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One of the most important decisions you’ll have to make for your new business is to determine a business entity type. While the topic may seem daunting for new entrepreneurs, establishing a business entity early on is vital because the structure you choose will have financial and legal implications for your business.
One of the most important things that your businesses entity type will impact is the financing options available to you.
Let’s explore why.
Business entity and financing
At some point in the business cycle, companies will eventually seek outside financing. When this happens, they often turn to commercial lenders for the additional capital injection. However, before the lenders approve business loan applications, they first need to determine how much risk they will be facing.
One of the things they look at is the company’s business entity or structure. A business entity or structure simply refers to how a business is incorporated. The entity the business owners choose not only determines how their business will be taxed but will also affect the liability or risk they face in the event of a loan default or litigations.
The United States currently recognizes four types of business entities: sole proprietorship, general partnerships, limited liability companies (LLCs), and corporations (S or C Corp). Each business entity holds a different level of liability or risk exposure, which lenders will assess as part of the application process. Depending on the structure you choose, you could be personally liable for your business’ debts in case of a loan default or not.
Sole proprietorship and general partnerships
During the early stages of your business, you might want to consider two business entities: sole proprietorships or general partnerships (if you’re establishing a business with a partner). There is generally no separation between the personal and business assets in both entities. The lenders can turn to the owners’ personal assets if the company cannot pay the debt.
Sole proprietorship and partnerships are straightforward and easy to understand. In a sole proprietorship, only one person (or a married couple) owns the business and manages the operations. This means that only one owner carries all the business liability. The most common businesses that use this structure include freelancing, service businesses, or independent landscapers.
With a sole proprietorship, applying for loans from lenders, specifically traditional ones, can be difficult. Since you (the owner) and the business are essentially one entity, you alone will be accountable for all your debts. And since you won’t be able to sell company stocks, bonds or shares, which are assets the banks and other lenders consider the most liquid forms of assets, banks may hesitate to lend to you. With more people going after your business and personal assets, the less likely it is for banks to get repaid.
According to the Small Business Administration (SBA), “Banks are also hesitant to lend to a sole proprietorship because of a perceived lack of credibility when it comes to repayment if the business fails.” This puts much of the risk on the lender’s side.
Businesses structured as general partnerships have two or more owners, and each partner carries equal liability for the business. If one of the company’s owners took out a loan and defaulted, all the partners will be personally liable for the debt regardless of the percentage of the company they own.
Though there’s still a higher risk involved, they’re regarded as a higher entity than sole proprietorships since more people are involved. When a business involves more people, the bank can pursue each partner’s personal assets for loan repayment. This increases the business’ likelihood of getting affordable funding.
Corporations and LLCs
Corporations and LLCs offer the strongest personal asset protection. Unlike sole proprietorship or partnership, companies structured as a corporation or LLC are considered separate from their owners. That said, your business and personal assets will also be regarded as separate entities. This eliminates the risk of losing your personal assets in case of loan default.
Obtaining commercial loans for corporations is also less challenging because the company can easily sell bonds, shares, and equity through the stock market. Investors are more likely to invest and buy stocks since they’re assured that their personal assets are safe if something happens to the company.
An LLC is a hybrid entity that features the flexibility of a partnership but the personal asset protection of a corporation. It’s the most recommended business entity type for many growing companies.
LLCs are usually the best structures if you want better chances of getting financing from banks and investors. The lenders perceive such business structures as most credible as they usually have an established financial record, business history, and profitability, increasing their likelihood of getting paid. Plus, they have more liquid assets (bonds, shares, stock, etc.). In turn, lenders are more likely to approve loan applications from corporations and LLCs and may even offer high funding amounts on top of flexible financing terms.
Alternative financing options for sole proprietors
As mentioned, the lack of credibility and risk involved in sole proprietorship may limit their financing options. While they will have lesser chances of qualifying for affordable loan options (i.e., bank loans), that is not to say that they don’t have options.
One loan option is the SBA Microloan. These loans are extended by private lenders but backed by the SBA. They are also more challenging to qualify for than conventional loans, and the application process can be lengthy (usually around a few weeks to months). But once approved, you’ll be able to take advantage of low rates and flexible financing terms.
Business lines of credit and credit cards are also viable options. These are specifically designed to cover short-term business needs. With a credit card or a line of credit, you’ll be given access to a credit line with a set credit limit. You only need to draw the amount you need and pay that back with interest. The best part is that the proceeds can be used towards a variety of purposes, giving businesses more spending flexibility.
Many alternative peer-to-peer lenders specialize in high-risk borrowing, such as lending to sole proprietorships. But the process of taking out financing as a sole proprietorship can be long and difficult, and the rates tend to be higher than usual, so you’d need to prepare yourself for this.
Sole proprietorships can also consider business grants. Grants are monetary awards given by the federal government or private organizations to businesses with a high potential for success. Unlike business loans, grants do not require repayments. You simply have to submit an application and create a powerful business proposal to convince the organization why your business deserves the grant money.
What entity type is right for my business?
Being a sole proprietorship or general partnership company limits your financing options and significantly decreases your chances of qualifying for affordable loans, such as those offered by banks. There are, however, other forms of financing, such as those offered by alternative peer-to-peer lenders. These options usually come with higher interest rates.
On the other hand, corporations and LLCs can choose among various business financing options. They have better odds of receiving financing with higher loan amounts and flexible terms, like bank loans, because they’re considered the most credible forms of business. If you’re currently established as a sole proprietorship or partnership company, and you’re looking to access more financing options, switching to a more
Only you can decide which type of entity is best for your business and situation. As you plan for your business structure, it is wise to research extensively on the topic and options. And, consider talking to an accountant or lawyer to help you navigate through the legalities and jargon. The more you know, the better informed you’ll be when it’s time to decide.