Investing in your own business: when you start a business, or when it’s time for your business to grow, it will need money like a commercial loan or an infusion of new equity. There’s really only two ways to invest non-revenue money into a business (ignoring grants for now), which are to exchange ownership for money; or to lend money to the business. This needs to be figured out beforehand because there are tax and personal and business liability issues associated with either kind of contribution, and as a result the documentation is different but critical to have in place.Let’s talk about equity. Equity is the same thing as ownership. If you have equity in a business, you own shares (in a corporation) or a membership and/or a right to receive an economic distribution (in a limited liability company). You own it. You get some decision making authority over the control of the business, and you get a right to receive profits when the business is profitable. Those profits are taxable at the dividend tax rates. If you sell the business or if the business assets are liquidated, you receive the proceeds after all business debts are paid, that is to say, last. You then pay capital gains on any amounts paid back to you over what you initially invested.
On the flip side, if the business is not profitable or goes bankrupt, you might not get the money you invested back, or you may just get a portion back after creditors are paid. If there’s a liability event that isn’t covered by insurance, and the business is forced to liquidate and close, all the invested money may be lost.
Lending money to your business can be a way to avoid some of these pitfalls. This is usually done with more risky businesses or with established businesses that need cash but don’t want to bring in new owners, or sometimes when an owner wants to receive money from the business (the interest payments) at a taxable rate that’s lower than the dividend rate. Lenders get paid back the principal sum lent, and an agreed upon interest rate. Earlier lenders to the business will have priority over later lenders and other creditors if there’s a liquidation event such as an asset sale or bankruptcy.
The interest paid to the lender is taxed as ordinary income – again, there may or may not be tax advantages to putting money into your business this way. Lent funds may be at less risk of loss with an asset-rich business because creditors to a business are paid back before investor monies are distributed; and if the lent funds are being used to purchase equipment or inventory the lender can set up a security interest in those goods to ensure payment if that particular piece of equipment is sold. If the business is not profitable, but has assets, the lender will get paid back at least something before the owners can take money back.
Whether starting a business, investing cash into your own growing business, or investing in a business someone else started, when you put money into the business be sure you know what form the money is taking. The funds can be a purchase of equity, or they can be a loan, or possibly even some combination of the two depending on how vested you want to get into that business. But before you hand over a dollar, talk with an experienced lawyer like me, and your CPA, to make sure your investment is protected against loss as much as it’s possible to do.
For this and all your businesses legal needs, call me in Asheville, Hendersonville, Fletcher, Waynesville, and all of Western North Carolina at (312) 671-6453, email at email@example.com, or for more information palermolaw.com.