So you want to start a small business? You have your business plan at the ready, you can get a start-up loan with an interest rate that is at an all-time low, and your determination is at an all-time high. You are ready to go. Ironically, now – during this flurry of energy, excitement, and enthusiasm – is the time when you should slow down and become careful and contemplative. The decisions you make could have an enormous impact on whether your business succeeds or fails. Legal mistakes are amongst the most deadly. Knowing some of the pitfalls to avoid can make all the difference. Follow our series on the Top 5 Legal Mistakes in Starting a Small Business.
Mistake #1. Choosing the Wrong Ownership
Choosing an ownership structure is one of the most important decisions you will make. Your decision should be based on a careful consideration of the specific needs of both your business and yourself as well as a thorough understanding of your options and how these options relate to your needs.
There are three general business structures: sole proprietorship, partnership and corporation. Each has different and important implications for matters such as liability, risk, taxation, and succession. In deciding which of these options will suit you best, you should consider the following questions.
What are the risks involved in your proposed small business?
Some businesses are more financially risky than others. Are you building houses or selling office supplies? In a sole proprietorship, you, the business owner, can be held personally liable for the debts and obligations of the business. This includes loans, taxes, money owed to suppliers and landlords, and any judgments against the business. This risk can even extend to liabilities resulting from acts or omissions by employees. While you can protect yourself against lawsuits by buying business liability insurance, this won’t help you with business debts. You could potentially lose everything you own if the business debts are not paid. For the case of partnershps, because partners can make commitments that bind the entire business (without even consulting you first), your liability may be even greater than in a sole proprietorship.
A corporation, on the other hand, has limited liability. This means that normally no shareholder can be held personally liable for the debts, obligations, or acts of the corporation. However, in certain limited circumstances, a judge can look behind the corporation and hold one or more shareholders liable (this is known as “piercing the corporate veil”). For example, this may happen if a shareholder personally guarantees a debt, or if the corporation is a sham company used for nefarious purposes. The limited liability advantage can also be undermined if one or more of the shareholders sign any personal guarantees.
How much start-up capital do you have?
Do you have all you need or will you need investors? Sole proprietorships and partnerships have lower start-up costs as you do not incur the costs of setting up a corporation. In addition, sole proprietorships and partnerships are easy to form; there is no long list of statutory requirements as there is for a corporation.
How do you plan on obtaining any additional capital?
Investors won’t usually invest in sole proprietorships. For partnerships, there are more potential sources of investment capital (for example, through the concept of the limited partnership), but many investors prefer shares in a corporation. Before accepting any additional capital from a new partner, you will want to ensure that this partner is suitable and that the addition of this new partner conforms to the partnership agreement. For a corporation, it is easier to raise capital because investors know that they will not be held personally liable for business debts. A corporation also has many avenues to raise money, such as selling current shares, or creating new types of shares, such as preferred shares, with different voting or profit rights.
What are your expected profits and losses in the first few years?
Will you need to deduct losses from other income? Sole proprietorships and partnerships offer numerous personal tax advantages, because, as an owner, you can deduct business losses from your other income. In addition, it is the owners that benefit from all of the profits. In a corporation the profits and losses belong to the company and have to be distributed accordingly.
Are you the kind of person who wants to be in full control of all decision-making?
In a sole proprietorship, you are in control of all decision-making. Any future sale, transfer, or dissolution of the business is entirely at your discretion. In partnerships and corporations there can be a broader management base. This can lead to divided authority and the potential development of conflict between partners or shareholders.
Can you adapt to many formal small business requirements?
In sole proprietorships and partnerships, there are few formal business requirements. However, partnerships do require an operating agreement, and this creates slightly more record-keeping than a sole proprietorship. In contrast, corporations are very closely regulated. Corporate record-keeping is extensive and can be complex.
Do you want or need statutory name protection?
If name protection is important to you, you may wish to incorporate your business. Part of the process of incorporation is ensuring that the name you choose is not the same as, or too similar to, other corporate names in the jurisdiction. The same protection will be offered to your corporation once it is set up. In general, there is no such automatic name protection for sole proprietorships and partnerships. You can find exact details about other name protection options (such as the registration of trade names) in provincial business name legislation.
What are your plans for the small business should something happen to you?
Sole proprietorships and partnerships lack continuity of business in your absence. The business has no separate existence, so you will need to make a succession plan through a Power of Attorney, a Personal Directive, and a Will. A corporation, on the other hand, as a separate legal entity, does not depend on the continued existence or membership of any of its shareholders, directors, or officers.
Continue reading: Mistake 2: Not Having an Operating Agreement (Partnerships and Corporations).