For the second in his series on starting a new company, Business Advice expert David Walker, founder of Grid Law, helps new owners decide which is the most suitable business structure for their venture.
You’ve decided to make the exciting leap to start a new business and be your own boss. One of your next decisions will be choosing the best structure for your business.
Traditional advice says that you basically have three options – you will either be a sole trader, partnership or a limited company. That advice also says that this is likely to be a difficult decision and your choice will be made after considering three main issues – liability, tax and administration.
However, in my view, this traditional advice doesn’t give you the full picture and that’s why it can be a difficult decision. Believe me, this decision doesn’t have to be difficult at all, and in this article, I’m hoping to give you a new perspective to consider.
So, you’ve been told you have three options? Wrong – you only have two.
You only have two options because one will automatically be eliminated depending on the number of people starting the business. If you’re starting a business on your own, you have the choice of being a sole trader or incorporating a limited company.
If two or more of you start a business together, your choices are a partnership or incorporating a limited company.
Now, before you email in, I know there are plenty of other business structures you could choose from, for example an LLP (limited liability partnership). But the fact is, there are very few businesses that start using these alternative structures so therefore I’m not going to cover them here.
However, if you do have a question about a particular type of business structure, please email me and I’ll happily answer it for you.
Right, now that your choice of business structure has been narrowed down to a 50/50 decision, let’s look at the three main issues I referred to above.
At first glance, choosing a limited company is the best option here because (as its name suggests) its liability is limited. So, if the company is sued or becomes insolvent you, as a shareholder, won’t have to contribute any more to settle the debts of the company than you have already paid or agreed to pay for your shares. All of your personal property is protected.
This sounds great, especially when compared to the potentially unlimited liability you have as a sole trader or a partner in a partnership. In both of these situations, you are personally liable for the debts and liabilities of the business and if you are sued you could lose everything.
Now, before we think this is a deciding factor, let’s consider what’s meant by liability.
Does this mean the risk you’re exposed to if you sell a faulty product that leads to someone being injured or killed? Is it the risk of making a mistake or giving poor advice whilst providing a service?
No business structure gives you complete immunity from these risks. However, you can obtain product liability or professional indemnity insurance to protect you from the consequences of them. In most cases, your maximum exposure will be any policy excess you have to pay if a claim is made against the business.
A far greater risk for any startup is financial liability, particularly if you borrow money.
If, as a sole trader or partnership you take out a loan or any finance to buy equipment or provide working capital, it will be your personal responsibility to repay it.
So, if the business doesn’t keep up with the repayments, you could be forced to sell your personal assets to cover the shortfall. If this still isn’t enough, you could be made personally bankrupt.
Again, this is where a limited company sounds appealing because any loans or finance will be in the name of the company, so it’s the company’s obligation to make the repayments, not yours. If the company defaults and ends up being wound up, your personal assets are safe.
The trouble is, anyone lending money to a startup company will know that there’s a higher risk of it defaulting on the loan. Therefore, the lender will most likely protect itself against this risk by insisting on personal guarantees from the shareholders.
This makes it your responsibility to repay the loan if the company defaults and so the advantage of limited liability is lost.
Traditional advice used to say that by declaring dividends, you will pay less tax as a shareholder of a limited company than you will as a sole trader or partner paying income tax.
However, this is now far from clear and trying to work out whether you will be better off as a shareholder is very complicated, especially after recent legislation changes.
In the early days of a business this is probably going to be irrelevant anyway. This is because the company must be profitable and have sufficient profits available for distribution before it can declare a dividend.
If it doesn’t, then the shareholders (assuming they’re working in the business) will take a salary and pay income tax on it in the same way as a sole trader or partner.
The final deciding factor is the administrative burden of running a limited company. This is always given as a disadvantage compared to a sole trader or partnership, because you have to keep records and file accounts at Companies House, which are open for public inspection.
However, if you are sole trader or partner and you take running your business seriously, you will keep the same records as a company. Otherwise, how else are you going to know how your business is performing? The only difference is that you don’t have to file them at Companies House.
Yes, there will be a cost associated with having proper accounts prepared, but that shouldn’t be such a significant factor that it determines your choice of business structure.
So, if these three issues aren’t really deciding factors, how do you decide what structure your business should take?
I’m by no means saying these three issues aren’t important, because they are. However, they’re not as significant as you might think.
Therefore, when you’re making your choice, look at other factors too.
For example, what is the perception of your clients. If you’re trading in a business to business environment and your clients are used to dealing with other limited companies, then you will probably want to form a company to fit that perception.
If you are looking to grow your business, again it is probably better to start off as a limited company so you don’t have to change its structure as it expands.
However, if you’re starting your first business and you want to test the waters with a new product or service, you may want to start as a sole trader (or partnership if you’re going into business with a friend).
Likewise, if for example you’re a personal trainer and you have no desire to take on staff or grow your business beyond the client’s you can look after yourself, remaining as a sole trade is probably your best option.
So, when you’re thinking about which business structure to choose, take all factors into consideration, not just liability, tax and administration.
As a final point, it’s important for you to know that you can change structures as your business develops. For example, if you start as a sole trader and want to grow you could form a partnership or limited company.
If you have a question for David Walker regarding the most suitable business structure for you, send an email to email@example.com and he will be happy to respond.
Catch up on the first article in the startup series – Starting a new business? Make these your legal priorities
Sign up to our newsletter to get the latest from Business Advice.