Not sure what legal structure to adopt for your new startup business? Should it be a company, with shareholders and directors? Or should it be a partnership? And what’s the difference, anyway?
How Partnerships Work – Is This Structure Good For Your Startup?
A partnership is a more basic form of organisation than a company. It consists of two or more people pooling assets, engaging in a common business activity to generate income, paying their business debts, and sharing the profits. It is a relationship. The smart way to set it up is to have a partnership agreement, where the inputs and outputs of each partner are set out clearly. Having an agreement usually makes things run more smoothly, and prevents misunderstandings. It can map out how the partners will deal with all the important issues that they would be likely to encounter in their joint enterprise, including accepting new partners, leaving the partnership, splitting profits, leaving money in the business to fuel growth, and so on.
One important thing to appreciate is that both partnership and company structures work against a background of general legal principles. These principles vary from country to country, but a lot of countries have similar basic rules. One common rule is that each partner is 100% liable for the debts of the partnership, in relation to outside parties, even though they may have unequal shares of the business, internally. Therefore, if your partner disappears, even though you only own 10% of the business you will be liable to pay 100% of its debts. The solution the law offers you is to sue your partner, probably now your ex-partner, for his or her 90% contribution. This is what you might consider a downside of having a partnership.
Another thing that varies between countries is taxation rules. Commonly, partnerships are treated as tax transparent entities. That means that the partnership itself is not taxed on its income, each partner is taxed on the income he or she receives from the partnership business. There may be variations on this. For example, the partnership may be regarded as an entity for the purposes of paying sales tax or other types of taxes. Also, some countries allow partnerships to acquire limited liability, which is a feature borrowed from the company structure (which will be discussed below). The UK, for example, has Limited Liability Partnerships (LLPs). The tax transparency of a partnership is an upside of that type of business structure. The capacity to acquire limited liability is an added bonus, in certain countries.
How Companies Work – Is This Structure Good For Your Startup?
A company is treated by the law as an artificial, legal person. A company can own property, sue and be sued, just like an individual person. It survives the death of its shareholders and/or directors, in other words, it has its own separate legal personality. This has positive and negative features for the “owners” or shareholders. A possible negative feature is that a company is a separate taxpayer, unlike (in many countries) a partnership. The company pays tax on its income, then pays wages, dividends or directors’ fees to its “owners”, who pay tax again on their income derived from the company.
In many countries, this situation is made less punitive by various features of the taxation system. In Australia, for example, shareholders receive a credit for tax already paid by the company, so that income derived by dividends is taxed at a lower rate than income from other sources. Be these things as they may, introducing a company into a business set-up takes the business to a new level of complexity. Companies usually have to deduct income tax from their employees’ wages before paying the wages, they have to obtain various kinds of insurance such as workers compensation insurance, and set up or contribute to retirement funds, and they have other compliance obligations.
Also, the internal structure of a company is more complex. There are the shareholders, who may hold shares of different classes that have different rights attached, and then there are the directors nominated by the shareholders, called the board of the company, who have a set of important legal obligations and who in most places are subject to serious criminal penalties if they misuse the company for illegal purposes. Companies have a constitution, which can be called different things in different countries (like “memorandum and articles of association”), which is the set of basic rules that governs things like the issue of new shares, the transfer of shares between shareholders, and the ultimate winding up or “death” of the company.
As an added layer of rules on top of the generic set of constitution rules, many companies also have shareholder agreements. These are specific rules designed for each particular set of shareholders, and cover many of the same rules as partnership agreements do, such as what their imputs and outputs will be from the company: how many hours they will work, for example, and what their directors’ fees or dividends will be.
One of the benefits of a company structure is the flexibility of adding or deleting people. It is easy to sell shares and leave. In fact, all of the shareholders can sell their shares at once and transfer control of the company and its business to a new “owner”. Another benefit is the separation of the company from the people that are involved in it, in terms of liability. If a company has a debt, then that is the company’s debt, not that of its shareholders. Normally, shareholders are liable to pay the full value of their shares, and no more, unless there has been some kind of improper activity. This barrier between corporate and personal liability is lowered when company directors give personal guarantees, or breach their legal duties. Otherwise, the company is normally treated as a separate entity financially as well as legally, from the people involved in it.
In this blog post, we have covered some complex topics at a very high, or simplified, level. If you are are setting up a new startup business, it is usually worthwhile getting some good advice from a lawyer and an accountant, and, of course, learning as much as you can about the basic legal and financial concepts concerned.
[The author of this blog post, James Irving of Irving Law Commercial Lawyers, practices law in Perth and Melbourne, Australia, and has assisted many clients to set up new businesses. Please visit his website if you require assiatnce with any of the issues covered in this blog post. Photo credit: Novatek’s Annual General Meeting of Shareholders 2016 by Krassotkin, a publoic domain imagecourtesy of Wikimedia Commons and used here under the Creative Commons CC0 1.0 Universal Public Domain Dedication.]