Before starting your business, you must decide it’s legal framework. Legal framework of a business determines share of profit/losses and responsibilities to business associates, investors, creditors and employees.
This article will help you to understand why a company is the right structure for a startup in India.
To start a business, you have following three options;
- to start business on your own as a sole trader; or
- join other interested persons as a partner; or
- form a company
In general, small business owners choose to start the business as proprietorship. If more than one person is involved, then they prefer to start it as a Partnership firm. However, in certain cases, company form of business is the best structure for a startup.
Why incorporating a company is best for your business
Company is a legally incorporated business owned and controlled by its members or shareholders. Incorporating a business as a private or public Limited company confers life on the business as a separate legal entity.
This means company is separate from its owners. Company will incur it’s debt and have obligations to do business with outsiders. It will continue to operate despite the death or resignation of it’s directors.
Here are 6 reasons to know why a company form of business is the right structure for you to start.
As per law, company is the owner of all properties, management and employees are the caretakers or agent. If shares change hands, then management and employees may change but company will continue doing business for ever. Company can only be liquidated or ceased to exist by order of Court or by the ROC or by initiating the process of winding up.
Existence of a company will continue despite death or resignation of management or in case company files for bankruptcy.
Whereas in case of proprietorship, business ceased to exist if sole trader or proprietor dies. In absence of proper agreement, partnership firm dies on death of partners or dissolved in case of resignation or death of a single partner.
To raise capital
To raise fresh capital for your company, you are required to increase authorized and paid up share capital by issuing fresh shares. You also have option of issuing preference shares in exchange of debt or loan. Preferential shares are issued to have a preferential right to payment of interest or dividends and preferential repayment of share capital before other class of shareholders in the case of liquidation or the company is winding up.
In partnership firm, based on the agreement, you are required to raise capital either from the existing partners or outsiders. If you want outsiders to invest, then he or she should also be included as a partner. In this case, entire partnership agreement has to be changed based on shareholding and profit sharing ratio. In this way, if you raise capital number of times, then at the end it will be difficult to prove to outsiders the exact shareholding partnern. However, in case of a company, outsiders can know the present shareholding pattern by downloading company documents from ROC.
A private or public limited company is generally a preferred choice among young entrepreneurs as it offers easy participation of outside investors for further capital requirements. However, in private limited company, you can’t raise money from general public by offering shares. You can allow a particular investor to invest by offering shares with boards approval.
In future if you want to raise capital from outside investors, then we suggest you to avoid registering your business as a one person company or OPC, even though it’s falling under the category of private Limited company.
The most important advantages of a private and public limited company is it’s limited liability. This means shareholders or members are liable up to the amount they have invested as share capital. If things go wrong, shareholders will be losing the value of shares.
In case of proprietorship and Partnership form of business, sole trader and partner’s not only lose business assets, such as plant and machinery, furniture, buildings and inventory, but also their personal assets such as own residence, cars, cash and bank balance.
For instance, due to financial conditions, if a company is unable to pay its creditors, then these people have right to initiate proceedings against the company to recover their dues by selling company’s assets. In this case, they don’t have rights over the personal property of shareholders.
In another case, assume for a moment that you are manufacturing a product to be used in cars. One of your customer has faced serious damages due to faulty design of your product. If such customer own the legal battle in court, then he has right to recover damages from company’s assets not from shareholders. As a Shareholder or member, you are not personally liable to the debts, liabilities and act of the company.
Sole proprietorship and Partnership form of business is best choice where personal liabilities is not a big worry. For instance, in case of small retail shops, it’s very unlike to get sued from creditors or other parties.
The biggest disadvantage of proprietorship business is that the owner is personally responsible for all debts and liabilities of the business. This means, if business fails and business assets didn’t compensate the loss, as a owner your personal assets can be seized and used to discharge all liabilities and debts.
Sole traders or proprietors are taxed for the income generated out of business. This means as a sole proprietor, you have to include business profit in your own personal tax return.If more than one business is carried by a sole trader, then all those business Income gets added to sole trader’s tax calculation. If business Income is higher, then the sole trader may end up paying more taxes.
In case of Partnership firm, it’s taxed at the rate of 30% flat, but you have restrictions to claim certain type of expenses as tax deductible such as partner’s remuneration and interest paid on partner’s capital. Partner’s are required to include their share of profit or loss in their personal tax return. Limited Liability Partnerships are taxed as a partnership firm.
A company is taxed at corporate rates. However, you don’t have restrictions as we have in partnership firm. In general, all business expenses of a company are allowed as tax deductible. Both private and public limited companies are taxed at corporate rates for the business.
If a company is operated and managed properly with right tax planning, then a corporate form of business can save you more tax than a proprietorship or Partnership business. We suggest you to hire a finance professional to help you in tax planning.
Transfer of ownership
Transferring a company to its new owners is easy as you just required to transfer the shares to take over. However, in case of proprietorship and Partnership business, you have to transfer each individual assets of the business one by one. This not only increases paperwork for you bust also a very costly affairs.
Keep in mind that initial choice of legal form of business is not always the last choice. If you want, business can be started initially as a proprietorship or Partnership. Later, when business grow and personal liability is at stake, you can convert it to a company. Before you start, we suggest you to contact a finance consultant to help you understand the whole process and get you legal registrations based on your business requirements.