The legal structure of a business is crucial in determining how serious the financial impact is on the owners, if things go wrong. It has an impact on the taxation levels to be paid by the business and its owner. With businesses there are many different legal structures such as Unlimited and Limited Liability, Sole Traders, Partnerships and Private and Public Limited. Choosing the legal structure for a business start-up is crucial to it's success.
Businesses With Unlimited Liability
Lets's start off with Unlimited Liability. Unlimited liability means that the finances of the business are treated as inseparable from the finances of the business owner(s).
This means if the business loses £1 million, the people owed money (the creditors) can get the courts to force the individual owners to pay up. If that means selling their houses, cars etc..so be it. If the owner(s) cannot pay, they can be made personally bankrupt. Two types of business organisations have unlimited liability: sole traders and partnerships.
A sole trader is an individual who owns and operates his or her own business.Although there may be one or two employees, this person makes the final decisions about the running of the business. A sole trader is the only one who benefits financially from success, but must face the burden of any failure. In the eyes of the law the individual and the business are the same. This means that the owner has unlimited liability for any debts that result from running the firm. If a sole trader cannot pay his/her bills, the courts can allow personal assets to be seized by creditors in order to meet outstanding debts. For example, the family home or car may be sold. If insufficient funds can be raised in this way the person will be declared bankrupt.
With sole traders, it is one of the most common ways people now start up businesses in the UK. It requires not much finance to start-up and confidentiality can be maintained because accounts are not published. As a result may business start-ups adopt this structure.
The main disadvantage is that a sole trader are the limited source of finance available, long hours of work involved (including the difficulty of taking a holiday) and concern with respect running the business during periods of ill health. You should start-up a business as a sole trader if:
- the entrepreneur has no intention of expanding the business such as someone who wants to just run a restaurant.
- there is no need to borrow substantial amounts of money from a bank (start-up costs are low).
- the business is small enough that one person can make all the big decisions.
Partnerships exist when two or more people start a business without forming a company. Like a sole trader, the individuals have unlimited liability for any debts run up by the business. Because people are working together but are unlimitedly liable for debts, it is vital that the partners trust each other. As a result this legal structure is often found in the professions, such as medicine and law. If the partners fail to draw up a formal document, the 1890 Partnership Act sets out a series of rules that govern issues such as the distribution of profits.
The main difference between a sole trader and a partnership is the number of owners. The key advantages and disadvantages are outlined below:
- Additional Skills - a new partner may have abilities that the sole trader does not posses. These can help to strengthen the business, perhaps allowing new products or services to be offered, or improving the quality of existing provision.
- More Capital - a number of people together can inject more finance into the business than one person alone. Thus, plus the extra skills, makes easier expansion.
- Shares Strain - the new partner will help to share the worry of running the business, as well as taking on a share of the workload. This should help to reduce stress and allow holidays to be taken.
- Sharing Profit - the financial benefits derived from running the business will have to be divided up between the partners according to the partnership agreement made on formation. This can easily lead to disagreements about 'fair' distribution of workload and profits.
- Loss of Control - multiple ownership means that no individual can force an action on the business; decision making must be shared.
- Unlimited Liability - it is one thing to be unlimitedly liable for your own own mistakes (a sole trader), but far more worrying, surely, to have unlimited liability for the mistakes of your partners. This problem hit many investors in the Lloyds insurance market in the 1990s. Certain partnerships (called syndicates) lost millions of pounds from huge insurance claims. Some investors lost their life savings.
Limited liability means that the legal duty to pay debts run up by a business stays with the business itself, not its owners/shareholders.
If a company has £1 million of debts that it lacks the cash to repay, the court can force the business to sell all its assets (cars. computers, etc.). If there is still not enough money , the company is closed down, but the owner/shareholders have no personal liability for the remaining debts.
To gain the benefits of limited liability, the business must go through a legal process to become a company. The process of incorporation creates a separate legal identity for the organisation. In the eyes of the law the owners of the business and the company itself are now two different things. The business can take legal action against others and have legal action taken against it. Each owner is protected by limited liability, and their investment in the business is represented by the size of their shareholding. Limited liability sounds unfairly weighted towards shareholders, but it encourages individuals to put forward capital because the financial risk is limited to the amount they invest.
To gain separate legal status a company must be registered with the Registrar of Companies. The following two key documents must be completed:
- The Memorandum of Association, which governs the relationship between the company and the outside world. This includes the company name, the object of the company (often recorded simply as 'as the owners see fit'), limitation of liability and the size of the authorised share capital.
- The Articles of Association, which outline the internal management of the company. This includes the rights of shareholders, the role of directors and frequency of shareholder meetings.
- Shareholders will get the benefits of limited liability which will encourage them to have the confidence to expand.
- A limited company will have wider range to borrowing opportunities than a sole trader or partnership. This makes funding the growth of the business potentially easier.
- Limited companies must make financial information available publicly at Companies House. Small firms are not required to make full disclosure of their company accounts, but they have to reveal more than would be the case of a sole trader or partnership.
- Limited companies have to follow more, and more expensive, rules than unlimited liability businesses (e.g. audited accounts and holding an annual general meeting of shareholders); these things add several thousand pounds to annual overhead costs.
A small business can start-up as a partnership, sole trader or a private limited company. The start-up capital will often be £100, which can be wholly owned by the entrepreneur, or other people can be brought in as investors. The shares of a private limited company cannot be bought or sold without the agreement of the other directors. This means the company can not be listed on the stock market. As a result it is possible to maintain close control over they way the business is run. This form of business is often run by a family or small group of friends. It may be very profit focused or, like Global Ethics Ltd, have wholly different objectives than maximising profit. You should start-up a business as a private limited company if:
- the entrepreneur wants to expand the business quickly, therefore easier to raise extra finance.
- there is large amount of borrowing therefore chances of large losses if things go wrong.
- the business may require others to make decisions when the entrepreneur is away.
- a public company can raise capital from the general public whereas a private limited company is prohibited to do so.
- the minimum capital requirement for a public company is £50,000 whereas there is no minimum for a private limited company.
- public companies must publish far more detailed accounts than private limited companies.