Raising capital involves knowing your strengths and weaknesses as a firm, as well as understanding what investors
are looking for. There are many factors that can influence your ability to fundraise for your business. Market
conditions, your team, your value proposition; these all play a part. One of the more overlooked factors is the legal
structure of your company. The type of legal entity you register your business as plays a huge role in your access to
financing. Below we will go through the pros and cons of the different business entities and its implications in raising capital.
A sole proprietorship is the simplest business entity to establish. For legal and tax purposes, the business owner and
the business entity are one and the same. All of the firm’s income and assets belong to the owner and they are solely responsible for business liabilities and debts. When it comes to financing, a sole proprietorship significantly narrows one’s options. Lenders will need to review the owner’s personal credit profile to determine whether the business qualifies for lines of credit or loans. Once approved, the business owner will need to sign a personal guarantee or commit collateral. In general, most investors consider giving capital to sole proprietorships risky. Lenders may passon giving financing to a sole proprietorship, save for friends, family or colleagues.
A partnership is two or more individuals who share ownership of a business. They share profits, losses and the
management of the firm. Partnerships offer more flexibility with financing since it may be easier to quality for a loan or a line of credit using the business’ credit profile. Lenders however will still review the personal credit score of each partner. Business News Daily specifies that there are two types of partnerships, a general partnership and a limited partnership. The former is a setup where everything is equally shared, while the latter involves general partners who are in control of operations and limited partners who are insulated from personal liability. This is the case of Standard Capital, a New York hedge fund in partnership with traditional investors who are limited partners. Partnerships may pursue equity financing, where partners invest more in exchange for a larger ownership. Firms can also bring new partners on board who can receive shares of the business proportionate to the capital they invest.
Incorporation creates a separate legal entity which protects both founders and the management team against liability. Corporations pay income tax on their profits and in some cases are taxed again when dividends are paid to
shareholders on their personal tax returns. Corporations offer the strongest protection to its owners from personal
liability, so operating as a corporation offers more financing options. Corporations can seek funding through venture capital funds or angel investors, and can also raise funds through sale of stock. In many cases, angel investors and VCs will only consider giving funds to firms that are structured as a corporation.
Limited Liability Company
A limited liability company combines elements of a partnership and a corporation. The US Small Business
Administration notes how all LLC owners are protected from personal liability like in a corporation, but avoid double
taxation. According to ZenBusiness’ guide to starting an LLC in California, LLCs offer better tax options, limited
personal liability and more business freedom. However, an LLC differs from a corporation in that it might not be an
option for funding from venture capitals. Since it functions as a “pass through” entity, a VC would be subject to
taxation on the LLC’s income, even if it isn’t earning dividends. Because of this taxation issue, some VCs prohibit
investing in LLCs.