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Dec, 21 2009

Business Entities for Start-ups

You have mustered all the courage to start your own business. And now, a hundred decisions await your approval stamp. One of the most important decisions is organising your venture around a legal framework. One of the most preliminary decisions relate to

Business Entities for Start-ups

You have mustered all the courage to start your own business. And now, a hundred decisions await your approval stamp. One of the most important decisions is organising your venture around a legal framework. One of the most preliminary decisions relate to your business structure. In India, popular models an entrepreneur can chose from are proprietorship, partnership, a private limited company or a limited liability company. Exploring the merits and demerits of each can help you make the right choice.

What You Should Consider

Nature of business

The most important consideration should be the nature of your business. For entrepreneurs offering professional services like doctors or lawyers, the proprietary form is the most suitable one. Other businesses that require pooling of skills and funds, a partnership firm is more feasible. Whereas for manufacturing businesses which are generally large in size, the public or private set up is generally opted for.

Scale of operations

The volume and scale of your business is a key consideration. Consider if your business is large, medium or small in terms of scale of operations and also the size of the market, whether it is local, national or international. For large scale organisations catering to national and international markets, a public company set up or private company set up is best suited. Small and medium scale firms are generally set up as partnerships and sole proprietorships.

Degree of Control

For an entrepreneur who wants to control his business directly, sole proprietorship is the best option. But an entrepreneur who can be comfortable with separate ownership and management, a company set up will be desirable.

Capital requirements

Sole proprietorships are most suited for businesses requiring limited investments for establishment and operation of the business. However, when a business requires funds to be pooled in by different heads, then a partnership or private limited company is more favourable.

Risk appetite

Risk appetite is an important consideration. An entrepreneur who is comfortable with bearing all the risks associated with the business would fit in the proprietor model. On the other hand, if one wants risk sharing between all stakeholders, a partnership or a private limited company will be the best bet.

Feasible structures for start-ups

Sole Proprietorship:

This is the most common type of start-up entity in India. The entrepreneur is the sole owner of the business, who fund as well as operates the business. It is the simplest form of business entity, which can be easily set up with minimum formalities. No rules about records are required to be kept, no requirement of having your accounts audited and no requirement of filing financial information to the registrar of companies. In other words, there is no legal distinction between you and your business.

Pros:

  1. Very easy to set up and start your business
  2. Less formalities required. So, less time spent upfront in legal procedures
  3. No public disclosure of your finances required
  4. No sharing of profits, so you keep all profits with you since there aren’t any shareholders.

Cons:       

  1. Unlimited personal liability. If you go bankrupt, creditors get the right to your possessions – house, property etc.
  2. Very difficult to get investment from VCs, angels etc.

Partnership firm

In a partnership, you partner with other individuals to own and run the business. By partnering with other individuals, you get access to a bigger pool of capital, skills and other resources to fund and run your business. All partners contribute capital equally, share profits and losses equally and have an equal say in business decisions.

Pros:

  1. Access to larger pool of resources and capital
  2. Good model if you lack confidence to start business on your own and need to share the responsibility with others
  3. Partners can bring in their skills and expertise, thus complimenting your skills and help running the business efficiently

Cons:

  1. If your partner makes a business mistake, without your knowledge or consent, and it adversely affects your business, you are equally liable to bear the consequences – even though you had no role to play in the mistake
  2. If your partner goes bankrupt, his share in the business can be seized by his creditors. Although you are not liable for his personal debts, your business may be put into jeopardy
  3. Because of the drawbacks related to partnerships, it is very important that you trust the person before considering to make him a business partner. It is generally a good idea to have a legal document that highlights the partnership agreement between partners – the profit sharing, duration of partnership, admitting-expelling additional partners, dissolving the partnership etc.

Limited Liability Company

This type of business entity is most common and preferred type for a start-up. A limited liability company is a separate legal entity from its founders, shareholders and managers. The liability of the shareholders is limited to the paid-unpaid capital that is issued as part of the company. Thus, in case of bankruptcy, personal assets of the founders/managers are not affected. A limited liability company needs to keep record of accounts, audit their records and file an annual report on return with the registrar of companies.

Pros:

  1. Founders financial liabilities are limited
  2. Proper structuring of the company management – for example, who will be the managing director, etc.
  3. Easy to get funding from VC’s and other sources – by selling a stake (shares) in the company
  4. Additional members / directors can be added to the company structure
  5. Selling the company is a relatively easy (legally) because of the legal incorporation records, financial records, annual returns etc. have already been filed

Cons:

  1. Time and effort required to complete the initial incorporation
  2. Additional overhead of keeping records, having those records audited and filing annual reports
  3. Double taxation

Private Limited Company

A private limited company is a preferred choice for those who want the advantages of limited liability but at the same time desire to keep control over the business within a limited circle and maintain privacy of their business. A private company can be formed by more than two and less than 50 members. Members are not liable for losses incurred due to decisions or actions of other members.

Pros

  1. Limited liability of members, thus shielding them from business risks
  2. There are lesser legal formalities in the incorporation, it is easier to organise and operate as compared to other formats.
  3. A private limited company enjoys unlimited existence. It continues to exist even if it is deserted by all other members.
  4. A private limited company is good to attract institutional investment. 

Cons

  1. A private company cannot raise capital by inviting the public to subscribe to its shares in public

There is scope for frauds in a private company

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