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For business owners, your entity type might seem like a complicated and, frankly, boring topic to think about.
But if you’re looking for business financing, your business’s entity type could matter more than you think. The structure you chose for your business can influence lenders when they’re processing your loan application—and can have a drastic effect on your business and personal finances if you get funded.
It all comes down to how much personal liability your entity type will subject you to.
What Is Liability and Why Does It Matter?
Liability is essentially how much you’re responsible for—and when it comes to your business, you can either be fully personally liable or not.
Being personally liable for your business can be frightening. If you run a business by yourself, take out a loan, and default, the lender can go after your personal assets in order to recover its losses.
In other words, you’re putting your personal life on the line for the health of your business… And if you lose one, you might lose both.
That doesn’t mean business entity types with a lot of personal liability are bad. In fact, sometimes they’re the best options for your business. But lenders prefer the stability of entity types with minimal personal liability, since they can seize business assets instead of personal assets if you wind up unable to pay back your loan.
On the other hand, entity types with more personal liability usually give you greater flexibility—which is an important tradeoff.
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Let’s take a look at the different business entity types and how they can impact your loan application.
Entity Types Without Much Protection
Small businesses are often sole proprietorships or general partnerships.
What Are Sole Proprietorships & General Partnerships?
Both of these entity types are simple to setup, easy to manage, and straightforward to understand.
They’re incredibly popular, too: 70% of businesses in the United States are sole proprietorships, while over 3.3 million small businesses are general partnerships.
A sole proprietorship is a single person who owns and is responsible for the business, while a general partnership is two or more at the helm. There isn’t much regulation—partnerships are simply governed by Partnership Agreements that each partner helps create—but these entity types give you a lot of flexibility. You can run the business how you want.
Sole Proprietorships, General Partnerships, and Liability
On the flipside, the owners of sole proprietorships and general partnerships have full liability for the debts and obligations of their business.
The Small Business Administration explains that lenders might shy away from these entity types because of the “perceived lack of credibility” associated with them.
All owners have unlimited liability, which means their personal assets will be used to pay back a loan if the business cannot. And in fact, all owners in a general partnership have joint and individual liability: every owner is responsible for the entire business, not just their fraction.
Some lenders, especially traditional banks, might see this as a risky situation, since those assets are harder to seize in case of a default.
Entity Types With Limited Liability
On the other end of the spectrum are limited liability corporations, C-corporations, and S-corporations.
These entity types exist especially to protect their owners’ personal assets—although, as a result, they’re often more complicated and expensive.
Corporations & LLCs: A Quick Review
C-corporations and S-corporations are considered individual entities: they can enter contracts, pay taxes, and live on even after all of their founders have left.
Whether the corporation can be owned by an unlimited amount of shareholders, like a C-corporation, or only 100 individuals, like an S-corporation, all owners have their personal assets protected.
LLCs, or limited liability corporations, are a hybrid entity. They have the flexibility of general partnerships with the limited liability of corporations, and tend to be the recommended entity type for many growing businesses. With fewer state regulations than corporations but more protection and credibility than sole proprietorships and general partnerships, LLCs can offer a lot.
Corporations, LLCs, and Liability
When you incorporate your business, you’re protecting personal assets from the the company.
Lenders prefer that your business bears the burden of a loan without personal finances mixed in—and they also appreciate the credibility of a corporation or LLC. Your personal assets become protected against seizure if your business defaults on a loan in almost all cases.
There are a few instances where your limited liability disappears, like when lenders pierce the corporate veil to show you’ve committed fraud, but by and large, these are the entity types that lenders prefer—and that will keep your personal finances separate and safe.
Entity Type Isn’t Everything
Just keep in mind that, while your entity type can definitely have an effect on your loan application, it’s not the only or even the most important factor.
Plus, your financing eligibility isn’t the only way you decide which entity type to become. Your business’s size, ownership structure, location, and much more matter when picking an entity type, too.
