An important consideration in deciding what organization form (i.e. corporation, partnership, LLC) your business will take is the type of investor the business has or is seeking. For example, a sole proprietorship that is actively seeking investment may want to reconsider how the business entity is formed. Below are some questions to consider when deciding how the makeup of your investors will influence what form of business you will create.
Some businesses rely on sales to build their capital, while others must rely on investors to raise the amount of money they need to get started or to expand. One type of business that might depend on investment is a company that produces software — while it may have an excellent idea, the company cannot pay its staff of developers or market its product until it has something to sell. If a business will need a large amount of invested money, its organizers should pick an entity that will be attractive to the kind of investors that best fit its needs. This may mean forming a corporation, which represents the best opportunity for an initial public offering (IPO), a tantalizing prospect for investors.
When deciding what business form to choose, a business should consider its financing needs. Investors can come from many different areas — friends and family, individuals involved in the business, the business’s suppliers or partner companies, venture capitalists, and others. Each type of investor has similar desires. For example, none of them want to be liable for the business’s debt should the venture fail. However, they also have very different needs.
A partner company that is financing a venture which will be key to its own success may want some control over the business’s management. An individual working for the company may want to share the profits, but may not wish to be directly involved in the headaches of management. The business also may wish the management help of a successful and more experienced company, or it may want to limit control of its management to a few key individuals. Some business entities may even be limited by law as to who can own their shares; for example, a professional corporation’s shares may only be owned by individuals licensed to provide its type of professional services.
Partnerships and LLCs are financed with contributions and loans from partners (or members) and others. Corporations can issue stock to shareholders and raise money through bonds and other debt instruments.
Investors like to minimize their risk. That generally means that a business entity that provides a liability shield is preferable. In a partnership, an investor would effectively become a partner by contributing capital and sharing in the right to manage and to receive profits. A general partner has no liability shield, while a limited partner’s liability is limited to the amount of his or her contribution. Members in a limited liability company (LLC) also enjoy a liability limitation.
Only corporations provide a true liability shield and can issue stock. Stock can be issued either as voting shares (which allow shareholders some control of the company) or non-voting shares. A corporation can issue just a few shares to a small number of shareholders, including investors, or it can make a public offering to the broader market of investors.
Several business forms allow a company to balance its desire for financing with its desire to retain control within a select group of individuals. In a limited liability partnership (LLP), only general partners exercise management control. A corporation can issue several types of stock, both voting and non-voting. The sale of non-voting shares can prevent dilution of certain shareholders’ controlling interest.
The only business form that can be publicly traded is a corporation. It is possible for a business to start in another form, then be converted to a corporation. A popular initial form for a business of this type is an LLC. While an unlimited number of members can be added to an LLC, this will eventually dilute controlling interests and can become problematic. Conversion to a corporation will allow the company to decide what types of shares it wishes to issue, and to whom.
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