Financing Corporations

A corporation is a separate legal entity that can be created only by complying with state statutes. The business enters into a kind of contract with the state (called a corporate charter) in which the business agrees to abide by the governing state regulations, in return for the state's agreeing to treat the business as a separate legal entity for legal liability and tax purposes.

For many small businesses, incorporation provides the easiest method for raising capital from multiple investors, particularly those investors who are not necessarily interested in actively participating in the business. In some instances, it may be easier to persuade 15 people to invest $5,000 than to convince one person to contribute $125,000, and a corporation permits this kind of widespread ownership.

Active and Passive Investors

Several alternative types of corporations may be available for small businesses, including S corporations , close corporations, and C corporations . Each of these types of corporations have different requirements but they all permit equity financing through the sale of stock in exchange for a capital contribution of money or property. Stock comes in a variety of different types and, depending upon your negotiating strength and the interests of your investors, a small business can limit the extent of ownership control being sold by limiting the number of shares for sale and/or the rights associated with each class of stock. Nonvoting shares, preferred shares, redeemable shares, and a variety of hybrid shares are possible.

The sale of either nonvoting shares or a minority percentage of voting shares in a small company could represent an acceptable investment to a family member who doesn't want to be actively involved in the small business and trusts the business judgment of the company's active managers.

Other prospective shareholders, such as venture capitalists and investment "angels," may demand a more active role in exchange for their capital contribution. As a condition of investing, they may even require a public sale of the business within a certain time period in order to ensure a quick return on their investment.

Advantages and Disadvantages

• Advantages of corporations include ease of transfer, limited personal liability for the investors, and a great deal of flexibility in structuring ownership and control over the business.
• Disadvantages of corporations include the expense and administrative burden of maintaining the formalities of corporate structure, double taxation of dividends paid to shareholds, and (absent sound tax planning) double taxation of capital gains upon dissolution.

For more information on the pros and cons of incorporation, see our discussion of establishing a corporation.