In this article, Aditi Katyan discusses pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, The downsides of setting up a partnership instead of a private limited company.
Are you a budding entrepreneur trying to build a start up? If yes, then the first challenge as a business owner you will have is to decide on the appropriate business structure for your venture. Various choices are available in India including but not limited to Sole Proprietorship, Partnership, Limited Liability Partnership (LLP), Private Limited Company, Public Limited Company, Unlimited Company and Cooperatives. Each business structure has its own pros and cons. Every business owner must choose his business structure based on his individual circumstances and what best suits his business needs. In this article, a comparison is made between two specific forms of business structures that are Partnership and Private Limited Company. Also, have tried to understand why setting up a partnership is difficult as compared to a private limited company.
Under Section 4 of the Partnership Act, 1932 Partnership has been defined as
“….the relation between persons who have agreed to share the profits of a business carried in by all or any of them acting for all. Persons who have entered into partnership with one another are called individually, “partners” and collectively “a firm”, and the name under which their business is carried on is called the “firm-name”.
From the above definition, the essential components of a partnership can be derived which are as follows –
- The existence of an agreement (written or oral)
- The agreement must contain the scheme of sharing profits
- The business will be carried by all or any of them acting for all.
Forming a partnership can be advantageous for the following reasons –
- Easy formation – Partnership does not require compulsory registration. It is a cost-effective option and is easy to operate. Partnership will take only around 7 days to incorporate. It need not hold the statutory general meeting nor file a statutory report.
- Operational flexibility – As there are limited number of partners, quick decisions about all the aspects of the business can be made by mutual consent.
- Cost of incorporation – A Partnership comes into existence through a partnership deed which is cost effective. The cost of incorporation is less than thousand rupees.
- Protection against cheating – Fraud or scams can be easily prevented in case of partnership because it is in the interest of every partner to protect each other against fraud.
- Specialization – Each partner of the firm is also the owner so he/she will try to actively participate in the workings of the business per their specialization and expertise. For instance, if few lawyers come together to form a law firm, one can specialize in civil, one in criminal, one in corporate and so on.
Under Section 2(68) of the Companies Act , Private company is defined as –
“…means a company having a minimum paid-up share capital of one lakh rupees or such higher paid-up share capital as may be prescribed, and which by its articles,—
(i) restricts the right to transfer its shares;
(ii) except in case of One Person Company, limits the number of its members to two hundred:
Provided that where two or more persons hold one or more shares in a company jointly, they shall, for the purposes of this clause, be treated as a single member:
Provided further that—
(A) persons who are in the employment of the company; and
(B) persons who, having been formerly in the employment of the company, were members of the company while in that employment and have continued to be members after the employment ceased, shall not be included in the number of members; and
(B) prohibits any invitation to the public to subscribe for any securities of the company;
On an inin-depthnalysis, a Private Limited Company seems to be a better form of business structure as compared to a partnership for the following reasons –
- No Separate Legal Entity – A partnership firm has no separate existence from its members. This makes it very uncertain and it may dissolve upon the death of its members or upon separation from them, or due to retirement of a partner. Also, any unsatisfied or discontented partner can give notice at any time for the dissolution of a partnership. This makes it a risky form of business structure. On the other hand, a private limited company has a separate individual legal entity from its shareholders/members. Members of the company are not personally liable for any loans and liabilities of the Company.
- Unlimited Liability – In a partnership, each member or partner has an unlimited liability and is personally liable for all the debts of the firm. At times to satisfy debts, even personal properties of members may be seized. Whereas in a private limited company, as is evident from the name itself, the shareholders or members have a limited liability. The debt of each shareholder individually is limited to the unpaid amount of money towards the shares held by them. If they have no dues towards the payment for shares, then they do not own anything to the company personally. A shareholder is not personally liable to pay anything towards a debt or loan incurred by the company.
- Legal compliances – It is easy to form a partnership because less amount of legal compliances is needed. This also means saving of time and money. It is not necessary to register a partnership firm. But there are certain disadvantages of not registering the partnership firm like – 1) A partner cannot file a law suit against the firm or any other partner 2) The firm and partners cannot file a law suit against the third party. Also, no compulsory legal documentation would also lead to less transparency in the working of the partnership. On the other hand, a private limited company must be compulsorily registered with the Registrar of Companies (ROC) under the Ministry of Corporate affairs. It is easy to carry out due diligence of a private limited company as all the legal paperwork is in order. More number of legal formalities right from the incorporation stage to the daily workings like audits etc, makes the proceedings more transparent.
- Decision making – Consent of each partner is essential for taking any decision in a partnership. This may result in delays and unnecessary complications. But in the case of a company the board of directors, elected by shareholders, control and manage the business. Each shareholder need not worry about the management of the company. Only majority voting power (>50%) is needed to control the most operations of a company (in a few very important cases >75% is required).
- Limited Capital – The capital that can be raised in a partnership firm is limited as there is a restriction on the number of partners. Limited resources mean that the possibility of the partnership growing into a big business is low. Whereas a private limited company should have a minimum paid up capital of Rs.1 lakh and no upper limit is specified.
- Accountability – The administration and control of the firm is in the hands of all partners in a partnership. Each partner may want to run away from responsibility and it will become difficult to hold each one accountable. In a private limited company, the control is with the Board of Directors thereby eliminating any accountability issues.
- No confidentiality – Maintaining secrecy is a daunting task in case of partnership. Sensitive information is known by all partners and chances of leakage are immense. On the other hand, each member of a company does not need to know the trade secrets. So, there are less chances of leakage of vital information.
- Insolvency – In an unfortunate incident of insolvency, the solvent partners may have to pay the debts of insolvent partner also.
- Internal conflicts -In a partnership, every member has a say which may give rise to more disputes and differences. These conflicts may cause harm to the firm.
- Improper use of assets – There is a greater possibility that the partners may use the assets of the firm for their personal use. Misuse of assets is harmful to business interests. This is a rare possibility in the case of a private limited company.
- Lack of public trust – There is no kind of government intervention in the working of a partnership. As such public, may not have confidence in the firm.
- No transferability of shares – A partner or member of a partnership firm cannot transfer his share to any outsider without the consent of other partners. So, if a partner wants to leave the firm, he has no option to sell his shares to others. In a private limited company, there is not such an outright restriction.
- Involvement of foreign nationals – A partnership firm cannot be formed by foreign nationals. They can only be shareholders in a private limited company. Also, as compared to private limited company, partnership would attract less amount of foreign direct investment (FDI).
To conclude, a partnership would be a more suitable business structure for small businesses like retail, wholesale trade or small manufacturing units, legal firms etc. Whereas private limited company would be a more suitable business structure for businesses, trade, manufactures, large industrial establishments etc.