Tips for Creating and Funding an eCommerce Business
This post is Part 8 of a series covering core legal issues for eCommerce and Internet-based businesses.
Founding and Funding eCommerce Businesses – What You Should Know
Although many aspects of operating an eCommerce business are very different from a traditional business, at its heart, an eCommerce business is still a business.
As such, eCommerce business owners must address many of the same legal and operational issues faced by more traditional businesses. This includes choosing an appropriate type of business form, and ensuring they have the necessary capital to get the business up and running.
This article discusses some of entity choices available to eCommerce businesses, as well as common means of raising capital.
eCommerce Business Entity Types – Founding an eCommerce Business
Owners of eCommerce businesses have several types of entities they can choose from. However, most eCommerce businesses operate as a sole proprietorship, a limited liability company (LLC), or a corporation.
Sole Proprietorship
As the name implies, a “sole proprietorship” means “one owner”. This type of business form is not legally distinct from the person, and thus all assets of the business are also assets of the individual owner.
A sole proprietorship is the most common type of business entity in the United States. In fact, more than 2/3 of all businesses in the United States are sole proprietors. However, these sole proprietorship businesses tend to be relatively small. 99% have annual revenues of less than $1 million.
Pros
The main benefit of a sole proprietorship is that it is simple and easy to form. Anyone who offers services or buys/sells products is a sole proprietor by default. No legal filings are necessary to create a sole proprietorship. Of course, if the sole proprietor’s business requires a permit or license, such as a local license or food vendor certificate, the sole proprietorship must obtain those licenses or permits, just as any other business would.
Also, if a sole proprietorship operates under a trade name or any name other than the legal name of the sole proprietor, the owner would need to file an assumed name certificate to register the trade name.
Because the sole proprietorship is not legally separate from the owner, the business does not pay separate income taxes. All income taxes would be paid by the owner, personally, typically on Schedule C of the owner’s personal income tax form.
Cons
A key drawback of sole proprietorships is that the owner’s personal assets are not shielded from liability for business debts. This means the owner is personally liable for business debts, lawsuits, contracts, and other obligations of the business.
Also, because sole proprietorships cannot have more than one owner, the options for raising capital are limited, since they cannot sell equity. If a sole proprietorship takes on an additional owner, if becomes a common law general partnership.
Finally, because the sole proprietorship is connected to the owner, the sole proprietorship terminates if the owner dies – though the businesses assets can be transferred to an heir or new owner.
Limited Liability Company (LLC)
LLC’s offer many of the benefits of a more traditional corporate structure, but without as many of the required formalities. LLC’s are formed by filing articles of formation with a state – typically the state where the business is based.
The owners of an LLC are called “Members” and their ownership interest is called a “Membership Interest.” LLC’s can be managed by the members, themselves, or can appoint managers, who function similar to the directors of a corporation.
Pros
A key benefit of LLC’s is that the LLC has a separate legal identity from its owners. Thus, the liability of LLC owners for business debts is limited to each owner’s investment in the company. In other words, an individual owner’s personal assets are not subject to claims against the LLC.
With respect to management and operations, LLCs can function in many ways like a corporation: appointing officers, selling equity, legal standing to sue and defend lawsuits, owning property, etc. However, LLC’s are permitted more flexibility than the more traditional corporate model, and aren’t even required to have annual meetings. LLCs are governed by an operating agreement, which can be similar to a partnership agreement. The company agreement functions as a partnership agreement among the owners, as well as bylaws for how they operate the company, make major decisions, allocate profits and losses, and determine all other aspects of business operations.
By default, an LLC with only one owner is treated as a “disregarded entity” by the IRS, which means it is taxed like a sole proprietorship. If there are multiple owners of the LLC, the default tax status is that of a partnership. In both instances, the LLC, itself, does not pay taxes. Moreover, the LLC could choose to be taxed as a corporation and can even receive the benefits of a “Subchapter S” election.
In addition, because LLC’s can be managed by managers, LLC’s can separate management from ownership, similar to how corporations have both shareholders and directors, each with their specific role and function.
Thus, LLC is an entity choice that offers eCommerce businesses a great deal of flexibility and custom-tailored options for management and operations.
Cons
There really aren’t a lot of drawbacks to an LLC. As an entity type, LLC’s are still relatively new compared to proprietorships, partnerships and even corporations. Most states didn’t have LLC as an entity option until the 1980s. The law governing LLC’s can vary greatly from state to state, and that variation can create some challenges for the owners.
For these reasons, some investors prefer a more traditional structure of a corporation, so they might not be as interested in investing in an LLC.
That said, over the past few decades LLC’s have become a well-established entity choice, and most investors are comfortable putting their capital into an LLC.
Corporation
Corporations have been around for hundreds of years, and range from small, family-owned businesses all the way to the most dominant enterprises on the planet such as Apple, Amazon, and Google.
Pros
Corporations remain the standard for a traditional business enterprise. Corporations can offer stocks, bonds, and options, which create ample options for raising money. Moreover, for companies seeking to raise outside capital from venture capital and private equity funds, corporations present a familiar and favored option that appeals to these types of investors.
Because a corporation has its own legal identity, the liability of stockholders for business debts is limited to each owner’s investment in the company.
Corporations are managed by elected directors and act through appointed officers and employees to enter into contracts, buy/sell products and services, sue and defend lawsuits, own property, and conduct business.
Cons
For a small business with one or a handful of owners, the formalities of a corporation can be a bit onerous. For example, a corporation must maintain a board of directors who must meet at least once a year. These meetings should be documents on records that are kept on file with the company. Similarly, shareholders must meet at least once a year, and these meetings should also be recorded on records that are kept on file with the company.
Failure to observe these and other corporate formalities can result in a creditor making a claim that the corporation is merely an alter ego of the owners and that the owners therefore should be liable for company debts. This is called “Piercing the corporate veil” and could result in personal liability for the owners of the corporation.
By default, a corporation pays income tax on its profits. If it also distributed the after-tax profits to its shareholders, those shareholders will also pay tax personally on the distributions. Thus, the profits are taxed twice. This “double taxation” can sometimes be avoided if the corporation elects “Subchapter S” status, which would allow the corporation to avoid the initial tax, thus passing all tax liability down to the owners. However, not all corporations are eligible for a Subchapter S election.
Getting Started with Business Capital – Funding eCommerce Businesses
All businesses rely on capital to operate, especially in the beginning before cashflow makes them self-sufficient, eCommerce businesses are no different in that respect. There are a number of options for generating the necessary capital to start, sustain or grow an eCommerce business, including: self-funding, selling equity, and taking on debt.
Self-funding
The simplest way to fund an eCommerce business is for the owner(s) to put up their own money. Depending on the financial situation of the owners, the needs of the business, and the speed with which the eCommerce business can self-fund, it might be possible for the owners to use their own funds to finance the venture.
This personal money can come from cash in a bank or savings account, personal credit cards or personal lines of credit. Although this form of self-funding can be risky and cause financial strain, it allows the founders to retain control of the business without having to bring in additional owners.
Selling Equity
Another way an eCommerce business can raise capital is to sell equity. The investor provides money to the business, and in exchange for that money they receive an ownership interest in the company.
Once an investor receives their equity, they are owners of the company and thus are entitled to attend meetings, vote, and receive financial and other information regarding the company. Investors retain their interest in the company as long as they continue to own their equity, but they can also sell their interest to others and profit from any increase in its value.
Before issuing equity interest to the investor, the eCommerce business should require the investor agree to certain provisions to protect the company, such as restrictions on transfer and sale of their interest.
The sale of equity is regulated by a host of state and federal securities laws, which can sometimes be a bit complicated and onerous. eCommerce businesses must ensure that their investment transactions are in compliance with all of these laws. As such, an eCommerce business seeking to raise capital through equity investment should work closely with experienced legal counsel.
Debt
Loans, notes, lines of credit, and other forms of debt can be used to provide cash for an eCommerce business. The creditor can be an institution such as a bank or credit union, as well as individuals.
With debt, a creditor loans money to the company and gets paid back over time – with interest. The interest rate can vary depending on the risk involved to the creditor. An SBA loan might also be possible, although options for using an SBA loan to finance an eCommerce business are somewhat limited.
Creditors are not investors. They must be paid as agreed, or they can take legal action against the company for default.
Debt can be unsecured or can be secured by assets of the company. Thus, if the debt is not repaid, the creditor can take ownership of the secured assets.
Sometimes creditors will require loans be guaranteed by the owners. In these instances, even if the company is a limited liability entity such as an LLC or corporation, any owners who personally guarantee a company debt can be personally liable for those debts if the company defaults on the loan.
Unlike equity investors, creditors don’t have the right to vote or attend company meetings. Moreover, once a debt is paid, the creditor no longer has an interest in the company. Thus, using debt to raise capital can allow the owners to retain more equity in their company.
As described above, debt and equity are quite different. There is, however, one type of debt that companies often use to raise capital combines aspects of both equity and debt. Convertible debt is structured like a typical loan, with payment terms and interests, etc. However, it will also provide that the debt can be converted into equity at some point in the future. Because these transactions can potentially convert into equity, they are regulated as securities under state and federal laws.
Founding and Funding eCommerce Businesses Should Include Careful Considerations
Choosing an entity type and raising capital involves a number of legal and tax considerations, and there is no structure or method that is perfect for all eCommerce businesses and all situations.
Because the needs of every eCommerce business should be considered carefully, eCommerce businesses should consult their legal and tax advisors before making any decisions about entity choice or seeking funding.
To view previous articles in this series:
Part 1: eCommerce Law for Internet-Based Businesses
Part 2: Privacy Law and Requirements for eCommerce Businesses
Part 3: Understanding and Protecting IP in eCommerce Business
Part 4: The Key Agreements Every eCommerce Business Should Have
Part 5: Legal Issues to Know for International eCommerce Businesses
Part 6: The Key Roles of Human Capital in eCommerce Business and Their Importance
Part 7: The Key Elements to Selling an eCommerce Based Business
ABOUT THE AUTHOR: Jim Chester is a 25-year technology business lawyer, professor and entrepreneur. He is a recognized authority in buying and selling technology businesses, global technology transactions, and providing strategic legal counsel for innovation-based companies. For more on Jim, visit his professional profile. You may email Jim at jim.chester@klemchuk.com.
For more information on eCommerce legal issues, see our Internet Law and eCommerce Legal Services and Industry Focused Legal Solutions pages.