Benefits of Forming a Limited Liability Company
Once you have determined the viability of your business idea and are ready to start your venture, you need to choose a legal structure for your business and register it with government. Almost every country requires that you register a new business with a relevant regulatory authority that is established by the government. Most countries typically permit a variety of legal structures for a business, such as a sole proprietorship, a partnership and a limited liability company. In nearly all cases, the type of legal structure that offers the most benefits and flexibility to a new start-up is a limited liability company.
Early-stage entrepreneurs can often get discouraged from incorporating their business due to the initial costs involved, but this is a mistake. Apart from creating an image of professionalism with partners and clients, incorporation brings numerous other advantages, including limited shareholder liability, easier access to venture capital, ability to align interests of multiple stakeholders and various tax benefits. This is true regardless of what jurisdiction the company is founded under. Moreover, since a corporation is a legal entity in the eyes of the law, it can continue to exist even after its founders have deceased or moved on to a new venture, and can be passed from owner to owner relatively easily.
This article will discuss the benefits of running your business under the corporate structure of a company. If you would like to learn what a company is, see our article what is a company and how it works.
Unless you incorporate your startup with a business structure that provides limited liability, you can be held personally responsible for the debts and mistakes of your business. For example, if you run your business as a sole proprietor, you are taking on unnecessary personal risk. Because you are a sole proprietor, the law does not differentiate between your personal assets and that of your business. To satisfy the legal judgement, you could be legally forced to do things such as remortgage your house, sell your car and deplete your children’s college fund if your business did not have sufficient money to satisfy the judgement. The fruits of your hard work over many years can evaporate overnight.
One of the greatest benefits of structuring your business as a limited liability company is that it limits the liability of all shareholders. Your business becomes a separate legal person, the only one responsible its own debts and liabilities. In other words, liabilities of the business are insulated from its individual shareholders and therefore do not endanger the personal assets of any shareholder. A creditor can only attack the assets of a shareholder that he or she has invested in the business.
Ultimately, limited liability promotes entrepreneurial behavior by allowing companies to make business decisions on their individual merit, without risking personal assets. Business owners are more likely to take considered business risks when they know that their personal assets will remain secure regardless of the extent to which their venture succeeds.
A company is owned by shareholders, which can be individuals or other business entities, such as another company. Portions of a company, divided into shares of stock, can be bought or sold without having any effect on the underlying structure or function of the company. This makes companies robust and flexible when it comes to sharing ownership or attracting experienced managers and employees.
Dividing a company into shares makes it easy for founders to share ownership of the business with each other and with new hires. Let’s say that Anton, Bernard and Chris decide to start a sweet shop together. Because Anton is independently wealthy, he funds the business in its early stages. In return, he receives the most equity, and the founders split the business 50:25:25. Since all three founders own a stake in the business, it is in each of their interests to make it a success.
As the sweet shop develops into a chain of businesses nationwide, the ability to issue stock gives the founders great flexibility in their operations. If none of the founders has management experience, they can hire a professional CEO to run the company on their behalf, while still retaining ownership. Google did this famously in 2001 when they hired Eric Schmidt to replace founder Larry Page as CEO. For example, Bernard’s friend Daniel might be drafted to run the company once it reaches 100 employees. If Daniel, or any other senior manager, proves to be a good hire, the founders can choose to give him or her a stake in the business. Once the business reaches a certain size, the founders can choose to “exit” by selling the company to a larger corporation or taking it public on the stock exchange. None of this would be possible without incorporating the business as a company.
In a partnership or sole proprietorship, the process of reassigning the ownership of parts of the business is cumbersome, time-consuming and expensive. In most cases, a partner cannot transfer his or her stake in the business to another partner without the written consent of all the partners. If a partner decides to terminate his or her involvement in the partnership without acquiring this consent, the partnership may have to be dissolved.
Incorporating a company might not prevent shareholder disputes altogether, but it does ensure that they cause minimal disruption to business activities. In corporations, the stakes held by individual business owners are represented by the shares of stock that they own. For the inevitable times when a founder decides to leave, incorporation allows the easy transferability of stocks from one person to another.
Easier Access to Capital
Another consequence of limited liability is that it enables other investors to provide capital to the company. Banks, angel investors and venture capitalists have one thing in common — they seek to minimize unnecessary risk on their investments. As incorporation limits liability to the amount these investors put into the company, it makes a business more attractive to investors. This is not the case with a sole proprietorship or a partnership.
Another problem facing sole proprietors and partnerships looking for investment is that, unlike a company, they have no shares to offer potential investors. To encourage investment, the legal structure of your business must be able to easily accept the investment. With a company, shares can be sold or transferred between shareholders without difficulty. This permits a business owner to transfer some of his or her equity in a company in exchange for investment or issue new shares. Moreover, it gives the investors assurance that they can exit the investment by simply transferring their shares to another buyer. The most successful companies sell their shares to the general public in stock exchanges, increasing the amount of capital available to the corporation and potentially the size of the investor’s return.
Another reason investors prefer companies is that they allow for different classes of stock. A venture capitalist investing in your business will expect preferred stock, as opposed to common stock. A common key difference is that preferred stock gets its investment back before common stock.
Incorporating your business generally will reduce the taxes you pay, making your business more profitable on a “take home” basis. Sole proprietorship and partnerships are taxed based on the owner’s personal income bracket as if the business’ profits were the owner’s salary. Because companies are considered separate legal entities, companies are taxed at the corporate rate. The corporate tax rate varies depending on where your business is located. In many countries including Singapore, corporate tax rate is lower than the personal income tax rate.
Companies can also reduce their tax burden through deductions. Most businesses can deduct business expenses, such as marketing, travel and entertainment. Incorporated businesses can also deduct employee salaries, health benefits, and contributions to qualified pensions and retirement plans. Furthermore, specific tax rebates may be made available to certain types of companies as part of government’s scheme to promote business is a particular segment or geography.
Progressive and entrepreneur-friendly countries like Singapore make sure that company shareholders pay tax only once on profits of the company. Consequently, Singapore imposes no tax on dividends that the company pays to its shareholders.
Incorporating a company established a professional identity. It increases credibility with customers and suppliers as it conveys legitimacy, authority, and permanence. As well as increasing revenue, this helps in the long-term as the business engages in marketing activities and seeks to establish itself as a brand in the consumer consciousness.
Consumers often prefer to do business with an incorporated company, because if a business takes itself seriously enough to incorporate, the chances are that it takes its product offering seriously, too. In some industries, a formal business structure is a prerequisite to winning contracts. Many companies are more comfortable hiring a company rather than a sole proprietor.
Incorporating has a positive effect on the self-image of a founding team. Incorporation marks the start of a new era in the life of the business as it moves from vague idea to tangible reality. Sometimes, the act of incorporating can reassure the founders in their own minds that they are serious business professionals. This can give them the confidence required to keep pushing ahead with growing the business.
Let us close by returning to a fictitious grocery store. Let’s say the store is a partnership between you and your business partner, Jim, rather than a limited company. Tragically, Jim dies prematurely as a result of complications arising from the injuries he sustained in his alcohol-induced car crash. As your business is not incorporated, it is summarily dissolved on the spot, leaving you to deal with complicated, expensive legal problems relating to what used to be the business’ assets.
All of this can be easily avoided by incorporating the business as a company. Corporations exist independently of their owners, and continue to exist indefinitely regardless of whatever fate befalls individual directors or shareholders. The only instance which the corporation will cease to exist is when the directors and shareholders decide to dissolve it.
This is important for attracting partners and employees who do not want to be adversely affected by one individual’s premature death. In this way, incorporation avoids ridiculous situations like multinational corporations being forcibly shut down because of the death of an elderly shareholder who held less than 0.01% of stock.
Forging ahead with a startup without incorporating a company is a foolish idea. Corporations give founders flexible ownership and tax advantages, while minimizing the chances of disputes or deaths shutting the company down prematurely. Limited liability protects owners. And, incorporating increases credibility among clients, other businesses, banks and investors.
For general topics on how to plan and grow your startup, see our Startup Mentor section. For specific details of how to launch and manage your startup in Singapore, see our Launch in Singapore section.