We have covered a lot over the past several days. We have talked about Limited Liability, Compliance Programs, the Different Types of Entities, and some funding basics for starting your entity. Now, we are going to look at the starting of a company. Today, we will talk about self-funding a business and how it might work with the owners.
When you are dealing with a startup, you have to know what you are trying to accomplish by owning the business. This affects so many of your decisions. Today, we are going to talk about funding a business. Today, we are going to take a slightly different approach than you normally see when reading about entrepreneurs and small businesses. We are going to talk about self-funding a business. What we discuss today can help you whether you are bootstrapping a business until you get to a place where you seek funding or if you are looking to get your business off the ground with a partner and you never plan to seek funding.
Often with small service businesses, you will see a strong desire by the founders to not take any investment (if they ever even consider that as an option). The problem that often happens is you do not have owners in equal personal financial positions. This is one of the most common issues I see with small businesses getting started.
For today, we are going to discuss a business that needs to raise about $60,000. This number covers all of the necessary startup expenses with an estimated cash reserve of approximately $18,000. In the grand scheme of things, this is not that much money for the starting of a business. Let’s say we have two partners. They are both doctors. One is a bit further in his career (so he has more money) and the other is young, but has BIG ideas. In this case, both partners need each other. Because of this, the partners are insistent that they split everything 50/50. The younger partner only has $10,000 he can possibly invest in the business. The older partner easily has enough money to make his $30,000 investment plus the $20,000 shortfall created by the younger partner. So, what do you do to make sure the partners are equal?
The first thing to do is say that the partners each invest $10,000 for an equal share of the company. These will be the common shares. That will be the 50/50 side of the partnership. With this structure, the owners will share everything equally.
That gets us to $20,000 invested in the company. What about the other $40,000? In this case, we do not need to look for investors because we have the money among the partners. We are simply looking to decide how that money is invested. For the older partner, he becomes both a partner and an investor in the business. He is part of the business and he is investing money in the business for which he will expect a return. Because he is investing more money than his younger counterpart, he needs to receive a return on that initial investment. The difference is that the investment of $40,000 does not come with any of the rights of the partnership. It is a passive investment. Remember, the owners want to split everything 50/50.
The two options that may be used for this investment are debt and equity.
If the partners chose an an S-Corporation as their legal entity, there is no way to give any more equity away and keep the partners equal. With a C-Corporation or an LLC, it is possible to give away preferred shares of equity that do not have voting rights and only receive a benefit in the form of some type of special dividend or extra payment on the sale of the business. The issue with that is that, with a small operation, that is a lot of complexity just to make it work. I point this out to highlight this limitation of the S-Corporation. With the C-Corporation, this would also create some tax issues with the double taxation on the special dividends as well as the regular dividends. This would also overly complicate the books of what should otherwise be a simple operation. Then, you would have an added expense of employing a bookkeeper with the understanding of how the dividend structure was designed to work and make sure everything worked properly.
There must be a simpler way.
Debt. There are a couple of different ways to structure a deal like this from a debt standpoint. Either the older partner could loan the $20,000 to the younger partner who then invests that money into the business. Then each partner invests $30,000 into the business, but the younger partner personally has a loan for $20,000 to the older partner. That would keep the business books clean and the younger partner would simply pay the older partner just as if he had borrowed the money from the equity on his home.
Each partner invests $10,000 and the older partner loans $40,000 to the business. Then that money would be subject to a promissory note (of whatever kind you work out – we only have so much time today, so we will leave it at that). That means you would need to go back to the cash flow and add in the payments (monthly, quarterly, yearly) to the cash flow. The debt service then becomes a liability of the business. At this point, I will also point out the benefit of creating a credit line with the older partner instead of borrowing the $40,000 up front. Basically, there would be a credit line of $40,000 and you would only use what you needed. Based on our example the money sought include cash reserves of $18,000, so the business may not need all of the $40,000. Using a credit line allows the older partner to keep his money earning some kind of interest, but keeps the business from paying on money it didn’t need. That will help to keep your expenses low.
This scenario is possible with S-Corporations, C-Corporations, and LLCs. See how the decision to select an entity can hinge on more than one factor?
Of course, this is not the only way to handle this kind of investment. Do you have any thoughts on other options to invest the money? I would love to hear them. Hit reply and let me know!
I will talk to you next week, unless you talk to me first 😉