Structure
The legal structure you give your business matters. Businesses may organize as sole proprietorships, partnerships, limited liability companies (LLCs), subchapter S corporations, or C corporations. Our focus here on finance does not warrant full treatment of the various forms of business organization. Yet consider how a business’s legal structure can have financial implications. One significant financial consideration in choosing a corporate form is to limit the personal liability of owners. That liability may be on a long-term office lease, mortgage loan, or bank line of credit. That liability may also be related to products liability, premises liability, negligence liability, or malpractice due to the actions of one or more participants. Another financial consideration for businesses in choosing a legal structure is to avoid double taxation at both the corporate and personal levels. Consider each legal structure with these two concerns, liability and taxation, in mind.
⤠ Don’t withhold anything you owe and are able to pay. ⤟
Solos
Some business owners choose a proprietorship without any corporate form. Doing so avoids double taxation at the personal and corporate level. Sole proprietorships also reduce accounting expense and administrative complexity. Sole proprietors do not offer liability protection. Whatever liability the business accrues, its sole proprietor also accrues. Sole proprietors would be personally liable when signing leases, financing equipment purchases, and opening bank lines of credit. Any interruption of the practice, whether because of family or medical leave, or economic recession, could leave the sole proprietor with personal liability for all business debts.
Partnerships
Businesses have the option of organizing as partnerships. A partnership avoids double taxation. Partner earnings flow through the partnership to partners who pay the only income tax on those earnings. In that respect, partnerships accomplish a significant financial objective. However, partnerships do not protect partners from liabilities. Each partner remains liable for the partnership’s obligations, meaning that each partner is likely to be an individual defendant in any proceeding brought by a landlord, bank, or other partnership creditor. Each partner also remains liable for obligations incurred by the partnership through other partners. One partner’s malpractice becomes the liability of all other partners. While the flexibility and informality of partnerships can make them attractive, their pass-through liability has made them an increasingly disfavored legal structure.
⤠ Value the hidden timeless things over material exhaustible things. ⤟
Limited
Some states authorize a limited liability partnership as an alternative form. Limited liability partnerships have the same pass-through feature of a partnership for income-tax purposes, avoiding double taxation. Yet unlike a traditional partnership, limited liability partnerships restrict liability to the partnership, protecting individual partners. Individual partners do not ordinarily have the liability of the partnership for a lease, mortgage, equipment financing, or lines of credit. Limited liability partnerships thus look like a favorable form. Yet partnerships of all kinds face issues treating partners who join or withdraw. Every new or withdrawing partner technically creates a new partnership, complicating partnership agreements and administration.
LLCs
Limited liability companies (LLCs) are a popular business form. Limited liability companies satisfy all three interests, (1) pass-through income taxation, (2) liability limited to the entity, and (3) ability to add and remove members while reflecting their percentage interests in the company. State laws also authorize sole proprietors to form single-member LLCs. Sole proprietors doing business through a single-member LLC can obligate the company without obligating the sole proprietor, provided that the entities with whom the sole proprietor deals do not require a personal guarantee.
The first thing Pat did for his sole proprietorship was to form a single-member limited-liability company. He had bank accounts to open and service contracts to sign. Pat wanted to do both through a business entity rather than in his own name. He reviewed a few template LLC operating agreements and adopted one of them with few changes. The suppliers with which he then dealt accepted his LLC entity without requiring his personal guarantee. Yet Pat recognized that his LLC’s bigger value beyond limiting his liabilities was in helping him treat his business as something formal and serious. The moment that he handed out his first card with his LLC’s name on it, he felt on his way toward building something of lasting value.
Labor
Businesses use various arrangements to retain the labor necessary to produce their goods and services. Employment is one form, typically beginning with a probationary period. Be clear on the terms when retaining employees. By far most businesses retain employees at will, meaning terminable without cause for any lawful business reason or no reason. Avoid promising job security, unless you are prepared to live up to the promise. Retaining temporary employees through a temp service is an alternative, allowing a business to determine labor needs and evaluate candidates with greater flexibility than employee hires.
Costs
Beware employee costs. Those costs go well beyond base compensation. Employers not only withhold and pay over to the federal and state governments the employee portions of income taxes. Employers also match Social Security and Medicare taxes, known as FICA, and pay for unemployment and worker’s compensation insurance. Other employee benefits, potentially including health and dental insurance, disability insurance, paid vacation, paid sick leave, and retirement contributions, can add 25% or more to the base compensation costs.
⤠ Cheating workers of a fair wage brings condemnation. ⤟
Contractors
Treating workers as independent contractors rather than employees may be an alternative. Businesses do not incur employment tax, unemployment insurance, and benefits costs for contractors. But beware mischaracterizing employees as contractors, to avoid taxes and other employment obligations. The substance, not the form, of your business’s relationship with its workers determines its tax and other obligations. If you control a worker’s actions, dictating the time, tools, and methods, while hiring, disciplining, and firing, the worker is likely an employee, not an independent contractor, no matter what you call the worker.
Capital
Your business’s capital structure is also an important financial consideration. Capital is the owner’s financial contribution on which the business draws for operations, expansion, valuations, and other interests or needs. Some businesses start and operate with little investment. Yet if your business requires an office, supplies, furniture, equipment, a website, marketing, labor, and other startup costs, then you must contribute the necessary financial resources. You may have savings to contribute or investors who are willing to do so, or you may be able to borrow startup costs. Your cash contributions and cash contributions from investors represent capital contributions, while borrowing provides debt capital. Possible sources of capital include partner investment, partner loans, bank borrowing, loans from relatives, credit cards, and retained earnings.
⤠ Help another, and you’ll receive another’s help. ⤟
Equity
Equity is the value that owners hold in a business in excess of the business’s debt. Equity can depend on capital contributions, accumulation of retained earnings, and appreciation of business assets including intellectual property. You may not be thinking about your equity in the business as long as things are going well. But economic trends affect businesses and the equity that owners hold. Recessions tend to depress owner equity and increase business debt. The willingness of banks to extend loans to businesses can depend on equity to debt ratios. When an owner’s capital decreases or debt increases, lenders may require the owner to contribute more capital to secure the debt. And your equity in the business can have a lot to do with the business’s sale price, if you decide to sell. Pay attention to equity.
Contributions
Businesses acquire capital by contributions from their owners. Businesses may require their owners to contribute additional capital to expand, in a business downturn, or for other objectives. Businesses may also require capital contributions for a new owner, including current employees, to join other owners in the business. Some business partnerships distinguish between equity partners and non-equity partners. Equity partners own an interest in the partnership’s business while also sharing in the partnership’s profits. Non-equity partners do not own an interest but may still share in the partnership’s profits. Partners may prefer equity for its value or avoid equity for the risk of required contributions.
Accounts
Businesses with multiple owners should keep a capital account for each owner. Capital contributions need not be equal. An owner’s capital account records the amount of capital the owner has contributed. The business may then tie owner distributions (the amount the owner draws from the business for ownership) to the percentage of the owner’s capital account. Each owner gets a percentage equal to the percentage of the firm’s total capital the owner contributed. Businesses may alternatively pay interest to owners based on capital-account percentages. Tax law provides an advantage to owners who accept interest payments rather than draws, related to payroll taxes.
⤠ Don’t trumpet your generosity. Be generous in secret. ⤟
Accumulation
Businesses can also acquire capital by accumulating rather than distributing or spending earnings. When a business profits, the business may spend the profit on acquisitions, improvements, bonuses, or owner distributions, or may save and bank the profits to increase or replenish capital. Firms have various reasons for increasing capital and owner equity out of earnings. Increased equity can mean richer and happier owners. Or a business may need to replace capital out of earnings to offset increased debt due to acquisitions or improvements. The business’s bank may also require capital increases to maintain the firm’s line of credit.
Debt
Equity capital is not a business’s only financial resource. Companies also borrow to fund operations, expansion, and other interests and needs. Debt capital may involve longer-term bank loans to purchase a building, furniture, or equipment, or it may involve a revolving line of credit. The distinction between equity capital and debt capital is important. Debt capital enables owners to use someone else’s money rather than their own money to finance the business. But banks lend with conditions that influence a business’s mission and operation. Businesses heavy in debt may also find it harder to retain or recruit owners and employees.
Credit
Firms routinely maintain a bank line of credit to smooth out the roller coaster of cash flow. A line of credit secures the ability to borrow before the business needs it, on more-favorable terms than a lender might offer when the business needed it. A line of credit gives the business the option of borrowing or not borrowing on the business’s timetable and at its discretion. The business pays interest only when it invokes the line of credit. This discretion not only creates financial options but also improves the firm’s ability to make prompt commitments of new capital, to seize an opportunity. That flexibility increases a business’s negotiating power. On the other hand, a line of credit can tempt managers into making poor decisions on when to draw on the line to fund current operations or new ventures. A line of credit is still debt with all of its attendant risks and obligations.
⤠ Sharing with the poor brings hidden returns. ⤟
Security
Banks secure a firm’s line of credit with liens on accounts, receivables, equipment, and other firm assets. Banks examine accounts receivable and may lend as much as 80% against qualified receivables that have not aged unduly and involve reliable clients. Banks may also require personal guarantees from owners. The willingness of a candidate to guarantee a line of credit may determine whether a firm adds the candidate as an owner. Be cautious about personally guaranteeing what would otherwise be company obligations. Personal guarantees subject one’s household finances to business obligations, in what is always a dangerous cross-collateralization risk.
Alternatives
Companies have other ways of financing operations, acquisitions, or new ventures in the short term, in addition to capital infusions from owners or a bank line of credit. For smaller companies, especially for sole proprietors, credit cards can be one credit source, albeit an expensive one when comparing interest rates to conventional business loans. Some companies may be able to obtain short-term bank loans. Larger companies may find bond financing available. Venture capitalists may be willing to extend credit for special ownership or security interests. The risks associated with such actions are considerable.
Just before Erin started with her new company and Pat went solo shortly later, they had saved a little extra money that they felt they could devote to one or the other of those new ventures. They had figured that Erin’s launch would be more expensive because of the corporate nature of her work, and the higher service and compensation expectations. Yet they had figured wrong in one respect. While Erin’s new company did need more up-front capital to start serving its corporate clients, the older partners were able to attract debt-capital financing including a substantial line of credit secured against furniture, equipment, and receivables. Each of the older partners contributed $100,000 in cash to purchase furniture and office equipment but expressed to Erin and the younger partner that they had no immediate capital-contribution expectations for either of them. They would keep capital accounts and revisit capitalization later as the company grew. Pat and Erin were thus able to launch Pat’s sole proprietorship sooner than they had anticipated and with more capital than they had hoped. Things were working out well so far for both of them.
Working Capital
Analyze your business’s capital and debt structure to determine your business’s ability to pay coming debt. Ratios tell a business’s financial health. Working-capital ratio compares current assets to current liabilities, estimating your firm’s ability to pay short-term debts. Current assets are cash, receivables, and other assets available to spend within the coming year. Current liabilities are wages, rent, utilities, insurance, and other overhead due within one year. Working-capital ratio is current assets divided by current debts. If current assets equal current debts, then the working-capital ratio is 1:1, indicating a business just able to pay its debts. A working-capital ratio of 2:1 or 3:1 indicates a business’s ready ability to pay short-term debt. A working-capital ratio below 1.0 indicates a business’s inability to pay short-term debt. Use median working-capital ratios in your field to benchmark your business’s health. How healthy is the following firm?
[Table omitted. See print guide.]
Debt to Equity
Another measure, debt-to-equity ratio, helps you determine your firm’s ability to pay long-term debt. Debt-to-equity ratio is all short-term and long-term debt divided by capital, the latter meaning the difference of all assets and all liabilities. Unlike working-capital ratio, debt-to-equity ratio need not be 1:1 for your firm to appear solvent. Long-term debt may, within reasonable bounds, exceed capital without indicating insolvency. Two-to-one ratios of debt to equity would not be unusual, provided that the firm has good reason for the excess debt, such as an expansion or purchase and sound plans to service the excess long-term debt. Three-to-one debt-to-equity ratios and higher, though, would ordinarily raise cause for concern. Debt-to-equity ratios under 1.0 indicate more equity than debt and greater financial health and resources. Benchmark your business’s debt-to-equity ratio against your sector’s median.
⤠ Money can’t buy the most valuable things. ⤟
Value
A business’s value can depend in part on owner equity. Liquidation of the business should realize something close to the equity. But a firm acquires a different value as an ongoing concern. Some businesses operate and account on a cash basis, counting money in and money out. Other businesses operate on an accrual basis, not counting the cash but counting the value of work including (beyond the cash) work that is in progress, complete but unbilled, or billed but uncollected. Equity as an ongoing concern is the difference between cash accounting as the firm collects its fees and pays its expenses, and accrual accounting reflecting the uncollected work. Owners who build equity in a firm by increasing the firm’s productive and collectible work over amounts actually collected can sell that equity when retiring or otherwise departing.
⤠ Turning away from the poor brings curses. ⤟
Monitoring
You should monitor and manage your business’s income, profit, cash flow, and equity. Failure in any of these areas can disrupt your business operations. Failure to monitor equity may result in the defection of partners and termination of credit lines. Failure to monitor revenue may mean conceal declines in paying customers or clients, discovered too late for a turnaround. Failure to monitor profits may mean production without net gain, wasting capital, opportunity, and effort. Failure to monitor cash flow may mean inability to pay suppliers timely, ruining relationships and reputation even when the business is otherwise financially healthy. Ignore any of the four measures of income, profit, cash flow, and equity at your business’s peril.
Erin and Pat had frequent conversations about their new businesses’ finances—too many, they would joke with one another, even as they knew that their conversations were helping each other learn and were giving them another strong connection. In those conversations, they agreed that cash flow was the greatest challenge. Equity interested them. Erin sometimes felt a twinge of regret that she had not insisted on matching her older partners’ initial capital contributions because she wanted a sense of equal ownership in her company. Pat was always pleased when his sole proprietorship seemed to have a little bit of value of its own, which was ever more the case since he had hired his first employee. Both Erin and Pat paid close attention to keeping revenues up, just as they watched expenses closely so as to ensure decent profit on those revenues. Yet cash flow was all at once the hardest to predict and the most important day to day. They had much yet to learn but were pleased at their early progress.
Valuation
Owners and managers have two primary ways of valuing businesses, first as a going concern and second in liquidation. Goodwill, an important accounting concept, is the difference between the two valuations. Goodwill is the difference between what an acquirer pays for a firm and the value of the firm’s assets. When an acquirer purchases a firm, it tends to pay significantly more for the firm than the value of its assets in dissolution. Firms are usually worth more operating than dissolving—at least those firms that anyone is willing to purchase. When an acquirer purchases a firm, it represents on its books as goodwill the difference between the price it pays and the value of the acquired firm’s net assets. You may prefer to think of goodwill as the value of the firm’s reputation. Going-concern value depends on earnings. Buyers value firms based on a multiple of earnings. Effective management ensures that a firm’s going-concern value substantially exceeds the dissolution value of its assets.
⤠ Loving money gives a root for all kinds of evil. ⤟
Return
Earnings multiple for the going-concern value of a firm has one drawback. Earnings multiple does not account for the capital invested in the firm. A firm might look like it has substantial value based on anticipated earnings over the next several years, but if the firm has substantial capital invested in the firm, then the firm’s value is not as great as it may look. The investors might have done just as well by investing their capital in mutual funds or even certificates of deposit. A better way to measure going-concern value is with a figure called internal rate of return (IRR). Earnings multiple is a rough way of calculating the present value of a future income stream. To calculate a firm’s internal rate of return, you first project the firm’s future cash flow, then calculate the discount rate that makes that future cash flow equal the amount of capital invested in the firm (for a buyer of the firm, its purchase price). That discount rate is the firm’s internal rate of return, meaning in effect the annual percentage that the purchase would earn on the capital invested. The internal rate of return should substantially exceed the percentage that the purchaser could earn by investing the capital elsewhere, whether in the stock or bond market or by purchasing a different firm.
Checklist
Reflect, research, investigate, and act until you are able to confirm each of the following statements summarizing the advice and counsel in this section:
I pursue my business within a legal structure that provides the best capitalization, tax treatment, liability protection, governance, succession, and other conditions and opportunities.
I pursue my business with adequate resources acquired and maintained through a responsible capital structure that recognizes return on equity and pursues equity increases.
Any line of credit or other debt on which my business depends falls within reasonable and regularly monitored working-capital and debt-to-equity ratios ensuring debt repayment.