A startup business, regardless of form, generally will find it difficult to obtain outside financing. The statistical failure rate for new businesses is high, and many lenders view financing the startup business venture as extremely risky.
Banks and other creditors generally will require a significant capital investment by the business owner, and a personal guarantee that the owner will repay the loan. Corporations may issue securities to pool capital from a large number of investors; however,the costs of complying with complex federal and state securities laws may be prohibitive, and there is no guarantee that a market will exist for the securities of a new firm.
Likewise, limited liability companies may increase capital by admitting more members, but will need to offer prospective members some likelihood of return on their investment. Thus as a practical matter, startup financing for the new venture – whether it is a sole proprietorship, a partnership, a corporation or a limited liability company – often is limited to what the owner and others closely associated with the venture are able to raise.
The discussion which follows addresses the relative ease with which firms with established credit histories may be able to attract financing.
The sole proprietor’s ability to raise capital generally is limited to the amount he or she can personally secure. Accordingly, the sole proprietorship ordinarily will have less capital available to finance operations or expansion than will other forms of organization that may be able to attract outside investors.
In most cases, a partnership will be able to raise capital more easily than a sole proprietorship, but not as easily as a corporation. The borrowing power of each partner may be pooled to raise capital, or additional partners may be admitted to increase this pooled borrowing power. Or, if the partnership does not wish to distort the ownership position of the original partners, a limited partnership may be established to raise capital. Unlike a corporation, however, partnership assets generally will not be accepted as collateral by a lender. Instead, assets of the individual partners are used to secure loans, which are made to the partners in their individual capacity.
The corporation generally is the easiest form of organization for raising capital from outside investors. Capital may be raised by selling stocks or bonds to investors. As noted in the section of this Guide on securities registration, the sale of securities is regulated by federal and state laws. Due to the complexity of these laws, the sale of securities is expensive, and the cost may be prohibitive for startup firms. Long-term financing by lending institutions is easier for a corporation to structure because corporate assets may be used to secure the financing. Personal assets of the principals of the corporation and its shareholders also may be used to guarantee loans to the corporation.
The number of shares of stock a corporation may issue must be authorized by the articles of incorporation. If a corporation has issued all of its authorized shares, it is necessary to amend the articles of incorporation to authorize additional shares. The amended articles of incorporation must be filed with the Secretary of State, and a filing fee paid. The corporation can avoid these additional costs by authorizing a large number of shares at the time of incorporation.
An S corporation may have only one class of stock outstanding. This may limit the financing alternatives available to the S corporation.
Limited Liability Company
The limited liability company is financed by contributions from members. It also may invest its own funds, borrow money and trade in the securities of other organizations and the government. The limited liability company offers more flexibility in structuring outside financing than does the S corporation. The S corporation is limited by the single class of stock rule and it generally must allocate profits and losses proportionately.
The limited liability company may create multiple membership classes and series, and may provide in its articles of organization that profits and losses may be allocated other than in proportion to the value of a member’s contribution. (Tax counsel should be consulted on the tax consequences of a disproportionate allocation.)
Limited liability company members may, unless denied in the articles, have preemptive rights to increase their own contributions and maintain their proportion of ownership before the company accepts contributions from outsiders. Also, the articles of organization may need to be amended to allow the limited liability company to create additional membership classes or series of membership interests.
Another potential issue in attracting outside financing is that lenders and venture capitalists may not be familiar with the limited liability company as a form of organization. They thus may be unwilling to finance a deal without substantial equity participation and personal guarantees by limited liability company members or principals.
CREDITS: This is an excerpt from A Guide to Starting a Business in Minnesota, provided by the Minnesota Department of Employment and Economic Development, Small Business Assistance Office, Twenty-eighth Edition, January 2010, written by Charles A. Schaffer, Madeline Harris, and Mark Simmer. Copies are available without charge from the Minnesota Department of Employment and Economic Development, Small Business Assistance Office.
This is also part of a series of articles on How to Pick the Right Business Entity Type. These articles help you select the right business type for your circumstances.