Equity Interest in the Operating Entity

April 13, 2006

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In terms of maximizing your asset protection planning, there are a number of funding strategies available when structuring a business using holding/operating companies. But you must be careful to balance the combination of equity and debt funding.

Funding the operating entity with debt (i.e., leases and loans) will mean those assets used by the business will not be vulnerable to loss. Further, exempt assets personally owned and leased to the operating entity will be doubly protected--they will not be exposed to liability with respect to the business's creditors, and the owner can still claim his exemption in the assets with respect to his personal creditors.

However, the owner will have to contribute some assets to the operating entity in exchange for his equity interest. Unless additional steps are taken, these assets will be vulnerable to the business's creditors after all.

Ultimately, you should always try to minimize the actual amount contributed for the equity interest. This can be done by funding the balance of the investment with debt (leases and loans). There is, in practice, no one ideal formula for determining the ratio of equity and debt. Traditionally, in large, publicly held corporations, analysts have used a ratio of 30 percent debt and 70 percent equity as a benchmark. (These are the relative percentages of the business's assets funded through debt and equity contributions).

In small businesses, the ratio of debt to equity is often much higher. The limit to debt funding, in practice, is usually dictated by the business entity's ability to pay back the debt.

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The small business owner should experiment, on paper, with various funding schemes for the operating entity, including different ratios of debt and equity, before starting or expanding his business. The ideal structure will depend on unique factors, including the amount and type of capital available.

In many cases, it may not be necessary to go beyond a 30 to 70 percent debt-to-equity ratio. The assets contributed for the equity interest can be protected through the use of liens, and you also can invest cash and services. However, remember that debt provides the legal basis for the creation of liens and, in part, for the withdrawal of vulnerable funds by the owner.

Since the purpose of debt funding, from an asset protection viewpoint, is to give the owner a priority claim on the assets and to saddle the entity's assets with liens in favor of the owner, monthly repayments of the debt should not necessarily be the main focus of your actions. After all, a demand note can be issued to the owner or the holding entity, depending on the source of the loan. As the operating entity generates funds, the owner or holding entity can demand payment.

However, it would be a mistake to fund the equity interest with nothing, or only a miniscule or token amount of assets. This kind of undercapitalization could trigger an exception to limited liability.

A reversal of the traditional ratios, with 70 percent of the funding coming from debt, generally would still be reasonable, provided the entity's ability to service its debt were not impaired. A decision to use debt beyond this ratio should probably be made with the advice of an attorney.

Further, using debt beyond this amount may be unnecessary, for three reasons:

As discussed, the use of debt (leases, loans and other extensions of credit from the owner) provides the basis for another asset protection strategy (i.e., encumbering the operating entity's asset with liens in favor of the owner or the holding entity). These liens protect assets contributed though both debt and equity funding. Thus, assets that otherwise would be vulnerable (i.e., assets contributed for the equity interest) are protected.
Cash can be contributed in return for the equity interest. This contribution then can be quickly withdrawn from the operating entity in the form of payments for the entity's expenses, including payments to the owner for leases, loans and other extensions of credit, as well as salary. Thus, debt provides yet another basis for protecting assets contributed for the equity interest.
Future services can be contributed in return for the equity interest in the operating entity. When services are performed for the equity interest, no specific assets are contributed to the operating entity. With no assets in the business form, protection is not even an issue. Yet, the owner will have established, on paper, a significant equity interest in the business. As noted in our discussion on the tax aspects of funding decisions, an entrepreneur can usually justify a substantial salary as being "reasonable" in the eyes of the law.

In addition, when an asset contributed for an equity interest carries an especially high risk of injury, the asset should normally be contributed to the operating entity, and then encumbered with liens in favor of the holding entity or owner. Where the assets are especially valuable, and of only moderate risk, the holding entity should own these assets.

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Another way to look at the relative amount of equity and debt funding is the debt-to-equity ratio. This is the amount of debt divided by the amount of equity.

A debt ratio (debt/assets) of 50 percent is the same as a debt-to-equity ratio of 1. Similarly, a debt ratio (debt/assets) of 60 percent is the same as a debt-to-equity ratio of 1.5 (60/40).

Most large businesses have a debt-to-equity ratio between .5 and 2, with most of these companies averaging less than 1. As discussed above, small businesses will typically have higher ratios.