//

Legal & Compliance

A growing small business moving from sole trader or partnership to a more “grown up” legal structure – like a Limited Company, Limited Liability Company and Limited Liability Partnership.

Growing small business legal tipsWhen you start out small, a common legal structure to use in a small business is “Sole Trader” (or a “Partnership” if there is more than one founder). This is fine in the early days, if you want to take a punt on a business idea. It is low cost and easy to make a start with. But as you grow your small business you need to move to a more robust legal structure. For greater legal protection and often too, more efficient tax structure.

The question can often be – when do I move my small business legal structure from Sole Trader or Partnership, to a Limited Company (Ltd), Limited Liability Company (LLC) or Limited Liability Partnership (LLP)?

This came up recently from a businessperson I have been mentoring since 2004. She has just started working IN and ON her boyfriends’ business, which is growing nicely and needs more management time and expertise – especially with a focus on business development.

A few weeks after an initial chat with them both for about an hour I was emailed a question around the legal details from one of my main pieces of advice in the mentoring session:

be sure to get the shareholding split agreed now, and a shareholders agreement in place.

Now, I’m no law talkin’ dude – I don’t particularly enjoy it (in fact, it was my weakest area at university I think because I don’t have a passion for a lot of detailed reading). But I know the value and importance of legal agreements in small business, and having an excellent legal adviser on your small business team (the third adviser you should recruit in your growing business).

Why is a shareholders agreement important in a growing small business?

Especially in a small business where you are in a relationship with your business partner, getting an integral legal document like this in place is crucial, and quickly. Even if you go into business with a friend, if the business goes poorly and/or your friendship/relationship deteriorates – having an agreed document which outlines how a split would happen takes a lot of angst, noise and pain out of an already painful parting.

Small businesses that are growing are stressful and can be all-consuming. The best and worst of people comes out under this pressure and if things go south, having this in place upfront saves a lot of time, cost and stress.

The question my mentee asked was “I was told that if I take a shareholding in my boyfriends’ business, and it went under, the bank could pursue me and potentially sell my house to get their loans repaid.”

The first thing I thought when I read this was – the business must currently be structured as a Sole Trader. If my mentee became a shareholder a quick and easy way would be to move the legal structure to a Partnership, so it is the two of them 50/50. But this would indeed leave her exposed to the banks.

Sole trader and partnership legal structures are generally a bad idea for a growing business.

Here are the main reasons why:

  • No real legal protection: you can be sued, as a sole trader or a partner in a partnership
  • Usually not as tax effective as other structures

Often, a better legal vehicle to use is one of Limited Liability, a very comment one is a Limited Company. It is a standalone legal entity, like a person. It allows you protection from creditors – they can go after the limited company, not the Directors or Shareholders of the company personally (unless you have acted negligently or against the law of course).

In this case, the banks can only pursue Shareholders in the Limited Company for any issued shares where the capital is not paid up in full. Basically, if your Limited Company had 1,000 shares with a value of $1 per share, the total issued share value would be $1,000. But if when starting the company you only put in $200 as share capital, that means there is $800 of unpaid share capital the bank could ask the Shareholders to put into the business. It doesn’t matter if the loan to the bank was $80,000, all they can legally force you to stump up is $800 between the shareholders – the Shareholders liability is “limited”. This is one of the attractions to using a Limited Company – the legal separation of people (Shareholders) with the legal entity (Limited Company).

Keep in mind, if you as a Director of the company sign any personal guarantees then the creditors/banks can pursue you. A guarantee is an agreement from you that if the business defaults on its debt to the creditor/bank, you will “guarantee” to pay the missing amount. It is obviously best to avoid ever having to sign a guarantee but especially with banks after the global financial crisis – and the need for growing businesses for more cash flow, it can be hard to avoid these.

One way to limit the number of guarantees signed is the number of Directors in the business. For example, if there are 2 Shareholders, each with 50% of the business, the one Shareholder that has the most assets outside the business could not be signed-on as a Director, simply be a Shareholder.A Director is different from a Shareholder.

That way, when the bank asks for the Directors of the business to sign a guarantee, the Director which has the least assets is the only Shareholder that is a Director, and therefore only they need to sign. The bank cannot ask the Shareholders to sign the guarantee, although, if they are not comfortable with the personal assets of the sole Director they may ask the business to provide an additional guarantor (which can be anyone, you just have to find someone willing to back you). Again, seek professional legal advice on this for your jurisdiction as there are many many quirks and hurdles in the legal systems around the world.

The way to avoid needing to sign guarantees is to grow patiently, conserving cash and reducing risk so you don’t need to take on debt – or much of it. Once your business is large enough banks will compete for your business so you have more leverage and negotiating power with them – i.e. “I’m not signing a personal guarantee”. And, ask for a small amount of debt in proportion to your business turnover.

Leveraging debt in a growing small business is common but don’t extend yourself too far  and get a millstone around your small business neck.

The history of Limited Liability.

The concept of Limit Liability was created in England in the 15th century. The protection a Limited Liability vehicle provides its Shareholders meant investors could take a risk on business ventures, for a proportional return. This protection meant capital flowed into businesses and funded the growing economic for of the Empire, and soon after, the United States.

According to Wikipedia, Limited liability is:

a concept whereby a person’s financial liability is limited to a fixed sum, most commonly the value of a person’s investment in a company or partnership with limited liability. If a company with limited liability is sued, then the plaintiffs are suing the company, not its owners or investors. A shareholder in a limited company is not personally liable for any of the debts of the company, other than for the value of their investment in that company. This usually takes the form of that person’s dividends in the company being zero, since the company has no profits to allocate. The same is true for the members of a limited liability partnership and the limited partners in a limited partnership. By contrast, sole proprietors and partners in general partnerships are each liable for all the debts of the business (unlimited liability).

Can a Limited Liability Company (LLC) or Limited Liability Partnership (LLP) be a good legal structure for a growing small business?

In many countries – like the UK, US and Australia – a hybrid between a partnership and a limited company is becoming popular. These are called Limited Liability Company (LLCs) Limited Liability Partnerships (LLPs). They couple a key benefit of a partnership (it is simple, and suits many types of businesses – like professionals, accountants, lawyers etc) with the key benefit of a limited company (legal protection for the Shareholders).

The tax benefits are not always the same as for Limited Company so it is always best to seek professional legal and tax advice before deciding on your structure.

 

Basically, if in your growing small business you have a handful of staff it is generally a good idea to move from a Sole Trader or Partnership legal structure, to one of Limited Liability vehicles listed above – the most common being Limited Company.

What a small business owner/manager can do to ensure they have the right legal structure for their growing business:

  1. Google and read up on the differences in the legal structure for your country (e.g. sole trader, partnership, limited company, limited liability partnership). Here is a quick start to a few of the main structures, as explained by Wikipedia:
    1. Sole trader
    2. Partnership
    3. Limited Company
    4. Limited Liability Partnership (LLP)
    5. Limited Liability Company (LLC)
  2. Talk with your legal expert and explain which structure you think is relevant to your business, and why
  3. Listen to your legal expert and act on their advice
  4. Get a shareholders agreement in place (or if you don’t go with a Limited Company, LLC or LLP structure put in place a similar agreement so all parties have the same understanding of all the important facets of when business is going good, as well as bad)

Disclaimer: this is not legal advice. You should always seek professional legal advice when deciding on the legal structure for your business. Especially as every country and even state has its own laws, always check with a local legal expert.

Podcast Survey

Our Podcast is launching SOON! Help us design this by answering these 7 questions - it takes less than 1 minute.

Subscribe To Be Emailed Blog Updates