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What do I need to know about capital when starting my business?
Most individuals forming a new entrepreneurial venture have deep and meaningful expertise in their area of practice. However, many people need advice regarding elections they should make when forming the business, making a good lawyer and accountant especially valuable.
The financial questions to be addressed and considered when starting a new venture are broad and highly dependent on the specific issues related to the business being formed, including:
- How many parties will be owners of the business?
- How the business will be funded?
- What is the value of any property the founders are contributing to the business?
- How will future financial matters be addressed?
And, especially important at the time the business is formed or reorganized are matters related to taxation and capital structure.
Presently, most new business ventures are formed as limited liability companies (“LLC”) because of the flexibility this business structure provides in the management of a company. However, the Internal Revenue Service has no special tax election for LLCs, meaning, at the outset, members must elect how the company will be taxed. While some LLCs with multiple members will elect to be taxed as an S-corporation, the default tax election for multimember LLCs is to be taxed as a partnership.
Partnership taxation is fraught with perils that often create unanticipated challenges for members, especially when the members have not addressed potential matters of a dispute at the time at which the company was formed.
Every member in a multimember limited liability company that is taxed as a partnership will have what is referred to as a capital account. A capital account represents a member’s economic interest within an LLC. On an ongoing basis, capital account balances are adjusted in accordance with applicable tax law and the provisions of the company’s operating agreement to reflect the profits, losses, distributions and liabilities of the company that are allocated to a member. Often, if an LLC has multiple classes of members, the members will agree to special allocations that define which members are allocated certain items of gain or loss.
While a benefit of an LLC is that it generally shields its members from personal liabilities, operating agreements can create obligations for the members relative to capital accounts if not carefully negotiated. Some operating agreements may require that if a member’s capital account has a negative balance that the member must make contributions to bring the capital account balance to zero at the time of liquidation or exit from the LLC.
Capital structure also is an incredibly important consideration for all members. Often, when starting a business, members elect to contribute funds, assets or property to a company. This structure can be advantageous by allowing the company to maximize its cash flow during the startup phase and provides the owners with the long-run benefit of any appreciation in the value of the company.
There are risks associated with capital contributions. When a party will not have control over the management of a company, it should understand the conditions under which the majority party may be able to either force the party to make capital contributions to the company or, alternatively, dilute the party if it elects not to make additional capital contributions.
Sometimes, when a party wishes to minimize the risk of its investment and improve its upfront likelihood of a return, it may wish to instead loan funds to a company. This allows a party to get paid prior to distributions to owners and may allow the party making the loan to fight other creditors for assets if the company fails. Additionally, parties that make loans can structure the loan so it is convertible to equity, allowing the lender the opportunity to either guaranty the early repayment of its funds or to share in upside gain by converting its loan.
At the time a company is formed, matters related to the economic relationship between the parties should be addressed to reduce future disagreements and risks to the founders of the company.