What Ownership Options Do You Have?
October 21, 2021 •Oak Street Funding
One of the first things people who are seriously considering starting a business need to address is which business ownership options and capital solutions are most appropriate for their situation and goals. These are critical decisions that need to be considered before any planning for the eventual business begins because some business ownership options involve more complicated preparation than others.
The choice you make will affect every aspect of your business, from the types of records you'll be required to keep, how you'll pay taxes (and how much you'll have to pay), and the freedom you’ll have for decision-making. Perhaps most important, it will affect the amount of potential liability you may face as a business owner if the business fails or there’s a catastrophic problem.
We’ll explore the most common business structures and discuss the advantages and disadvantages of each, and then examine potential sources of working capital for sustaining the business. First, we’ll look at potential ownership structures.
Business structures don’t get any simpler than the sole proprietorship, in which one person owns and operates an unincorporated business. A sole proprietor receives the revenues from the business and is responsible for all expenses and debts. Income from the business is generally taxed through the owner's personal tax return.
It's the most common structure among new small businesses, particularly those with no or few employees. In most states, there are minimal legal requirements, such as government registrations and licenses.
There is one significant negative to a sole proprietorship: any assets owned by the sole proprietor, even those separate from the business, receive little or no legal protection. If the business becomes bankrupt or is successfully sued, creditors can seize the owner’s personal assets, such as savings, investments, or even their home. Additionally, it can be more difficult for a sole proprietorship to access capital.
As the name implies, partnerships are businesses with more than one owner. There are many different types of partnerships, with the primary two being general and limited partnerships. With a general partnership, all partners share in the business’s liability. In a limited partnership, one or more partners benefit from limited liability, so their personal assets cannot be seized to cover the business’s obligations.
New businesses often choose partnerships when each of the partners brings resources that are needed. For example, one partner may be skilled at sales, one may be a great behind-the-scenes manager, and the third may have access to funding. Like sole proprietorships, partnerships generally face little legal paperwork, and any profits are claimed on each partner's tax returns, based upon the proportion of ownership or other agreement.
The biggest drawback to partnerships is the potential for conflict. Like a marriage, the partnership can begin with great hopes and friendly relationships, but those connections may erode over time or when faced with challenges.
In some states, partners can establish what’s known as a Limited Liability Partnership (LLP). This business structure provides many of the benefits of a general partnership while limiting the legal liability assumed by partners. It’s often used for groups of professionals such as medical practitioners and accountants. Tax laws and limitations vary by state.
Limited Liability Companies
A business structure that’s something of a cross between a partnership and a corporation, Limited Liability Companies (LLCs) protect the owners' personal assets while allowing income to be claimed on the owners' tax returns. It offers many of the benefits of corporations with amuch simpler structure and fewer requirements.
As the name suggests, this structure limits the owners' legal liability. Downsides include more complex paperwork and filing requirements and the fact that LLC members may be required to pay self-employment taxes like sole proprietors and partnerships.
There are two primary types of corporations, each with its advantages and disadvantages. Both allow for multiple owners, all of whom have limited liability. The most familiar type is what’s known as a C Corporation, which issues shares of stock to owners based upon the size of the investments they make and distribute profits by issuing dividends to shareholders.
The corporation’s operations are overseen by a board of directors elected by shareholders, who can issue additional shares of stock if the company needs to raise capital.
A significant downside is that a C corporation’s profits may end up being taxed twice. First, the company will pay corporate income tax, and then the shareholders will be taxed on any dividends they receive. In addition, C corporations face extensive regulation.
That’s why some owners opt for what’s known as an S Corporation, in which corporate taxes are bypassed, and profits or losses flow directly to the shareholders and are reported on their personal taxes. However, S corporations face limits on the number of shareholders.
Choosing the right capital solutions
No matter which type of business structure you choose, your business’s continued viability depends mainly on the amount of working capital it can access. You may have plenty of assets, but working capital is what provides the “fuel” for day-to-day operations, whether that’s paying employees or vendors, buying materials, or covering overhead costs.
Businesses without adequate working capital are more likely to struggle, and not having enough money is often a cause of business failures. Where can you turn when additional capital is needed? Here are several options:
Self-funding. Also called “bootstrapping,” this approach involves investing assets you already have, such as your personal savings, or reaching out to friends and family. While self-funding allows you to maintain control over the business, it puts your assets at risk. If the business fails, what you and others have invested may be lost.
Crowdfunding. Thanks to online platforms, this is an increasingly popular approach that makes it easier to reach out to potential investors. Typically, you post your business need and funding goal on a crowdfunding site and invite individuals to contribute funds. There's usually no obligation to repay those people, but it's customary to provide something in return, such as a sample of your product. Crowdfunding works best when looking for small amounts of money
Angel investors. Some wealthy people are willing to invest in promising small businesses in return for a financial share of the success. Typically, angel investors are successful businesspeople who will also expect to provide advice for running the business.
Venture capital. This approach is similar to angel investors but relies on firms willing to make substantial investments in companies for a share of profits. Most will also expect a large percentage of ownership and the ability to play an active role in managing the company.
Lines of credit. A line of credit is one of the most convenient ways for businesses to access capital. It's similar to a credit card, except that it's issued by a lender for a specific length of time. The business may borrow up a maximum amount whenever needed and repay it according to the terms. A line of credit is a powerful tool for cyclical businesses, as it can help them meet their needs during slow periods and repay the debt when business picks up.
Business loans. Getting a loan from either a bank or a specialty lender familiar with your industry can be an excellent way to boost your working capital over a longer period or make it possible for the company to make a significant purchase or acquire another business.
Lenders will want to see proof that the company has the resources and cash flow to make the payments. The stronger your company's finances appear to be, the better the chances you'll qualify for a loan with lower rates and better terms.
If you are an established business with a cash flow model and are looking to discuss which capital solutions might be best to further your business growth, please feel free to contact us. At Oak Street Funding, we have experts in lending who have helped thousands of clients determine if a loan from a specialty lender is right for them.
Disclaimer: Please note, Oak Street Funding does not provide legal or tax advice. This blog is for informational purposes only. It is not a statement of fact or recommendation, does not constitute an offer for a loan, professional or legal or tax advice or legal opinion and should not be used as a substitute for obtaining valuation services or professional, legal or tax advice.