Startup Guide for Small Businesses

Guide for Small Businesses

Founding a business, regardless of its size, is a daunting task. While those interested in starting medium or large sized businesses have an even more difficult time of it, starting a small business is no cake walk either. Indeed, choosing the correct business structure itself involves answering many questions, some of which an entrepreneur may not be entirely sure of.

As difficult as it may be, it is nonetheless achievable. The following guide answers some key questions that an entrepreneur may face and attempts to provide a simple codification of the prerequisites of starting a small business.

Which business structure is most suitable for a sole owner?

Most small businesses are started in the form of sole proprietorships, considering the ease, affordability, and efficiency of registration. Unlike other business structures, sole proprietorships do not require registration of the business with the Registrar of Companies. Obtaining a business license under the Shops and Establishment Act is sufficient to start a small business under sole proprietorship.

Why are all small businesses not sole proprietorships?

As beneficial as sole proprietorships are, they are not suitable for every entrepreneur who is interested in starting a small business. There are several factors that limit the appeal of sole proprietorship as a business structure, namely –

The necessity of singularity of ownership  - A sole proprietorship can be owned by only one person. Hence if two or more individuals want to start a small business, this structure is invariably ruled out and hence not opted for by all small business owners.

Unlimited liability – All assets of the owner of a sole proprietorship are fair game in case of settlement of business debts. Hence, personal liability in case of a sole proprietorship is not limited and can have severe financial consequences for the owner if the business goes south. On the other hand, business structures like limited liability partnership and companies normally shield their owners’ personal assets from such debts.

Tax incidence - A sole proprietor and his/her business are considered to be the same legal entity for tax purposes. Therefore, all of the business’s income, expenses, and deductions are to be listed on the individual tax return of the sole proprietor.

What are the pros and cons of forming a general partnership?

Minimal compliance – As compared to Limited Liability Partnership (LLP) and Limited Company, a general partnership has minimal compliances and is therefore relatively easier to establish. To that effect, registration and payment of registration fees to the State are not usually mandatory in case of general partnerships.

Trust requirement – As the partners are legally bound to be responsible for the acts of other partners, it is necessary to enter into a general partnership only with partners who are trustworthy. Moreover, it is advisable to enter into a written partnership agreement that dictates each partner’s share of profits/losses, daily duties, as well as the expectations that will follow a partner’s death or retirement.

Limitless liability – In the case of a general partnership, the personal assets of all partners are liable for business debts and liabilities. Hence general partnership does not offer limited liability and this may prove to be a major con depending on the kind of business risks that the owners expect to be undertaking. This con may, however, be countered with a good insurance policy in case of a risky venture. In most cases, this con may not present a problem at all considering the scale of a small business.

Nonetheless, it is advisable for a business that anticipates significant risks to organize itself as a Limited company or LLP to be able to benefit from the limited liability these business structures provide.

What is the meaning and importance of limited liability?

Some types of businesses like Limited Companies and Limited Liability Partnerships shield their owners from personal liability for business debts. For instance, if the business goes insolvent, its owners are not required to use their personal assets to make good on business losses—unless they voluntarily assume responsibility.

Other types of businesses—sole proprietorships and general partnerships—do not provide this shield, which means their owners are personally responsible for business liabilities.

To see how this works, assume someone obtains a large court settlement against an incorporated business. Because corporate stockholders are not personally liable for business debts, their houses and other personal assets cannot be liquidated to pay the settlement, even if the Limited companies files for bankruptcy. By comparison, if a sole proprietorship or partnership gets into the same kind of trouble, the houses, bank accounts, and other valuable personal assets of the business owners (and possibly their spouses) can be attached and used to satisfy the debt.

Why is a limited liability not a popular business structure among small business owners?

Many small businesses simply don’t have major debt or lawsuit worries, and hence do not require limited liability protection. Moreover, when it comes to liability for many types of debts, creating a limited liability entity makes little practical difference for new businesses. Often, if you want to borrow money from a commercial lender or establish credit with a vendor, you will be required to pledge your personal assets or personally guarantee payment of the debt, even if you’ve chosen a limited liability business structure.

When is it advisable to opt for a limited liability business structure?

You should consider forming a business that offers its owners limited liability if:

your business subjects you to the risk of lawsuits in a sector where insurance coverage is unaffordable or incomplete; or

your business will incur significant debts, is well established and has a good credit rating so that you no longer need to personally guarantee every loan or credit application. The easiest and most popular way to gain limited liability status is to form a Private Limited Company or a Limited Liability Partnership (LLP).

Is forming a Limited company difficult?

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What is the nature of operation of One Person Company and LLP?

Owners of small businesses often struggle to choose between operating as sole proprietors or partnerships, depending upon the number of owners, or operating as an incorporated company. The indecisiveness existed due to the contrasting benefits and drawbacks offered by the business structures – while one form had a simple tax-reporting structure and unlimited liability, the other offered personal liability protection and numerous technical rules.

The dual goals of limited liability and simplified tax reporting structure could be attained only by forming a Limited Company and then conforming to numerous regulations until the mid-1990s. When the Limited Liability Partnership (LLP) was introduced in 2008, it gained popularity as a simpler means of achieving the aforementioned goals.

LLPs and OPC have most of the most admired attributes of both partnerships. An LLP may be formed via registration with the Registrar of Companies (ROC).

Are there any drawbacks to forming a limited liability company? 

An LLP requires a modest amount of paperwork in order to be established along with a filing fee. However, at LegalRaasta, we offer the service of incorporating an LLP on your behalf and limit this particular drawback to a large extent.

The other conceivable drawback is that a Venture Capitalist is more likely to invest in Private Limited Companies than in LLPs.