Choosing a legal structure

What this topic is all about

• There are several choices of business structure for a start-up

• Setting up a new business is a simple, straight-forward task

• The trick is to choose a legal structure to minimise the risk of investment which is also appropriate for the business

• The most important issue is whether the entrepreneur is personally liable for the debts of a start-up

Importance of limited liability

• An important protecting for shareholders in a company

• Shareholders can only lose the value of their investment

• However limited liability does not protect against:– Wrongful or fraudulent trading, or– When personal guarantees have been given by

directors

Sole trader

• The most common type of business structure

• A sole trader is just an individual owning the business on his/her own

• Remember that a sole trader can also employ people – but those employees don’t share in the ownership of the business

• The sole trader owns all the business assets personally and is personally responsible for the business debts. A sole trader has unlimited liability

Sole trader + / -

Advantages Disadvantages

Quick & easy to set up – the business can always be transferred to a limited company once launched

Simple to run – owner has complete control over decision-making

Minimal paperwork

Easy to close / shut down

Full personal liability – “unlimited liability”

Harder to raise finance – sole traders often have limited funds of their own and security against which to raise loans

The business is the owner – the business suffers if the owner becomes ill, loses interest etc

Pay more tax than a company

Partnership

• Where a business is started and owner by more than one person

• The legal partnership agreement sets out how the partnership is run, covering areas such as:

– How profits are to be shared– What the partners have to invest into the business– How decisions are taken– What happens if a partner wants to leave or dies

• The partners between them own all the business assets and owe all business liabilities

• Partners, therefore, also have unlimited liability

Partnership + / -

Advantages Disadvantages

Quite simple – certainly the simplest way for two or more people to form a business together

Minimal paperwork once Partnership agreement set up

Business benefits from the expertise and efforts of more than one owner

Partners can provide specialist skills

Greater potential to raise finance – partners each provide the investment

Full personal liability – “unlimited liability”

A poor decision by one partner damages the interests of the other partners

Harder to raise finance than a company

Partners are bound to honour decisions of others

Complicated to sell or close

Limited company (1)

• Limited companies are separate legal entities to the founders. A legal entity can own things itself (assets), can sue and be sued

• Companies are owned by their shareholders and run by directors. The shareholders appoint the directors (who in most cases are one and the same people!) who run the company in the interests of the shareholders

• Shareholders own a share of the company, but they do not own the assets of the company and they are not liable for the debts of the company

Limited company (2)

• The company owns the assets and pays the debts. If the company becomes insolvent (i.e. it cannot pay its debts), then the company is closed.

• Shareholders are not liable for any debts owed by the company that cannot be settled. That is the importance of unlimited liability

• By far the most common form of limited company is a private limited company. Private, in this case, means that the shares of the company are not traded publicly on a stock exchange

• By contrast, a public limited company (“plc” after its name) tends to have a larger value of share capital invested and its shares may be traded publicly. It is rare for a start-up to be a plc

Limited Company + / -

Advantages Disadvantages

Limited liability – protects the shareholders (the big advantage)

Easier to raise finance – both through the sale of shares and also easier to raise debt

Stable form of structure – business continues to exist even when shareholders change

Can pay less tax

Greater admin costs

Public disclosure of company information

Directors’ legal duties

Not-for-profit organisations

• Not-for-profit organisations are businesses that trade in order to benefit the community. These business have social aims as well as trying to make money

• Examples of social aims are job creation and training, providing community services and fair trade with developing countries

• There are many different types of social enterprise, including community development trusts, housing associations, worker-owned co-operatives and even sports clubs

Social enterprises

• Trade in goods or services for a social purpose

• The Triple Bottom Line:– Financial (surplus)– Social– Environmental

• Surplus goes towards one or more social aims

Exam Tips

• Getting the protection of limited liability is essential if the entrepreneur is investing significant capital into a start-up or if the business will have large debts

• Most small businesses don’t employ other people – however, that doesn’t mean that the entrepreneur should set up as a sole trader. The are many benefits from being a limited company.

• Make sure you have a good knowledge of the advantages and disadvantages of the various forms of business organisation