We have covered a lot over the past several days. We have talked about Limited Liability, Compliance Programs, and the Different Types of Entities. Now, we are going to look at the starting of a company. Today, we will talk about investment and what it can look like in a startup.
The two primary categories of business investment are debt and equity. In an LLC the equity holders are called members and in a Corporation (of either variety) the equity holders are called Shareholders. Let’s start with debt, as there are not many restrictions on this.
Debt is a way to make money with an obligation to repay it. Everyone is familiar with debt – mortgages, credit cards, notes, etc. Most everyone understands secured debts versus unsecured debts. Can anyone give me an example of each: Mortgage, Credit Cards. Companies often sell debts with different repayment structures. These can be promissory notes, with a promise to repay. Sometimes they use instruments called Bonds and Debentures. They are effectively the same thing, the difference is the way the debt holder can get his money back if the company does not pay. Debentures are simple debt. There is no security to it. Bonds are secured by the net income of the business. That means, if someone (say Jefferson County) does not pay a bond, the debt holder will have a lien on the future earnings of the company until it is paid. Banks, of course, lend money, but what we are talking about is in the private community.
Equity is a bit different in that the company, in exchange for money (services or property sometimes, but mostly money), is offering ownership of the company. That means a share of the profits. That also means a share in the liabilities of the company if things go wrong. There are many ways to structure equity purchases, but the important elements for our purposes today are going to be in the type of equity available and how a deal can be structured.
First, there are two major categories of equity available for most entities. Those are Preferred and Common. Preferred stock is equity that receives special treatment. Any time a dividend is declared, preferred equity holders get money first. Sometimes they get money when the common stockholders do not. Common stockholders are your average stockholders. The founders who are working every day in the business. They make their money in their salary.
Typically, your investors want at least some form of preferred stock to ensure they get their money back as quickly as possible. Often, when you issue preferred stock it has a guaranteed dividend it will pay every year. The Common stockholders only get dividends if the company can afford it and the board decides to give it to them.
Now, let’s talk about how this works in specific entities.
S Corporations are limited in the ownership that can be offered. S Corporations can only have one class of stock. Every owner in an S Corporation must have the same economic rights. That means, if one owner in an S Corporation receives a dividend, all of the other owners must receive a proportionate share of the same dividend. The only difference can be in the salary.
S Corporations are also limited by who or what can own it. You can only have 100 shareholders. Only individuals can own S Corporations. That means, no Corporations, LLC (multimember), trusts, or other entities may own an S Corporation. This seriously limits the ability to take investment or to make any kind of interesting deals to get your startup moving.
Corporations have many options when it comes to how to pay people. Corporations can issue many different classes of stock, each with different rights and payouts. Corporations are not restricted by how they are owned. You can give distributions to one class of stock, but not another in a corporation
Limited Liability Company
With an LLC, you have the benefit of Flow Through Taxation AND the benefits of Corporate equity structure. Further, you can make the business look like you need it to for taxes or management.
This is one of the few places the LLC looks more like the Corporation than than the S Corporation. LLCs allow for almost anything. They are contractual. The one limitation you could see on an LLC is if you elect to have it taxed as an S Corp, in which case the limitations would be placed on it.
Who Gets What?
Often with small service businesses (like doctor’s offices or other healthcare providers), 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.