The Author, Bhumesh Verma is a Corporate Lawyer with over 2 decades of experience in advising domestic and international clients, with a place in “The A-List – India’s Top 100 Lawyers” by India Business Law Journal. He keeps writing frequently on FDI, M&A and other corporate matters. He was assisted by Student Researchers team of Ishan Chauhan, Harshdeep Singh Bedi, Ankesh Kumar and Vanya Srikant
Legal structures shape your journey as a business – therefore, choosing the best structure for your business merits your time and careful consideration.
There are many kinds of business entities, each with its own pros and cons. Your choice can greatly affect the way you run your business, impacting everything from liability and taxes to control over the company.
In India too, to start a business, you need to select a particular business entity. Before zeroing in a particular business entity, you need to be aware of factors such as taxation, owner liability, compliance burden, investment and funding strategies.
Business can be carried in various forms and structures in India. These structures include sole proprietorships, general partnerships, limited partnerships, limited companies, unlimited companies and one person companies.
Typically, technology startups in India incorporate themselves either as companies limited by shares or as limited liability partnership or as general partnerships.
Choice of legal entity for starting-up a business in India would depend on the short to medium to long term goals of such business. In some instances, Indian laws prescribe the type of entity for conducting specific activities (for example, insurance business).
While a partnership is the most non-complex form of business entity after sole-proprietorship, it exposes its partners to unlimited liability.
In case of Limited Liability Partnerships, liability of members/partners is limited, they require lesser compliances and they provide for greater flexibility (in terms of constitutional documents, etc.).
However, LLPs may not be suited for raising foreign capital (depending on their activities), external debt or capital from public.
Companies, on the other hand, have greater flexibility when it comes to raising capital or raising debt but they require more statutory compliances than LLPs.
It is also important to note that the nature of a business can be changed from one form to another depending on the needs or stage of such business.
Therefore, it is not a decision to be taken into lightly or one that should be made without sound counsel from business experts.
The key is to figure out which structure gives your business the most advantages to help you achieve your organizational and personal financial goals. We’re outlining the most popular business entities, and the factors to consider when choosing your business structure.
Factors to consider before choosing an entity
Following are some factors requiring consideration before choosing a form of entity for your venture:
1. Flexibility – You should ask yourself where your business is headed, and whether your structure allows for it. Turn to your business plan to align your goals with a proper structure. Your entity should support the possibility for growth and change, not hold it back from its potential. Your goal should be to maintain flexibility by considering the unique needs of the business as well as the personal needs of the owners from time to time.
2. Complexity – When it comes to startup and operational complexity, there is nothing simpler than a sole proprietorship. You simply register your name, start doing business, report the profits and pay taxes on it as personal income. However, it can be difficult to procure outside funding. Partnerships, on the other hand, require a signed agreement to define roles and percentages of profits. Companies have various reporting requirements with the state and central governments.
3. Liability – A company or LLP carries the least amount of personal liability, since the law holds that it is its own entity. This means that creditors and customers can sue the company for any claims, but they cannot gain access to any personal assets of the officers or shareholders of the company. Partnerships share the liability between the partners as defined by their partnership agreement.
4. Taxes – An owner of a sole proprietorship pays tax as personal income. Individuals in a partnership also claim their share of the profits as personal income. However, a company files its own tax returns each year, paying taxes on profits after expenses, including payroll. If you pay yourself from the corporation, you will pay personal taxes for what you were paid throughout the year.
5. Cost of Formation – Tax advantages, however, may not offer enough benefits to offset other costs of conducting business as a company. The cost of accounting, auditing, record-keeping and paperwork is significant, as well as the costs associated with incorporation. Taking care of administrative requirements often eats up the owner’s time and therefore creates costs for the business.
6. Control – If it is important for you to have sole or primary control of the business and its activities, a sole proprietorship may be the best choice for you. You can negotiate such control in a partnership agreement as well. A company, however, needs a board of directors that makes the major decisions to guide the company. A single person can control a company, especially at its inception, but as it grows, so does the need to operate it as a board-directed entity. Even for a small companies, the rules intended for larger organizations – such as keeping notes of every major decision that affects the company – still apply.
7. Capital Investment – If you need to obtain outside funding sources, like investor or venture capital and bank loans, you may be better off establishing a company, which has an easier time obtaining outside funding than does a sole proprietorship. Companies can sell their shares easily, securing additional funding for growth, while sole proprietors can only obtain funds through their personal accounts, using their personal credit or taking on partners.
8. Future Needs – When you’re first starting out in business, it’s not uncommon to be “caught up in the moment.” You’re consumed with getting the business off the ground and usually aren’t thinking of what the business might look like five or ten-let alone three-years down the road. What will happen to the business after you die? What if, after a few years, you decide to sell your part of a business partnership?
Another important question to ask yourself is, “What do I want to happen to the business when I’m no longer around to run it?” While a sole proprietorship or partnership may dissolve upon the death of its owner or owners, shares in a company can be easily distributed to family members.
Keep in mind that the business structure you start out with may not meet your needs in years to come. Many sole proprietorships evolve into some other form of business-like a partnership or corporation-as the company grows and the needs of the owners change.
9. License, Permits and Regulations – In addition to legally registering your business entity, you may need specific licenses and permits to operate. Depending on the type of business and its activities, it may need to be licensed at the local, state and federal levels.
Happy thinking !