Company structures for startups

November, 2015

The current economic climate in the UK has been referred to as a “Golden Age” for startups. It is anticipated that more than 600,000 new businesses will be launched in 2015. Getting the right company structure is of huge importance to ensure that the new business is structured for growth, investment and tax efficiency.

What company structure is most appropriate for your startup?

There are a variety of legal structures through which a business can be operated. The right choice of business structure will vary depending on individual circumstances. The most common entities used by for-profit businesses are private companies limited by shares and limited liability partnership (LLP).

A private company limited by shares is a company with a share capital. Shares in the company construe an ownership stake and are purchased either at their nominal value or at a premium. Ordinary shares generally carry three rights: the right to a vote at a meeting of the shareholders, the right to receive a dividend and the right to share in the capital of the company. Crucially the liability of shareholders is limited to the amount unpaid on their shares.

A limited liability partnership (LLP) is a quasi-partnership structure which is nonetheless recognised as a separate legal entity from its members for the purposes of entering into contracts and carrying on its business. An LLP also has limited liability. Unlike a limited company, however, an LLP is not taxed as a separate entity but each limited partner is taxed annually on the profits of the LLP in accordance with his proportional entitlement to such profits. An LLP must be set up by two or more people with a view to carrying on a profit making business.

Legal structures are equally important in terms of setting up a social enterprise or not-for-profit entity. A social enterprise can operate via one of numerous legal structures. These include a community interest company and a registered charity.

Community interest companies (CIC) were established as a social enterprise structure for businesses with a social purpose which did not wish to become a charity. The CIC structure requires the business to offer safeguards to protect its community purpose. This is done via the imposition of an asset lock which operates to protect the community purpose. Assets cannot be distributed to the CIC’s shareholders (except in limited circumstances). Upon a winding up of the CIC, the assets must be applied for the benefit of the community and not to repay creditors. The CIC cannot transfer any assets for less than market value apart from to another CIC, other asset locked company or charity. CICs are much more flexible than charitable structures and can offer limited returns on investment to investors and reasonable remuneration for directors. They are regulated by the CIC Regulator (Companies House) which offers a lighter touch approach to regulation than the Charity Commission.

Charities: a social enterprise can become registered as a charity if it has been set up for a purely charitable purpose and it meets the stringent requirements of charities legislation. There must be an asset lock in place to ensure that all assets are applied solely for the charitable purpose. One of the biggest benefits of becoming a registered charity is that charities are entitled to a number of very beneficial tax breaks.

Incorporated Entity vs Sole Trader

There are three main reasons for operating a business through an incorporated entity as opposed to operating a business as a sole trader:

• To take advantage of the limited liability nature of some incorporated entities with the result that (absent the directors committing criminal offences or the shareholders giving personal guarantees of the business’s liabilities) the founders will not be personally liable on an insolvency of the business.

• To have the business taxed separately to its owner (applicable to companies but not to limited liability partnerships).

• To raise equity investment using tax relief schemes.

What should you consider before choosing a legal entity?

Before choosing a legal entity you should consider the following questions:

• Is my business selling a packageable product, software or service or is it a means for me (and my fellow founders) to sell our time, experience and knowledge? If the former, in almost all cases a limited company structure will be most appropriate. This is because a limited company is the easiest structure through which to take on investment and also to sell the business. If the latter, increasingly a limited company will be used, but an LLP may be appropriate for tax reasons.

• Will the business need investment in the future? If it will, and that investment is likely to be equity investment, a limited company is the most suitable structure. The two main tax relief schemes for startups, SEIS and EIS, are both structured around limited companies.

• What is my exit strategy? A limited company is easy to exit – the shareholders simply sell their shares. Exiting an LLP can be more complex and may be less tax efficient.

• Is there any reason why I would want to be taxed personally on the profits of the business? For those taxed outside the UK as well as certain higher rate taxpayers, it might be more tax efficient to operate through an LLP rather than through a limited company. The government announced an increase to dividend tax rates for higher rate taxpayers which may result in more individuals considering an LLP structure.

What other factors should be taken into account?

As a general rule, limited companies are ideal structures for businesses that want to bring on board investment, or commercialise a mass market product or service. Bringing on investment is effected (relatively) simply by issuing shares. SEIS and EIS are designed around limited companies as are VCT and other later stage tax reliefs. Similarly tax incentivised employee option schemes are generally designed around limited companies making them an attractive vehicle for incentivising employees.

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