The legal structure you choose for your company can change many times as your business grows, but begin with a structure that is a good fit for where you are right now.
Considering your legal structure options
Choosing the right legal structure for your company is an important decision that can be influenced by various factors. Considerations such as the complexity of your business, its growth potential, and the level of risk you’re willing to assume are all relevant. However, in the early stages of your venture, your choice should primarily be guided by who you are starting out with and the purpose of your business, including ethical or charitable considerations rather than solely focusing on financial aspects.
Many businesses initially begin as sole traders or informal partnerships, where the founder(s) are personally liable for all business debts. However, as your business evolves and you anticipate the need to acquire significant debt or experience rapid growth, it’s advisable to transition to a legal entity such as a limited liability company (LLC). This structure provides protection for shareholders’ personal assets against company debt, while also facilitating access to secure loans and other financing options, including angel investment.
Let’s now examine the advantages and disadvantages of the most common company legal structures:
1. Sole trader
Operated by the owner under a business name; may need to register as a limited liability company if the business grows rapidly.
Pros...
- Simple Setup: Establishing a sole trader business is straightforward and requires minimal paperwork and legal formalities.
- Profit Retention: As a sole trader, you have the advantage of retaining all the profits generated by the business after taxes.
- Low Capital Requirement: The initial investment required to start a sole trader business is typically low, making it accessible to aspiring entrepreneurs with limited funds.
- Simplified Tax Obligations: Instead of filing separate business accounts, sole traders only need to include their business income and expenses in their personal income tax return.
Cons...
- Unlimited Debt Liability (Important!): One significant drawback is that sole traders have unlimited personal liability for business debts. In the event of financial difficulties, the owner's personal assets can be at risk to settle outstanding business obligations.
- Limited Venture Capital Potential: The ability to raise substantial venture capital can be challenging for sole traders, as investors may prefer business structures with greater legal protections.
- Sole Decision-Making: As the sole decision-maker, the responsibility for all aspects of the business rests solely on the owner's shoulders, which can lead to a heavy workload and potential limitations in terms of diverse perspectives and expertise.
- Lack of Continuity: Sole traders face potential challenges in terms of business continuity if the owner is unable to operate the business due to personal reasons or desires to retire. Transitioning or transferring the business can be more complex compared to other legal structures.
It’s important to carefully assess these pros and cons in the context of your specific business circumstances and long-term goals. Seeking guidance from legal and financial professionals can provide valuable insights to help you make an informed decision about the most suitable legal structure for your venture.
2. Contractor
Tends to work for one client at a time for the duration of a contract; can also operate as a limited company.
Pros...
- Income Security: Contractors often enjoy the benefit of steady income through long-term contracts, providing a sense of financial stability.
- Flexible Work Choices: Contractors have the freedom to choose which contracts to accept, giving them control over their workload and the ability to take time off between contracts.
- Lucrative Pay: Contractors typically receive compensation at a higher "day rate" compared to salaried employees, allowing for potentially higher earnings.
Cons...
- Contract Uncertainty: One downside of being a contractor is that contracts can end abruptly and without prior warning, leading to periods of uncertainty and the need to actively seek new opportunities.
- Long and Distant Work: Contractors may face long working hours and assignments that require being away from home for extended periods, which can impact work-life balance.
- Credibility Building: Establishing credibility as a contractor often takes time and requires a track record of successful projects and positive client feedback. Building a reputation may involve an initial period of proving oneself to potential clients.
It’s crucial for contractors to carefully evaluate the risks and rewards associated with this legal structure, considering factors such as contract stability, lifestyle preferences, and the level of effort required to establish themselves in the industry. Professional networking, showcasing a strong portfolio, and maintaining a good reputation can contribute to long-term success as a contractor.
3. Freelancer
Self-employed sole trader who typically works on multiple projects for more than one clients at a time.
Pros...
- Low Start-up Costs: Freelancers typically have low start-up costs since they can work remotely and may not require a physical office or specialized equipment.
- Flexibility and Autonomy: Freelancers have the freedom to choose their workload, projects, and clients, allowing for a flexible work schedule that can be adapted to personal preferences.
- Ability to Supplement Employment: Freelancing can be pursued alongside other employment commitments, providing an opportunity to earn additional income or explore personal passions.
Cons...
- Cash Flow Volatility: Freelancers often experience sporadic work and irregular income, which can lead to cash flow challenges and the need for effective financial management and budgeting.
- Potential Isolation: Working as a freelancer may result in a sense of isolation, especially if you primarily work alone. It is important to proactively seek opportunities for networking and collaboration.
- Self-Responsibility for Finances: Freelancers are responsible for managing their own finances, including invoicing, tracking expenses, and ensuring tax compliance.
- Work-Life Balance Challenges: Balancing work and personal life can be demanding for freelancers, as boundaries between work and personal time can blur. Establishing boundaries and self-discipline are crucial for maintaining a healthy work-life balance.
Freelancing offers individuals the freedom to work independently and pursue a diverse range of projects. However, it is essential to consider the potential income fluctuations, the need for self-motivation, and the ability to handle financial responsibilities effectively. Developing a strong professional network, building a reputable brand, and delivering high-quality work can contribute to long-term success as a freelancer.
4. General partnership
Enterprises where two or more people share the ownership, control and profits of a business.
Pros...
- Diverse Knowledge and Expertise: Each partner brings their unique skills, knowledge, and contacts to the partnership, allowing for a wider range of capabilities and potential business opportunities.
- Shared Workload: Partners can divide responsibilities and workload, leveraging each other's strengths and easing the burden of running the business.
- Increased Borrowing Capacity: General partnerships often have a greater borrowing capacity compared to sole traders, as multiple partners can contribute capital and assets to secure loans or investment.
- Flexibility in Annual Accounts: Unlike limited liability partnerships, general partnerships are not required to file annual accounts, reducing administrative burdens.
Cons...
- Personal Liability for Business Debts: Each partner is personally liable for the business debts and obligations, meaning that their personal assets may be at risk if the partnership fails to fulfill its financial obligations.
- Communication Challenges and Conflict: Partnerships can face emotional issues resulting from a lack of communication, misunderstandings, or conflicting visions for the business. Effective communication and clear agreements are essential to mitigate these challenges.
- Workload Distribution Discrepancies: Pre-agreed workloads may not always be evenly distributed, leading to potential conflicts among partners and a strain on the partnership's dynamics.
General partnerships can be beneficial when partners bring complementary skills and resources to the table. However, it’s crucial to establish clear partnership agreements, define roles and responsibilities, and maintain open and effective communication to navigate potential challenges and ensure the success of the partnership. Seeking legal advice when forming a general partnership can also help in protecting the interests of all partners.
5. Limited liability
Legally registered businesses whose assets and liabilities (debts) belong to the company itself, not the owners; can also be a limited liability partnership between two or more owners.
Pros...
- Limited Personal Liability: The owners of a limited liability business are not personally liable for the company's debts or legal obligations. Their personal assets are generally protected from business liabilities, reducing personal financial risk.
- Potential for High Growth: Limited liability companies have the flexibility to attract public investors and "go public" through an initial public offering (IPO), allowing for increased capital investment and potential rapid expansion.
- Separate Legal Entity: The business is treated as a separate legal entity, distinct from its owners, which can provide credibility and professionalism to clients, suppliers, and partners.
- Transferable Ownership: Ownership interests in a limited liability company can be easily transferred or sold, providing flexibility for business succession or attracting new investors.
Cons...
- Initial Investment Required: Owners must invest their own capital or assets into the business to establish and operate a limited liability company.
- Distribution of Profits: Limited liability companies typically distribute profits among shareholders, which may reduce the amount available for reinvestment into the business.
- Tax Obligations: Limited liability companies are subject to corporation tax on their profits, and tax returns must be filed and paid annually, adding administrative and financial responsibilities.
- Registration and Compliance Costs: There are costs associated with officially registering a limited liability company, including registration fees and potential legal or accounting fees for compliance and ongoing maintenance.
Limited liability structures can provide important legal protections for business owners, shielding personal assets from business risks. However, they also come with additional legal and administrative requirements. Consulting with legal and financial professionals is advisable when establishing and operating a limited liability company to ensure compliance and optimize the benefits of this legal structure.
6. Franchise
An independent branch of another company; franchisee pays a fee for the right to represent the parent company.
Pros...
- Established Brand: Franchisees benefit from an established brand with existing customer recognition and loyalty, eliminating the need for extensive brand-building efforts.
- Training and Support: Franchisors typically provide comprehensive training programs and ongoing support to franchisees, helping them understand and operate the business successfully.
- Proven Business Model: Franchises operate based on a proven business model, reducing the risk associated with starting a new venture from scratch.
- Lower Capital Requirements: Compared to starting an independent business, franchisees often benefit from lower initial capital requirements once the franchise fee has been paid.
Cons...
- Lack of Independence: Franchisees must adhere to the franchisor's established operating procedures, limiting their ability to make independent decisions or implement creative changes.
- Dependence on Franchisor: Franchisees are subject to the decisions and actions of the franchisor, including the possibility of the franchisor going out of business, which can have significant repercussions for all franchisees.
- Ongoing Royalty Payments: Franchisees typically need to pay ongoing royalty fees to the franchisor, usually based on a percentage of sales, which can impact profitability over the long term.
- Contractual Obligations: Franchise agreements often come with strict contractual obligations and restrictions, requiring compliance with specific policies, standards, and reporting requirements.
Entering into a franchise relationship can offer a balance between independence and support, allowing entrepreneurs to leverage an established brand and proven business model. However, it’s crucial for prospective franchisees to thoroughly review and understand the terms and conditions outlined in the franchise agreement before making a commitment. Conducting thorough research, seeking legal advice, and speaking with existing franchisees can provide valuable insights into the pros and cons of a specific franchise opportunity.
7. Not-for-profit
A cooperative, social enterprise or charity that is committed to a cause rather than to making a profit.
Pros...
- Social Impact: Not-for-profit organizations have the opportunity to make a positive impact on society or address specific social or environmental issues.
- Reinvestment of Profits: Instead of focusing on maximizing profits for owners or shareholders, not-for-profits can reinvest surplus funds into advancing their mission and supporting their cause.
- Grant and Tax Exemptions: Not-for-profit organizations are often eligible for grants and tax exemptions, providing financial support and reducing their operational costs.
- Self-Governing: Not-for-profits have the autonomy to set their own agenda and make decisions based on their mission and values.
Cons...
- Limited Financial Rewards: As not-for-profits prioritize their mission over generating personal financial rewards, individuals involved may receive lower compensation compared to their counterparts in for-profit organizations.
- Uncertain Financing: Not-for-profits often rely on various sources of funding, including donations, grants, and fundraising activities. This can create uncertainty and competition for limited financial resources.
- Reliance on Donations: Not-for-profits heavily depend on the generosity of the public and donors to support their operations and fund their programs. Fluctuations in donations can impact their financial stability.
While not-for-profit organizations may face financial challenges and rely on external support, their primary focus is on driving positive change and contributing to the betterment of society. They play a crucial role in addressing social and environmental issues, advocating for causes, and providing support to communities in need. Effective fundraising strategies, community engagement, and strategic partnerships can help not-for-profits sustain their operations and make a meaningful impact.
Expert Entrepreneur Advice
Buying an existing business can be a viable option, but it’s important to approach the process with caution and thorough research. Here are some personal recommendations if you’re considering buying a business:
Conduct Due Diligence: Take the time to investigate and understand why the business is being sold. Look for any underlying issues or challenges that may have contributed to the decision to sell. This step helps you make an informed decision and avoid potential pitfalls.
Seek Professional Advice: Engage the services of professionals such as business brokers, accountants, and lawyers who specialize in business acquisitions. They can provide valuable insights, help evaluate the financial health of the business, and guide you through the purchasing process.
Assess Financial Value: Obtain a comprehensive financial assessment of the business. This includes reviewing financial statements, tax returns, cash flow projections, and any outstanding debts or liabilities. Ensure you have a clear understanding of the business’s profitability, assets, and potential risks.
Review Online Reviews: Research and analyze online reviews and feedback about the business from customers, suppliers, and employees. This can give you valuable insights into the reputation, customer satisfaction, and market perception of the business.
Check Owner’s Background: Conduct a light background check on the owner(s) and assess their personal reputation. This step can help you understand their track record, expertise, and credibility within the industry. It’s important to align your goals and values with those of the current owner to ensure a smooth transition.
By following these recommendations, you can make an informed decision and mitigate risks when considering the purchase of an existing business. Thorough research and professional guidance are key to assessing the viability and potential of the business, as well as identifying any red flags that may impact its future success.
