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Here's How To Choose The Right Legal Entity For Your Business

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Oct. 12 2022, Published 8:05 a.m. ET

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According to Forbes, The 2021 State of Latino Entrepreneurship Report shows that Latino-owned businesses are growing faster than other businesses in the U.S. However, this good news is tempered by a disparity in how Latino-owned firms were able to raise capital. According to the report, Hispanic-owned businesses are more likely to encounter obstacles while obtaining the funding needed to start and grow their businesses, despite Hispanic-owned and white-owned businesses posing a similar credit risk.

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A company’s business structure may be one factor that weighs into a lender’s or investor’s decision-making regarding investment funding. So choosing the correct legal entity from the beginning may make it easier for Latino-owned businesses to raise money and grow. Here’s what to know about how each legal structure can raise capital and how to change your business structure if needed.

Sole Proprietorships

Although a sole proprietorship is the easiest and least costly business structure to establish, it may be the least attractive to investors for funding purposes. Here’s why:

  • In a sole proprietorship, the business has no legal separation from the business owner. In other words, the business’s assets, profits, losses, and debts belong to the owner, not the company.
  • Lenders and investors use the owner’s personal credit profile to assess the borrower’s ability to be financed.
  • Most owners of sole proprietorships need to provide a personal guarantee, some collateral, or both, for loan and investment approval.
  • Business credit card approval also relies on the strength of the business owner’s personal credit score.
  • Sole proprietorships cannot offer shares in the business, making investment funding impossible. To provide a piece of the company as an incentive, business owners can structure their business as a partnership.
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Partnerships

In a partnership business, the legal and money responsibilities are divided among the partners, which may or may not help secure funding.

  • Lenders with two or more partners have more credit history on which to base their funding decisions. Strong credit profiles could mean a better chance for loan approval; however, even one bad credit score or delinquency could mean rejection.
  • One partnership funding option is equity financing, which allows existing or new partners to invest in the business.
  • Unless otherwise documented in the partnership agreement, all partners share equally in the company’s profits, losses, and responsibilities. Before bringing on new partners, it’s vital to decide whether that person will have an active role in the business’s operations or if they’ll be a silent partner. Typically, each partner receives shares in the company in proportion to the money they’ve invested.
  • Investors in a partnership also take on the partnership’s profits, debts, and responsibilities—something not all investors want to risk.
  • A Limited Partnership allows silent partners to invest in the company without having personal liability for the business’s debts and legal responsibilities. Be aware that the rules for Limited Partnerships vary by state.

Corporations

Unlike sole proprietorships and partnerships, forming a corporation will legally separate the business from the business owner(s), which provides owners and investors personal protection against the company’s liabilities. In addition, corporations are the preferred legal structure for lenders and investors.

  • Corporations build a separate credit profile from their owners, which allows the company to obtain corporate credit cards and loans based on the business’s credit history.
  • Private investors, such as venture capitalists and angel investors, may only want to fund a C Corp for the protection from personal liability it provides.
  • Lenders, such as banks or alternative lenders, also prefer that the business bear the burden of a loan, not the owner.
  • Corporations can sell stock in the business, allowing the owners to raise capital without necessarily bringing active partners into the company.
  • Corporations can offer an unlimited number of shares to raise money.
  • Shareholders only pay taxes on distributed dividends, not the corporation’s profits.
  • Shareholders can be businesses or individuals, foreign or domestic.
  • Shares in a corporation can be easily transferred.
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Limited Liability Companies (LLCs)

A limited liability company, or LLC, has the most flexible legal structure regarding personal liability and tax benefits. Like a C Corp, LLC owners (called members) also have limited liability protection which primarily shields their personal assets in case of a legal or money dispute. Regarding raising capital, the LLC has several funding options to pursue.

  • Although LLCs cannot sell shares, they can bring in new members to infuse money into the business.
  • LLCs can structure new members’ ownership rights to meet the business’s needs. For example, the primary members can specify in the LLC’s operating agreement how much or little responsibility new members have in the company’s daily management. Also, the number of shares the new members have is determined by the amount of money invested and how much work the member contributes.
  • Members can only lose up to the amount of money they have invested in the company.
  • LLCs are a “pass-through entity,” which means members are taxed on the profits and losses of the company.
  • Traditional lenders, such as banks, may ask LLC members for personal guarantees on loans, especially if the LLC has been in business for less than three years.

Changing Legal Structure

You may want to switch business structures for several reasons, with liability protection and funding options at the top. Although a structure conversion is possible at any stage of your business, not all states allow conversions. Depending on its current structure, some states may require the business to dissolve completely and form an entirely new company under the new structure. Before making any changes, discuss the options with your business attorney and accountant and check the rules in your home state.

The Struggle Is Real

Getting access to funding is a complex undertaking for any small business. Still, for Latino-owned companies, the challenge is even more significant, especially when dealing with large national banks, which use dated algorithms to wean out the “unbankable” companies. Be sure to explore all the available options for getting funding, such as adding partners or shareholders or changing your business structure if that’s an issue.

This article was written by Nellie Akalp and originally appeared on Score.

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Since 1964, SCORE has helped more than 10 million aspiring entrepreneurs. Each year, SCORE’s 10,000 volunteer business experts provide 350,000+ free small business mentoring sessions, workshops and educational services to clients in 300 chapters nationwide. In 2016, SCORE volunteers provided 2.2+ million hours to help create more than 55,000 small businesses and 130,000 jobs. For more information about starting or operating a small business, visit SCORE at www.score.org. Follow @SCOREMentors on Facebook and Twitter for the latest small business news and updates.

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