Starting a business is a daunting process with many complex decisions along the way. One of the first decisions you must make as a founder is choosing the optimal business structure for your startup.
There are various considerations in making this decision; you must consider:
- the set-up costs,
- tax implications,
- legal and liability risks, and
- your comfort level with each type of startup structure.
Today, we’ll look at common startup ownership structures, the basic conditions of each startup structure, and how you can appropriately weigh the pros and cons to make the right decision for your new business.
Types of business structures
There are three main types of startup ownership structures, each with unique advantages and disadvantages, plus a couple of other, more complex options to consider.
A sole proprietorship is precisely what it sounds like – sole individual trading as a business. In this structure, the business owner is entirely responsible for all aspects of the business and all the liability risks that come with it. Perks quick, easy and cheap set up, and filing only one tax return at year-end with the option to claim business losses to offset other income.
While this structure is quick and easy to set up with minimal costs both at set-up and ongoing, there are risks. If you choose to trade as a sole proprietor, all your business and personal assets are considered the same for legal purposes. This means that, should someone sue your business, your personal assets are at risk in the event of any legal action. Also, it is more difficult to bring on investors because you can not give them a “share” in an individual. If you plan to scale your business quickly or have lofty long-term plans, this is probably not the structure for you.
A partnership is also a relatively straightforward structure to set up, and it’s often used when two or more professionals, such as lawyers or accountants, wish to set up their own business together. In a partnership, it’s crucial to have watertight legal documents that set out all parties’ rights and obligations. If you skip this step, things could get messy very quickly.
Income tax is handled on an individual basis. In day-to-day operations, the members of the partnership share control of business management according to the guidelines set out by the partnership agreement. However, it’s vital to be aware that all members of the partnership are liable for the partnership’s debts, actions, and obligations. If your partner makes a bad business decision without consulting you, you are still liable for the consequences of that decision.
In a way, a partnership’s pros and cons are quite similar to a sole proprietorship – the partnership is relatively easy, cheap and quick to set up, but its members are exposed to a lot of risks, and it will usually be more difficult to convince investors in the startup space to invest in a partnership.
As a general rule, a private company is an ideal vehicle for a startup. An incorporated company is a separate legal entity, a dedicated vehicle that creates a clear separation between the business itself and the founders. It does not matter if a company has a single founder who serves as the sole director and sole shareholder of the company – the law will continue to view the company and the founder as separate. This means that the sole founder will not be liable for the debts of the business unless very special circumstances apply. This is massively important for founders and investors alike – both founders and investors must have the confidence that creditors of the business will not be able to come after the founder’s/investor’s personal assets.
There are other benefits to using a company to run a business or startup. Since companies have a share capital, it is easy to quantify, allocate and transfer shares between founders, investors and employees (including through an employee share option plan). Also, companies have a flat tax rate which can make them ideal vehicles to accumulate cash in.
The downsides of incorporating a company are usually that it is (comparatively to sole proprietorships and partnerships) a bit costlier and more complicated to set up and maintain. However, the cost and administrative burden are not huge. We consider it more than worth it, in light of the considerable benefits that this structure provides.
While other options are available, such as trust arrangements or joint ventures, these are generally unnecessarily complicated for a new startup. Should your circumstances suggest using another structure, this is something your lawyer would discuss in detail with you – as these structures require legal assistance to create anyway.
Why a two-company structure is something you should consider
As already established, an incorporated company is generally the best structure for a startup. However, did you know there are further options for a two-company structure? In many situations, a two-company structure is advantageous for risk mitigation.
When dealing with a one-company structure, you should be aware that the single company – the startup – automatically holds all ownership and responsibility. So, the company conducts business operations; holds contracts with suppliers, customers, investors and more; hires employees; and holds ownership of all financial, physical, and intellectual assets. This is a heavy load to carry in terms of liability and risk.
A two-company structure usually consists of a holding company and a subsidiary company. As the name implies, the holding company holds ownership of all intellectual property, assets, and trade secrets. The subsidiary company enters into a contract with the holding company to use these assets to conduct business. In this situation, the subsidiary company conducts all day-to-day business operations such as trading, hiring, and contracting with suppliers.
Let’s look at a startup offering cybersecurity software that has accidentally leaked client data. The loss incurred by the clients will likely result in claims against the startup and suddenly the startup will find itself in the middle of an extremely costly legal dispute. If the startup’s assets such as their software IP, brand, and cash are all in one company, they will be vulnerable to claims and the startup faces a likely risk of losing valuable assets such as their software and brand name. However, if the startup is using a holding company to hold its software IP, brand, and most of its cash reserves, those assets would be protected from the operating company’s creditors. This would allow the startup to form another operating company and continue operation even if their previous operating company enters administration. It should be noted that this structure is complex and requires legal assistance to set up (if you wish to do it properly).
Overall, an incorporated company is the best structure for a startup that plans to scale rapidly or expects a great deal of growth. While this may seem like a straightforward decision, it’s still important to engage in legal consultation to ensure that you make the best possible choice for your business and its future. At UX Law, we provide startups and entrepreneurs with practical legal solutions to protect and empower their businesses. Book a free consultation to explore how we can help your startup.