1. Limited Liability
For many people this is the deciding factor.
Starting a new business is often a risky venture: usually people are putting into the business their personal savings and often they are giving up secure employment to start their own firm. It is often important to them to know that their risk is limited to these amounts and that if the business fails they will not be liable beyond the amount of capital they have decided to put in. in this way they can protect their house and other personal assets from being sold to pay the business debts. Without such limited liability, the ultimate risk of business failure is personal bankruptcy.
The limited company will, however, operate subject to the following practical considerations:-
(i) Bank Borrowing
If the company borrows money from a bank, the bank will automatically require the directors of the company to give personal guarantees (i.e. to contract that they will pay back the bank if the company fails to do so). The bank may also require security over the company's assets (see below: floating charge) and/or the directors' personal assets (e.g. a mortgage - or second mortgage - on a director's house).
(ii) Landlords
A landlord may insist that if a small limited company is going to take a lease of premises the directors give personal guarantees, for payment of the rent, or other obligations under the lease.
(iii) Trade suppliers
Some trade suppliers may also require personal guarantees. This tends to happen only with major suppliers of the business, e.g. breweries to pubs/winebars, petrol companies to garages, franchisors to franchisees.
(iv) Liability for insolvent trading
In the vast majority of cases there is no personal liability on the directors or shareholders of a company that fails. In exceptional cases, if a limited company does become insolvent, the people running it can be made personally liable for some or all its debts if they have incurred debts which they knew the company could not pay (fraudulent trading) or, once they knew or ought to have known that the company would become insolvent, they have failed to take steps to minimise the loss to the creditors, by failing to put the company into liquidation or at least stopping the business (wrongful trading). Apart from being made liable for the company's debts, the directors could incur other penalties, such as a fine (or even imprisonment) for fraudulent trading or being disqualified from acting as a director. See related topic: What legal liabilities could directors incur?
(v) Non-legal pressures to pay creditors
People do not like not paying their debts and creditors do not like not being paid. Sometimes people will personally pay their company's debts, or some of them, because they do not wish to default, and feel obliged by moral pressures or the unpleasantness of being pursued by creditors.
(vi) The amount of risk
Some types of business involve substantially more financial risk than others. This depends on such factors as the amount of capital involved in setting-up the business, the nature of the trade itself, and how easy it is to reduce the outgoings to match the income.
At one end of the scale a service business which can be run from home, with little or no assistance, without expensive capital equipment and where very little has to be expended before invoicing the client, involves low risk and can probably be safely run as a sole trader/partnership.
On the other hand a manufacturing business which needs premises, expensive machinery, the purchase of raw materials, the employment of staff, etc. all before anything can actually be made, let alone sold, involves high risk and would normally be incorporated.
2. Taxation
Registered companies are subject to a different tax structure (corporation tax) from sole traders or partnerships. The choice of structure can make a substantial difference to the amount of tax paid on the same trading profits.
3. Formalities
Registering a limited company and the continuing registration requirements are additional formalities which do not apply to sole traders or partners.
The initial formalities are those of setting up the company . The continuing formalities are:-
Keeping the registered information up to date, both at Companies House and on the company's own registers. (Information to Companies House must be sent on the right official form). Submitting an annual return and accounts. (In some cases accounts must be audited). Holding board and general meetings and keeping minutes.
A sole trader is not involved with any of these. A partnership should have a partnership agreement drawn up (though this is not an absolute legal requirement).
A Limited liability Partnership LLP is a hybrid between a company and a partnership. It has to be registered at Companies House but the formalities are less than for a company.
4. Privacy
A registered company has to send information about itself to Companies House, where it is put on public file. Anybody can request a copy of the file and so can look up all the registered details of the company. Information from Companies House is increasingly being made available on-line. The information includes a copy of the annual accounts (though for small companies this need be only a simplified balance sheet) and details of the company's directors, including share ownerships, other directorships, home addresses, etc. Some people do not like this amount of information being publicly available.
On the other hand, the availability of this information can make it easier for the company to get credit, once it is established, because a search at Companies House can show that the company is of a certain size and appears to be stable and growing.
5. The floating charge
A floating charge is a mortgage of (usually) all the company's assets, both present and future, and on terms that the company may deal with the assets in the ordinary course of business. It is a good way, and in practice the only way, of using the assets of a business other than the premises as security for a loan. A floating charge is usually included in a debenture (perhaps with a conventional mortgage on the premises and other fixed assets) and is usually in favour of a bank.
The floating charge is a factor in the choice of business format because only registered companies can create floating charges. A sole trader or partnership, with exactly the same assets, cannot give this type of mortgage.
So if the business needs to borrow money and the bank (or other lender) wants a charge on all the assets, the business will have to be a registered company.
The bank may have a second reason for wanting the business to be a limited company. It is usual for banks to require directors of small companies to give personal guarantees of any loans to their companies. If the business fails, the bank is better protected if the business is a limited company because only the bank will have a personal guarantee and so access to the owner's personal assets. If the business is in the format of a sole trader or partnership, all the creditors have access to the owner's personal assets.
6. Name protection
The only system for the registration of names is that for registered companies. If the name is important to the business, its owners may want to obtain registration so as to prevent anybody else registering it and to warn anyone searching the index of companies to avoid similar names.
Even if the business is to be a sole trader or partnership, a company can be registered in the same name and kept dormant indefinitely (provided an annual return and dormant company accounts are registered each year). This will prevent the same name being registered by anybody else and in practice, will tend to inhibit the registration of similar names. See further How do I protect my company name?
7. Continuity
One of the advantages of a registered company is that, being a separate legal entity, it keeps going indefinitely, regardless of who owns or directs it. This can be an advantage where ownership or control is going to change.
8. Flexibility
A sole trader/partnership structure is very flexible provided the ownership and control patterns are simple, i.e. a small number of people owning and contributing to the business in a very straightforward way.
The company structure, with the possibility of creating different classes of shares and having directors who may, but need not be, shareholders, allows much more complex patterns to created.
9. Appearance of size
Bigger businesses are nearly always companies and so some small businesses are registered so as to create an impression of size.
10. Outside investment
A further advantage of becoming a limited company is that the shareholders do not necessarily have to be directly involved in the running of the company. It is also often the case that it will be easier to acquire further investment for the business if it is a limited company again mainly due to the benefit of limited liability. The company structure is ideal for offering outside investment in the business as appropriate amounts and types of shares can be set up. Investment in a partnership is legally risky as someone who shares the profits of a partnership may be regarded as a partner and may incur unlimited liability for all the debts.
Incorporation Services Limited provides an expert service for all your company formation and company law requirements.
