The Perfect Business Entity For Passive Investors

Business entities are some of the most misunderstood legal tools on the market. Many people just form them because it is something you are supposed to do. In truth, the various entities are designed for specific purposes. Let’s consider a common scenario.

You’ve come up with the greatest business idea since sliced bread. The only problem is you need some capital to get the business off the ground. You’ve found a few investors who are willing to pony up some money so long as they are not put in a position of risk. Now what?

This happens all of the time. The passive investors are usually friends and family members. They are willing to help out, but remember some of the more “interesting” events of your youth and don’t want to risk their homes and so on. Is there any particular way to go about meeting the goal of getting your funding without putting them at risk? Of course.

Our magic entity is known as the limited partnership. To understand the value of this entity, we first have to step back and discuss the concept of a general partnership.

A general partnership is a business venture undertaken by two or more people for a profit so long as no other business entity, a corporation or limited liability company, has been designated as the official business. A general partnership may exist even if the two parties don’t put anything in writing. The classic scenario of two kids selling lemonade in the front yard is an example of a partnership.

The advantages of the general partnership are two fold. First, they are not formal entities. You can pretty much do everything orally and not run afoul of any laws regulating how a business entity should work. Second, you can pass the tax liability directly down to your personal taxes, which lets you avoid double taxation issues that arise with other entities.

The downside to a general partnership, however, is found in the liability area. Basically, a general partnership provides you with none. If the business gets sued, your home, car, bank account and so on are all on the line. This represents a huge risk and is one of the reasons a general partnership is frowned upon by most people when it comes to selecting business entities.

A limited partnership takes the best aspects of the general partnership and mixes them with a dash of the advantage of incorporating. It works like this. There is a general partner. That partner then sells limited partnership interests. People who buy the interests cannot participate in the running of the partnership. The can only collect profits when the general partner decides to do distributions. In exchange for this passivity, the limited partnership can only lose their investment in the limited partnership and nothing else. In short, they get the same protection afforded a shareholder in a corporation.

So, why is our limited partnership such a magic entity? Well, go back to our initial scenario. We have passive investors who are willing to pony up money, but do not want to put their personal assets at risk. If you form a limited partnership, this can be accomplished by having them by limited partnership interests. You get the money and the only risk they face is the loss of the money they paid for the interest.

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Business Entities – Avoid These Pitfalls

In our modern society, you can get sued for just about anything. All it costs is a couple hundred dollars to file a lawsuit. If you are starting a business, you need to protect yourself.

Given the number of lawyers [including me] and lawsuits in the country, most business owners know it is wise to open a business entity to protect their personal assets from lawsuits. By definition, businesses offer something to the public be it services or goods. Inevitably, a problem arises. The problem can turn into a full blown dispute and then lawsuits are filed. If your business is not protected by a business entity, this can result in a judgment that can be collected both from business assets and your personal assets. In short, a disaster. Forming a business entity creates a shield that protects your personal assets from such judgments so long as you stay away from general partnerships.

While you probably already know you need a business entity, you probably do not know there are pitfalls to avoid when forming them. Knowledge is the key and knowledge I will give you. Here we go…

1. Equal Equity – In many situations, a business is owned by two people. When they go to form an entity, they often each take a 50 percent share. This is a mistake. Why? If a dispute arises, how are you going to solve it? Each party has 50 percent of the voting shares, to wit, a decision cannot be made. In a worse case scenario, a judge may resolve such a dispute by dissolving the business and distributing half of the assets to each. So much for your future business plans. If nothing else, you are looking at total deadlock in the business.

2. How Many Businesses? – Another major problem I see with businesses is they often come up with multiple ideas that work, but put them all at risk by using the same business entity. If you have multiple business lines, form a distinct business entity for each one. If one gets sued, the others will not be impacted or face the risk of a judgment.

3. Equity is Gold – The equity in a business entity, such as shares in a corporation, should be treated as gold coins. Would you haphazardly give out gold coins? Of course, not. Yet many businesses will trade large amounts of ownership equity for relatively small sums. This often occurs at the outset of the business when money can be tight. If the business takes off, keep in mind it will grow in value. As it grows, you will really regret giving away 10 percent of the ownership for $20,000 to loan shark Lou. If you need cash, try to get loans from people secured by stock in the business.

Once you make the decision to form a business entity, you need to take the time to think through what you are doing. How will problems be resolved? How will ownership be handled? How much money will you need and where will it come from? All of these questions must be addressed or you could really regret the decisions you made down the line.

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