When a person takes out a loan to fund a business start-up, the person must guarantee that the loan will be paid back in full with interest. If a person turns to shareholders to invest in their business, they do not have to guarantee to each shareholder that they will be paid any return on the money they invest. Any person who invests money into the person’s business is essentially buying a piece of the business and taking a risk on whether the business will succeed.
The benefit to the shareholder is that when your business does succeed and grows in value, so does their investment. In addition, when the business starts making a profit, generally the founder will have to share that profit with any shareholders in the form of dividends. Also, since stockholders own a piece of business, they generally get a say in how the business is run. A founder of a business must keep in mind that the business no longer belongs exclusively to them if equity investors are brought in.
How Will Financing through Equity Investments Affect the Structure of My Business?
Generally, investors do not want to be equal partners in the management of a business. Investors usually want to play a passive role in which they contribute money to the business, hoping for a good return on their investment.
Therefore, it is important to adapt the structure of a business to reflect the passive nature of the start-up investors, while ensuring that they do not have the same type of liability in the business as its primary owners might have. While investors are willing to risk losing all the money they voluntarily put into the business, they are generally not willing to lose more than that through liability for the business’s debts or any court judgments against the business.
There are at least 5 common types of legal entities that a founder can use for a new business that will limit the liability of the investors:
- Limited Liability Company (LLC): With this structure, the liability of owners is limited to the value of their investment. Any income is passed through to the owners for the purpose of paying taxes. An LLC with one owner is taxed in the same way as a sole proprietorship and an LLC with many owners is taxed in the same way as a partnership. Each member would report profits and losses on their personal tax returns. The personal assets of the owners are protected from all corporate liability (except for taxes).
- An LLC needs to have an operating agreement, but the members are, for the most part, free to adopt any manner of operation that suits the needs of their business. If one of the owners serves as a manager, the company can pay them as an employee. An LLC can choose to be taxed as either a regular corporation or an S corporation. An LLC can have an unlimited number of members. LLCs are not required to maintain records of either company meetings or decisions as S corporations are required to do.
- Professional LLC: A professional LLC is established and owned by a group of professionals, such as engineers, doctors, lawyers or accountants. The law regarding which kinds of professionals can set up a professional LLC varies from state to state.
- Series LLC: A series LLC (SLLC) consists of one main LLC that includes other separate LLCs within it; they are segregated for liability purposes. A series LLCs is sometimes used for real estate holdings, because each LLC in the series can own different properties. Owners and shareholders are shielded from the liabilities of the business.
- C corporations: This is the most common corporate structure. C-corporation must pay corporate income taxes. Then profits shared with shareholders or owners are also taxed on their personal tax returns. Owners and shareholders are protected from all corporate liability.
- S corporations: The S-corporation also protects the personal assets of owners and shareholders from all corporate liability. Income is passed through, usually as dividends, to the owners and shareholders who are taxed on the dividends. The corporation generally does not pay income tax. However, in some states, the corporation is required to pay state income tax. The S corporation can have no more than 100 owners or shareholders and owners must be U.S. citizens or permanent residents. An S corporation cannot be owned by any other kind of corporate entity.
- S corporations are legally required to observe many operational formalities. For example, they must adopt corporate bylaws, conduct an initial shareholders’ meeting and conduct annual shareholders’ meetings thereafter, keep minutes of meetings and obey regulations regarding the issuing of shares of stock. An LLC is not legally required to observe these formalities.
- S corporations must have a board of directors and officers. The board of directors oversees the management and makes the major corporate decisions, while the officers manage the corporation’s day-to-day business operations.
If a person is starting up a new business, LLCs are easier and less expensive to set up. They are also easier to maintain. An LLC must comply with fewer laws and regulations regarding its operation.
Setting up an S corporation is more complicated and there are more restrictions on how it can operate. However, if a person is going to seek outside investment financing or thinks that they will issue common stock at some time in the future, then the S corporation structure may well be preferable.
What Regulations Do I Have to Follow When I Finance My Business through Equity Investments?
Whenever a person gives an investor an interest in their company in return for funding, they are giving the investor what is known as a security. There are both state and federal laws that regulate how, when, and how many securities a business can issue to investors. There are also different options as to the type of shares that are issued.
Local and national securities authorities, such as the Securities and Exchange Commission (SEC), impose rules on the process of seeking equity financing for a business. These regulations are designed to protect potential investors from unscrupulous operators and fraudsters who may attempt to obtain funds from naive investors and may even perpetrate financial crimes on gullible people.
Equity financing is usually done through an offering memorandum or prospectus, which contains extensive information that should help the investor make an informed decision on the merits of the investment. The memorandum or prospectus identifies the company’s business activities, information on its officers and directors, how the financing proceeds will be used, the risk factors, and financial statements.
In addition to securities regulations, there are legal requirements for establishing every type of corporation. This usually involves a number of technicalities, such as choosing a name, filing articles of organization with the state authority in the state in which the business is located, applying for a federal identification number and the like. An experienced business lawyer can help with these procedures.
Should I Consult an Attorney before I Start Seeking Equity Investors?
As you can see from the information shared here, the process of choosing a structure for a new business and issuing shares can become quite technical and complex. It is best to consult an experienced corporate lawyer. An experienced corporate lawyer can help you weigh the pros and cons of each type of business structure and pick the one that is best for your purposes. They can also guide you through the process of issuing shares, helping you decide on share types and compliance with state and federal securities laws.
There is a lot to think about when you start a business with equity financing. You will probably have the best chance of success if you have an experienced corporate lawyer to guide you through the process.