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Startups | Which legal form to choose for business?

In the journey of setting up a business entity, the choice of the appropriate legal structure is a pivotal decision, 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 organized 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 analyze the implications before proceeding with any particular structure.

Sole Proprietorship

A sole proprietorship is a business organization solely controlled, managed, and run by an individual. There are no partners. Starting a sole proprietorship is the easiest and least expensive way to begin operating 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 to exist upon the owner's demise unless a specific succession plan is in place.

Partnership Firm

A partnership involves two or more individuals running a business. In India, the maximum number of partners is capped at 20 for general businesses and 10 for banking businesses. Since there are multiple partners 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 organizing 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 there are further claims on the company from various parties, 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 neglectfully running 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 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 certain company-specific schemes (such as ESOPs) cannot be issued by LLPs.

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. In terms of 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 organized structure prescribed under the Companies Act of 2013.

Charitable Organizations

A good number of 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, drinking water, besides others to make a positive impact on society. In India, such activities can be legally organized in three forms – trust, society, and section-8-companies.

A society is suitable if you want an elected body to manage the organization. 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 made in charge of the activities and the property of the trust. The beneficiaries are the public at large (say, children who benefit from the educational activities of the trust). Trusts are very common vehicles for charitable activities and the regulator for trusts as well as 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 dividend 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 utilized only for the promotion of its charitable objects.

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

Conclusion

For those who opt for the rigor 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 in pursuit of 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 utilization of resources. Whichever structure a startup selects, it is imperative to recognize that these legal frameworks are more than just paperwork; they serve as the foundation upon which the startup's future endeavours and impact are built.

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

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