Structuring a Business: Your Essential Considerations
The present state of the economy may appear fairly doom and gloom with talk of recession, businesses struggling and the increase in living costs affecting all ends of the supply chain - such uncertainty within the economy can be frustrating and unnerving for businesses and investors. Businesses will inevitably be feeling under pressure to maintain profit-levels and retain staff now that Government support, in respect of COVID at least, has ceased.
Navigating through the various pandemic-related reliefs and restrictions was tricky enough, but it may have been even more complex if your business was lacking formal structure and governance.
Let's take a look at various ways in which a business can be structured, providing you with a quick guide to some key corporate documentation relating to those structure options.
Please be aware: you should always obtain professional and independent legal and accounting advice before you undertake any of the actions set out below – the legal and tax positions of different business and their owners will be varied.
I am a sole trader, buying and selling construction materials. I currently have no written contracts in place with my customers or suppliers. Is there anything I could be doing differently in terms of how my business is set up?
A good solicitor will want to speak to you to get to know your business, your industry sector and to determine the existing terms on which you do business with your customers and suppliers. They will guide you through the process of protecting your business interests while strengthening these relationships via formal documentation of the various unwritten contractual relationships that you have in place.
If you do not operate through a limited company then it is possible that you will benefit from incorporating a company through which you can carry on the business. A company limited by shares is the most common business structure for individuals who wish to make a profit from their business whilst enjoying the benefit of limited liability. Incorporated by registration at Companies House, a company limited by shares is a separate legal entity from its members (or shareholders) who own them and, as such, the members' liability in the company is limited to the amount that they have invested in return for their shares. This structure is particularly useful for separating out your personal assets (for example, your family home) from the assets which belong to the business, offering a degree of legal protection for each.
Operating through a limited company can also streamline your business processes. As the company is a separate legal entity it can do all of the things that an individual can do: it can employ staff; it has the capacity to hold property; it can enter into contracts in its own name; and it can sue or be sued in its own right. There are various different types of companies and we can guide you through the key features of each to help you decide on the most appropriate structure for you and your business.
My business is going well and I have decided to collaborate with various other individuals in an effort to expand. What are the options in terms of structuring the business?
There are several legal structures that can be used to document a collaboration - the three most common of which are:
- a joint venture or collaboration by way of simple contract;
- a corporate venture by way of company limited by shares (which we have already looked at briefly above) with multiple shareholders; and
- a limited liability partnership (LLP).
There are of course other options that you may wish to consider, notably: public limited companies; unlimited companies; companies limited by guarantee; limited partnerships; and general business partnerships (depending on the nature of the venture in question). Again, this options analysis is something we can help you with.
The simplest form of association for a collaboration is an arrangement under which the parties agree to associate as independent contractors, bound together by contractual commitments, rather than as members in a company or partners in an LLP. The contract will set out all of the agreed terms that will govern that relationship, including: the commitments of the participants as between themselves and third parties; the obligations and scope of the venture; the use of each other's property and rights in connection with the venture; the duration of their legal relationship; and the exit strategy.
There are a number of benefits to a simple contract, including:
- the individual parties retain greater control over their assets as there would be no merging or transfer of such assets into a separate corporate entity;
- a simple contract has fewer administrative and filing requirements compared with other corporate structures; and
- the formal establishment and permanence of a company is avoided, which in turn will simplify the operation, and indeed dissolution, of the venture.
There are, of course, also a number of drawbacks, including:
- there is no separate legal entity, so if you need to enter into contracts, open a bank account, employ staff etc., the parties will need to do that in their own name. Likewise, there is no limitation of liability for the individual parties in respect of the venture;
- when considering a third-party investment or sale, the lack of a corporate structure may prove a disadvantage; and
- transferring an interest in a company to a third party by sale of shares is a relatively easy process, however, securing a successor to a purely contractual arrangement can be difficult. In reality, the parties may need an entirely new contract if a new party invests or takes a position in the venture.
Limited Liability Partnership (LLP)
An LLP combines the benefit of limited liability for its members with the flexible structure and tax transparency of a partnership. Liability is generally limited to each member's respective capital investment. Like a company limited by shares, an LLP is a separate legal entity from its members and is incorporated by registration at Companies House. As such it has unlimited operating capacity and it can do anything a legal person can do, including: the ability to sign contracts and enter into business transactions; hold property; employ staff; and to sue and be sued.
Designated members perform administrative legal duties that would otherwise be performed by a director of a company. Unlike a company limited by shares, however, there is no separation between management and ownership as every member has a right to participate in the management of the partnership.
An LLP agreement, which is a private contract between the members, documents how the partnership will function and be governed, including: setting out how members are to share profits; who is responsible for the management; how decisions will be made; and how members can be appointed and retired.
Raising capital in a company by issuing new shares can be relatively complicated when compared to the process of admitting new members to an LLP. With an LLP there are fewer formalities to bringing in additional members owing to the flexible nature of the structure. There are also few filing obligations than with a limited company. However, due to the way in which an LLP operates, in particular the tax treatment of its members, LLPs are more typically suited to the operation of a business that would otherwise operate as a partnership, such as professional service firms or doctors and dentists.
How would we extract profit from the business?
For a business venture that is governed by way of a simple contact, where each party is to bear its own costs, it will usually follow that the net profits of the collaboration are not shared but rather accrue separately to the parties of the contract, however the intentions of the parties would need to be carefully documented in the contract itself.
Shareholders of a company may realise profit on their shares in two ways: Firstly, they can sell their shares to a third-party purchaser, although there are strict restrictions in the UK on the public offering of shares in a private company for sale, so there is no guarantee of a ready market for the shares, making them potentially difficult to sell on. If the shares cannot be sold, the shareholder may have to wait for the company, or its assets, to be sold, or for the company to be dissolved and the residual capital distributed to the shareholders.
Secondly, surplus profit can be extracted by the company making a distribution in the form of a dividend paid on the shares. The distinction between the company's money, and a shareholder's rights to it (if any), must be recognised - the company is a separate legal entity, with legal obligations to pay its debts and comply with statutory requirements before any money is even capable of return to the shareholders. The company may only declare a dividend out of distributable reserves – i.e. clear profit. Even then, the directors may decide to retain the profits in the business and not to return them to the shareholders if they feel that is in the best interest of the company and there is no overriding contractual arrangement to the contrary. If the company does not make sufficient profit to declare a dividend, then there can be no payment made to a shareholder.
A member of an LLP does not hold any shares, just their capital interest in the business, but it is possible for a member of an LLP to transfer their capital interest to another member for a return. However, as with a company, there is no guarantee of a ready market for the capital. In fact, it may be more difficult to sell a capital interest in an LLP because the selling member is not able to transfer an easily identifiable shareholding but instead a general interest in various assets of the business. The LLP agreement is key here as it will usually document the agreed exit strategy, or retirement, of the members from the LLP, which will typically involve the member's interest being bought back by the LLP at an agreed value, often with staged repayments over a period of time to protect the ongoing business. Available profits of the LLP are typically declared in accordance with the profit-sharing terms agreed between the members and set out in the LLP agreement.
What are Articles of Association and a Shareholders' Agreement?
The articles of association of a company (the Articles), in essence, govern the operation of the company. It is the formal rulebook that sets out the rights and powers of the directors and shareholders. All companies incorporated in England and Wales are required to have Articles, which are publicly available at Companies House. There are model Articles that can be adopted on incorporation of the company, however they are very basic and do not provide adequate protection for most trading businesses where there is more than one shareholder and so they are usually supplemented by the inclusion of additional terms agreed between the parties. It is important to note that a company cannot act outside the powers set out in the Articles.
The Articles typically include, for example:
- the process for appointing and removing directors;
- the process for calling meetings of directors and shareholders; and
- the classes of shares, the rights attaching to those shares, and the rules for their sale and transfer.
A shareholders' agreement, by contrast, is a contract entered into between the shareholders of a company and, usually, the company itself. A shareholders' agreement is often thought of as a future reference point - something to be referred to in the future if, for example, there is a disagreement about how the business of the company is to be conducted. A key benefit to a shareholders' agreement is that it is a private document and does not need to be filed at Companies House. As such, it will often include additional terms agreed between the parties as to the operation of the business that they wish to remain confidential.
A shareholders' agreement may typically include:
- a list of board decisions that are 'reserved' for approval by the shareholders, for which the directors need to obtain the consent of the shareholders to action;
- minority shareholder protections in respect of key decisions which will require a higher level of shareholder approval to action;
- dividend policies;
- pre-emption rights – i.e. a right of first refusal for continuing shareholders to buy an outgoing shareholder's shares before they can be sold to a third party; and
- restrictive covenants - i.e. a set promises that certain shareholders make to each other with regards to their conduct during and after the period of share ownership.
This is just a brief look at the various corporate structures and related documentation – there will be many more considerations to deliberate when navigating your way through the world of corporate law. It is integral to the success of any business to ensure that suitable structures and procedures are put in place, to help optimise business success while minimising your exposure to risk, protecting your assets and helping limit your liability. As stated at the start of this article, independent legal, tax and accounting advice is essential to help you determine what would best suit your business model. Whilst corporate law can appear daunting at first, advice from a knowledgeable and approachable solicitor is certainly a good first port of call.