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How to choose the legal structure for a successful startup or business in India?

How important is it to choose right legal structure for your startup in India? Image Courtesy: Pixabay

Business

How to choose the legal structure for a successful startup or business in India?

Choosing the right legal structure to operate a successful business in India is important and while various structures can be incorporated by a business, entrepreneurs must consider the financial needs of the business, its capacity to bear risk and propensity to progress before deciding.

After the historic economic revolution of Liberalisation in 1990, 2019 has witnessed a massive exponential growth in startups, and one of the big four accounting organisation has reported close to 50,000 startups in the Indian ecosystem. But it is not a child’s play to start a business. While the initial stages are interesting, the documentation involved in starting a business can be quite nerve-wracking. The next thing that is crucial for the business venture is determining the right legal structure. Entrepreneurs are required to invest an adequate amount of time and consideration while assessing the consequences of each structure based on various factors. This calls for understanding as which legal structure suits the Entrepreneurs for their smooth functioning and enhancing ease of doing business which broadly revolves around legal liability, control over the Company, tax implications, and expansion.

Primarily, there are five structures to operate the business in India. One needs to identify the most suitable structure to function worthily. Any person intending to undertake business in India may do so through one of the following structures:



1.) Sole Proprietorship: As the name suggests, it is “one-man organisation where a single individual owns, manages and controls the business.” It’s the ease of formation that makes it very convenient to function since it does not involve mandatory government registration. Regulatory paper-work and compliance are also minimal. Further, there is no minimum capital investment required, and thereby Proprietor has full control and ownership stake. The profits are fully accessible by the Proprietor. The added advantage is the ease of filing taxes since the taxes need not be filed under a separate entity of Sole Proprietorship. However, there lies unlimited liability of the Proprietor. If a founder is wanting to experiment and gauge feedback about a venture before taking the giant leap, then Sole proprietorship is the way out.

2.) Partnership: Partnership firm in India is described in the Partnership Act, 1932. In this form of structure, there are two or more people who have agreed to share the profits through business and bear the losses. A minimum of two persons are required to start a partnership business and which may be increased to 100 persons. It is not a separate legal entity distinct from its members. It is a collective name given to the persons comprising it. However, for the purposes of levy of taxes, it is a distinct entity from the persons comprising it and assessable separately. In cases of liability, it has a similar character to that of Sole Proprietorship.

3.) One Person Company: The Companies Act, 2013 completely revolutionised corporate laws in India by introducing several new concepts that did not exist previously. On such game-changer was the introduction of One Person Company concept. It has the only person as a shareholder, and that person must be a natural person and resident of India under the tax law. Such companies are generally created when there is only one founder/promoter for the business. Entrepreneurs whose businesses lie in early stages prefer to create OPCs instead of sole proprietorship business because of the added advantages that OPCs offer. Unlike Sole Proprietorship or Partnership, OPCs provide for the added protection of limited liability. 

4.) Limited Liability Partnership: Introduced and regulated by the Indian government from April 2009, LLP is an entity structure that is a union of a private limited company and a partnership firm. However, unlike the basic partnership entity, LLP is a separate legal entity that restricts the liability of its partners. While the incorporation process is similar to that of a private limited company, there is no minimum capital requirement. LLP does not require maintenance of registers, minutes, etc. but needs the partners to file the accounts and the annual return of the firm with the ROC.

5.) Private Limited Company: A Private Limited Company is a company which can have a minimum of 2 members and can go as far as to 200. It must have at least two directors. The members have limited liability but have many similar characteristics as a Partnership firm. Moreover, such companies also require significant compliances like having quarterly board meetings, maintaining registers for members, share transfers, etc. Since their operations are streamlined by regulations, it is possible for investors to evaluate potential risks associated with their investment. However, when it comes to shutting shop due to multiple possible reasons, it is not easy for the startups to wind up a private limited company. The entire process is court-driven, which might take up to two years or even more. So, if entrepreneurs are willing to only experimenting with their business idea, without investing much money in the entity, a private limited entity isn’t an ideal option. But for the investors, this is indeed a stable structure as not only does it keep their finances secure; it also validates the seriousness of the founders in doing business.

While any of the above structure can be incorporated by a business, entrepreneurs must consider the financial needs of the business, its capacity to bear risk and propensity to progress. The following factors may be considered in order to incorporate the right structure for the business:

1.) Flexibility: While deciding on an apt business structure, flexibility of the person intending to run the business in terms of ownership and management decisions shall be of vital importance. A sole proprietorship offers the most flexibility in case of ownership and management decisions.

2.) Complexity and Cost involved: Based on the value of a business, promoters intend to opt for the most cost-effective structure. A sole proprietorship has the lowest cost of formation and the administration because of the low regulatory burden. Similarly, the costs go high with the LLP structure, and the cost is at its maximum with the company structure of a business. Regulatory compliances and a need to hire professionals to meet those compliances adds to the costs of administration for the companies. 




3.) Risk/liability Associated: There is always more risk associated with a business which has unlimited liability because the maximum exposure cannot be ascertained in such cases. However, a sound business is always a safe bet, and due diligence and professional help must always be taken before running a business or investing into one in todays’ scenario. 

4.) Investment of Capital: Every business needs to have sufficient capital to run its operations and manage expansion. In a proprietorship, the entire capital is brought in by one person. All investors especially the angel investors and venture capital funds prefer a private limited company structure as they have added advantages in terms of disclosures and compliances of the Company and the promoters are required to safeguard the investments made by such investors.

To sum it up, entrepreneurs must understand that there is no one straight jacket formula which can fit different types of business model needs. They can compare all the aspects of every structure to determine the most suitable one for their purpose and goals. A strong legal foundation is key to the growth of any new business. Therefore, an ideal way to tackle such a situation is to have a basic understanding of these concepts and subsequently, businesses must take professional consultation. While the large corporates generally have professional advisors/ lawyers/ in-house teams in place to guide them through this, startup entrepreneurs must take note of all the factors listed above and hire legal advisory platforms that can cost-effectively help them in placing the groundwork for future growth and expansion of their business.

Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of the publication


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