Startups | Which Legal Form to Choose for Business?

The choice of the appropriate legal structure is a pivotal decision in setting up a business entity, and this decision often points towards establishing a private limited company in India. However, the array of available options, from sole proprietorship to limited liability partnerships, should not be dismissed lightly. Each structure comes with its unique set of advantages and disadvantages, ranging from simplicity and cost-effectiveness to limitations on liability and access to capital. Thus, making an informed choice becomes essential.

In India, businesses can be organised in various forms, such as Sole Proprietorship, Partnership, One Person Company (OPC), Limited Liability Partnership (LLP), and Private Limited Company. Each of these types has its own advantages and disadvantages, encompassing aspects like business planning, number of partners, investment requirements, foreign investment, operational scope, and risk tolerance. Consequently, it is crucial to thoroughly analyse the implications before proceeding with any particular structure.

Sole Proprietorship

A sole proprietorship is a business organisation solely controlled, managed, and run by an individual. There are no partners. Starting a sole proprietorship is the easiest and least expensive way to operate a business. There are no required documents or forms unless the business operates under a name different from the owner. However, note the drawbacks. The proprietor is personally responsible for debts and legal matters, and their liabilities are infinite regarding claims that third parties (customers, vendors, employees, etc.) may raise on the business. Further, financial assistance can be difficult to obtain as sole proprietorships cannot issue shares or bonds/debentures. Also, proprietorships cease upon the owner’s demise unless a specific succession plan exists.

Partnership Firm

A partnership involves two or more individuals running a business. The maximum number of partners in India is capped at 20 for general businesses and 10 for banking businesses. Since multiple partners are running the business, they can pool their capital, assets, and efforts for the business. A partnership can simply be created by an understanding between the partners, which may or may not be registered. However, for tax purposes, it would be compulsory to meet the regulatory requirements. The primary disadvantage of this vehicle is that the liability of the partners continues, like proprietorships, to be unlimited.

Company

A company is a legal vehicle that is created (incorporated) under the Companies Act, 2013. The first and crucial step in organising a company is determining the share ownership among founders, usually expressed as a percentage of the total number of shares. This ownership percentage is significant for each founder. Subsequently, directors are appointed to decide the allotment of shares to investors. The beauty of a corporate structure (company) is that it separates the ‘ownership’ of the company from its ‘management’. The ownership is with the shareholders, while the management of the company vests with the directors.

The liability of the shareholders is limited to the share capital that they have invested in the company—that is, once the company exhausts all the money that they’ve invested, and if various parties make further claims against the company, such claims cannot be recovered from the shareholders.

The same may not hold true for a director, though, and directors may be personally liable for wrongdoings or neglectful running of the company.

The disadvantages of choosing a company as the business vehicle are mainly linked to costly and cumbersome compliances. Corporations can be complex and expensive to establish, requiring extensive record-keeping, reporting, and operational procedures. However, the advantages (primarily, the limitation of liabilities, separation of ownership from management, and the ability to raise finances by issuing shares) far outweigh the disadvantages.

Limited Liability Partnership (LLP)

In the last decade, LLPs have gathered much traction. An LLP is a partnership, but, added with the protection of limitation of liability. The liability of the limited partners is limited to their agreed contribution to the LLP (akin to the share capital contributed by shareholders in a company). LLPs offer benefits such as easier starting procedures with fewer formalities and lower registration costs compared to a company. The annual ROC compliance for LLPs is also less than that of a company. In LLPs, however, transferring ownership rights requires the consent of all partners, and the LLP must be dissolved if the number of partners reduces to one. Also it is also important to note that FDI in LLPs is only allowed with prior approval from the Reserve Bank of India (RBI), and LLPs cannot issue certain company-specific schemes (such as ESOPs).

One Person Company (OPC)

Similar to a sole proprietorship, a one-person company is controlled by a single individual. For a one-person company registration, only one person is required to act as the shareholder and director. However, another person needs to be nominated as the nominee of the sole shareholder. The number of directors can exceed one and go up to fifteen. It is important to note that OPC is suitable if the company’s capital is up to Rs. 50 Lakhs and turnover is within Rs. 2 Crores. One-person companies must comply with all the regulations stated under the Companies Act of 2013. Regarding legal compliance, sole proprietorships are easier to manage since they have simpler requirements. However, one-person companies benefit from better management and control over the business due to the organised structure prescribed under the Companies Act of 2013.

Charitable Organisations

Many entrepreneurs today are venturing into the social entrepreneurship space with the intent of carrying out charitable, non-profit activities. The purposes of such entrepreneurs are not the usual ones—i.e., to run a successful business, garner investments, and make a killing in profits and exits. They choose sectors such as education, health, poverty relief, sanitation, and drinking water, among others, to make a positive impact on society. In India, such activities can be legally organised in trust, society, and section 8 companies.

A society is suitable if you want an elected body to manage the organisation. Society members are not bound indefinitely and can easily exit if desired. Among the three options (trust, society, and Section 8 company), winding up a society is the simplest process.

A trust is an association of persons where certain custodians (trustees) are in charge of its activities and property. The beneficiaries are the public at large (say, children who benefit from the trust’s educational activities). Trusts are very common vehicles for charitable activities, and the regulator for trusts and societies is the Charities Commissioner in the jurisdictional State.

A charitable company (i.e., a company incorporated under section 8 of the Companies Act) has all the characteristics of a limited company, as explained above. However, a charitable company cannot declare dividends to its members, and even in the case of a liquidation or winding up of the company, the shareholders cannot benefit from the property and assets of the trust. Its profits are to be utilised only for the promotion of its charitable objects.

Charitable organisations primarily rely on donations, grants, and gifts obtained from the public, government, private organisations (e.g., for CSR activities), and philanthropic individuals. However, such organisations can also carry out commercial activities, with the condition that the profits or surplus from such activities have to be ploughed back and used for charitable purposes. These organisations are granted tax exemptions and benefits, subject to certain statutory compliances and filings to be made periodically.

Conclusion

For those who opt for the rigour and compliance that come with a company structure, the benefits of limited liability, separation of ownership from management, and the ability to raise funds through share issuance far outweigh the complexities. However, for those pursuing a blend between partnership and limited liability, Limited Liability Partnerships (LLPs) offer a compelling alternative, offering protection while reducing formalities.

In the realm of social entrepreneurship and non-profit activities, understanding the distinctions between trusts, societies, and Section 8 companies becomes crucial. These entities play a vital role in driving positive change and making a meaningful impact on society while adhering to specific legal frameworks. The choice between them hinges on factors such as governance, ease of dissolution, and utilisation of resources. Whichever structure a startup selects, it is imperative to recognise that these legal frameworks are more than just paperwork; they serve as the foundation for the startup’s future endeavours and impact.

*Authored by Shivam Mishra, Advocate at Metalegal Advocates. The views are personal and do not constitute legal opinion. *