Author- Antonia Manti: Operating a newly formed business as an LLC. Is this decision a ‘double-edged sword’?

This article begins with a reference to the official statistics for limited-liability companies(‘LLCs’), followed by a comparative analysis of the factors in favour and against the entrepreneurs’ decision to operate their newly formed businesses (‘NFBs’) as LLCs. Moreover, it examines whether UK Company Law covers the needs of such businesses and finally, it highlights some other types of business which are possibly suitable.

The UK by the end of 2019 had around 4.197.714 registered LLCs, out of which, 4.191,185 are private companies, while the rest are public.[1] Out of all corporate-types of businesses, over 96% of the entrepreneurs chose to operate their businesses as private LLCs.[2] This does not make public companies less important because even though less in number, they generate a lot of wealth. It is significant to mention that the vast majority of businesses in the UK, are micro-small (‘small’), which in legal terms means that they are owner managed.[3]

To begin with, entrepreneurs look for a corporate vehicle which minimises their risk. This is because businesses, especially NFBs, face high-failure risks, either because of exogenous-risks, like competition or endogenous-risks, like mismanagement.[4] An LLC, having a separate legal personality, seems to be suitable for entrepreneurs, as it minimises their risk by offering them maximum protection through the limited-liability regime.[5] Specifically, they have limited-liability towards the debts of the company (‘limited by shares or by guarantee’).[6] Entrepreneurs enjoy beneficial consequences from the principle of limited-liability. For instance, as they bear a low risk losing their personal-belongings, they can diversify their funds in multiple businesses, because firstly, their holdings are not tied up in one company, and secondly, they have a decreased need to take part in the management, as they know they have little to lose.[7] Consequently, there is a higher probability of increased profits.[8] Also, managers are able to take risky decisions knowing entrepreneurs bear low risk, leading to higher earnings; if they turn out to be successful.[9]

However, entrepreneurs may not benefit from the limited-liability regime as major creditors with power bargain-power, like banks, can ‘contract around’ it.[10] Such creditors will seek to pursue the owners to give personal guarantees, to ensure repayment where the LLC is unable to pay.[11] This kind of ‘contracts will shift a large part of the risk back to entrepreneurs’ who may end-up being directly liable.[12] Also, the principle of limited-liability can be a ‘double-edged-sword’ because although the owners distance themselves from the company’s debts, they are unable to use its assets (e.g. property) as these belong to the company itself.[13] The aforementioned beneficial consequences of limited-liability, may immediately disappear once entrepreneurs give personal guarantees.

Additionally, entrepreneurs look for a vehicle which enables them to recover their investment easily. In such case, LLCs by shares seems appropriate, because entrepreneurs can easily recover their investment by transferring their shareholding. It is low-hurdle for them to find potential investors because the formers are more willing to purchase shares which carry the protection of liability-limited. This is really beneficial for public LLCs, where the shareholders’ shares are freely transferable and their holdings can ‘easily convert into cash’.[14] However, the majority of NFBs which operate as private LLCs, do not enjoy such benefit, because their Articles of Association often include provisions prohibiting the owners’ right to transfer their shares, e.g. a buy-back clause.[15] 

Furthermore, entrepreneurs who are unable or unwilling to manage their business, find LLCs attractive because it separates ownership from management.[16] This separation is advantageous because it lowers decision-making costs, and there are ‘lower information and coordination costs’ where ownership changes.[17] Those benefits are well enjoyed by public LLCs, which have a large number of owners and it is impossible for them to manage it daily. However, it is the case again that the majority of NFBs operating as private LLCs, do not enjoy the benefits of this separation as they are closely held having an identical group of owners and managers.[18]

Moving on, entrepreneurs may choose LLCs because they are a ‘capital-raising vehicle’, and ease in increasing capital is necessary for NFBs in order to expand and fund their activities. For example, borrowing money through debt-finance is easier, as the company can offer ‘floating-charge’ as an additional form of security for the lender.[19] Another benefit of choosing to incorporate an LLC is the prestige, credibility and legitimacy it offers.[20] Having their own existence, LLCs enjoy perpetual succession, and therefore, people considered it as a solidity, enabling them to maintain their creditworthiness and goodwill. So NFBs operating as LLCs are benefited considering that ‘banks, suppliers and customers’ will ‘feel more reassured to deal’ with them because they are subject to great regulation and disclosure.[21] Last but not least LLCs are taxed as entities and enjoy tax-benefits.[22]

Taking everything into consideration, it seems that the arguments in favour of the suitability of an LLC as a vehicle for NFBs are more. However, the UK company law hinders this idea because it focuses on regulating widely held companies. Its ‘legislation’s rules and procedures are designed with ‘‘public, large, quoted companies’’ in mind’, and in ‘ignorance that small LLCs will use it.[23] The length, detail and complexity of the primary legislation; Companies Act 2006 (CA06), create ‘unbearable burdens for small companies, as they lack economies of scale’.[24] The huge expense of set-up, the excessive regulation ‘in the interest of the outsiders’, the complicated ‘investor-protection rules and accounting standards’, increase costs and create barriers of growth to such companies.[25]

Company law is well-designed to cover the needs of large LLCs, it is ‘too impenetrable, time-consuming’, and ‘inaccessible’ to the owners of small companies.[26] It is seen as the ‘preserve of expert lawyers and academics’ and an example supporting this is how imprecise directors duties are.[27] Additionally, the obligation to ‘comply with the series of legal requirements’, ‘create administrative inconvenience and additional expense’, as a professional advice is essential and it is time-consuming.[28] The accounts and information filed at Companies House are publicly available, so privacy is lost.[29] Moreover, company law ‘includes lengthy provisions regarding separation of ownership and control’, which as explained above are unnecessary for NFBs operating as LLCs.[30]

It can be argued that a public company which is owned by the ‘general public’, and may be listed, should not be under the same regulation with a private company which is ‘privately-owned by selected individuals’.[31] The unsuitability of Company law for NFBs is a significant disadvantage for NFBs which operate as LLCs.

It is important to note that a real progress has been made in company law to mirror the needs of small companies. Some improvements include the amendments of CA06 which enable owners to take the majority of their decisions through written-resolutions.[32] Private companies are not required to hold an annual-general-meeting or have a company secretary.[33] Furthermore, small companies can file ‘abridged’ form of accounts.[34] New Model Articles of Association are also a step forward as they can now be ‘entrenched’.[35] Case law has been developed as well, by allowing informal-unanimous decisions to be taken.[36] Nevertheless, there is continued pressure for ‘simplification of company law, as it still favours public companies’.[37] One suggestion to make it more appropriate for NFBs is to ‘regulate only where essential’ and simplify the ‘statutory requirements for decision making, accounts, audit and dispute resolution’.[38] The quote ‘Think-Small-First’ should be implemented by making company law more ‘effective and accessible’.[39] Lastly, a ‘lighter approach could also benefit’ large-public LLCs.[40]

Regarding other types of businesses, sole-trader or partnership may be more desirable vehicles for NFBs, as they are ‘less onerous’ regarding administration costs and filing requirements. [41] They are also cheaper and easier to set up, they do not file accounts so they maintain their privacy, they offer freedom in decision making, and they owe and run the company, as opposed to LLCs by shares, where shareholders do not have an automatic-right to participate in the management.[42] Although they do not enjoy the advantage of limited-liability, they can limit their liability contractually or by taking out insurance.[43] The Limited-liability partnership may also be a suitable alternative, because it offers the advantages of LLCs, while allowing for internal organisational flexibility.[44]

Concluding, this article has demonstrated a controversy over the effectiveness of LLCs as appropriate vehicles for NFBs. Even though LLCs offer a lot of benefits to entrepreneurs, they seem to be more suitable for large companies, NFBs and generally all small companies, do not enjoy the majority of the benefits while bearing regulations designed for larger LLCs.[45]

[1]Companies House, ‘Companies register activities: 2018 to 2019’ (Companies House, 1 August 2019) <https://www.gov.uk/government/publications/companies-register-activities-statistical-release-2018-to-2019/companies-register-activities-2018-to-2019?fbclid=IwAR3Zafs1q9sR92fhQaeEEoTYSiE_GRyPTveoq-ezVW8TeXop_mEfJ932pj4> accessed 15 January 2020

[2]Companies House, ‘Number of companies in the UK from 2018-2019’ (Companies House, 16 July 2019) <https://www.gov.uk/government/news/uk-company-statistics-2018-to-2019> accessed 15 January 2020>

[3] Chris Rhodes, ‘Business statistics’, [2019] Briefing Paper Number 06152, House of Commons Library, 5

[4]Vanessa Finch and David Milman, Corporate Insolvency Law: Perspectives and Principles (3rd edition, CUP 2017) 123-145

[5]Salomon v Salomon & Co Ltd [1897] A.C. 22 (HL); Alexis Mavrikakis, Helen Watson, Jacqueline Kempton and Nick Hancock, Business Law and Practice (College of Law Publishing 2017) 25; Susan Watson, ‘How the company became an entity: a new understanding of corporate law’ [2015] 2 J.B.L. 120-141

[6]Companies Act 2006, s 3; Insolvency Act 1986 s 74(3)

[7]Judith Freedman, ‘Limited Liability: Large Company Theory and Small Firms’ [2000] 63 Modern Law Review 317, 328

[8]ibid

[9]ibid

[10]Roger E Meiners and James S Mofsky and Robert D Tollison, ‘Piercing the Veil of Limited Liability’ [1979] 4 Del J Corp L 351, 359; (n 7) 332

[11]Alexis Mavrikakis, Helen Watson, Jacqueline Kempton and Nick Hancock, Business Law and Practice (College of Law Publishing 2017) 17; Alan Dignam & John Lowry, Company Law (10th edition, Oxford University Press 2018) 10

[12](n 7) 332

[13]Macaura v Northern Assurance Co Ltd [1925] AC 619 (HL); Alan Dignam & John Lowry, Company Law (10th edition, Oxford University Press 2018) 23

[14]Reinier Kraakman, et. al., The Anatomy of Corporate Law: A Comparative and Functional Approach (3rd edition, Oxford University Press 2017) 10-11; Alan Dignam & John Lowry, Company Law (10th edition, Oxford University Press 2018) 10

[15]Companies Act 2006, s 544(1); Reinier Kraakman, et. al., The Anatomy of Corporate Law: A Comparative and Functional Approach (3rd edition, Oxford University Press 2017) 10-11; Alan Dignam & John Lowry, Company Law (10th edition, Oxford University Press 2018) 26

[16] Paul Halpern and Michael Trebilcock and Stuart Turnbull, ‘An Economic Analysis of Limited Liability in Corporation Law’ [1980] 30 U Toronto LJ 117, 125

[17]Sofie Cools, ‘The Dividing Line between Shareholder Democracy and Board Autonomy: Inherent Conflicts of Interests as Normative Criterion’, [2014] European Company and Financial Law Review 258, 272-3; Reinier Kraakman, et. al., The Anatomy of Corporate Law: A Comparative and Functional Approach (3rd edition, Oxford University Press 2017) 12

[18]Alan Dignam & John Lowry, Company Law (10th edition, Oxford University Press 2018) 10; n(8)

[19]Alexis Mavrikakis, Helen Watson, Jacqueline Kempton and Nick Hancock, Business Law and Practice (College of Law Publishing 2017) 19

[20]Judith Freedman, ‘Small Businesses and the Corporate Form: Burden or Privilege’ [1994] 57 Modern Law Review 555, 564;

[21]ibid; (n 19)

[22]Richard Partington, ‘UK corporation tax cut to cost billions more than thought’ (The Guardian UK edition, 28 January 2019)                           < https://www.theguardian.com/politics/2019/jan/28/uk-corporation-tax-cut-to-cost-billions-more-than-thought> accessed 15 January 2020

[23](n 20), 555, 568; Laurence Cecil Bartlett Gower, ‘Gower’s Principles of modern company law’ (5th edition, London: Sweet& Maxwell, 1992) 106- 107; European Commission, Enterprise & Industry Directorate General: Think Small First – Considering SME interests in policy-making - including the application of an ‘SME Test’ (Report of the Expert Group, 2009) 4

[24] European Commission, Enterprise & Industry Directorate General: Think Small First – Considering SME interests in policy-making - including the application of an ‘SME Test’ (Report of the Expert Group, 2009) 4, 6-8, 12-13

[25](n 20), 556 – 558, 562

[26]The Company Law Review Steering Group, ‘Modern Company Law For a Competitive Economy – Final Report’ (June 2001) <https://webarchive.nationalarchives.gov.uk/+/https://www.dti.gov.uk/cld/final_report/prelims.pdf> accessed 15 January 2020

[27]ibid; House of Commons Trade and Industry Committee, The White Paper on modernising Company Law, (sixth report on session 2002-03) 7

[28] (n 19) 18

[29] Company Accounts Guidance (Companies House, 6 September 2019) < https://www.gov.uk/government/publications/life-of-a-company-annual-requirements/life-of-a-company-part-1-accounts >

[30](n 20), 557–558; Model Articles of Association

[31]Companies Act 2006 s 4, s 755-756; Johan Henning, ‘The Company Law Reform Bill, small businesses and private companies’ [2006] Comp.Law 27(4), 97-98; Reinier Kraakman, et. al., The Anatomy of Corporate Law: A Comparative and Functional Approach (3rd edition, Oxford University Press 2017) 22; Tareq Na’ el Al-Tawil, ‘Piercing the corporate veil: when LLCs and corporations may be at risk’ [2019] 61 No2 International Journal of Law and Management 328, 329

[32] Companies Act 2006, s 288-297

[33]ibid s 270(1), 336(1)

[34]The Companies, Partnerships and Groups (Accounts and Reports) Regulations 2015, s 8, 16, 21; Prepare annual accounts for a private company, (Companies House) <https://www.gov.uk/annual-accounts/microentities-small-and-dormant-companies >

[35]Companies Act 2006, s 22

[36]Re Duomatic [1969] 1 All ER 161; Cane v Jones [1980] 1 WLR 1451; Rolfe v Bernard Samuel Rolfe Tulsesense Ltd [2010] EWHC 244

[37]David Milman, ‘The regulation of private companies in UK law: current policy developments and recent judicial rulings’ [2009] 257 Company Law Newsletter, 1- 4; (n 20) 557 – 558; (n 8)

[38](n 18) 11; (n 20) 558; Department for Business, Energy & Industrial Strategy, ‘The Impact of exempting small companies from statutory audit – BEIS Research Paper’, [2017]

[39](n 26)

[40] European Commission, Enterprise & Industry Directorate General: Think Small First – Considering SME interests in policy-making - including the application of an ‘SME Test’ (Report of the Expert Group, 2009) 5

[41](n 18) 12

[42](n 19) 18-19

[43](n 19) 17; Paul Halpern and Michael Trebilcock and Stuart Turnbull, ‘An Economic Analysis of Limited Liability in Corporation Law’ [1980] 30 U Toronto LJ 117, 128

[44](n 19) 18

[45](n 18) 9