My encounters with the start-up community in India has been quite enriching. Most of the people looking to start-up are dreamers, great strategists, good communicators, focussed. The ones that do not understand business initially prove to be quick learners in most cases. Almost all of them give up lucrative jobs to give a shape to their own dreams, to build their own companies. On the other hand, every now and then I come across entrepreneurs with faulty or no planning to protect legal interests of their business, bad business organisation, no understanding of dispute resolution systems.
They either have not thought of tax planning or are under the impression that this is too early to think about tax. Well, hello, it is probably too late! If you incorporate without clear understanding of how your revenue is going to be taxed, probably you are overestimating your revenues by up to 33%. Maybe you can start a partnership or organise the cash flow in such a way that you can save the entire amount from being taxed! And do I need to explain how important that is at a start-up stage?
Well, incorporation is not the first thing that you need to do when you are starting a new company. You may have come up with some sort of a rudimentary business plan, then working out the details over time. If you are bootstrapping, things will naturally remain a bit informal initially. If you are taking funding from someone, probably you already have a business plan in place. In both cases, you need a clear understanding of the nature and consequences of incorporation.
Tip: Don’t incorporate till you start getting some revenue or until you are hitting up investors to raise money. Keep 2 months in hand to incorporate. Much before incorproation, you should get a co-founders agreement in place.
How to go about incorporation: do you need to incorporate as a company?
First of all, not every business needs to be run in the form of a company. There are certain benefits of running a business as a company.First of them is the limited liability of the owners. If the company fails or accumulates unforeseeable debt that it can not pay off from its funds, the same can not be recovered from the shareholders. Liability of a company is not the liability of the shareholders. Shareholders at a maximum may lose their investment in the company, but not more. Compare this to a partnership business. If the business fails and accumulates debt, all of it will be the partner’s personal liability. Debtors will sue the partners directly if they need to.
A company has a legal personality independent of promoter, directors and shareholders
A company is a separate entity from its owners, it can own property, can sue others and be sued in its own name, enables sharing of risk amongst different shareholders at their own comfort level, and the best of all.Change of ownership does not change the existence or business of the company, the new owner just fits into the old shoes. Makes selling easy. The company does not have to renegotiate all its previous contracts like supply contracts etc. with third parties everytime ownership changes.Professional management is another benefit of companies. Ownership and management can be separate in a company. Naturally, everyone who has invested in the company does not get a say in how the company is run.Do these usual benefits of a company make any significant difference for you? For example, if you are planning to carry out a business in an area where the likelihood of legal suits is very high, incorporation is a must. For instance, if you are using an intellectual property that another person may claim to be proprietary, and there may be copyright infringement or patent infringement suits against you, you must start the business in the name of an incorporated company. If you have plans to get venture capital, you must incorporate before you can get the investment.
However, you must also take into account the disadvantages of incorporating. If you incorporate too early and you are not going to raise investment in near future, that can be very damaging to the lifecycle of the business and cause substantial loss of revenues.
Taxation of Companies
Biggest disadvantage will be taxation. The income of the company will be taxed once, and once the money comes to your hand as salary, you shall pay income tax on the same. The corporate taxation rate is very high in India compared to taxation rate applicable to individuals. First the company will be paying 33.99% tax on its profit no matter how much it earns. That means one-third of the profits, if you make any, will go straight out of the companies coffers. While making your business plan, or deciding pricing, have you taken this factor into account? If you are planning to bootstrap this is especially important because you are going to aim to be cash positive!
Taxation on salary of co-founders
Most Start-up entrepreneurs earn from the salary paid by the company to him for his position as a CEO/ manager/ officer/ director of the company. This salary will be subject to further income tax applicable to individuals.
If money is taken out in the form of a dividend, still dividend distribution tax will be applicable on the same. Your earning may not be as high you are expecting to be if you have not considered the tax angle.
3. Also, you shall be taking up a lot of compliance liabilities by incorporating. Compliance is costly and hazardous. You shall inevitably have to hire lawyers and chartered accountants. You shall have to file annual reports and a bunch of other reporting. You shall be on the radar of labour law enforcement agencies of the government. Are you ready to spend time and money on such things? Don’t open a company otherwise.
There is a reason everyone who engages in business doesn’t open a company. Are you going to reach the scale soon that makes incorporation sensible? If scaling up is years away, why waste energy and money in incorporation? Are you bootstrapping? Or planning to raise funds only after you have finished development of a product which is still going to take months? Is what you are doing is actually a consultancy sort of business.
Do you have a good initial funding that can cover legal and compliance costs of making a company? If the answer to any of the last four question is ‘yes’, it may be unwise to start a company right away.
For a start-up company taking venture capital or seed funding, the ideal time to incorporate is as late as possible but just before taking outside funds. For bootstrappers, it is unadvisable to form a company till they reach a large scale of the operation that justifies incorporation. It is possible to reduce compliance costs by opening a Limited Liability Partnership or LLP instead. It may also make sense to organise the business in such a way so that the risky part of the business is incorporated but the relatively riskless part of it, if severable and cash generating, is carried out by individuals or partnerships and is provided as a service to the original company.
A little strategic approach to incorporation can go a long way in saving a lot of money is tax and a lot of time and energy that you can direct towards making of a profitable business.