Primary features of different business entities

In our last article, we discussed the factors to be considered before incorporating a business entity. Now, let us discuss different forms of business entities (particularly if one is starting small and on a shoestring budget) with some pros and cons.

I.           SOLE PROPRIETORSHIP

This is the simplest form of a business entity. In a sole proprietorship concern, one person is in complete charge of an entity’s operations, profits and debts. This essentially means you and your business are synonymous. The entity is started in your name, and all payables are your responsibility and all benefits accrue to you.

The advantages of this arrangement are that you have no one else to answer to and the arrangement is the simplest. But there are many disadvantages to mingling your personal expenses with your professional ones and with a sole proprietorship, you are personally responsible for financial issues related to your business.  Raising money for a sole proprietorship can also be difficult.

Banks and other financing sources are reluctant to make business loans to sole proprietorships. In most cases, you'll have to depend on your own financing sources, such as savings, home equity or family loans.

In India, it is the most preferred entity, it requires only 1 person for its registration. It is easy to start with less costs and minimal legal compliances (under GST registration, Shops & Establishments Act, etc.). A person, if simply wants to test an idea, he or she can start the business with this form and then can simply convert it into other entities later, when business starts growing. The only disadvantage it comes with is that it has no concept of limited liability and it is also difficult to raise the funds in this form of startup.

II.           PARTNERSHIP

This entity is owned by two or more individuals. If you decide to bring in any partners, you will need to set up a general partnership which usually includes some sort of formal partnership agreement signed by all partners. This kind of business structure is also simple and easy to operate and forming a partnership will enable you to raise money by selling partnership interests.

This entity is ideal for anyone who wants to go into business with a family member, friend or business partner, like running a restaurant or agency together. A partnership allows the partners to share profits and losses and make decisions together within the business structure. However, you are liable for the decisions made, yours as well as those actions made by your business partner.

With a general partnership, there is still a fuzzy line between personal and business finances so all partners could find themselves in financial trouble as a result of a business issue. There’s also some potential confusion around partner roles, responsibilities, and liabilities.

A primary advantage is that the partnership does not bear the tax burden of profits or the benefit of losses-profits or losses may be "passed through" to partners (as salary) to report on their individual income tax returns.

However, primary disadvantage is unlimited liability-each partner is personally liable for the financial obligations of the business. Further, partnerships are more expensive to establish than sole proprietorships because they require more extensive legal and accounting services.

In India, a partnership firm is governed by The Partnership Act, 1932. 2 or more people can form a Partnership. It’s a relatively good choice for a family business. There is a lot of confusion between startups while choosing between Partnerships and LLPs. While former requires lesser compliances, the latter comes with unlimited liability. Hence, the choice is difficult to make. It is not mandatory to register a general partnership with the Registrar of Partnerships. However, an unregistered partnership cannot sue or be sued in its own name.

Limited Liability Partnerships (LLPs) governed by the Limited Liability Partnership Act, 2008 allows partnerships with limited liability. However, the costs and compliances are higher than that of a general partnership.

III.           COMPANY

A Company is a legal entity that is created to conduct business separate from those who founded it. Like a person, a corporation can be taxed and can be held legally liable for its actions.

The primary benefit of corporate status is the avoidance of personal liability. Another plus is the ability of a company to raise money. A company can sell its shareholding, either equity or preferred, to raise funds. Companies also continue indefinitely, even if one or more of the shareholders die, sell the shares or becomes disabled.

The primary disadvantage is the cost to formation and the extensive record-keeping that's required. A company must follow more complex rules and regulations than a partnership or sole proprietorship, it requires more accounting and tax compliances and reporting.

If it is intended to set up operations in India, the startup has the option of incorporating either as a company or as a partnership. Due to the restric-tions placed on foreign direct investment into part-nerships, startups prefer incorporating as a company in India. The company can be incorporated either as a private company or a public company or a one per-son company depending on the type of investment sought and nature and size of its operations. However, most startups prefer to initially start as a private company since such model offers greater cor-porate flexibility to the company. A private company is also easier to structure and is a relatively simpler vehicle for channelling foreign investments (through tax effective jurisdictions). A public company has to comply with stricter regulations and compliances. Further, a private company can be easily converted into a public company at a later stage. Further, as per the amended Companies Act, 2013, there is no requirement for minimum paid up capital which is a welcome move especially for startups. After decid-ing the nature of the entity, certain filing procedures with the Registrar of Companies must be complied with in connection with its incor-poration as provided below.

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This is second in our series of articles on startup ecosystem and related issues. Assisted by our Student Researchers team of Ishan Chauhan, Harshdeep Singh Bedi, Ankesh Kumar and Vanya Srikant.