Updated: Jan 26, 2022
Many small businesses depend on infusions of cash from their owners in order to start up, meet cash flow needs or finance expansion plans. The infusions can be nominal, such as small sums needed to meet an unexpected emergency, or can be substantial, as a way to start a business. How the advance is treated by the owner and business impacts tax treatment and whether the advance is repayable to the member who made it.
Three Types of Investments in Small Business
There are three primary ways to secure capital for your business: equity investments, debt investments, and convertible debt.
Equity Investment: When the company receives an equity investment, an investor contributes funds to the business in exchange for a stake in your company. These are also referred to as capital contributions. A capital contribution can be cash, property, services rendered, or other obligation to contribute cash or property or to perform services. While accepting these investments means giving up a portion of your company’s earnings, it can also mean bringing on well-qualified partners who are motivated to help your business succeed.
Debt investment: A debt investment is simply a loan you accept to get your business up and running. This is the most common form of capital for new businesses. Generally, a business owner will set an interest rate they are willing to pay and a general time frame for repayment when seeking out debt investors. The members of the business may also loan money to the company, separately from their capital contributions. The terms of a member loan to a business, like any other owner loan, should be documented carefully in a business loan agreement specifying the amount, interest rate, repayment terms, and default provisions. A loan by a member does not change the member's capital contribution or distribution of profits and losses. To receive a debt investment, you will usually need some collateral to back up your loan. While it’s possible to receive a loan without it, lack of collateral will often limit the amount of money you’re able to secure or will make the costs of the loan much higher.
Convertible debt: This is essentially a combination of the other two options. When a business owner takes on a convertible debt they accept a loan while agreeing to either repay the money or convert the debt into equity at some time in the future. Typically, the business owner will offer a discount of 20% to 25% when the debt is converted to equity, meaning a $1 million investment could potentially yield $1.25 million worth of equity at the time of conversion.
Pros and Cons of Capital Contributions vs. Loans
The classification of the advance of money to the company by a member or lender has a variety of implications for the company and the person making the advance.
Equity investments are an attractive option to business owners because they provide funding that does not need to be repaid. In addition, they are not reflected as company liabilities on the company books. When the company is seeking a loan, the lender looks at company liabilities to determine the creditworthiness of the company. Having fewer loans on the books will be viewed favorably by the lender. The downside for members making capital contributions is that they are not necessarily repayable. Most operating agreements for limited liability companies provide that members are not entitled to a return or repayment of their capital contributions, even when they leave the company.
If it is a loan, then the repayment of principal is tax free to the lender although interest paid on the loan is taxable. The company can also deduct interest paid on the loan, reducing the amount of profit that is passed through to the owners and taxed at their individual rates. For the member/lenders, they are entitled to be paid back and get a priority in the pecking order of payments that the company makes. In short, loans must be paid before members receive distributions.
Document Capital Contributions and Loans
Often, business associates feel as if they do not need to have everything in writing. This is particularly true if they have gone into business with friends or relatives. Not taking the steps to secure written financial details can have disastrous effects on the business as well as on the relationship between the partners. These usually happen when the business or the relationships between the parties breaks down.
A recent business divorce case provides an excellent example of why it’s important to document member investments into the business. Two acquaintances formed a real estate development company in the form of a limited liability company (LLC). When the business failed, a lawsuit ensued over whether each partner had made a capital contribution – which would be a business asset – or a loan to the LLC – which would be payable as a business debt. Partner number one alleged that he made capital contributions totaling $523,000.00 while the business was operating. He also argued that the second member, who had not invested money into the company, owed a like amount to the company. If successful, this would have forded partner number two to contribute a like amount, that would be used to pay debts or at least reduce the debts paid from partner number one’s investment.
The second member argued that he had no obligation to make any capital contributions because the operating agreement did not list any capital to be contributed by either member. The second member never signed an agreement obligating himself to make capital contributions to the company. Partner number two alleged that the funding provided by partner number one was in the form of loans, not capital contributions.
The Court agreed with the second member, finding that the operating agreement was ambiguous as to whether initial capital contributions were required by each member of the LLC. At the end of the day, despite an arrangement where the first member thought he was responsible for only half of the business debt, the first member lost out on hundreds of thousands of dollars. Let that serve as a wake-up call: if your capital contributions and other important financial agreements are not well-documented, you are at risk.
It is impossible to predict which business arrangements are destined to break down. Businesses co-owned by friends or relatives are just as likely to run into problems as any other business.
The experienced business attorneys at Fiffik Law Group launch hundreds of businesses each year and have guided thousands of business owners in making smart decisions for their companies. We can help you too. Contact us today and get your business on the right track.