Choosing the right legal structure for your startup is one of the most important decisions to make when starting a business. The type of legal structure you choose will decide your taxes, the amount of paperwork required, the personal liability you face, and ease of raising funds.
Whatever your business is, as an entrepreneur, you need to understand these basics of legal structure. Entrepreneurs often ignore legal matters of the business unintentionally as they are occupied in growth and other related activities. This culminates in common legal mistakes and affects the success or failure of the company in the long run.
Hence, it must be valuable to be aware of the legal matters of your business from the start.
Types of Business Entity
1. Sole Proprietorship
2. General Partnership
3. Limited Liability Partnership
4. Private Limited Entity
Before you choose a legal structure for your venture, you should consider some necessary points:
a) Tax liability of your company – you should choose a structure that minimizes tax as per your venture’s needs.
b) Your personal liability – how much of your personal assets are subjected to risk.
c) The ease of raising funds – If you are planning to raise funds for your venture, choose a preferred structure by investors.
d) The level of record-keeping obligations – the amount of paperwork required depends on the structure you select. It would be best if you opted for a legal structure according to your ability to handle it.
e) The cost required to create the entity – since certain entity forms need more capital to register, choose the entity considering your business goals.
f) Future Business goals – if your future goal is to scale up or diversify, choose a form that offers more advantages than others.
Now, let’s view the four common entities with their respective features.
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It is preferred by the owners who run stationery shops, small bakery shops, small-scale businesses, etc. This structure is for moderate level risk businesses that require low financial resources. You are all in all of your business under this entity.
Let’s recognize the pros and cons of this form:
● Sole ownership of the business, you are all in all of your business under this entity.
● Only you have the power of deciding on behalf of the entity.
● Least level of compliance and record-keeping.
● Unlimited liability- Suppose you started a business by taking a loan from a bank. After some time you failed the business, in that case, your personal assets will be used by authorities for paying up the loan.
● Not preferred by investors- Investors don’t prefer this structure as it lacks credibility.
● No provision to add partners- you cannot make others partner in this entity.
As the name suggests, a sole proprietorship is where you are the sole guy taking all the decisions and running the business. So, it is clear from the features and drawbacks that it is only for moderate to small scale business that requires only one person running the business informally.
A general partnership is an entity that is run by two or more than two individuals. This entity is generally preferred by professionals who work in the same service, such as law firms, marketing agencies, etc. The benefits and disadvantages of choosing this entity are:
● The low cost required for the formation.
● Definite profit-sharing – Profits sharing for partners is decided by the ratio of their capital contribution or any other terms that the partners may mutually agree.
● Partnership deed- It is an agreement between the partners made to specify the terms and conditions of partnership among partners. It outlines the various terms like salary, drawing & admission of new partners, profit/loss sharing, etc.
● Unlimited liability – Like Sole Proprietorship, the partners’ personal assets are subjected to the firm’s liability.
● This form of business requires a minimum of two partners and can go up to twenty partners.
Again, unlimited liability is the critical issue here, same as Sole Proprietorship.
Private Limited Company
As the name suggests, a Private Limited company is an entity privately held by private stakeholders. Under this structure, the liability of shareholders extends just to the number of shares held by them. Hence it is the most popular form of an entity among startup entrepreneurs. Advantages and difficulties the private limited entity consists:
● Limited liability – Unlike Sole proprietorship and general partnership, your liability is limited just to the shares you own. In case things don’t work correctly and the company has liabilities, the personal assets of any shareholder of the company will not be subjected to risk. So, this is the reason Pvt. Ltd. companies are more popular among entrepreneurs.
● Good for scalable business – It’s easier to scale business under this entity.
● Multiple shareholders – As per the new Companies Act, 2013, you can alone form this entity and add new shareholders up to 200.
● Separate legal entity – Entity has a separate legal existence like physical assets you sell or buy, and its liability is limited to itself only, which saves shareholders from unlimited liability.
● Suitable for raising funds – Since it’s a separate legal entity and more structured than other entities, you can raise funds from investors.
● High compliance requirements – It requires a higher level of compliance requirements like financial statements, statutory audit, annual filings with the RoC, and other compliances.
● Fewer tax advantages – If you register a company under this form, you are bound to pay your taxes at the full corporate tax rate (25.17%).
● The high cost of formation – A company under this form requires having and maintaining a minimum of 1 lakh paid-up capital.
Limited Liability Partnership
Limited Liability Partnership, commonly known as an LLP, is a corporate structure recently introduced under Indian law that combines the advantages of limited liability of a company and the flexibility of a partnership at a low compliance cost. It is preferred by businesses that are still in a wait and watch mode because it offers similar protections with fewer compliances.
Let’s examine the positives and negatives:
● Limited Liability – Like Pvt. Ltd. The company, there is no liability entitled to its shareholders.
● Unlimited shareholders – It requires a minimum of two partners to form an LLP. As per MCA, there is no upper limit on the maximum number of partners of LLP.
● Good for scalable business – If you want to scale up your business, go for this structure.
● Not preferred by investors – Investors don’t prefer LLP as it lacks professional structure.
● Low setup cost – You don’t require to have a high formation cost for this entity
● Moderate compliance requirements – Fewer compliances required compared to a Pvt. Limited company. If your startup’s turnover is below 40 lakh, you don’t have to file annual returns.
● Superior tax advantage – The taxation policy of LLP is similar to that of a Partnership firm.
You now understand the types of legal structures, their advantages & disadvantages, and why it’s essential to choose the right legal structure for your startup. It would be best if you were cautious of legal matters to avoid legal mistakes. It’s always good to take advice from lawyers before you pick the legal structure for your startup.