Top 5 Factors to Consider in Choosing the Business Structure for Your Startup
Let's say you have come up with a great idea for a business. Where do you start?
One of the first decisions a soon-to-be business owner is faced with is the type of legal structure to choose. Forget to be or not to be—the real question is to incorporate or not to incorporate? This is an important question to consider, because the business structure you choose will have important legal and tax implications for you and your business.
First Things First: What Are Your Options?
Here is the Coles Notes version of the main types of business structures that you have to choose from if you're starting a business in BC:
Sole Proprietorship: A sole proprietorship is the simplest form of business organization. The business entity is owned by one individual who performs all of the functions required for the operation of the business. In a sole proprietorship, no separate legal entity is created, so there is no distinction at law between the business and the owner. The sole proprietor is entitled to all the of the profits of the business, but they are also personally responsible for all of the business’s debts, losses, and liabilities.
Company: Unlike a sole proprietorship, a company is considered to be a separate legal entity that is owned by its shareholders. This means that the company itself—not the shareholders who own it—is held legally liable for the actions and debts the business incurs. Companies are more complex than other business structures and tend to be more costly because there are administrative fees and specific tax and legal requirements associated with operating a company. On the plus side, a company offers the ability to sell ownership shares in the business, which is often the key to attracting investment capital and high quality employees.
Partnership: A partnership comes about when two or more individuals (or companies) carry on business together. Each partner contributes to all aspects of the business and shares in the profits and losses of the business. In most cases, you do not have to take any formal action to form a partnership. In fact, if you are carrying on business activities with another person with a view of making profit, the law may consider you to be in a partnership even if you don't!
How to Choose the Right Structure
So those are your main options. But how do you choose the right one? Here are some factors to consider when deciding on the right structure for your new business:
One of the most important factors in considering whether or not to incorporate your business is liability. When it comes to taking responsibility for business debts and actions of a company, shareholders’ personal assets are protected. This is because, generally, shareholders’ liability is limited to the amount they have invested for their shares in the company.
In a sole proprietorship there is no legal separation between the business and the owner, which means the owner of the business can be held personally liable for the debts and obligations of the business.
If you have significant personal assets (such as a house, vehicles, etc.) and you will be entering into contracts with third parties that may open you up to liability (such as a lease or a supplier agreement), you’ll want to consider incorporating to protect your—and your family’s—personal assets.
Another advantage of being a separate legal entity is that companies file taxes separately from their owners. This means owners of a company only pay taxes on corporate profits paid to them in the form of salaries, bonuses, and dividends, while any additional profits can be kept within the company at the corporate tax rate, which is much lower than most people's personal income tax rate. In addition, there are certain deductions that small businesses may be able to take advantage of, such as the Small Business Deduction available to Canadian-controlled private corporations.
When you operate a sole proprietorship or a partnership, your business's income is your income. This does make tax preparation a bit easier and less expensive since you're only filing one set of tax returns. But, because your business is not taxed separately, you lose out on some of the tax benefits that companies have access to.
That being said, it is only at the point where you start making more money in your business than you need for your living expenses that you will get to really take advantage of those tax benefits. So, it may not make sense to incorporate until your business income reaches a level where you want to save or invest a good chunk of it.
3. Time and Money
A sole proprietorship is the simplest and least expensive business structure to establish. The costs associated with set up and maintenance are minimal—generally, you're looking at a few hundred dollars for name registration and a municipal business licence. There is also no annual paperwork to submit to the government.
On the other hand, companies are costly and time-consuming ventures to set up and operate. Between legal and accounting advice (both of which I recommend you don't skimp on), you will likely spend a couple of thousand dollars on structuring, incorporating, and organizing your company. Also, because companies are more regulated, there are increased paperwork and record-keeping burdens associated with running your business. The annual costs for maintenance are relatively low on the legal side (a few hundred dollars a year if you have your lawyer maintain your records books and prepare your annual filings) but your accounting costs will be a bit more substantial. You will likely want to hire a bookkeeper (at least part-time) to maintain your financial books throughout the year. And you will most certainly want to engage your accountant to prepare your annual financials and file your company's tax returns—and for that, you're looking at a couple of thousand dollars each year at minimum.
If you’re not quite sure how well your business will do or if you’re just wanting to try out your business idea to see if it might turn into something, it may not make sense to incorporate right off the bat and incur these costs. But keep in mind that if you accumulate assets for your business as a sole proprietor and later choose to incorporate, you may end up paying more to a lawyer and accountant to help you roll those assets into your newly formed company.
4. Multiple Founders
If you are starting your venture with a partner, think carefully about whether you want to enter into a partnership or form a company.
Similar to sole proprietorships, partners in a partnership can be held personally liable for the debts and obligations of the business. On top of that, the partners are not only liable for their own actions, but also for the business debts and decisions made by the other partners. This means the personal assets of all of the partners in a general partnership can be used to satisfy the partnership’s debts, regardless of whose idea it was to incur that debt.
Incorporating a company addresses most of the liability issues because the founders will generally only be held accountable for their investment in the company. Incorporating also tends to formalize ownership arrangements between co-founders. In addition, if there is intellectual property involved, a company helps create an entity that can hold intellectual property rights that the co-founders and any employees, contractors, or consultants create for the business.
While I won't go into too much detail here, I will note that there are also two specific types of partnerships that limit some of the shared liability among partners—limited partnerships and limited liability partnerships. Check back for a future blog post on the differences between the various types of partnerships!
Whichever way you decide to go, make sure you have the details of your agreement with your co-founders in writing. If you choose to form a partnership, you will want a partnership agreement setting out all the rights and responsibilities of the partners so there are no surprises down the road. Similarly, if you choose to go the incorporation route, you'll want to have a shareholders' agreement to deal with all the "what ifs". Remember: as rosy as things may seem at the beginning, co-founders will inevitably reach a disagreement regarding the operation of a business. You will save yourself a lot of headache (and possibly your friendship) by having your agreement written down on paper.
5. Raising Money
Sole proprietors often face challenges when trying to raise money. Because sole proprietors don't have the option of selling an ownership stake in their business, investors often avoid investing at all. Sole proprietors may also find that banks are hesitant to lend them money because of a perceived lack of credibility when it comes to repayment if the business fails. On the other hand, if the owner has an established credit history, a bank may be more willing to advance a loan to fund the business. Keep in mind, however, that any loans you take on as a sole proprietor will put your personal assets at risk (see point 1 above).
Companies tend to have an advantage when it comes to raising capital for their business because of their ability to raise funds through the sale of shares. On the flip side, a brand new company with zero credit history will probably find it difficult to secure a loan without a guarantor signing on. If the company does manage to secure a loan, its liability will be limited to its (not its shareholders') assets, but the guarantor will have opened themselves up to personal liability.
A new business venture can be exciting and terrifying at the same time! Just remember to step back and think through these factors before committing to a business structure. Better yet, work with your lawyer to think through these factors before committing to a business structure. The right lawyer can add significant value and save you a lot of time and money in the long run.