In this article, Ratnamala Hegde pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata discusses business structures that an entrepreneur should know before starting his own startup.
Introduction
The Prime Minister of India, Shri Narendra Modi had launched Start-up India Action Plan on 16th January 2016. It is a flagship initiative of the Government of India, intended to build a strong eco-system for nurturing innovation and start-ups in the country that will drive sustainable economic growth and generate large scale employment opportunities. The Government through this initiative aims to empower start-ups to grow through innovation and design.
As per the latest news in the media, India is the third biggest country for the technology-driven startups after US and UK in terms of the Assocham report. Bengaluru is the home for 26% of domestic tech start-ups, followed by Delhi (23%) and Mumbai (17%).
There are many entrepreneurs who have various business ideas. But they are not sure about the legal structure which they need to select for their business. Following are some typical questions that need to be answered before choosing an appropriate business structure for a startup. They are:
- What is the business?
- How many are involved in the business?
- How many will be involved in the business on a full-time basis?
- If anybody is still working in any company, whether employment agreement allows for doing any business?
- What will be the revenue generation period?
- What is the funding requirement of the business and how it will be done?
- Will the business require any outside funding from VC/PE/Angel investment etc. in near future?
Based on the above information, analysing pros and cons of each structure, one should decide which will be the best suited legal structure for their startup.
Alternate Forms of Business Structure
There are various forms of business structures available in India. Broadly they can be classified into the following:
- Sole Proprietorship
- One Person Company
- Partnership
- Limited Liability Partnership
- Private / Public Limited Company
Each kind of structure has its own merits and demerits. To choose a suitable business structure finally depends on the type and need of the business.
Sole Proprietorship Concern
This is the oldest and most common form of business structure. A single person owns, manages and controls the entire business. There is no separate legal entity here. All the profit belongs to the sole proprietor. Similarly, entire losses shall be borne by him. Liability of the owner is unlimited in this form of business.
This form of structure is suitable for the business which is simple in nature, where there is less risk, low capital requirement, which needs more personal attention, the market is limited and localised. Example Kirana shops, small home-based ventures. This is also suitable for the business which involves manual skills such as handicrafts, tailoring, jewellery making etc.
Legal compliances
- Opening of bank account
- Permanent Account Number (PAN) of the proprietor. No separate PAN required for the business. PAN of the owner is treated as PAN of the business.
- Registration under Shops and Commercial Establishment Act
- Professional Tax registration
- Various other government registrations like Service Tax, Value Added Tax (VAT), Excise, Importer Exporter Code (IEC) etc. to be obtained on need basis.
- Trademark Registration, if required.
Following are the merits and de-merits of Sole Proprietorship structure:
|
Merits |
Demerits |
| Simple form of structure, starting up easy | Unlimited liability |
| Freedom to take decisions | Limited financial resources, difficult to raise outside capital |
| Tax advantage | Single talent |
| Less legal compliance | Limited life, no perpetual succession– enterprise dies with its proprietor |
| High secrecy | |
| Easy dissolution | |
| Cost-effective | |
| Control over finances |
One Person Company (OPC)
This is a new form of business structure introduced in India through the Companies Act, 2013. Earlier, whenever a person wanted to start a private limited company, he had to look for a co-founder just for the sake of compliance. With the OPC structure, this problem has been resolved. Following are the key features of OPC structure:
| No. of Members | There should be Only ONE member in any OPC at any point of time. |
| No. of Directors | OPC shall have minimum 1 director. Sole Shareholder can himself be the Sole Director. The Company may have a maximum number of 15 directors. |
| Threshold | Paid-up capital of an OPC shall be less than Rs.50 lakhs, and turnover shall be less than Rs.2 Crore. If anyone exceeds, OPC shall convert itself either into Private Limited Company / Public Limited Company within 6 months. |
| Eligibility | Only natural person who is an Indian citizen & resident can incorporate an OPC. For the purpose of this provision, the term “Resident in India” means a person who has stayed in India for a period of not less than 182 days during the immediately preceding one calendar year. |
| Status | OPC shall be incorporated as Private Limited Company. |
| Nominee | Appointment of a nominee is a must for an OPC who shall be an Indian citizen & resident. |
| No. of OPCs | A person can’t incorporate more than one OPC and become the nominee in more than one OPC. |
| Voluntary conversion | Voluntary conversion is possible only after 2 years of incorporation. |
| Restriction | OPC cannot carry on NBFC activities including investment in securities of any body corporate. |
| Compliances |
|
Though the OPC has many advantages in relation to compliances under the Companies Act, 2013, it has the following disadvantages as well:
- Investment – Fund Raising through equity issue is not possible since an OPC should have only one member. If an OPC requires any investment from outside party, it has to convert itself into either Private Limited Company or Public Limited Company. Unless it reaches the prescribed threshold limit, voluntary conversion before 2 years from the incorporation date is also not possible.
- ESOP – Many companies attract good talent by offering equity shares through Employee Stock Option Plans (ESOP). It is an effective way of incentivising the employees. Since an OPC cannot have more than one member, it is not possible to issue shares through ESOP.
- Tax Liability – An OPC does not have any tax advantage. It is taxed in the same way as any other companies. There is both Income Tax and Dividend Distribution Tax for OPC.
Partnership Firm
The partnership is governed by the Partnership Act, 1932. A partnership is defined as a relation between two or more persons who have agreed to share the profits of a business carried on by them or any of them acting for all. Two or more persons can form a Partnership subject to a maximum of 20 partners. There is no separate legal entity here. The owners of a partnership business are individually known as partners and collectively as a firm. Partnership Deed (verbal or written) will be entered into between the partners which detail the terms and conditions of the Partnership, including partners’ contribution, profit and loss sharing ratio etc. Registration of partnership is optional. However, registration gives legal protection to partners.
This model is suitable for the business like retail trading, professional services, small manufacturing units etc.
A partnership has the following merits and demerits:
Merits |
Demerits |
| Easy to form – minimum 2 partners and maximum 10 in case of banking business and 20 in case of others | Unlimited liability |
| More capital contribution compare to sole proprietorship since the number of partners are more | Conflict of interest as the ownership & management are same |
| Tax advantage – the tax on firm and there is no tax for partners on profit sharing | Third party funding is difficult |
| Less compliance | No perpetual succession |
| Combined talent of all the partners are pooled together | Possibility of misuse of funds |
| Partners can get salary, drawings and share in profit | No transparency |
| Easy dissolution | Lack of co-operation and understanding |
| Confidentiality | Delay in decision compared to sole proprietorship business |
| Flexibility of operations | Difficulty in the transfer of interest |
| Effective supervision | Lack of public confidence |
Limited Liability Partnership (LLP)
Limited Liability Partnership is one more form of business structure governed by Limited Liability Partnership Act, 2008 and respective Rules. It is a hybrid of partnership and company, which has a separate legal entity. It has the operational flexibility of a partnership with limited liability. The liability of each partner in an LLP is limited to the extent of his/her investment in the firm. Compliance requirement is higher for an LLP as compared to a partnership but lesser than the limited company.
This structure has become quite popular for SMEs, professional services etc.
Like all other forms of business, LLP also has its own merits and demerits:
Merits |
Demerits |
| Limited liability | Penalty for non-filing is huge – Rs.100 per day of default |
| No maximum limit for partners | Less transparency |
| Perpetual succession | No shares, only capital contribution |
| Less compliance vis-a-vis company | Not attractive for angel / VC funding
Bank funding |
| FDI is allowed under automatic route as per recent change | Scaling up of business is difficult |
| LLP can sue & be sued in its name | Direct conversion to Private Limited Company not possible at present |
| Individual immunity is available (except fraud) | Dissolution of LLP is time-consuming |
| Better governance structure vis-à-vis partnership | |
| Audit is required only if turnover exceeds Rs.40 lac/capital contribution exceeds Rs.25 Lacs | |
| Tax benefit as a partnership firm |
Private / Public Limited Company
It is the most popular form of business structure in India. It is governed by the Companies Act, 2013 with various Rules made thereunder. It is a separate legal entity having perpetual succession. The minimum number of members is 2 and maximum is 200 in case of Private Limited Company. For Public Limited Company, the minimum is 7 and there is no maximum limit. Shares of Public Limited Company are freely transferable whereas it is not so in a Private Limited Company. It is a highly regulated form of business structure and more transparent as there is a requirement of compliance and disclosures in various stages. It is a form of structure which is most preferred by all the investors.
Company form of structure also has its own merits and demerits:
Merits |
Demerits |
| Limited liability | Raising capital is more procedural |
| Stable & mature form of entity option | Cannot take a loan from everyone |
| Highly regulated, more compliance, better governance structure – more disclosures | Shares are not freely transferable in case of Private Limited Company |
| Scaling up is easy | Increased penalty for non-compliances |
| Attractive for investment & talent – FDI norms are easy | Not tax efficient – income tax, DDT etc. |
| Enforcement of rights & other legal aspects are well settled | Too many disclosures |
| Valuation is easy in case of Merger & acquisition | Conversion to LLP is not easy |
| No minimum capital requirement as per latest change | Dissolution time consuming |
Conclusion
After analysing the pros and cons of each form of business structure as mentioned above, an entrepreneur can decide the structure which is most suitable for his/her start-up.
