Did you ever find out that you did something years ago that turned out to cause you big headaches later on? This is one of those issues that few small business owners think about only when they are just starting up, other than to listen to well-intended friends and family who think they have degrees in corporate law. Making the wrong decision can cost you money, time and throw a big obstacle in front of you when you want to finance your small business. The issue is – the legal structure of your business.
When I refer to legal structure I am talking about the formation your business as a corporation (Inc.) and either as a “C Corp”, an “S Corp” or possibly forming as an LLC. Perhaps you feel no need to form a legal business entity prefer to be a “sole proprietorship” or partnership thereby using your personal tax IDs for your business. Lastly you will need to determine which state is right for you to form this business and why you believe that is so. There are quite a few options.
Depending on your business type and the state where you operate, your choices might vary. Tax considerations, reporting requirements and fees are very often the main drivers in choosing the structure for your business. Ask your accountant and lawyer for some guidance.
Each structure offers benefits and protections along with costs and other requirements that some small business owners feel unnecessary. That’s why they make chocolate and vanilla, my friends, because everyone has their own preferences.
To cut to the chase, electing to operate your small business as a sole proprietorship or even a straight partnership is NEVER a good idea, particularly if you are in the restaurant business. You leave yourself wide open to all kinds of direct personal liability, lawsuits, tax issues and more. Why do it? An important thing to know is that many small business lenders will not consider financing sole proprietorships or un-incorporated partnerships because there are blurry lines between a small business financing and consumer loans. Rather than risk being confused as a personal loan, small business lenders will just say “no” unless you are incorporated or an LLC. So make sure you incorporate or form an LLC.
The majority of small business applications that we see at Strategic Funding are for LLCs or “Limited Liability Companies” seeking financing. This LLC structure offers exactly what the name infers – limits on the personal liability for the owners. This is a very good thing particularly in the restaurant business where you could be targeted for accidents, food claims, labor disputes, liquor liability etc. Like an “S Corp” it also affords the owners a direct pass through of taxes at your personal tax rate as opposed to a “C Corp” which taxes the corporation first, then you as the owners against personal income earned from your business. Not so good!
The one curious thing that we often see is a restaurant operating in one state that is formed as an LLC in another state. Imagine a restaurant operating in New York which is formed as a Delaware or Nevada LLC. My big question is – why??
Uncle Louie may tell you that you will receive a lower tax rate if you form your company in states like Delaware and Nevada. Many larger corporations choose Delaware because it offers some of the most flexible, pro-business laws in the country, particularly if you are seeking to “go public” in the future. Nevada on the other hand is becoming a popular choice for businesses due to its low filing fees and boasts of zero state corporate tax, franchise fees and personal income taxes. Who could refuse that?!! Maybe you should!
For a bigger company, these states can offer advantages. However, for a local restaurant or foodservice company there is no point. As a general rule of thumb, if your corporation or LLC will have less than five to six shareholders or members, it’s best to incorporate or form an LLC in the state where your business has its physical presence. This means the state where your business is physically located. For the average Main Street (and mid-sized local) business it’s going to be much easier and less expensive for you to incorporate or form an LLC in your home state.
You may have to file as a foreign or out of state business and face extra fees, filings and restrictions on the opening of bank accounts in your state and more. Unless you are bigger and have a bunch of shareholders you can easily eat up all the benefits you hoped for in unrealized fees and filings that you never expected.
If your financing goals are far grander and you will be looking for capital from commercial banks, the private equity (PE) world or in the public markets, your structure may be the key to your success. Many successful LLCs get financing through these channels, with one exception. If you qualify and are willing to go through the gauntlet of an IPO (Initial Public Offering) of your stock, you MUST be a corporation. If you formed in Delaware it will be an easier regulatory chore than if you were a New York corporation. No matter what, you can’t take an LLC “public” regardless of the state.
Piercing the protections of a corporate veil? Even with the right legal structure, ownership, members, shareholders will often be required to sign personal guarantees for business financing. The very protections from liability you were seeking are still in place, however you are now stepping forward to assure the lender that if the business fails, the owners will make good on the obligation. Without it banks, the SBA and most alternative lenders will not finance you. If you aren’t willing to stand behind the loan, why should they?
So ask yourself – to be or not to be – an Inc. or LLC and why? Determine what state is the best state for you to form in and then structure your business accordingly. Sole proprietorships may seem cheaper at the outset, but can cost you dearly later. If you want banks and alternative non-bank finance companies to consider financing you – form an LLC at minimum. If you want to become a titan on Wall Street and see your stock on a ticker – an “Inc.” should follow your businesses name.
How do I know? As a serial entrepreneur I have formed dozens of companies, financed all of them and taken two restaurant companies public on NASDAQ. I have made many mistakes and taken many lumps. No reason for you to do the same. Think it through before you choose.
Questions for Dave? Write to firstname.lastname@example.org