In this blogpost, Rohan Chawla, Student of Delhi University and Diploma in Entrepreneurship Administration and Business Laws by NUJS, writes about the pros and cons of a sole proprietorship and explains what a one person company is. Diploma in Entrepreneurship Administration and Business Laws by NUJS, writes about the pros and cons of a sole proprietorship and explains what a one person company is.

Perhaps, one of the principal questions an entrepreneur has to face is regarding the structure of the business. While there are multiple options available (sole proprietorship, partnership, company etc.), there are factors that trump one over the other.

In a sole proprietorship, there is a single businessman and he runs the business by himself. He is the founder, manager, shareholder and the boss. He is the recipient of all profits and is also liable for all losses. Your local grocer, chemist, florist, baker, salon etc. are best examples of sole proprietors.

Given the nature of sole proprietorship, the foremost question to be answered is the number of founders. If there is a plurality of founders or shareholders, then a sole proprietorship may not be the optimal arrangement and structures such as partnership and LLP maybe preferred.

The second factor is the requirement of funds. The proprietor is the sole shareholder and manager and as a result, the business is constrained by the personal wealth and creditworthiness of the proprietor. If the business is simple and does not require extensive funding, then a sole proprietorship may be preferred. It could also be the case that the business starts as a sole proprietorship, and as and when the business needs additional funding, it can be converted into a partnership/company.

Ganesh Ram (who later founded VETA) established his first teaching institute (in 1981) by borrowing a sum of Rs 500 from his mother. For his further ventures, he relied on the profits generated from the business. It was only in 2004 that VETA took a loan from the bank for the purposes of expansion. When he was served a notice from the income tax department, he decided to form a private limited company. Until then, his business did not have any official legal structure and was in the nature of a sole proprietorship^[2].

The riskiness of the business is also crucial. In cases of a sole proprietorship, the business is not a separate legal entity from the proprietor. In the eyes of the law, they are one and the same. Accordingly, a liability of the business is a personal liability of the proprietor. Moreover, such liability is not limited to the capital contribution of the proprietor. It is unlimited in nature and the personal assets of the proprietor may be utilised to satisfy the debts of the business. Hence, riskier businesses or businesses where the degree of the downside is significant should avoid the sole proprietorship route.

Thus, if a sole proprietor provides tutoring services or is a freelance writer, then the risk of unlimited liability is minimal. However, if he owns a cafe or a bookstore, the risk is relatively higher.

An advantage of a sole proprietorship is quick decision making and full control. The proprietor is the sole controller and decision-making body, and thus, decisions are turned around quickly. In fields such as stock market trading, where spontaneous decision making is of the essence, an entrepreneur may prefer going solo.

However, a sole proprietor suffers from the lack of expert advice and the perils of a confirmation bias. The entrepreneur cannot be an expert at everything and may not have the skill to effectively handle all aspects of business. He may hire the services on another on an ad hoc basis, but nothing can replace the counsel of a partner. Good employees may not stay for long as they do not taste the fruits of profit in the same way as the proprietor does.

When R. Sriram (who later set up the Crossword chain of bookstores) was setting up Walden (another bookstore) in Hyderabad, he realised that he had a bit of knowledge, but not enough. While he knew some parts of the business, he needed partners who would know other aspects he had no clue of. People who would complement his skills & strengths and most importantly had similar values^[3]. He did not approach them as his employees, but instead as his partners.

The sole proprietor maintains personal relations with all the stakeholders of the business. Since he is the only person, he is able to maintain a close relationship with the suppliers, clientele, employees etc. Thus, if the business is small and has limited clientele (market size is small), then a sole proprietorship will be ideal. For instance, a salon owner usually has personal relationships with his clientele. He usually has 5-6 employees with whom he has a great degree of interaction.

A sole proprietor also enjoys confidentiality of trade secrets. The crucial information of the business is stored in the proprietor’s mind. He would, at best, share it with his closest aid and employee, but no one else. Hence, the commercial secrets remain within a tight circle. For instance, let’s say there is a sole proprietor who is in the home cleaning business. Not everyone is comfortable allowing strangers into their house, and so the proprietor advertises heavily and as a result is able to generate a decent clientele. Now imagine, if this clientele list came into the hands of a third person, then such third person has to only approach these customers and offer his services at a competitive price. The third person doesn’t have to go through the entire process of advertising and finding out the persons who are predisposed to allowing cleaners^[4]. A risk such as this is eliminated in case of sole proprietorship as the proprietor is in complete control of his business information. However, this risk may exist in cases of partnership, where a retiring partner may start a competing business and solicit the clients of the erstwhile business. Clients leaving with partners is not uncommon in the legal field.

Setting up a sole proprietorship is cost effective as there isn’t an elaborate procedure. Only basic things like PAN Card, business licenses, bank account, VAT registration etc. are needed. There is no requirement to register a sole proprietorship, and a “Proprietor Declaration” document is purely optional.

However, a sole proprietorship lacks perpetual succession. The business comes to an end with the insolvency or death of the proprietor. The business may be continued by the legal heirs/family members of the proprietor. However, the same would not be easy. The sole proprietorship is individualistic and in the absence of the individual (proprietor), the other stakeholders (such as employees, customers, suppliers, creditors etc.) may not continue their engagement. Their trust was in the original proprietor, and the same may not continue in his absence.

What is a One Person Company

Thus, there are many preconditions to a successful partnership, and it is only in a limited number of situations that a proprietorship is workable. However, an alternative to a partnership is the concept of a “one person company (OPC).” The OPC was introduced in the amended Companies Act of 2013 and was notified on 26 March 2014. It plugs the disadvantages of a sole proprietorship while still retaining its major advantages.

An OPC does not suffer from unlimited liability and as a private limited company, the liability of a shareholder is limited to the unpaid subscription money in his name. It also provides for the facility of “nomination” wherein the nominee assumes the control of the business on the death of the sole member. In a limited fashion, OPC provides for perpetual succession. While the compliances are greater compared to a sole proprietorship, there are certain provisions that are exempt for an OPC compared to a private company. Thus, an OPC is a mixture of a sole proprietorship and a private company. OPCs will provide an opportunity to bring in a formal corporate structure to the otherwise unorganised sector^[5].

Thus, when contemplating on a sole proprietorship as a form of business, the  following checklist make come handy:

• Are there multiple founders? If yes, go for a Memorandum of Understanding or a Partnership.
• At its inception, does the business require a large amount of funds? If yes, a company might be a better structure for the business.
• Is the business risk? If yes, go for a limited liability form of business such as an OPC or an LLP or a company.
• Does the business require specialised personnel or elaborate functions such as marketing, planning, auditing, production? If yes, then a business setup that has a multiplicity of people such as partnership or company may be preferred.
• Does the business require personal relations with the clientele? In case the clientele is small, then a sole proprietorship is preferable. However, where the clientele is large or where each client requires special attention (as in law firms), then a partnership may ben preferred.

Conclusion

Thus, there are many ifs and buts when it comes to choosing a sole proprietorship as the form of business. The business structure seems ideal when the business is in its initial stages, and the idea is being tested. It is also ideal for businessmen who have a small establishment and do not have any extensive growth plans. Your local grocer, chemist, salon owner etc. maybe running the establishment for several years and earning handsome profits without any need for expansion. In those cases, a sole proprietorship is ideal.

However in cases where the businessmen want to grow and will need large funds, a sole proprietorship should give away to a partnership or a company, as the case maybe.

^[1] Image source: http://www.mymoneyblog.com/images/0901/ch.jpg

^[2] Connect the Dots, Rashmi Bansal, p. 37, 44, 51

^[3] Connect the Dots, Rashmi Bansal, p. 160

^[4] Example inspired from Trade Secrets: A Valuable and Often Overlooked Asset, Gene Quinn, IP Watchdog : http://www.ipwatchdog.com/2011/01/14/trade-secrets-valuable-overlooked-asset/id=14411/

^[5] One Person Company- A Concept For New Age Business Ownership, Vatsala Singh, Mondaq : http://www.mondaq.com/india/x/278154/Corporate+Commercial+Law/One+Person+Company+A+Concept+For+New+Age+Business+Ownership