How Start ups make mistake in
statutory matters – Part 1
From the Adam’s era, men always
made mistakes, tried short-cuts and great suffering followed. Modern day
entrepreneurs are no different. Most importantly the first generation business
men are more prone to errors.
The whole world has become that competitive
and every mistake has your reputation or money in stake. In this fast changing
world you cannot afford to make mistakes. From the inception to the exit, unless
you tread cautiously, the fall is inevitable.
Those who have inherited businesses
are in a better position, in a way. They have a legacy of experiences.
Experience is the best teacher, they say. (But why should those be your own
mistakes?). To a first generation start
up entrepreneur, learning from own experiences will be costly.
So what are the mistakes you tend
to commit and what should you do to avoid these pitfalls? Let us start at the
very beginning and discuss one by one:
1. Which is the right constitution suitable to you?
Issues arise from the moment you
think of starting a new venture. How should I form my entity? You have several
options. You will get several advises also!
Hey, you start your business
on your own in your individual name. For example Mr. Sabir, Software Developer.
Or you can give a fancy name to your entity, say Dream High Fly Solutions and
Mr. Sabir is the proprietor.
Why should I do it alone? Why
not I invite my classmate and childhood friend Mr. Vinod also. After all, we
always shared our dream of becoming the Indian Bill Gates and Steve Jobs. We
share common ideas, we share common dreams and our ‘wavelengths’ are also same.
Okay, let’s start a
partnership firm, say Sabir and Vinod Technologies. Hey, Mr. Narayanamoorthy
says, you should form an LLP because its liability is limited. (What the hell
is this ‘limited liability’? I don’t know!). Any way, Moorthy is my well wisher,
so I need to think of his advice.
Last week, we had a concall
with a US company for a proposed project. They want to see our incorporation documents!
They didn’t understand what a Partnership Deed is. They say we should be a
corporation! What? a Corporation?
Uncle next door advised we
should form a Limited Company. He introduced us to a ‘consultant’ (?). He asked
several documents and information. He spoke about DIN, PAN, TIN, TAN – all Greek to us! We have heard of
Tintin and Snowy only! He wanted 5 more people to join. So we ran from pillar
to post and managed to rope in my mother, the neighbour uncle and aunty, the
medical shop guy at the corner and my cousin’s close friend to reach the magic
number.
After several rounds of
sitting and signing a lot of documents including stamp papers and paying a hefty
amount as registration fee and consultant’s fee, we got an incorporation
certificate of public limited company
with the name “Ihatethisname Industries Limited”. Saaaar, but this is not the
name of our company we wanted! The consultant said this is the only name
available! But, Whyyyyy?
Gosh, there is a huge gap in
our budget! We didn’t expect the
formation cost to be so high around 100K. We are just out of the college and
still begging for our pocket money from Dad. What is more, the consultant says
there will be annual expenses of 50K for filing the documents with the
government department, every year!
Idiot!, I should have accepted
that offer from that company in Hyderabad during the Campus interview!
I just narrated what a typical startup young
entrepreneur is going to experience and how depressed and dejected will be his
mindset, after this.
So what should be done? Yes; what
you have read is partly correct.
There can be multiple options
for a form of your entity as per the current laws in India:
a
Individual / Proprietary Firm
b
Partnership Firm
c
Limited Liability Partnership (LLP)
d
Private Limited Company
e
Public Limited Company
There can be other forms like
Trust etc. But they are best suitable for no – profit organisations. So let us
concentrate on the above five.
There is a major and most
important difference between the first 2 and the rest. It is relating to the
personal liability you may have. The first 2 forms are with ‘Unlimited
Liability’ means if something worse happens to your business and there arises a
huge loss or liability on account of that, in that situation, where your
business assets are not sufficient to meet those liabilities, your personal
assets and wealth will also be used to set off the same. (Confused? Uh?)
It can be explained in another
way. You have a private limited company with your capital contribution is, say
50K, which you have already deposited to the company’s bank account. Now, the
company incurs a huge liability of, say one crore rupees. Your company has
assets and bank balances worth 10 lacs rupees only. It will be utilised to pay
off that 1 crore. Still 90 lacs liability remains. So who will bear that 90
lacs? Will your personal assets like car, house, wife’s ornaments, parents
properties etc will have to be sold to pay off 90 Lacs? The answer is NO,
because, company is a limited liability entity and is a distinct legal entity
different from the people who promoted it and hence the company’s liability
will be paid off by the company only and not by the promoters.
Suppose, you agree to invest 50K
as capital contribution, but paid only 25K. So you will be asked to shell off
remaining 25K, that’s all. If some creditor catch you up, ask him to take the
money from the company, if anything available there or go to hell. (Beware,
this is theory, but your reputation is lost!). One more caution. The limited liability
principle works only if you conducted your business straight forward. If it is
proved that you have defrauded the creditor through the company, you will be in
soup!
So the decision as to a
suitable format should be based on 5 factors:
a
Control
b
Liability
c
Ease of formation
d
East of maintenance / statutory compliance
e
Public image
f
Scope for
Future expansion
g
Ease of Exit
a
Control
- From
the control point of view, Format No. 1 is the ultimate. You are the sole
owner and you need not answer to anybody else.
- Then
come Partnership Firm and LLP. Here you have to consult your partners
only. But you can collectively take a decision. But, no partner can thrust
their decision upon you. The principle behind the partnership is ‘all for
one and one for all’. In this case, who controls the entity is exclusively
defined by the Partnership Deed executed by the partners. The investing
party need not hold the control, if he chooses so.
- Private
Limited Company is also safer from the control aspect, as there will only
a limited number of people involved who are mostly your friends and
relatives. It may be called and extended form of LLP. But, unlike LLP,
control depends on the quantum of investment each party makes in the
company.
- Public
limited company envisages participation of more people including strangers
and hence the control depends on how much shares you hold in the company.
Any person or group holding substantial portion of the share capital
control the company.
b
Liability
As I discussed
earlier, Individual / Proprietary Firm and Partnership Firm entails unlimited
liability, whereas LLP and Limited Companies have only limited liability imposed
on shareholders.
c
Ease of formation
- Formation
of Individual / Proprietary Firm is very easy. You have to find out a workspace,
get a license from the local authority – that’s all. There is no formal
document creating such an entity. You can choose a trade name, if you
like.
- For
creating a partnership firm, all the partners must sign a deed of
partnership, agreeing the terms and conditions between them. The deed
should be on a stamp paper of requisite value (in Kerala it is Rs.
1000/-). Then you have to register it with the concerned Registrar of
Firms. You will have a Partnership Deed on a stamp paper evidencing the
creation of the entity and you will get a certificate of registration from
the Registrar of Firms. You can give any name of your choice for the
entity.
- When it
comes to LLP, things are a little different. LLP’s are administered by the
Ministry of Corporate Affairs, Government of India. You have to choose a
name, first and apply for the availability of that name. If same or
similar name exists, you will not get permission to form an LLP with that
name. Once, the name is approved, the partners have to sign the LLP
agreement as per your agreed terms and file it with the Ministry. If
everything is ok, they will issue a Certificate of Incorporation.
- Formation
of a Limited company (both private and public) is also similar to that of
LLP. Once you get your name approved, you have to file the Memorandum and
Articles of Association of the company and on satisfying the terms and
regulations of the Companies Act, you will get Certificate of
Incorporation.
d
Ease of maintenance / statutory
compliance
- Ease of
maintenance or compliance with statutory formality flows inversely from
No. 5 to No. 1.
- For an Individual
/ Proprietary Firm, you have to file Income tax return only if you have
taxable income.
- While
filing of Income Tax Return is compulsory for all others, LLP has to
additionally file certain annual forms with Ministry of Corporate Affairs.
- In the
case of Company, annual audit is compulsory whereas, in other cases, audit
under Income Tax Act is compulsory, if your turnover for the year exceeds
Rs. One Crore.
- Moreover,
in the case of LLP and Company, any change in capital structure, partners,
directors or situation office etc. you need to inform the authorities
filing the required forms.
- There
are some other restrictions applicable to companies on day to day functioning.
But private companies are exempted from some of them.
e
Public image
- From
the point of view of public image or marketing, Companies ranks first,
followed by LLP.
- In many
countries, including USA, no Individual / Proprietary Firm format of
business. So when you negotiate a business deal, being an incorporated
body (LLP or Company) will be of substantial image.
- In the
case of incorporated bodies, many information on the formation,
constitution, persons at the helm of affairs, important financial information
etc are available on public domain which can be viewed and verified by
stakeholders.
f
Scope for
Future expansion
- When
you start a business, you have to think long term. Your business is going
to grow leaps and bounds and you will need more resources either as
investments or funding. The investors or funding agencies will be more
comfortable with incorporated form of business entity rather than an
Individual / Proprietary Firm.
- Or at
times, you may decide to monetise what you have amassed in the business
over the years, either partly or fully by divesting your stake in the
business fully or partially. There are investors who are ready to invest
in your green field projects and when it starts yielding they will sell
their stake and move out of the company.
- To have
a better valuation as well as ease of transfer, the incorporated form will
be quite useful.
g
Ease of Exit
- As an
Individual / Proprietary Firm, if you decide to close down the business,
what you have to do is to collect the receivable, settle your creditors
and close down the shutters. Finished. But if you want to sell the
business, you value your business, find a willing buyer and sell the
business.
- In the
case of partnership, in addition to the above, you need to execute a Deed
of Dissolution of Partnership with other partners. So all partners must
agree on winding up the business. Alternatively, you can ask other
partners to value your share and buy you out, if they are willing. Then
you can get out of the business.
- If it
is a LLP, you need to file necessary forms with the Government, if you wind up the
business or get out of the LLP.
- In all
the above cases, if your assets are not sufficient to meet your
liabilities, please refer my discussion on page 2 on limited liability
concept.
- In the
case of a company, the basic principle is that Company has a perpetual
succession. Shareholders may change, but the company remains. No
shareholder can ask to wind up a company otherwise than through High
Court. But if all the shareholders decide so, it can be voluntarily wound
up. In either case, winding up of
Company is a hell lot of work.
- Alternatively,
if somebody is willing to buy the company lock, stock and barrel, you can
transfer all the shares to the prospective buyers and the company is transferred.
- If one
shareholder wants to get out of the business, he can transfer his share to
the willing buyer. But, if it is a private limited company, you cannot
transfer to a third party unless the Board of Directors consents. But in
the case of a public limited company, no such consent is required and if
you transfer the shares even to a stranger, the shares stand transferred.
So selecting a suitable form of
entity is not a child’s play. It has a long standing implication on the
business and personal life of the entrepreneur. The best thing to do is to get
a professional help.
(Second part of this article will
follow)
(Send in your comments on this article, please!)
