How Start ups make mistake in statutory matters – Part 1

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)

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