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If you have an ownership stake in a company, it’s not uncommon to experience growing pains. As your company expands and your goals shift, you might even decide that you want a bigger ownership percentage. On the flip side, you might want to sell your shares or bring in a new partner to lower your ownership stake in a company.
Ownership percentages are obviously important because they determine what profits you’re entitled to from the business. They’re also important when you apply for a small business loan. Individuals who own at least 20% of the business must personally guarantee a business loan.
Because change can be overwhelming, especially when running a growing company and managing daily tasks, many small business owners put changing ownership shares on the backburner or opt to change ownership percentages informally. But taking the proper steps is important and the only way to ensure that your ownership stake in a company is protected. We’ll explain the importance of ownership percentages and how to change your ownership stake.
Ownership percentages in a business should be established at the outset. When starting a business, you’ll need to agree to ownership percentages in your founders’ agreement that is signed by all owners. Your ownership percentage depends primarily on how much money you contribute to the business, compared to the amount of money it will take to get the business off the ground. However, other factors, such as the amount of work you do for the business and the other types of resources you bring to the table, matter as well.
For example, take the situation where you have two owners in a technology startup. The owners, Owner A and Owner B, decide that it will take $100,000 to fully capitalize the business. Owner A contributes $30,000 of the money to the business, but also brings valuable coding skills and contacts to investors. Owner B contributes contributes $70,000 of the money to the business but brings no other resources. Since Owner A brings skills and contacts that will help the company grow, it could be reasonable for the owners to decide on a 50/50 ownership split.
The ownership share determines the amount of business profits you’re entitled to. It also determines the amount of losses you’ll be responsible for, so tread carefully. If the business takes a loss, and you’re a 70% owner, you’ll be hit with 70% of the losses.
If you have a S-corporation or C-corporation, you’ll need to specify the total number of shares for your company. If, for instance, your business has 1,000 shares, ownership of 300 shares would equal 30% ownership. Your founders agreement (which is usually part of the corporate bylaws) should clearly specify each owner’s name, the total number of shares, and the shares owned by each owner. Each owner should carefully review and sign the agreement, and it should be stored with other important business records.
Ownership percentages are important for the obvious reason that they impact your profit potential. But that’s not the only reason they’re important.
Here are some reasons ownership percentages matter:
Understanding your ownership percentage, and how to change it, can help you leverage significant influence over the future of your company.
Ownership percentages become particularly important when applying for a business loan. In most cases, only owners with a 20% or higher ownership stake in a company have to sign a personal guarantee.
A personal guarantee is a promise to pay back a loan, backed by your personal assets. If your company defaults on a business loan, and the business’s assets are sufficient to compensate the lender, the lender can come after the personal assets of anyone who has signed a personal guarantee. Personal assets includes anything of financial value that you own—your house, car, retirement fund, your kid’s college fund. All of that will be fair game if your company can’t pay the lender back.
There’s a relationship between credit scores and personal guarantees too. By signing a personal guarantee, you’re tying your business finances to your personal finances. If you default on the loan, it’ll get reported to the credit bureaus and will appear on your personal credit report, drastically lowering your credit score.
Personal guarantees come in different flavors. In an unlimited personal guarantee, every owner who signs is liable for up to 100% of the outstanding loan balance. Limited personal guarantees are more common and come in two types:
Usually, signing a personal guarantee is a nonnegotiable requirement of qualifying for a business loan. Occasionally, lenders will waive personal guarantees for silent partners—partners who invest in a business but don’t actively participate in the business. If you’re an active participant in the business with a 20% or higher ownership percentage, however, expect to sign a personal guarantee.
The process for changing the ownership percentage in a company depends on the structure of your business, so we’ll break it down by the three most common types of small businesses: S-corporations, C-corporations, and limited liability companies (LLCs).
S-corporations, which have a maximum of 100 shareholders, are a popular setup for small businesses because they avoid the double taxation of C-corporations. C-corporations are entities in themselves, meaning that the corporation itself has to pay taxes, and then the individual owners will have to pay taxes a second time on any dividends they receive. In an S-corporation, the company’s income is passed directly through to its shareholders, so taxes are only paid on the individual level.
There are four steps involved in changing the percentage of ownership among corporate shareholders:.
If your business is an LLC, you’ll need to refer to your LLC operating agreement that you drew up and signed when setting up your business. This agreement will include buy-sell provisions that specify how owners can transfer membership units (the LLC equivalent of stock) among themselves.
With an LLC, you probably won’t need to file updated paperwork with your state, but that depends on whether or not your original incorporation paperwork included the names and ownership percentages of its partners. If it does, you’ll need to fill out an amendment with the new names and percentages. Read over your operating agreement carefully to make sure all of its provisions still apply, and if not, revise it. Finally, you can issue new membership certificates to all owners that reflect the new percentages.
Sound complicated? Your best bet is to consult the professionals—lawyers and tax attorneys—because every business, document, and state is slightly different. They’ll make sure that you understand and fill out the necessary paperwork. They’ll also advise you on whether or not signing a personal guarantee makes sense given your specific personal financial situation.
Let’s illustrate with an example.
John and Jimmy are partners with a new seasonal landscaping business. Jimmy, who owns 30% of the company, has a personal credit score of 620. John owns 70% and has a stellar credit score of 700. Both of these credit scores are pretty good, so they shouldn’t have trouble receiving approval for that $50,000 loan they need in order to purchase new equipment.
Because they both hold more than 20% of the company, their lender will need each to sign a personal guarantee. But Jimmy has a wife and three teenage kids, and he knows that if he signs the personal guarantee and their new business fails, he might have to worry about his house and children’s college funds. Understandably, Jimmy doesn’t want to sign and put his family at risk.
In this situation, one option would be to transfer 15% of Jimmy’s ownership percentage to John, so that he no longer has to sign a personal guarantee.
How do they do that?
Remember that the process depends on the setup of the company. Their business is an S-corporation, so first they consult their tax attorney, who can value their company’s stock. Then, with the help of their lawyer, Jimmy transfers some of his shares to John using a stock repurchase agreement. Their lawyer destroys their old stock certificates, issues them new ones, and updates their company stock ledger. Finally, Jimmy and John file their new information with their state’s Secretary of State.
Once all of these steps have been completed, they can apply for a loan. Now that John owns 85% of the company and Jimmy only 15%, Jimmy’s off the hook for signing a personal guarantee. Of course, Jimmy is only entitled to 15% of the profits now.
Now that you have a basic roadmap for how to go about changing your ownership percentages, it’s a good time to consider some common reasons why you’d want to do so in the first place. Here are some typical situations that motivate a change in ownership stakes in a company:
Say, for example, you started your company with a friend or family member, and you each initially contributed an equal amount to start up your business. As the company grows, more capital is needed, and you have the money to contribute but your partner does not. You decide you want to contribute the funds, but you’d also like a bigger stake in the company to account for your larger monetary investment.
In this situation, you and your partner each own 50% of the business. Up until now, neither of you has been able to afford to leave stable jobs to devote 100% to the growing business. Now, however, your personal life will allow you to take a risk, quit your job, and work at the company full-time. In order to do this, you’ll want to own more than 50% of the company.
This is a common scenario with small companies and a good opportunity to take a percentage of the company shares in exchange for your work. For example, say you’re a graphic designer and the company needs new logos. You have a valuable skill that doesn’t require that you quit your job, and can instead do some work on the side and get a percentage of the company’s profits.
If your company decides to take out a small business loan, the lender will typically look at the financial qualifications of all owners holding more than 20% of the company. If you fall under this criteria, your credit will be considered, and you’ll likely be asked to personally guarantee the loan. In order to qualify for many business loans with lower interest rates, your credit score will also need to be above 620.
Sometimes businesses will opt to shift ownership percentages so that the company can access funds at the best interest rates. But this isn’t always a wise way to go, cautions Anna Dodson, partner at Goodwin Procter LLP.
Dodson also cofounded Goodwin’s Neighborhood Business Initiative in Boston, which provides pro bono business legal services to low-income entrepreneurs. Changing ownership percentages just for appearance’s sake for loan programs can get murky, especially when nothing else has changed in terms of your investment stake or the amount of work and capital (or other property) you’re contributing to the company, says Dodson.
“If there is a big gap between how you actually do things within your business and what your organizational papers say, this could be a problem,” says Dodson.
Instead, if you need a loan, another option could be to seek out a lender that will qualify you with your current ownership percentages. This may mean higher interest rates, and although this isn’t ideal, it could help you build better credit in the long-run. As your credit improves, you could pay off the higher interest loan and eventually move into a better type of loan program without changing your ownership stake, according to Andrea Ierace, manager of lending at Accion East in Cambridge, Massachusetts. “At the end of the day, we don’t want to put anyone in debt,” says Ierace.
Though selling or taking on more ownership stakes in your company might feel like a deeply interpersonal process, it also needs to include a bit of paperwork to be done right. Whether you decide to sell your ownership shares to a partner, buy your partner’s ownerships shares, or have your company create more ownership shares, make sure you make it official with the four steps we highlighted in this guide.