Sooner or later, more business owners need to seek external financing. This is certainly true in the SaaS world, where third-party investments can help provide cash flow infusions, the capital needed for expansion, and more.
There are a number of factors that can affect the financing options available to you, starting with your legal structure. For example, your decision to choose a corporate structure or an LLC over Sole Proprietorship can open up a lot of financing options that might otherwise be inaccessible.
The bottom line is, the legal structure you choose for your SaaS business can affect all aspects of your operation, and your financing in particular.
Legal Structures for Your SaaS Business: What are the Options?
When we talk about different legal structures, what are we talking about? There are a few primary options for SaaS entrepreneurs to consider.
Sole Proprietorship. Any time you start generating income on the basis of self-employment, you are automatically considered to be a Sole Proprietor. Sole Proprietorships do not recognize any legal distinction between the business and its owner; to put it differently, the business is not considered to be a distinct legal entity. This means there are no legal protections for investors, which means Sole Proprietorships generally don’t have as many options for securing financing.
Partnership. A Partnership works in much the same way as a Sole Proprietorship, only it involves splitting managerial duties (and business profits) with one or more partners. Again, this legal structure does not offer a lot of opportunity to secure financing.
Limited Liability Company. An LLC allows you to establish your business as a distinct legal entity, to keep business assets/liabilities separate from personal ones, and to enjoy some robust personal liability protections. These protections may attract third-party investors. LLCs can also access business loans and lines of credits, an alternative way to fund your SaaS business.
Corporations. A Corporation must sell shares and hold annual shareholder meetings, among other regulatory necessities. This may be too onerous for smaller SaaS companies, but if you actually want to go public and bring in a bunch of investors, incorporation is probably the best bet.
Legal Structure and Business Financing: Key Issues
As you consider the ways in which legal structure might affect financing opportunities, there are a few issues to keep top-of-mind.
Liability and Risk Perception
First and foremost, different legal structures offer varying levels of liability protection for owners. For example, a lawsuit that is brought against an LLC will only imperil business assets, not the personal assets of the LLC’s members. With a Sole Proprietorship, no such protections are available.
Lenders assess this when deciding whether to extend credit, as they naturally want to limit their own risk exposure. For example, an LLC or a Corporation will typically offer liability limits, which can make them more attractive to lenders who want to ensure their personal wealth is shielded.
Types of Financing
It should also be noted that different legal structures can provide access to different types of financing.
For example, if you choose to make your SaaS business a Corporation, it provides you with the opportunity to sell shares of your company, allowing potential investors an ownership stake. This is not an option with other legal structures.
Likewise, an LLC can usually obtain different types of business loans and lines of credit, with terms far more favorable than what a Partnership or a Sole Proprietorship could access.
Taxes
The legal structure you choose for your business will also affect the way you report to the IRS. This can influence cash flow and ultimately make it either easier or harder for you to repay loans.
For example, a Corporation is subject to double taxation. The business itself pays corporate taxes, while each shareholder must declare their share of the profits on their personal tax return. An LLC can opt for “pass through” taxation, avoiding double taxation altogether.
Business Ownership
Finally, note that lenders are likely to consider who owns and controls the business when assessing creditworthiness and financing terms.
With a Sole Proprietorship or a Partnership, where ownership is typically concentrated among a small number of individuals, personal credit histories and financial standings may weigh heavily in loan decisions. By contrast, corporate ownership is more fluid and may involve multiple shareholders, each with varying degrees of control. The business credit history may prove more salient here.
Opting for an LLC
While there is no one legal structure that’s right for all businesses across the board, a majority of SaaS companies will benefit from the LLC format. That’s because:
- LLCs offer much more robust personal wealth protections than Sole Proprietorships and Partnerships.
- They also provide a few different ways to attract investors and to procure financing.
- They do not have the same regulatory burdens that you’d experience with a Corporation.
Additionally, registering your SaaS business as an LLC is fairly straightforward. Note that the process can vary a little from state to state, so to register for an LLC in Wyoming will be different from registering in New York. Generally speaking, though, the process unfolds like this:
- Choose the state in which you wish to register (likely the one where you are headquartered and generating income).
- Appoint someone to serve as a Registered Agent for your LLC.
- Complete a legal document known as the Articles of Organization, then file it with your Secretary of State.
- Pay the filing fee, which could be anywhere from $20 to $300, depending on the state.
- Consider making an Operating Agreement, which outlines the management structure of your business.
- Request an Employer Identification Number (EIN) from the IRS.
- Ensure you have a bank account that’s separate from any personal checking or savings accounts.
Seek Financing Options for Your SaaS Business
Ultimately, growing your SaaS business may require you to seek external financing. Before you do so, make sure you’re making strategic decisions about your desired legal structure.
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SaaS Weekly Roundup #53 – Funding; M&A
