What is the best legal entity for your business?
A decision to collaborate has been taken. The founders are eager to start their business. Difficult conversations (though an ongoing process) are mostly done. The next question that the founders typically have to tackle is - what entity should we pick to kickstart our venture?
Most ‘established’ startups are incorporated as a private limited company. The question is - why? What is so special about a private limited setup that almost all startups pick it? Why are other entity options, such as a partnership firm, Limited Liability Partnership (LLP), One Person Company (OPC) or a sole proprietorship not as preferred? Through this article, my aim is to analyze the different options and give a broad overview of their pros and cons. Since most of the below mentioned entities are highly regulated, it is not possible to cover all their key features. Accordingly, this article lists down some important considerations, which, in my experience, have been of interest to founders.
A sole proprietorship, perhaps the easiest way of starting a business, is nothing more than the proprietor itself. It is not an independent legal entity and all its assets are deemed as the assets of the proprietor. There is no specific registration requirement either, which makes the process of starting a proprietorship a lot less cumbersome. In case the profile of the proprietorship triggers the requirements under the Shops & Establishments Act, a specific registration has to be done. This registration, along with bank statements, often acts as name and address proof of the proprietorship.
Even in terms of operation, there are no restrictions or continuous compliances as such. Note that the personal income of the proprietor as well as that of the proprietorship is deemed as one and no separate tax returns are filed. Clearly, this model is not suited for ventures where there are two or more founders.
Foreign investment permitted: No.
Partnership firm under the Indian Partnership Act, 1932
A partnership firm is (relatively) more structured and requires registration under the Indian Partnership Act, 1932. Two to 20 partners come together, decide their contributions, duties, salaries, etc., sign a partnership deed and register it with the Registrar of Partnerships. Clearly, there is a cap on the total number of partners. Further, it is important that all partners are physically present before the Registrar at the time of registration. So, it is not most suitable if one founder resides in a different city/state.
Once registered, the terms and conditions of the partnership deed will govern how the firm will operate and the extent to which each partner will be liable. While the partnership firm is not a separate legal entity, it has a limited identity for the purpose of tax where the firm is taxed separately from its partners. One of the biggest advantages that a partnership firm has over its competitor entities is that it is less cumbersome to wind up if the partners so desire. This is a big factor when the founders are looking to start a venture more as an ‘experiment.’ Further, it can also be converted into a LLP (the benefits of which have been explained below) by filing requisite forms with the Registrar of Companies (ROC).
For founders looking to raise money, a partnership firm may not the ideal entity type. No financial investor would take on the liabilities that are associated with being a partner, and would always ask the co-founders to convert the partnership structure into a LLP or a private limited company. So, even though it is relatively the most cost effective and easy to manage entity structure, it is not suited for a startup looking for investors.
Foreign investment permitted: No
Private limited company under the Companies Act, 2013
A private limited company is perhaps the most sought after entity form that startups (and most companies in India) use. It is a distinct legal entity, different from its shareholders and key managers, unlike a partnership firm described in point two above. Incorporating it requires a minimum of two shareholders and two directors and the shareholders and directors are not personally liable for the acts of the company but can be fined and/or imprisoned in their official capacity. Therefore, it is important to understand the role, duties as well as the liabilities that are associated with being a director. Further, the minimum authorized and subscribed capital of a private limited company has to be Rs. 1,00,000. For a lot of early stage startups, this can be a hurdle because they have to put in their own money. In addition to Rs. 1,00,000 that has to be transferred in the company’s bank account for share subscription, there are also costs associated with incorporating the company and paying stamp duty.
A company requires substantial compliances as well. For instance, there have to be quarterly board meetings, various registers have to be maintained (register of assets, share transfers, etc.), accounts have to be adopted within six months from the closing of the financial year and filed with the ROC, etc. In short, laws are drafted in a manner that they keep a check on how the company is being managed. Since the manner in which a company has to operate is streamlined by regulations, it is possible for investors to conduct a due diligence and evaluate potential risks associated with their investment.
Unlike a sole proprietorship or a partnership firm, in case the co-founders decide to shut shop because the venture did not work, winding up a company is not easy. It is a completely court driven process and can take anywhere between one to two years. No founder is happy about spending (more) money just to wind-up a company, especially since the company is being wound up because it did not make enough money!
So clearly, if the founders are only experimenting with their idea or don’t want to invest too much money in the entity but use it towards their business, a private limited company may not the best option. From an investor’s perspective, a private company is a stable structure because not only is their investment relatively secure (due to the ongoing monitoring by regulatory authorities), it also demonstrates the seriousness of founders to do business.
Foreign investment permitted: Yes, subject to the latest foreign direct investment policy issued by the government. Some sectors can receive 100% FDI under the ‘automatic’ route while some require prior government approval.
One Person Company under the Companies Act, 2013
OPC is a very recent concept introduced through the new Companies Act, 2013. As the name suggests, the Companies Act allows one shareholder to incorporate a private limited company with only one director. This gives operational ease and comfort to proprietors looking to give a more stable and independent structure to their business. Of course, since OPC is a legally incorporated entity, it has to ensure compliance with the Companies Act, 2013. However, it has been given some operational freedom. For instance, OPC does not have to include a cash flow statement in its financials, it is required to hold only two board meetings in a calendar year (one in each half with more than 90 days gap between two meetings), etc.
In terms of capital, an OPC, like a private limited company, also requires a minimum authorized and subscribed capital of Rs. 1,00,000. In case the subscribed capital goes beyond Rs. 50,00,000 or the turnover exceeds Rs. 2,00,00,000, OPC has to file the requisite forms with the ROC to get its status converted into a private limited. Winding up of OPC follows the same process as that of a private limited company. It takes time and can be fairly expensive.
Based on the above characteristics, OPC is best suited for a single founder who wishes to launch his/her/its product/service in a more structured manner and get a taste of how to run a private limited company. However, like a private limited company, it is not meant for a founder who is still looking to ‘experiment’ with the venture.
Foreign investment permitted: Yes, subject to the other OPC-centric thresholds.
LLP under the Limited Liability Partnership Act, 2008
LLP was introduced and regulated by the Indian government from December 2008 through the Limited Liability Partnership Act, 2008. It is an entity structure that is a fusion of a private limited company and a partnership firm. Unlike the latter, LLP is a separate legal entity and limits the liability of its partners. Two designated partners are required to incorporate a LLP. The incorporation process is similar to that of a private limited company and OPC and is entirely online. There is also no minimum capital requirement.
In terms of compliance, a LLP does not have obligations similar to that of a company. There is no requirement to maintain registers, minutes, etc. However, it is required to file its accounts and annual return with the ROC. Even in terms of taxation, the profit after tax from a LLP’s operation is reflected in the personal income of partners. Finally, with respect to winding up, the process is not complex and can be done by filing the requisite forms with the ROC.
Based on the above, LLP does appear like an ideal entity structure. It gives operational ease to partners to manage the business and creates a system of accountability through the mandatory ROC filings. However, conversion of a LLP into a private limited company is still a grey area. Therefore, if the founders wish to convert their LLP into a company, they will have to independently incorporate a company and have that company acquire the LLP.
Foreign investment permitted: Yes, but only after seeking government approval and only in sectors where 100% FDI is permitted under the automatic route for a private limited company without any FDI-linked performance conditions.
Needless to say, all entity options have their pros and cons. According to me, the decision to pick an entity can be summarized as follows:
- In case the founders have a definite plan and vision and are looking to get funding: LLP or private limited company, subject to how much money they wish to invest upfront.
- If the venture is an experiment and the founders are unsure of how it will run: partnership firm or LLP.
- In there is one founder who has a well defined business plan for the venture and is looking to start small but grow as the venture grows:
- If there is one founder who wants to experiment with the venture and gauge feedback before diving deep: Sole proprietorship.
Tip for founders: 1) Don’t rush into incorporating a private limited company and make sure you consult your advisors. Once you board the train, it is very expensive to get off!
2) No matter what entity you pick, take compliance seriously. It is an area where founders get very relaxed till they don’t get to a Series A round of funding (provided the entity is a company). While I understand the approach, you definitely don’t want potential liabilities to lower your company’s valuation at that stage!