Jack had worked for a pest-control company for years. But the ownership had changed hands, and Jack didn’t like the way the new owners treated the long-time customers whose homes and businesses Jack serviced. So Jack quit to plan his own exterminator business. He had to wait a year for his non-compete agreement to expire, but when it did, he was all set up with his new LLC. And Jack had spent the year quietly acquiring the vehicle, equipment, and supplies he would need to jump right into business on the one-year anniversary. Jack was surprised at the money it had taken to get started but glad he had found the sources.
Finances
Businesses generally require some amount of start-up finances. Nearly no matter what business you decide to conduct, you’re going to need at least a few things to get started, things that cost at least some money. Some businesses are notorious for needing substantial start-up capital. Other businesses have a relatively low entry threshold. Do some research into the average start-up cost in your field, before you plan and launch your LLC business. Make a start-up expense budget, and compare it to the average start-up costs in your field to be sure you’re being realistic. Then plan to raise the necessary capital. Don’t start your LLC without counting the cost. Otherwise, your LLC may fail for lack of financial planning and start-up resources.
Contributions
Member contributions are the primary source for LLC start-up costs. Many individuals who organize a new LLC have planned to do so for years, including saving for start-up costs. Other organizers of LLCs plan to recruit other members specifically for the capital they may bring, effectively as investors in the LLC’s business. The organizer may have the time, skill, and experience, while one or more members have no time, skill, or experience but available funds. Or the organizer may recruit LLC members who, like the organizer, have a healthy mix of funds, time, and skill to contribute. The LLC’s organizer may offer contributors membership interests in exchange for their contributions. If all agree, they execute the operating agreement indicating the contribution amounts, which the contributors may then pay into the business as promised and arranged.
Sources
Members may get their cash contributions from any number of sources. They may have worked for some time for another employer, saving up funds with which to start their own business. They may have a working spouse or other working family member willing to give, share, or loan funds for a start-up contribution. Individuals wishing to make a contribution in exchange for a membership interest may sell property they own to raise the necessary funds, or they may even borrow the funds, using a home-equity loan or loan secured by other assets. Some LLC organizers might even draw funds from their personal credit cards for start-up contributions. Beware incurring debt for LLC start-up contributions, especially at exorbitant interest rates or secured by a home or other precious asset, the foreclosure of which you could not stomach. New businesses can be risky propositions. Plan to succeed, but anticipate and minimize the consequences in the event you fail.
Loans
Members may loan money to the new LLC business rather than or in addition to making a cash contribution. Making a start-up loan rather than or in addition to a cash contribution is one way to get back some of the contributed cash, if the LLC’s business makes enough cash to repay the loan. Members are generally more willing to loan money to a new LLC than to give money to the LLC. The practical effect for both sides is the same. The member transfers the money to the LLC, and the LLC uses it for start-up and operating costs. But the outcome may be different. A member loaning start-up funds may have priority for the funds’ repayment, before the LLC makes member distributions, again assuming that the LLC profits. If you need to raise more capital than members are willing to contribute, then consider arranging loans rather than or in addition to contributions.
Credit
You may also finance your LLC’s operations through lines of credit. Banks offer business lines of credit, usually secured against LLC accounts receivable and any other LLC assets. Banks also often require personal guarantees from the LLC’s members to secure a business line of credit. A line of credit can be highly useful to manage the highs and lows of cash flow. Beware using a line of credit to finance start-up costs, when income to service and repay the line of credit may be uncertain. Suppliers may also extend credit so that the LLC can get started with supplies before having to pay for them. The LLC may also find a loan available to the LLC through a relative of a member or similar unconventional source. Borrow with caution and a clear eye to having to pay loans back.
Security
Beware offering security for LLC lines of credits or loans. Lenders can foreclose on, seize, and sell security if the LLC violates the terms of the loan, especially by failing to timely repay it. Lenders to new LLC businesses often require security. The security may take the form of the LLC’s pledge of the LLC’s accounts receivable, mortgage of any LLC real property, and lien against any LLC personal property like equipment, inventory, and vehicles. You may have to offer the lender security to obtain a line of credit or loan for the LLC. But read and understand the terms of the security agreement. Be sure that the lender doesn’t prevent you from using the security, such as selling inventory, converting supplies, or leasing a premises, in a way that prevents you from conducting the LLC’s business.
Guarantees
Avoid personal guarantees on LLC loans if possible. Your purpose in forming an LLC may have been to limit business liability to the LLC entity. By personally guaranteeing a loan, you lose the limited liability as to that LLC loan obligation. If the LLC defaults on the loan, the lender may recover from you personally on your guarantee. Anytime you pledge a personal asset for a business risk, or pledge the assets of one of your businesses for the obligations of another of your businesses, you substantially increase your personal financial risks by cross-collateralizing obligations. If the failure of one business can bring down not only that business’s finances but also your personal finances and the finances of your other businesses, you’ve undertaken risky business. If you can, avoid personal guarantees and having one of your businesses guarantee the obligations of another one of your businesses. Don’t build a house of cards.
Cards
Speaking of cards, credit cards are another potential source of LLC start-up capital or operating capital. Credit card companies often offer credit to businesses with no earnings history and no assets. Credit card companies may even do so without requiring a member’s personal guarantee and without requiring other security. Credit card companies justify their doing so by charging exorbitantly high interest rates. While a business loan from a bank might come at the prime rate plus 5% to 8% annual interest, and so around 9% to 12%, credit card companies may charge double that interest rate. Avoid using credit cards for start-up or operating capital. Many LLCs fail due to accumulating credit card debt, compounded with fees and interest.
Calls
LLCs often reserve the right in their operating agreement to call on members to contribute additional capital, beyond the initial capital with which they obtained their membership interest. If, for instance, your LLC runs short of operating funds to pay current obligations, a majority of its members may call on all members to put up additional capital to meet the LLC’s needs. If, for another example, a majority of the LLC’s members see a new business opportunity to pursue, requiring additional capital, they may make a similar call for capital contributions. As explained in a prior chapter, the operating agreement may call for diluting the non-contributing member’s percentage interest if other members make the contribution in the non-contributing member’s place. Alternatively, other members may loan the LLC the funds the other member fails to contribute, treating the loan as an unmet obligation of that other member to reduce that other member’s future distributions.
Accounting
In whatever manner you help your LLC finance its start-up capital and obtain additional operating capital later, keep accurate records of capital contributions and unmet obligations to make contributions. Capital contributions aren’t simply gifts of cash. They instead represent ownership interests. The LLC’s manager should consider the LLC obligated to respect the continuing value of those capital contributions. If the LLC is not earning members a reasonable return on their capital contributions, then the LLC should probably be modifying its operations until it can do so. Determine your field’s benchmarks for capital to earnings, capital to debt, and other ratios, to ensure that your LLC remains financially viable and suitably rewarding. Accurate accounting can help you do so. If you don’t have the accounting skills, then learn them or retain them. Financial skills are key to a successful business.
Key Points
An LLC raises capital through member contributions.
An LLC can also raise capital through member and bank loans.
An LLC can raise operating capital through supplier credit.
Avoid credit card debt for operating capital because of its high cost.
An LLC can meet shortfalls in operating capital through member calls.
Avoid personal guarantees and beware security for LLC debts.
Account accurately for your LLC’s finances.