Startup Financing and Operation of the Business
The Beginning of a Business
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 prohibited, 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 halted to the amount of debt 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 debt 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. While partnership assets may be accepted as collateral by a lender, the separate assets of individual partners are often needed to secure loans, either through loans made to the partners in their individual capacity or loans to the partnership that are guaranteed by individual partners, often with pledges of individual assets as security.
The corporation generally is the easiest form of organization for raising capital from outside investors. Equity capital may be raised by selling stock 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 is limited by restrictions on who can be owners as well as the single class of stock rule which requires it to allocate profits and losses proportionately. This may limit the financing alternatives available to the S corporation.
Limited Liability Company
The limited liability company is financed by contributions from members. The limited liability company offers more flexibility in structuring outside financing than does the S corporation. The limited liability company may create multiple classes and series of membership interests, and may provide in its operating agreement (or its articles of organization) that profits and losses may be allocated other than under the default rule of per capita among the members. Unless the operating agreement provides differently, distributions by limited liability companies formed under Minn. Stat. Chapter 322C that are made before dissolution and winching up are to be in equal shares among members (i.e., per capita), and upon dissolution and winding up are to be made first to return prior contributions that have not been previously returned and then in equal shares among members and dissociated members. (Tax counsel should be consulted on the tax consequences of a misappropriated allocation.) The ability of a limited liability company to create additional membership classes or series of membership interests is typically governed by the operating agreement.
Transferability of Ownership Interests
A sole proprietor transfers ownership of the business by transferring the assets of the business to the new owner. The prior proprietorship is terminated and a new proprietorship is established under the new owner.
The transfer of a partner’s economic interest in a partnership is determined by the partnership agreement, or by statute if there is no partnership agreement. Unless permitted by the partnership agreement, no person may become a partner without the consent of all the other partners. If a partner attempts to transfer his or her interest in the partnership without such an agreement, the transferee does not become a partner but instead becomes entitled to receive the allocations of profit and loss and the distributions that the transferring partner otherwise would receive. A properly drawn partnership agreement will address the conditions under which an ownership interest may be transferred, and the consequences to the transferee and to the partnership.
Ownership in a corporation is transferred by the sale of stock. A change in ownership does not affect the existence of the corporate entity. Technically, shares of stock in a corporation are freely transferable. As a practical matter, however, the market may be limited for shares o1 stock in a small corporation that is not publicly traded. In addition, shareholders in a new venture often will want to restrict the transfer of shares and thus may provide for transfer restrictions in the articles of incorporation, bylaws, or a buy—sell or redemption agreement. In an S corporation, shares of stock are also freely transferable, in theory. However, the S corporation election may be inadvertently terminated if the entity to which the shares are transferred does not qualify as an S corporation shareholder, so a buy-sell agreement or other form of transfer restriction is even more important in these situations.
Limited Liability Company
Membership rights in a limited liability company generally can be viewed as consisting of financial rights (referred to as the “transferable interest”) — the right to share in the profits, losses and distributions of the limited liability company and other rights (rights to vote and to manage the business, information rights, etc.) Unless the operating agreement (or articles of organization) provides otherwise, a member may assign or transfer financial rights that comprise the transferable interest. Such a transfer gives the transferee all the rights to profits and distributions previously held by the transferor. Unless the operating agreement (or articles of organization) provides otherwise, a transfer does not create other membership rights in the transferee, nor can the transfer allow the transferee to directly or indirectly exercise governance rights, unless all other members give their consent. The operating agreement (or articles of organization) may provide for less—than unanimous consent.
Continuity of the Business Following Withdrawal or Death of an Owner
The business entity terminates at the death of the proprietor or if the proprietor becomes unable to manage it.
General partnerships and limited liability partnerships under the Revised Uniform Partnership Act (RUPA) do NOT automatically cease to exist when a partner dies or otherwise withdraws from a partnership. The partnership continues, unless certain other events occur. A limited partnership does not terminate when a limited partner dies or becomes disabled. The limited partner’s interest may be assigned, and if the limited partner dies, his or her legal representative may exercise all the partner’s rights for purposes of settling the estate.
A corporation is a separate legal entity, and therefore the death, disability or withdrawal of an owner has no legal effect on the business entity’s existence. As a practical matter, however, many small businesses depend heavily on the efforts of one or two individuals, and the death or disability of one of those key individuals can seriously impair the economic viability of the business. For this reason, a small business corporation, like a partnership, often will obtain life insurance on hey shareholder-employees. The articles of incorporation or a buy-sell or shareholder agreement may restrict the transferability of stock in order to retain control of the firm by the remaining key individuals.
Limited Liability Company
Limited liability companies governed by the new Minnesota Revised Uniform Limited Liability Company Act will not dissolve upon the termination of membership of a particular member unless specified in the operating agreement (or articles of organization) or, once a member has been admitted 90 consecutive days pass during which the limited liability company has no members. Otherwise, the termination of a member’s interest does not affect the existence of the limited liability company.
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, Thirty-fourth Edition, January 2016, 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.