Investor Issues To Consider When Choosing a Business Structure
When starting a small business, choosing the right business structure is crucial. Entrepreneurs must consider how income tax, personal liability, and the need for venture capital will affect their plans. Whether it's a sole proprietorship, a limited liability company, or a C corporation, each form has its own tax treatment and filing requirements.
Understanding the difference between tax-exempt entities and those that face double taxation can save business owners from future headaches. Bylaws, operating agreements, and the class of stock are also vital components to consider. The right legal entity can protect personal assets and influence the ease of obtaining capital.
An important consideration in deciding what organization form your business will take is the type of investor the business has or is seeking. For example, a sole proprietorship that is actively seeking investment may want to reconsider how the business entity is formed. See FindLaw's Start-Up Financing section for more information about funding your new business.
Below are some questions to consider when deciding how the makeup of your investors will influence what form of business you will create.
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1. Will the business be heavily dependent on investors for its capital?
Some businesses rely on sales to build their capital. Others must rely on investors to raise the amount of money they need to get started or to expand. One type of business that might depend on investment is a company that produces software. While it may have an excellent idea, the company cannot pay its staff of developers or market its product until it has something to sell.
If a business will need a large amount of invested money, its organizers should pick an entity that will be attractive to the kind of investors that best fit its needs. This may mean forming a corporation. This represents the best opportunity for an initial public offering (IPO), a tantalizing prospect for investors.
If your business relies on investors for capital, you'll need to understand their expectations. Investors might be looking for equity, which means sharing ownership interest through shares of stock. This is common in corporations where stockholders invest in exchange for a piece of the business.
Tax consequences and reporting requirements also become more complex. Businesses must file income tax returns that align with the Internal Revenue Code, and they must adhere to corporate laws. This dictates how annual reports are managed. A general partnership or sole proprietorship may have fewer complexities, but it also offers less protection against personal liability.
2. What kind of investors is the company seeking?
Identifying the type of investors you want is key. When deciding what business form to choose, a business should consider its financing needs. Investors can come from many different areas, such as friends and family, individuals involved in the business, the business's suppliers or partner companies, venture capitalists, and others. Each type of investor has similar desires but very different needs. For example, none of them want to be liable for the business's debt should the venture fail.
Partnerships and LLCs are financed with contributions and loans from partners, members, and others. Corporations can issue stock to shareholders and raise money through bonds and other debt instruments. If you're looking for venture capital, you may lean towards incorporation, which is more attractive to these types of investors. C corporations allow for various classes of stock, which can be appealing to those looking to invest without immediate tax returns.
For smaller, more personal investments, a sole proprietor or general partnership may be more suitable. Remember, getting legal advice early on can help navigate the tax-exempt status and personal tax implications that come with different investors.
3. What business forms are most attractive to investors?
Investors like to minimize their risk. That generally means that a business entity that provides a liability shield is preferable. C corporations often catch the eye of investors due to their ability to issue different classes of stock and their established structure, including a board of directors. These features can make them ideal for raising venture capital. However, they come with the downside of double taxation — once at the corporate level and again at the personal income level.
On the other hand, a sole proprietorship may not be as attractive since it doesn't separate personal assets from business debts. This puts personal assets at risk. Entrepreneurs must weigh the pros and cons of each structure, including the federal tax and personal tax rates, to determine which will be most attractive to potential investors.
In a partnership, an investor would effectively become a partner by contributing capital and sharing in the right to manage and receive profits. A general partner has no liability shield, while a limited partner's liability is limited to the amount of their contribution. Members in an LLC also enjoy a liability limitation.
4. Is one goal to raise investment capital without giving up control of the company?
Maintaining control while raising capital is a common concern. Several business forms allow a company to balance its desire for financing with its desire to retain control within a select group of individuals. In a limited liability partnership (LLP), only general partners exercise management control. A corporation can issue several types of stock, both voting and non-voting. The sale of non-voting shares can prevent the dilution of certain shareholders' controlling interest.
With a C corp, you can issue non-voting shares of stock. This allows you to raise funds without handing over control to stockholders. The operating agreement and bylaws you establish can set the groundwork for how much influence investors have. It's essential to consult with the Internal Revenue Service (IRS) guidelines and seek legal advice to ensure your tax treatment aligns with your goals for control and ownership interest.
5. Might the business become publicly traded at some point?
The only business form that can be publicly traded is a corporation. It is possible for a business to start in another form and then be converted into a corporation. If becoming publicly traded is a goal, incorporation is often the way to go.
A C corporation is set up for this path, with clear legal distinctions between personal assets and business operations, a board of directors to oversee corporate governance, and the ability to sell shares of stock to the public. However, the leap to public trading comes with stringent reporting requirements and increased scrutiny from lenders and regulators. Preparing for this includes detailed income tax returns, regular annual reports, and adherence to complex federal tax laws.
Have More Questions? Talk to a Business Attorney
Starting a business requires not only hard work and perseverance but also specialized legal skills at times. In particular, a business and commercial law attorney can help you determine the best legal structure for your business with respect to investor concerns. Then, use our easy, step-by-step DIY service to form your business legally.
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