Most construction entrepreneurs default to the limited liability company (LLC) when creating a new business. Since its modern-day inception in 1977, this company selection offers protection to the individual owners of the company from the acts and financial obligations of the company. But before diving straight into the LLC, five questions need to be asked. The answers to these questions may not change the choice of entity, but may change the customization of the operating agreement. Following are the five questions.
- Who will own the company?
- How will the owners exit the company?
- Who will control the company?
- How will the company be capitalized?
- Will owners need distributions in uneven amounts?
Although there are several additional questions that need to be asked to ensure the company is set up properly, the answers to these five questions will help determine which type of entity the business will be.
For a refresher, there are five commonly recognized business entities: sole proprietorship, partnership (two or more owners), S-corporation, C-corporation and LLC.
Who will own the company?
The owners of the company will determine the course and direction, as well as the hiring and firing of officers of the company. The owners will reap the benefits of profitable growth but could be exposed to economic hardship if a recession occurs. In the construction industry, banks and bond companies will look to the owners for personal guarantees on bonds and lines of credit. Entity selection will not shield or protect the owners from these third-party requirements.
If someone is going to be an owner, the type of entity could have direct tax consequences due to the tax classification of the company. The needs and expectations of the business owners will have a huge impact on entity choice.
How will the owners exit the company?
Since the owners can buy or sell ownership, it is important to determine any restrictions on who can buy into the company or under what conditions an owner can sell. This is important in determining the exit strategy of the owners. If the company is going to go public, it will have a direct impact on entity selection. If the company is going to remain with a few individuals or family members where unanimous decision is necessary, this will also affect entity selection.
Who will control the company?
Construction business owners commonly hire more skilled people to run operations, while the owners focus on strategy and long-term planning. But it is worth asking the question because how the controllers of the company will be chosen and compensated is a huge factor. An owner looking for a large profit could be disappointed if the operations manager is making six figures and leaving pennies at the bottom line. It might be smart for the bottom line to acquire copper piping when the demand is low, but if the cash flow is not there to support holding inventory for six months, there will be issues. The entity selection can determine how control is structured and layered between boards, committees and individuals.
How will the company be capitalized?
The business will need capital to operate. The structure of the capital will have direct impact on bonding and licensures. If capital is going to be raised by limited owners, who get a return and ownership but don’t have voting rights, an LLC is the easiest way, although C-corporations do allow for different classes of stock. Capital is either going to come from equity or loans. The source is important and needs to be understood.
Will owners need distributions in uneven amounts?
LLCs allow for two unique aspects of distributions. LLCs can be established to allow profits, losses and capital to be valued differently, therefore allowing unequal distribution. An investor could have 25 percent of the company capital, but only receive 10 percent of the profits and 40 percent of the losses. A second unique feature of the LLC (and some partnerships, if drafted properly) is that an owner can be granted a cash distribution from the company. Although the other owners are not offered or choose not to take a similar distribution. If this is situation that may be needed, then corporations will not be wise selections.
Laying the foundation for a new construction business is imperative for its long-term success. Asking the right questions will ensure fewer change orders and complications.
