This article is written by Venkat Ramaiah Chavali, pursuing a  Diploma in Entrepreneurship, Administration and Business Laws from LawSikho.

Introduction and scope

Business structure may be compared to a building framework in that it is initial among the activities, defining in character, and tough to change later. One needs to briefly understand the two terms ‘startup’ and ‘business structure’ in conjunction to select, adopt or adapt the most suited business structure for a startup.

The term startup – as come into use – is an enterprise producing goods or rendering services, or both. Customary trading and routine professional activities do not amount to startups. A startup is characterized by a new approach to fill a market gap with an entrepreneurial zeal.

Taking organizational structure as a simile – with which most are familiar – which deals with the administrative activities such as allocation of work, supervision, coordination and management towards the organizational objectives; the business structure deals with legal aspects like apportionment of liability, taxation, key persons accountability towards statutory compliances.

The aspects covered in this article are those which are common to small and medium size startups though other aspects are also touched upon, with focus on India, the law, and governmental schemes. 

Understanding the genesis of startups 

 With the advent of information technology and the internet in the West particularly the USA many startups sprung up. The success of likes of Yahoo, Microsoft and Apple with bootstrap financing lured many an entrepreneur to try their hand. 

The appearance of startups in India is a relatively new phenomenon but is fast catching up. After the success of startups like redbus.in (for pooled bus ticket booking), ‘Make my trip’, and Naukari.com which addressed the market gaps for pressing needs followed by Zomato, Ola, Flipkart, etc., the young and educated in India too are bitten by the entrepreneurial bug.

Startups can be in many fields – technical, environmental, transportation, education, food, healthcare, IoT, etc. – and sizes varying from small and medium to large. It is the nature, needs, means and future-plans of a startup that play an important role in deciding its business structure. 

Choosing the right business structure

There are many types of business structures; yet often unaware of implications, startups get into the mode of “monkey see – monkey do” and incorporate as a company. Somehow there is a misconception that without incorporation one cannot obtain investments or loans. But there is more to a business structure than mere funds and loans. Let us read on to find out more.

Importance of choosing the right business structure

The choice of business structure will affect how much a startup pays in taxes, the level of risk or liability on personal assets of founders, and costs of statutory compliances.

A startup after all is a commercial activity too, and so as much consideration must be given to the legal, financial and risk factors involved with the venture as is given to product excellence. 

A word of caution to technocrats and knowledge geeks venturing into startups is ‘do not underestimate the legal risks and complications. Some business structures are like ‘Padma Vyuh’ easy to enter but difficult to exit, some are easy to start and close at the speed of thought but are of unlimited personal risk, and so on. Each has its advantages and drawbacks. So, startups are advised to consult a good advocate in the field from the word go once they decide to go for a startup. 

First things first 

Instead of rushing to incorporate or get into partnership deeds, startups would be wise to follow a considered course of action. Here is one model sequence. One can improvise on it based on their specific venture and needs.

• Co-Founders’ Agreement

Also known as Founder agreement is an important piece of document to enter into by the founders once they have an idea and intention to start a business but before:

1. their product design has taken shape and are yet to come up with an MVP – minimum viable product,
2. the founders plunge full-time into the startup leaving whatever other occupation they are pursuing,
3. deciding the funding requirements,
4. deciding the type of business structure that is most suited to their means and wants. 

The founders’ agreement helps test the waters, reduces risk, and facilitates easy withdrawal in case they wish to pull out of the venture for whatever reasons. It also provides an opportunity to safeguard the founders’ interests by clearly stipulating their drag-along rights, their investment in terms of time and money. 

Founder agreement is not something to be drafted and signed as an afterthought but at the very beginning, the moment the idea of a startup sprouts. It is not some reference document but should be legally enforceable and startups should take professional help in drafting the same. A clearly delineated and drafted agreement saves many disputes and disappointments at a later date while giving time and opportunity for the founders to test and make informed decisions. 

• Plan your work and work your Plan

• Ensure that there is indeed a market gap and assess/survey market potential.
  Many startups fail at the very onset because they see a gap in the market but fail to make sure that there is indeed a market in the gap.
• Prepare a ‘Business Plan’. A good and properly made business plan apart from giving a roadmap to help launch the business facilitates in convincing the investors and banks to come forward.

The plan inter alia should have:

1. Production plan
2. Product Marketing plan
3. Financial estimates and projections
4. Capital requirement assessment and funding (Note that the size of the Capital at times dictates the type of Business structure(s))
5. Find a location to establish the business (Registered office etc.)
6. Build a website. It is said that if a startup does not have a website it is not in business! Though an exaggerated statement it underlines the importance of presence on the net in the modern digital world. 

• Come up with a minimum viable product.
• Decide on ways and means of funding. Unlike large startups which attempt and attract venture capitalists, most of small and medium enterprises in the initial stages of operation are typically financed by an individual or small group of individuals and banks against collaterals and personal guarantees. 

Some of the above activities are parallel activities and some sequential. The startup should work to complete these activities with minimum loss of time, for in business and particularly for startups time is not only money but a delay can be a loss of opportunity if someone else makes it to the finish line before them. 

Zeroing in on legally correct business structure

Many who are not familiar with business structures think it is just a box to be ticked, a legal impediment to be crossed to move ahead; and the simplistic criterion they adopt is:

• starting all by oneself – Sole proprietorship
• starting together with friend or partners – Partnership 
• Need funding, or respectability – incorporate

Things are not that simple and this naïve approach will many a time land a startup in avoidable course corrections or frustration sooner or later.

First let us see the types of business entities or structures of a business. 

Types of business structures and how they compare

The structures are tabulated below in the ascending order of simplest to elaborate. 

To a first-time startup choosing the appropriate structure is confusing and difficult due to lack of:

1. Appreciation of work involved and assessing starting capital required. 
2. awareness of advantages and implications of various types of structures aforementioned. 

In addition, in deciding the structure while optimism, positivity and entrepreneurship are good, the importance of being in touch with reality, staying rooted in the ground and knowing that there would be many a slip between the cup and lip are not to be underestimated. 

Therefore, following the steps given under sub-heading 3.2 First Things First, will give a safe and systematic approach, and by the time the startup nears or comes up with an MVP (Minimum Viable Product) it would be in better know of its needs and wants, the funding requirements etc., and better placed to choose the structure factoring in: i) flexibility, ii) complexity, iii) Liability, iv) Taxes, v) Control, vi) Capital investment and funding requirements, vii) Licenses, permits, viii) laws and regulations applicable to startups. 

Know that the simpler a business structure, less is the compliance, and more is the assistance provided by the governments – refer: 4. Some Aspects That Assist Startups – while more elaborate the structure higher is the compliance cost. A pragmatic observation is authorities focus more on enforcing laws on larger businesses than those with simple business structures – read: 5. Some Laws and Court Orders that Can Impact Startups. Choose wisely. 

Some aspects that assist startups

There was a time when there was over dependence on government for employment with security and respectability. Mostly since the advent of Software-design, IT and IT enabled services, there was a major shift to employment in the private sector. The scales amongst young are now tipping towards entrepreneurship and startups, for they see challenge, reward, an opportunity to grow big and be their own boss. For various socio, economic and political reasons the governments too are encouraging entrepreneurship and startups for self-employment as well as for employment generation. Here are some schemes:

PM’s Mudra Yojana:- Known for short as PMYY provides loans up to Rs. 10 Lakhs to small and micro enterprises. Though not directly beneficial to startups, they can induce known loyal individuals through PMYY where they need someone committed and with a small investment, to relieve them of delegable workload; a win-win solution. 

Startup India:- Startup India is a scheme introduced that greatly benefits startups in terms of self-certification under environmental and labor laws, Patent application and IPR protection, Income tax exemption, Easier public procurement norms, Easy winding up of company, for more details here is the link. 

It needs to be specifically mentioned that for startups it is in their best interest whenever and wherever possible to register under DPIIT (Department for Promotion of Industry and Internal Trade), and as MSME (Micro, Small and Medium Enterprise) under MSME Development Act. 

The reason being the Act and registration under DPIIT take care of two important aspects of money which is the chief resource that procures most other resources for a startup – it is said that money is not the only essential requisite for survival of a startup, but it is only next to oxygen!

1. The registration enables significant subsidies in patent costs, electricity bills, facilitates overdraft and interest rates, etc.
2. As to outstanding amounts – non-payment of invoiced amount as agreed by buyers from the startup – a stumbling block less known to first time startups, is mitigated by law making:

1.  realization of amount in time a right and with three times the RBI declared interest rates in case of delayed payment.
2. with deterrents for non-paying buyers on one hand and easy dispute resolution mechanisms for startups on the other hand. 

Some Other Schemes:

• Venture Capital Scheme,
• Single Point Registration Scheme (SRPS),
• Support for international trade protection, etc.

Law Reforms: for the promotion of and ease of doing business in India the Central Government is taking several initiatives like:

• The Code on Wages,
• The Occupational Safety, Health and Working Conditions Code, 2019,
• The Code on Social Security, 2019,
• The Industrial Relations Code, 2019.

With Specific reference to business structure, startups must know that Companies Act, 2013 provides for conversion between OPS, LLP, Pvt. Ltd Company and Public Limited Company whichever way one wishes. If one moves from LLP to private or public limited it is seen as progression and if it is other way round or the company collapses it is seen as regression, deterioration, or failure. After all public perception plays an important role in a company’s survival and growth. So, it is better to start at the appropriate size and progress than start big and go bust.

Some laws and court orders that can impact startups

A lot can be written here, but to be succinct and resist the temptation to be verbose, in bullet points:

• Oyo is a hotel room and tourist accommodation aggregator that provides online booking – like Ola and Uber provide cabs. It operates on a ‘Minimum Business Guarantee model’. The COVID-19 played havoc. Briefly:

Anam Datsec Pvt. Ltd. filed a suit against Oyo Hotels And Homes Pvt. Ltd., in Delhi High Court for damages worth Rs. 8 crores for alleged nonpayment of dues. The court has passed an initial order (on July 7, 2020) directing Oyo Hotels to file a “sworn affidavit” with a list detailing all unencumbered assets i.e.  properties free of debt and other liabilities. The court has also directed Oyo to submit certain other information in a ‘sealed envelope’. This will set a precedent affecting other defaulting startups. (The next hearing date is October 5, 2020).

• It is encouraging to know that laws are being tweaked to create an investment friendly and industry nurturing atmosphere (Refer to ‘Law Reforms’ under heading 4 supra), at the same time it is important for startups to know how the changes in some laws  impact them. Let us take the example of the new Consumer Protection Act and Consumer Protection (E-Commerce) Rules, 2020.

1. Terms used like, ‘arbitrary classification’, ‘ unjust prices’, etc. are not defined; will lead to litigation 
2. The rules have extraterritorial applicability
3. The rules are not just for ‘consumer’, who is primarily an end user but for ‘user’ – a term liberally used– which means any person with an access to and avails a computer e-commerce entity resource. 
4. New compliance implication: while the Act provides significant protection to a consumer (user too!) In a digital marketplace, the compliance burden and costs are going to hit the small and medium entrepreneurs, especially e-commerce based startups.  

Well-funded startups too can fail

Before concluding this article, it is felt pertinent to emphasize and dispel a prevalent misconception that having a large starting capital or investment will insure and ensure the success of a startup. Attention of aspiring startups is drawn to the failure of some well-funded Indian startups to learn from, and not to give in to the temptation to choose a structure just to garner funds to start big.

Some Well-funded Indian Startups that failed:

Lessons to learn and points to ponder by the aspiring startups

• Some startups go for large starting capital out of need or to edge out an existing dominant business or to induce and change consumer preference by offering heavily subsidized products. For example: Flipkart and Ola. Whatever may be the motivation behind such large startup outlays, they are fraught with problems peculiar to them and legal issues arising thereof.
• The startup entrepreneur is in love with his product, the venture capitalists/investors are in love with growing their money, and so there is always a conflict of priorities and interests that can lead to dispute and downfall of startups. Startups should be conservative in their revenue projections and ascertain reasonable alignment with investors’ understanding and priorities. 
• For a startup to succeed or fail there are factors that it can control (control factors) and circumstances beyond its control – called ‘noise’ in technical parlance – it must make sure that the noise is manageable and does not kill their venture. Is TinyOwl an example?
• Never rush because you see a gap in the market, make sure that there is a market in the gap – is Finomena a victim of this?

Summary and conclusion

• Business structure is the least appreciated and most vital aspect of any business, more particularly for a startup.
• Startup business structures could be small, medium, or large informed by an entrepreneurial streak. Conventional commercial businesses, or plain professional pursuits do not qualify as startups.
• The structure decides the flexibility, liability, taxability, sustainability and growth of a startup and due diligence in selecting the correct structure is vital. 

In my considered opinion the significance and key role played by the structure is not grasped by most startups until it is too late. Big funding is not a panacea and starting big does not guarantee success. 

To conclude, Business Structure is not a box to be ticked or a formality to be fulfilled. Select a structure wisely that assists like a ramp and does not become a slippery slope. The choice depends on the type of startup the laws and schemes for the time being in force that encourage the entry or raise the barrier to survival and growth. Take a holistic view by factoring in taxes, compliance costs, flexibility, etc. A startup should first consult an advocate conversant in business laws and companies’ affairs, for opinion and guidance, before reaching out to a chartered accountant for incorporation. Remember a step in the right direction leads a startup to its goal while an initial step in the wrong direction takes it farther away from the goal with every subsequent step. 

References

[1] LawSikho study material for Diploma in Business Laws

[2] TechGraph (Technology and Business News site) 

[3] Mint e-paper item dated August 25, 2020 

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