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Capitalization of a Company

One of the attacks that can be brought against your company and the corporate veil is a claim that your company was underfunded.  That means that your company didn’t have enough money, especially at the beginning of the company, to even begin to meet the needs of the company.  That is why item #19 on my formalities checklist is: “Was your LLC properly capitalized?”

Of course, many companies run at a loss at one time or another, but this is different.  The claim basically is that you didn’t intend to have this company operate as a viable company, because you never infused any capital into it–at least not enough to accomplish even the bare bones plan that you laid out for the company.

If the company is found by the court to be “underfunded,” the judge can pierce the corporate veil and let the creditors chew on the officers and directors.  Sometimes in a closely held company, where you are basically the only owner, the entire concept of the corporate shield is set aside and the judge lets the company’s creditors come after the owner(s).

In the old days, most states required the incorporators of a company to prove that they had a minimum amount of money in the company in order to form the company and file with the state.  The statement was actually made in the articles of incorporation, or the articles of organization for LLCs, that a specific amount of money was on deposit to form the company.  Many states required at least $1000 in the bank to avoid having the company automatically considered as “underfunded.”

That specific requirement is now history, but it is still important to fund your company both from a practical aspect and from an asset protection aspect as well.  Of course, you want the corporate veil to protect you.  It can be argued that if there is no money in company, then it is really just your alter ego.

A company can be funded by cash, real estate, equipment, or sweat equity.  It needs the actual money and assets to at least begin to do what the company is going to do.

As explained in this article on funding an LLC, make sure that any money or real estate or sweat equity put into the company is recognized by issuing stock or membership certificates.  Note that if you are contributing sweat equity, you will likely be hit with an income tax issue when you get your ownership in the company.  If you are putting property into fund the company, make sure you get the stock or membership interests back, so that there isn’t any tax consequence — you put one thing in and got something out of equal value in the IRS’s eyes.

When putting cash in, make sure that cash goes into a company bank account. You want to make sure enough is in the account to cover the operating expenses of the company for at least a short period, and always carefully document all deposits and withdrawals to establish that no commingling is occurring.

When putting real estate into the company, make sure to change the title on the piece of property to reflect that it is now owned by the company.  Use a warranty deed, not a quit claim deed.  Properties held in the company should be ones that you are doing business with.  Do NOT put your personal residence into the company.  Homestead protections and tax breaks are LOST and your creditors would likely argue that the company is simply your alter ego.

Sweat equity is a bit trickier, but just as important to document.  Your operating agreement should reflect the authorization for sweat equity to count for membership/ownership interests.

4 Comments
  1. What exactly is sweat equity? does all this information pertain to franchises as well? I bought a Carpet cleaning/restoration franchise in 2015 I have a 50% owner-partner. I put in all the cash, he had exp. in shampooing carpets, is that considered sweat equity? We had no exp. in running a business, I just had the cash he had some exp. in carpet cleaning.

    • Anna,
      Sweat equity is just a term for the amount of equity you have in a business or property that was created through work instead of investing. In your situation your ownership was based on investment and your partners interest was based on services rendered or “sweat equity”.

  2. Thank you for your answer. So does an investment of 100k in a carpet cleaning business and experience in carpet cleaning constitute a 50 50 ownership legally between two people? What I’m asking is how to put a percentage of ownership in the money invested versus experience. Seems to me money would be a higher ownership.

  3. That is entirely up to you and your partner and how you want to negotiate it. Some people value money more and other value experience and work more. There is no set or prescribed way that you have to do it.

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