Small Business Legal Structures - Big Is Better, But Not Always
The legal structure of a small business may also play a role in determining the terms and conditions of a project’s financing. The following are examples of common legal structures:
Sole proprietorship is a type of business entity in which there is no legal distinction between the owner and the business. Profits (and losses) go directly to the owner(s) and are reported on his/her personal income tax returns. In a sole proprietorship, the owner’s credit history is one of the primary considerations for a loan approval along with time in business, prior loan history, and trade references.
A general partnership in civil law refers to the participation of two or more individuals in a common business activity. Individuals are personally liable (jointly and individually) for the obligations of the general partnership. As such, all partners’ personal credit histories are primary considerations for loan approvals along with time in business, prior loan history, and trade references.
Corporations are considered natural persons under the law and can enter into their own contracts (including loans). A corporation’s legal exposure is limited to its balance sheet, which excludes the owner’s personal assets. There are different kinds of corporations:
A “C corporation” is taxed as a stand-alone entity, meaning earnings may be subject to “double taxation” (once at the corporate level and again as dividends to the owners). C corporations may be able to obtain credit without the owner’s personal guarantee if the corporation has done so in the past for a similar or larger lending amount and can show profitability and a strong balance sheet. However, most small business C corporations are required to give the personal guarantee of the owners to obtain financing, especially when the owner is needed to run the business.
A “Sub-chapter S corporation” is not considered a tax-paying entity and passes all profits (and losses) on to the owners. This type of corporation fits somewhere between sole proprietorships and C corporations when it comes to the need for the owner’s personal guarantee on loans.
In general, small businesses that are commercial properties or projects involving real estate are organized as either Limited Partnerships (LPs) (wherein financial exposure (liability) is limited to the assets of the Limited Partnership and the general partner, but not to the limited partners) or Limited Liability Companies (LLCs) (a blend of partnership and corporate benefits by limiting liability to the balance sheet and passing tax obligations to the owners). There are two kinds of partners in a Limited Partnership: General and Limited. The General Partner is the managing partner. Typically the General Partner is a corporation, which, in turn, provides individual owners with legal protection against creditors.
Upon credit evaluation, many LPs and LLCs have balance sheets that reflect small equity positions in the company. These firms frequently operate at a tax loss, and positive cash flows realized from operations are often distributed to the owners. Financial institutions usually request personal guarantees on loans to LPs and LLCs, especially when the balance sheet is not strong.
Even when a small business is legally considered a separate entity from its owners, with separate liabilities and assets, the personal guarantees of the owners of small businesses are usually required to obtain credit from traditional lenders (e.g., a bank, leasing company, or commercial lender) unless the business has been established under the same ownership for many years (10+), has a strong balance sheet, predictable positive cash flow, and professional management in place.
In summary, smaller businesses often find it more difficult to obtain loans than larger businesses. When they can obtain financing, it is often at a higher interest rate with shorter terms and requires additional collateral and guarantees. In general, owners must demonstrate a personal net worth in excess of the amount being borrowed, and they must support the borrowing via personal guarantees. Some commercial lenders will fund up to $100,000 for any kind of project simply based on the personal credit report and FICO score of the owners.