The ownership of your business indicates the profits you’re entitled to, but they also come into play when applying for a business loan. Anyone who owns 20% or more of the business is required to personally guarantee the loan.
While changing ownership percentages can be a bit overwhelming, it’s important to take the steps required to change your ownership formally rather than putting it off or changing them unofficially.
Doing it right is the only way the owners of your business can protect their stake. Here, we’ll review ownership percentages, what they mean, and how to change them if needed.
Table of Contents
- 1 Defining Ownership Percentages
- 2 Establishing Ownership Percentages
- 3 Importance of Ownership Percentages
- 4 Reasons to Change Ownership Percentages
- 5 Changing Ownership Percentages
- 6 FAQ
- 7 Final Thoughts
Defining Ownership Percentages
The stake that each owner has in a business is expressed as a percentage and referred to as their ownership percentage. The amount of the business each owner possesses is based on what they contribute to the company. It could be time, money, or something else entirely, but in exchange, they receive some sort of ownership.
How much money you invest, the amount of work you do, or the goods or services you provide will all play an important role in how much ownership of the company you get in exchange.
As a result of your ownership percentage, you will receive a certain about of the business’s profits, but it can also determine how much responsibility you take for its losses. It might sound like a good idea to own a large portion of a successful business, but it also means it’s time to pay up if the business doesn’t do very well.
Establishing Ownership Percentages
Ownership percentages need to be set up from the beginning. That doesn’t mean they won’t ever change, but everyone must agree on the ownership percentages and how they’ll be awarded. A founders agreement signed by all owners can be filed to make it official.
These percentages can be awarded in several ways. Two owners may contribute an equal amount of funding to the business in the beginning, and therefore each owns half of the business.
Or perhaps each owner contributes a different amount monetarily, but they each also bring a considerable amount of knowledge in their field, and therefore still decide to split ownership 50/50.
There may be situations in which more than two owners are contributing varying amounts of capital and services, in which case it’s up to you to decide who gets what percentage of ownership.
For C-corporations and S-corporations, you also have to specify the total number of shares in the company. Your founder’s agreement will list each owner, the number of shares they own, and their ownership percentage.
Owner shares do not need to amount to the total number of shares if you plan on selling more shares to raise money. If your business has 1000 shares, owning 300 shares would mean you own 30% of the company.
Importance of Ownership Percentages
While it might be obvious that ownership percentages affect your profit potential, there are some other reasons why these percentages are important as well.
- They directly correlate with your voting rights. While they don’t have to line up exactly, they typically have something to do with it. The more ownership you have in the company, the more say you have in its operations and path forward when making important decisions.
- They also impact your personal liability when taking out loans against the business. If the business defaults on the loan, you’ll be personally responsible for paying it back according to how much of the company you own.
By understanding the impact of your ownership percentage on these things, you can leverage your influence to direct the future of the company.
Ownership percentage and business loans
Most of the time, when applying for a business loan, only owners with at least 20% ownership have to sign a personal guarantee. This means you promise to pay the loan back out of your personal assets if the business is unable to do it.
The lender has a right to seize personal assets if the business defaults and you don’t pay up. This could include your child’s college fund, a retirement account, your car, or your house.
A personal guarantee can also affect your credit score. Even though the loan is in the business’s name, it’s backed by you, meaning you’re responsible. If you default, it will report to the credit bureaus and show up on your credit report.
There are several different types of personal guarantees, and it’s important to know the difference.
- Unlimited personal guarantee – Each owner is liable for up to 100% of the outstanding loan balance. Even if you only own 30% of the company, you’ll be responsible for paying back 100% of the loan if the other owners can’t or won’t.
- Several limited guarantees – Each owner is responsible for the percentage of the loan balance that’s equivalent to their ownership in the company. If you own 30% of the company, you’re personally responsible for paying back 30% of the loan if the company defaults.
- Joint and several limited guarantees – This is a combination of the previous two options. You’re responsible for your portion of the loan if the business defaults. However, if any of the other owners can’t pay off their portion, you’re on the hook for the remainder. This ensures that everyone is responsible for their portion, but it doesn’t protect you if they’re dishonest or fiscally irresponsible.
Signing a personal guarantee is usually unavoidable if you need to take out a loan against your business. It’s possible that silent partners (those who invest in the business but don’t actively participate) can get their personal guarantees waived, but it doesn’t happen very often.
Reasons to Change Ownership Percentages
After understanding how ownership percentages work, you can consider some reasons why they might need to change. Typical situations include the following.
Putting more money into the business
You may have started your business with a friend or family member and agreed on how much everyone was going to contribute as well as how that affected your ownership percentage. However, sometimes companies need more capital later to float them through a rough patch or to fund growth.
If you decide you want to contribute more funds, you may want to own more of the company since you now have a bigger stake and more to lose. Changing ownership percentages can account for a larger monetary investment.
Working full time for the business
Perhaps you own half of the business and you and your partner are both bi-vocational. That might have worked in the beginning, but now the business is growing and really needs a full-time employee dedicated to daily operations.
If you decide you want to quit your full-time job and work for the business, you may be entitled to more ownership. You’re offering something that you and your partner have both agreed upon, and you’re taking more of a risk.
You are now working full-time for the company, you’ve quit your stable job with a predictable income, and you are deserving of owning more than 50% of the business now.
You’re working but the business can’t pay you
This is very common with small businesses. They often have employees working for ownership rather than earning a paycheck. You may not even currently be an owner of the company, but if they ask you to come work for them for ‘free,’ you’re entitled to some sort of compensation.
It doesn’t have to be full-time work either. If you’re a graphic designer by trade and the company needs some marketing materials or a new logo, you can draw those up without quitting your day job. In return, you earn increased ownership in the company rather than getting paid a fee for your work.
The company can’t qualify for a loan
Maybe the company needs to take out a small business loan but the lender can’t qualify the business for any amount of capital. It could be for any number of reasons, like limited cash flow or poor revenue.
In any case, the lender will then look at the personal qualifications of 20% of owners to see if they can qualify the business based on any of the owners’ credit. However, if someone with excellent credit owns less than 20% of the business, shifting ownership percentages around could help your business qualify.
By making someone with better credit than the existing owners have is made a larger owner, they could help the business get a loan.
Be careful doing it this way, though. Making your business appear better than it really is on paper rather than awarding ownership percentages based on how the business actually operates could run you into trouble later. It creates a gap between what your papers say and the way you actually do things.
Consider lenders who can qualify you based on your current ownership instead, which could mean higher interest rates. While it’s not ideal, it can help the business build better credit, which is beneficial in the long run. It can also help you graduate to a better loan program to more easily pay off the loan balance.
Changing Ownership Percentages
There are several ways to change your ownership percentage based on how your business is structured. The most common types of small businesses are LLCs (limited liability companies), C-corporations, and S-corporations, so we’ll go through each here.
When you formed your LLC, you drew up an operating agreement to help you through times like this. You’ll need to refer to it because it includes buy-sell provisions that indicate how owners can transfer membership units among themselves.
If your original paperwork includes the names and ownership percentages of your partners, then you’ll need to file new paperwork with the state. Sometimes, your paperwork doesn’t say, which means you won’t have to revise it.
Make sure you read the operating agreement carefully so it’s still accurate. If it’s not, revise it, and then issue new membership certificates that reflect the updated ownership percentages for all owners.
If this all sounds a bit too complicated, you can consult a tax attorney for help. Every state has different requirements, every business operates differently, and every document is subject to variations. They can also advise you on whether or not you should sign a personal guarantee.
C-corps are taxed at the business level and the personal level, so it results in double taxation. Every owner will also pay taxes on their personal tax return based upon the dividends they receive from the business. S-corps can help you avoid double taxation, but they’re limited to a maximum of 100 shareholders.
While the structure of the company varies between a C-corp and an S-corp, the way you change ownership percentages is the same.
- Assess current ownership – First, you’ll need to clarify how much the company is currently worth so you can value the shares you own. By changing your ownership percentage, you’ll also affect your taxes, so consulting a tax attorney for guidance may help.
- Agree on the change – Every owner should agree on how the ownership percentages are to change. Some owners may buy more shares from the company while others may decide to purchase them from another owner.
- Buying shares from the company means you increase the number of shares you own without decreasing the number of shares another owner has. It will, however, decrease everyone’s ownership percentage because there will be more shares in the shareholder pool. You’ll need to issue stock purchase agreements when buying shares from the company.
- Buying shares from another owner increases both the number of shares you own and your ownership percentage. It will decrease the number of shares and ownership percentage of the shareholder you purchase them from, but everyone else’s number of shares and ownership percentage will remain the same. In this case, you’ll need to issue stock repurchase agreements.
- Record the transfer – Cancel your original stock certificates and issue new ones according to how the change is taking place. An attorney can help you with this step if you don’t want to do it on your own. Stock numbers and certificate numbers should be recorded in the company’s stock ledger.
- File updated paperwork – To complete the change, you’ll need to file updated incorporation paperwork with your state so they’ll officially recognize the new ownership of the company. If your stock records aren’t accurate, a court could hold you liable for any business debt.
This isn’t always the easiest thing to understand. If you’re thinking about starting a business or changing the ownership of your current business, there’s a lot to think about. Here are some frequently asked questions that may help.
Answer: The best way to divide ownership in an LLC is to give each member an ownership stake equal to their cash investment. If they invested 50% of the starting capital, they own 50% of the company. There’s an unlimited number of ways to split ownership based on capital contribution or services offered. It’s up to you and the other owners to decide what’s best for you.
Answer: LLCs can distribute ownership however they see fit. The same rules don’t apply to an LLC like they do a corporation. Owners can decide how these ownership percentages are divided according to who offers what to the business and its operation.
In fact, ownership can be divided without regard to the initial investment. It can be distributed based on services, employment, knowledge, or any other contribution considered valuable.
Answer: There are two ways you can determine ownership in an LLC. The first is by percentage and the other is by membership units. However, an LLC can distribute its own however it needs or wants to, regardless of how much money, property, or services someone might contribute to the company.
Answer: Any partner in an LLC must have an ownership percentage greater than 0%, but there are no other minimum restrictions. Larger companies may have several owners with very small percentages while a two-person entity may add another person with only 1% ownership for additional decision-making or voting purposes.
It may be difficult to define or redistribute ownership in an LLC, or any company for that matter, but sometimes it’s necessary. As long as you’re doing it for the right reasons and you take the necessary steps to do it correctly, you can reorganize your company ownership to make it work for you.
It’s important to understand how ownership works and why you might want to change it before you do it. If you have any questions or you need more guidance, enlisting the help of an attorney to help formulate documents could save you a lot of money in the long run.
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