Impact of Organization Type on Finance Decisions

Selecting the form of business organization that is adopted by a business depends on many factors. One could begin by anticipating the eventual size and nature of the business.“Types of Business Organizations,” BusinessFinance.com, accessed December 2, 2011, www.businessfinance.com/books/startabusiness/startabusinessworkbook010.htm. The complexity of a business may dictate the type of business organization that is adopted. However, many of the factors that go into this determination are either directly or indirectly financial in nature. The indirect factors are as follows: the extent to which a business owner wishes to attain control of the business, the relationship that the owner would have with partners or investors, and the perceived risk associated with the business. This last factor is tied to the question of the extent to which the owner will invest his or her own money and assets. The direct financial factors that go into selecting the type of the business organization include the following: expected profits or losses, tax issues, the vulnerability and threat from lawsuits, and the ability to extract profits from the business for the owner’s use. The federal government recognizes six forms of business organizations for tax purposes: sole proprietorshipThe most basic type of business organization in which there is only one owner., partnership, C-corporationA legal entity that must be chartered by the state in which it is headquartered, giving it the capability to enter into legal agreements with individuals and other corporations., S-corporationA special format designed to eliminate the problem of double taxation that one might find with a C-corporation format., trust, and nonprofit. The last two are unlikely to be adopted by small businesses. It is useful to examine the financial implications of organizing along the remaining four basic formats.

Acquisition of Funds

Capital is the lifeblood of all businesses. It is needed to start, operate, and expand a business. Capital comes from several sources: equity, debt, internally generated funds, and trade credits (see Figure 10.1 "Sources of Capital").

Figure 10.1 Sources of Capital

Equity financing raises money by selling a certain share of the ownership of the business. It involves no explicit obligation or expectation, on the part of the investors, to be repaid their investment. The value of equity financing lies in the partial ownership of the business.

Perhaps the major source of equity financing for most small start-up businesses comes from personal savings. The term bootstrapping refers to using personal, family, or friends’ money to start a business.“Financing,” Small Business Notes, accessed December 2, 2011, www.smallbusinessnotes.com/business-finances/financing. The use of one’s own money (or that of family and friends) is a strong indicator that a business owner has a strong commitment to and belief in the success of the business. If a business is financed totally from one’s personal savings, that means the owner or the operator has total control of the business.

If a business is structured as a corporation, it may issue stock. Generally, two major types of stock may be issued: common stock and preferred stock. It should be noted that in most cases, owners of common stock have what are known as voting rights. They have a proportional vote (directly related to the number of shares they own) for members of the board of directors. Preferred stock does not carry with it voting rights, but it has a form of guaranteed dividend.

Corporations that issue stock must comply with several steps to meet both federal and state statutes, including the following: outlines to issue stock to shareholders, determining the price and number of shares to be issued, creating stock certificates; developing a record to record all stock transactions; and meeting all federal and state securities requirements.“Checklist: Issuing Stock,” San Francisco Chronicle, accessed December 2, 2011, allbusiness.sfgate.com/10809-1.html. Smaller businesses may choose to issue stock only to those who were involved in the initial investment of the business. In such cases, one generally does not have to register these securities with state or federal agencies. However, one may be required to fill out all the forms.“How to Form a Corporation,” Yahoo! Small Business Advisor, April 26, 2011, accessed February 1, 2012, smallbusiness.yahoo.com/advisor/how-to-form-a-corporation -201616320.html.

Chapter 5 "The Business Plan" discusses two sources of capital investment: venture capitalist and angel investors. Venture capitalists are looking for substantial returns on their initial investment—five, ten, sometimes even twenty-five times their original investment. They will be looking for firms that can rapidly generate significant profits or significant growth in sales. Angel investors may be more attracted to their interest in the small business concept than in reaping significant returns. This is not to say that they are not interested in recouping their original investment with some type of significant return. It is much more likely that angel investors, as compared to venture capitalists, will play a much more active role in the decision-making process of the small business.

One area for possible capital infusion into a small business may come from a surprising source. Many students (and some adults) may find funding to start up a business through business plan competitions. These competitions are often hosted by colleges and universities or small business associations. The capital investment may not be large, but it might be enough to start very small businesses.

Debt financing represents a legal obligation to repay the original debt plus interest. Most debt financing involves a fixed payment schedule to repay both principal and interest. A failure to meet the schedule has serious consequences, which might include the bankruptcy of the business. Those who provide debt financing expect that the principal will be repaid with interest, but they are not formal investors in the business.

There are numerous sources for debt financing. Some small businesses begin with financing by borrowing from friends and family. Some firms may choose to finance business operations by using either personal or corporate credit cards. This approach to financing can be extraordinarily expensive given the interest rates charged on credit cards and the possibility that the credit card companies may change (by a significant amount) the credit limit associated with the credit card.

The largest source of debt financing for small businesses in the United States comes from commercial banks.“How Will a Credit Crunch Affect Small Business Finance?,” Federal Reserve Bank of San Francisco, March 6, 2009, accessed December 2, 2011, www.frbsf.org/publications/economics/letter/2009/el2009-09.html. Bank lending can take many forms. The most common loan specifies the amount of money to be repaid within a specific time frame for a specific interest rate. These loans can be either secured or unsecured. Secured loans involve pledging some assets—such as a home, real estate, machinery, and plant—as collateral. Unsecured loans provide no such collateral. Because they are riskier for the bank, they generally have higher interest rates. For a more comprehensive discussion of bank loans, see Section 10.2.1 "Relationships with Bank and Bankers".

The Small Business Administration (SBA) has a large number of programs designed to help small businesses. These include the business loan programs, investment programs, and bonding programs. The SBA operates three different loan programs. It should be understood that the SBA does not make the loan itself to a small business but rather guarantees a portion of the loan to its partners that include private lenders, microlending institutions, and community development organizations. To secure one of these loans, the borrower must meet criteria set forth by the SBA. It should be recognized that these SBA loan rules and guidelines can be altered by the US Congress and are dependent on prevailing economic and political conditions. The following subsections briefly describe some of the loan programs used by the SBA.

Capital Structure: Debt versus Equity

A critical component of financial planning for any business is determining the extent to which a firm will be financed by debt and by equity. This decision determines the financial leverageThe proportion of a firm that is financed by debt and by equity. of a business. Many factors enter into this decision, particularly for the small business. From the classic economic and finance perspective, one should evaluate the cost of both debt and equity. Debt’s cost centers largely on the interest rate associated with a specific debt. Equity’s cost includes ceding control to other equity partners, the cost of issuing stock, and dividend payments. One should also consider the fact that the interest payment on debt is deductible and therefore will lower a business’s tax bill.Gavin Cassar, “The Financing of Business Startups,” Journal of Business Venturing 19 (2004): 261–83. Neither the cost of issuing stock nor dividend payments is tax deductible.

Larger businesses have many more options available to them than smaller enterprises. Although this is not always true, larger businesses can often arrange for larger loans at more favorable rates than smaller businesses.Lola Fabowale, Barbara Orse, and Alan Riding, “Gender, Structural Factors, and Credit Terms between Canadian Small Businesses and Financial Institutions,” Entrepreneurship Theory and Practice 19 (1995): 41–65. Larger businesses often find it easier to raise capital through the issuance of stock (equity).

By increasing a business’s proportion of debt, its financial leverage can be increased. There are many reasons for attempting to increase a business’s financial leverage. First, one is growing the business with someone else’s money. Second, there is the deductible nature of interest on debt. Third, as more clearly shown in Section 10.3.2 "Capital Structure Issues in Practice", increasing one’s financial leverage can have a positive impact on the business’s return on equity. For all these benefits, however, there is the inescapable fact that increasing a business’s debt level also increases a business’s overall risk. The term financial leverage can be seen as being comparable to the base word—lever. Levers are tools that can amplify an individual’s power. A certain level of debt can amplify the “lifting” power of a business (see the upper portion of Figure 10.2 "Acceptable and Unacceptable Levels of Leverage"). However, beyond a certain point, the debt may be out of reach, and therefore the entire lifting power of financial leverage may be lost (see the lower portion of Figure 10.2 "Acceptable and Unacceptable Levels of Leverage"). Beyond the loss of lifting power, the assumption of too much debt may lead to an inability to pay the interest on the debt. This situation becomes the classic case of filing for Chapter 1 "Foundations for Small Business"1 bankruptcy.

Figure 10.2 Acceptable and Unacceptable Levels of Leverage

This major issue for small businesses—determining how to raise funds through either debt or equity—often transcends economic or financial decisions. For many small business owners, the ideal way of financing business growth is through generating internal funds. This means that a business does not have to acquire debt but has generated sufficient profits from its operations. Unfortunately, many small businesses, particularly at the beginning, cannot generate sufficient internal funds to finance areas such as product development, the acquisition of new machinery, or market expansions. These businesses have to rely on securing additional capital debt, equity, or some combination of both.

Many individuals start small businesses with the express purpose of finding independence and control over their own economic and business lives. This desire for independence may make many small business owners averse to the idea of equity financing because that might mean ceding business control to equity partners.Harry Sapienza, M. Audrey Korsgaard, and Daniel Forbes, “The Self-Determination Mode of an Entrepreneur’s Choice of Financing,” in Advances in Entrepreneurship, Firm Emergence, and Growth: Cognitive Approaches to Entrepreneurship Research, ed. Jerome A. Katz and Dean Shepherd (Oxford: Elsevier JAI, 2003) 6:105–38. Another issue that makes some small business owners averse to acquiring additional equity partners is the simple fact that the acquisition of these partners means less profit to the business owner. This factor in the control issue must be considered when the small business owner is looking to raise additional capital through venture capitalist and angel investors.Allen N. Berger and Gregory F. Udell, “The Economics of Small Business Finance: The Roles of Private Equity and Debt Markets in the Financial Growth Cycle,” Journal of Banking and Finance 22, no. 6–8 (1998): 613–73.

A recent research paperRowena Ortiz-Walters and Mark Gius, “Performance of Newly Formed Micro Firms: The Role of Capital Financing Structure and Entrepreneurs’ Personal Characteristics” (unpublished manuscript), 2011. examined the relationship between profitability and sources of financing for firms that had fewer than twenty-five employees. It found several rather interesting results:

• Firms that use only equity have a low probability of being profitable compared to firms that use only business or personal debt.
• Firms owned by females and minority members relied less on personal debt than male and minority owners.
• Female owners will be more likely to rely on equity from friends and family than their male counterparts.
• Firms that rely exclusively on personal savings to finance business operations will more likely be profitable than firms using equity forms of debt.