Corporate structure most suitable for big business
BY MOHD IQBAL BUTT and ROMAAN MUNEEB
In my experience of more than 30 years of legal practice I have found very few entrepreneurs who could convincingly answer to my question as to what do they mean by ‘limited’ in the name of a company. There are also certain misconceptions connected with incorporation and management of a company which deters some entrepreneurs from using the company structure for their businesses. Leave aside the misconceptions and the ignorance of the technical knowledge as regards this most successful form of the business structure, many of us fail to realise that almost all the goods and services we are surrounded in our daily lives are provided and produced by business organisations structured as companies. Further, richest individuals of the world are shareholders of big companies.
A company has a legal personality distinct from its shareholders/owners and has rights like any other individual. These rights include the ability to enter into contracts, take loans, sue others, be sued, own assets, and so on. A company is formed when individuals agree to contribute capital to a company in exchange for shares of the company, which in turn creates a right to a portion of profits of the company.
The word ‘limited’ in the name of a company indicates ‘limited liability’. Under ‘limited liability’, a shareholder/owner of a company is liable for the losses incurred by the company limited to the amount promised by him to the company while subscribing to the shares of the company. Once a shareholder who has subscribed to the shares of the company has paid the subscription amount to the company he is not liable for the losses of the company beyond the subscription amount already paid by him to the company. In case he has not paid for the shares subscribed by him he will have to contribute to the loss of the company to the extent of the subscription amount agreed by him to the company and nothing more. This explains the concept of limited liability in simple language.
As can be understood from the explanation above, the limited liability allows individuals to avoid personal liability for company’s losses. This allows individuals who otherwise are reluctant to take risks to expose a part of their personal resources to the risks involved in starting a business. This also allows individuals to jointly contribute their resources to achieve business objectives that would otherwise be difficult to achieve individually. A corporate structure also allows labor and capital to be aggregated for the purpose of undertaking tasks that would be too large for any one person.
The roots of the company structure for business can be traced back into history. One of the biggest examples is that of The East India Company. In the 1600s, the British Crown began granting monopolies to groups of investors willing to undertake certain ventures. The East India Company was one such monopoly, in which investors pooled capital into a single company from which profits would be distributed according to capital invested. Only members of The East India Company had the privilege of conducting trade with India. We are well aware how The East India Company eventually came to form a government over large portions of India and maintain an army. This example shows that by allowing the aggregation of resources, companies can be organized to carry out tasks too big for one person, or even one government.
The common misconceptions regarding doing business through a company structure are:
· Lots of compliances;
· High tax rate for companies;
· High cost of incorporation and maintenance of records;
· Requirement of minimum turnover.
In the past, yes, it required lots of paperwork to incorporate a company. But with the advance in information technology the process of incorporation has been streamlined and it is possible to incorporate a company by just filing one combined form. It is also not correct to say that companies are taxed at a higher rate in comparison to a partnership. The maximum tax rate applicable to both a partnership and a company is same. Doing business under a company structure may be tax efficient since certain companies having turnover below a prescribed limit are liable to pay income tax at a considerably lower rate. With online process of incorporation of companies, the cost of incorporation has also reduced considerably. An entrepreneur having basic knowledge of use of computers can incorporate a company without any assistance from a consultant/lawyer and save the cost of engaging such consultant/lawyer.
As regards maintenance of records a company once incorporated has to hold minimum four meetings of its board of directors in a financial year and one annual general meeting of the shareholders to approve the accounts. The company has to maintain minutes of these meetings. There are annual requirements of filing of annual return and accounts with the registrar of companies. Again, with the advancement of information technology and the government’s focus on ‘ease of doing business’ compliance of these annual requirements has become easy. There is also no minimum turnover required for incorporation of a company. Earlier there was a minimum paid up capital requirement for incorporation of a company which has now been dispensed with. It has been left to shareholders of a company to prescribe the same in the articles of the company. Hence theoretically you can start a company with Re.1 as minimum paid up share capital of the company.
There are various disadvantages of a partnership structure.
Unlimited Liability: Each partner of a partnership firm is liable for the losses of the firm jointly and severally. This restricts carrying of any large business activity by a partnership firm. There is a risk of personal property of the partners being taken over by the creditors of the partnership if the assets of the partnership firm are not sufficient to cover the liability.
No Continuity: A partnership firm may come to an end because of death of the partner, insolvency, insanity or retirement of a partner. Hence there is a perception of instability in the structure which may not be good for big business.
Restriction on Transferability of Interest: A partner cannot transfer his partnership interest to an outsider without the consent of all partners. A partner is also not authorized to bring any new partner without the consent of other partners. This shows that there is a restriction on transfer of interest. In case of a private limited company the restriction is to the extent that the shares are first to be offered to the existing shareholders and if they refuse to buy, the same can be offered to outsiders. In case of public limited companies there is absolutely no restriction on transfer of shares.
No Formal Structure: The Indian Partnership Act, 1932, does not give independent legal status to the partnership. Registration is not mandatory hence no differentiation is made between a partnership firm and its partners. In the absence of any regulatory control over the formation and management of a partnership firm, there is lack of public confidence in the structure. In the current age of fake news and online misrepresentations a structure the details of which can be confirmed/ascertained independently from a public repository, like registrar of companies in case of companies, is a must for the business.
Risk of Implied Authority: Each partner is considered an agent of the partnership firm. He/she can bind the co-partners by his/her activities. On account of this authority of one partner, other partners have to suffer for the wrongdoing of a partner.
Limited Capital: In the partnership firm, there is a restriction on the number of members of the partnership, therefore, the total amount of capital which can be invested in case of the partnership is limited to the sum total of the individual amount invested by each partner. It is not easy for a partnership firm to collect huge capital.
Limited access to Loans: The above disadvantages are also responsible for difficulty in raising funds from banks and financial institutions due to lack of formal structure under a regulatory framework and prospects of discontinuity of the business in case of death, insolvency of a partner.
A sole proprietorship structure also suffers from similar disadvantages as applicable to a partnership firm where in case of death or incapacity of a sole proprietor the proprietorship gets dissolved. Further, a sole proprietor cannot raise capital by selling his interest in the business.
There are several advantages of a company structure, including the limited personal liability, easy transfer of ownership, business continuity, better access to capital and tax benefits.
No Personal Liability: A company provides more personal asset liability protection to its owners than any other type of business structure. If a company is sued, the shareholders are not personally liable for the company’s debts or legal obligations.
Perpetuity of Business: There is flexibility in transfer of ownership in a company and hence perpetuating the business for the long term by simply selling the shares in a company. It is easy to buy and sell ownership in a company by simply transferring of shares. If an owner of a business wants to leave the company running the business, he can simply sell off his/her shares in the company. Similarly, if a shareholder dies, his/her shares can easily be transmitted to another.
Access to Capital: Public limited companies can raise capital by selling their shares to public at large through publicly traded shares. This helps in raising large amount of funds for growing a business and also for starting new projects. When a company is incorporated it is considered more reliable and hence easy for it to raise capital.
Efficiency: A company is managed through a Board of Directors which could be distinct from the shareholders of the company. Domain experts can be appointed to the Board and for each specific function of the company which in turn leads to improved accountability and efficiency. The availability of resources makes it conducive to offer good salary packages and attract the best talent available in the market.
Availing incentive under schemes and loans: Having a separate identity and being regulated under a well-defined legal framework it is always easy for a company to meet the requirements of incentive schemes and satisfy the requirements of banks and financial institutions to avail loans. Further the efficiency the company structure brings to the business goes a long way in helping in a good appraisal for raising loans.
Establishing reputation: A business incorporated as a company is always considered as a reputable organization. It enables the entrepreneur to set a mark of reputation among its customers and the stakeholders.
Hence, an entrepreneur needs to look into various advantages and risks involved while choosing the form of business. A well thought out business structure goes a long way in deciding the future of the business especially its scalability. Incorporating business as a company provides security, credibility, scalability which is unique to a company structure only. Depending upon the size of the project and the investment required an entrepreneur can decide to incorporate:
· a private limited company which requires minimum two shareholders and maximum 200 shareholders; or
· a public limited company which requires minimum seven shareholders and no limit on maximum number of shareholders.
The Companies Act 2013 has permitted setting up of ‘one person company’. A sole proprietor now also enjoys ‘limited liability’ if he/she incorporates a ‘one person company’.
Mohd Iqbal Butt, Senior Partner IMR Law Offices
Romaan Muneeb, Partner IMR Law Offices
Originally Published on July 10, 2023 at Corporate structure most suitable for big business – Greater Kashmir
