors. Because a corporation is a separate legal entity, investors aren't personally liable like they would be in less formal structures.
- Flexibility in structuring ownership. With the ability to separate ownership from management, you and several members can run the ship without too much interference from investors.
Corporations have their clear advantages, but as your business entity becomes more complex, so do the disadvantages.
Before you commit to corporate, consider these concerns:
Other prospective shareholders, such as venture capitalists and investment "angels," may demand a more active role in exchange for their capital contribution. As a condition of investing, they may even require a public sale of the business within a certain time period in order to ensure a quick return on their investment.
- Expensive and burdensome administration. State laws and regulations change. And even when they don't, you (or an employee or service provider) have a sizable amount of paperwork to complete just to maintain your good standing as a corporation.
- Double taxation of profits while operating. Because your shareholders and your business are considered separate entities, Uncle Sam likes to collect taxes on each.
For more information on the pros and cons of incorporation, see our discussion of establishing a corporation.
The LLC is a hybrid between a corporation and a partnership that offers the best of both worlds for many businesses. As with a corporation, the entity can only be created via compliance with state law formalities.
You and any other owners (aka, "members") will enjoy limited personal liability for the company's liabilities. And as with partnership business structures we've discussed in other articles, members benefit from pass-through (individual) tax treatment, meaning there's no taxation at the business-level, but all income, deductions, credits etc., "pass through" to the individual members and must be reported on their individual returns.
As tax laws currently stand, the LLC is one of the most popular entity choices among small business owners.
As entrepreneurs transform their ideas into business, they're opting to incorporate their companies as LLCs for a host of good reasons:
- Pass-through taxation. Unlike corporations, LLCs are not subject to double taxation. This maximizes profits for you and any other members.
- Equity financing and broad experience through multiple members. While you won't be able to attract as many equity investors as you would through a corporation, you can still have multiple owners, who can bring with them a variety of skills.
- Limited personal liability. Because the LLC is not, in the eyes of the government, interchangeable with the members, you and other owners will have limited personal liability for business decisions.
For an entity structure with so many advantages, there are relatively few drawbacks.
While the benefits of LLCs have persuaded many small business owners to opt for this business organization structure, it may not be the best option for your organization if any of these concerns raise a red flag:
- Potentially expensive and time-consuming statutory formalities. Creating and maintaining an LLC involves a certain amount of paperwork. Because LLCs are formed at the state level, the statutory formalities can vary widely. Regardless, you, an employee or a service bureau will need to spend time every year ensuring compliance with your state's laws.
- Complicated legal and tax issues. Conducting business as an LLC can be relatively straight forward if you remain small and local. But as your business expands, you'll likely run into some hairy legal issues. Common legal and tax problems LLCs face include multi-state transactions, whether single-member LLCs are allowed and conflicts between state LLC laws.
If you like the overall structure and are seriously considering establishing an LLC but would like to retain some characteristics of a partnership, a limited liability partnership may be a better fit.
A limited liability partnership (LLP) is like an LLC's cousin. They're clearly family, but there's enough different to tell them apart.
Just like an LLC, an LLP affords limited liability for partners while providing partnership tax treatment. But an LLP is fairly exclusive, often available only for certain occupations (e.g., professional groups such as attorneys or physicians). Professionals in these fields often find the LLP an attractive choice because one partner does not assume any liability for another partner's malpractice, misconduct or negligence. The only "punishment" you incur from a partner's wrongdoing is reputation damage to your practice.
You can form an LLP using a simple registration indicating the partnership elects to be treated as an LLP. General partnership law—with the important exception of no personal liability for business liabilities—will govern the entity. If a partnership can qualify as an LLP, it's almost always an opportunity you should capitalize on.
For those business that qualify, forming as an LLP is good business:
- Reduced risk for financiers. The limited liability feature of LLPs attracts investors who might otherwise balk at investing in general partnership. Some are also interested in the opportunity to be actively involved in management of the business.
- Pass-through taxation. Just like LLCs, LLPs are not subject to double taxation. This maximizes profits for you and your partners.
- Limited personal liability. In addition to you and other partners bearing limited personal liability for business decisions, the limited liability for a partner's professional misconduct makes the LLP all that more safe.
Of course, like an LLC, you'll want to verify the downsides are nothing to deter you from choosing this organizational structure.
It's unlikely the disadvantages will sway you, but be sure to verify that none of these are roadblocks to establish your LLP:
- Restrictive access. LLPs are only available to certain professionals, primarily doctors and attorneys. You'll need to consult your state laws to determine if an LLP could work for your business, but odds are if you don't have the initial "JD" or "MD" after your name, an LLP isn't happening.
- Potentially expensive and time-consuming statutory formalities. Just like an LLC, creating and maintaining an LLP demands a certain level of paperwork at the state level, meaning statutory formalities can vary widely.
- Complicated legal and tax issues. Like an LLC, conducting business as an LLP can get onerous if your business expands. The good news is that most doctors and attorneys practice in the same area. But if you start opening new offices in different states, get ready to encounter difficulties with multi-state transactions, whether single-member LLPs are allowed and conflicts between state LLP laws.
Now that you're familiar with your entity options and what role they play in financing, you're ready to delve into the business combinations and venture capital that can help you secure the financing you need (that is, if you still need it).