In this guide, we look at the most common types of start-up business structure and the advantages and disadvantages of each to give you an idea of what might be right for you.
- 3 common business structures
- The advantages and disadvantages of each business structure
- How do I choose the right business structure for my start-up?
3 common business structures
Here’s a snapshot of the types of legal business structures most successful businesses choose:
A company is a legal person, that means it can buy and sell things, own property, employ people and enter into contracts just as a human person can.
It’s a free-floating body, relatively independent of its owners, that has flexibility to do what it likes, within certain limits. It pays tax on its profits and rewards its owners with dividends on their shares in the business, if the directors decide that’s appropriate.
A company is ‘limited’ because its owners’ liability for its debts is capped at a certain amount.
In the case of a company limited by shares, that amount is equal to the base or ‘nominal’ amount paid for those shares, often £1 (although the price actually paid is likely to be more, depending on the company’s value). In the case of a company limited by guarantee, that amount is generally capped at £1 per member.
This means that if the company is no longer able to pay its debts, the company’s owners don’t need to put their hands in their pockets to fund it, absent of fraud or gross mismanagement on their part. The owners of a company generally don’t take any part in its business, unless they are also directors. This may seem strange at first, but in fact shareholders have little input into a company’s strategic direction. This is because the company’s day-to-day activities are run by a board of directors, its staff and employees.
The main practical difference between companies limited by shares and those limited by guarantee is financial. A company limited by shares, if profitable, will pay those profits to shareholders, and the shares themselves have a value equivalent to the company’s assets less its liabilities, together with its future prospects. With a company limited by guarantee, all profits are re-invested back into the company, and company itself has no ‘value’ – it cannot be bought or sold.
A sole trader is someone who does business on their own account. Both the assets and the liabilities of the business are directly owned by that person. Just like a company, a sole trader can enter contracts, employ staff, own property and so forth.
A sole trader is solely responsible for the strategic direction of their business. There are no third parties with a say in how they run their affairs. The buck stops with them.
In financial terms, any profits made by a sole trader belong to them alone, as are any losses. They bear all the costs that are deducted from revenues before they declare a profit and pay tax on it. Being a sole trader is the simplest way to run a business. Think market traders, plumbers and electricians. They’re probably sole traders.
Partnerships are a bit like an extension of the sole trader model. A partnership is formed when two or more people are working together with a view to making money. The relationship can be informal, and you can create a partnership just by agreeing to work together as partners, although we would advise you to enter into a formal partnership agreement if this is a path you’re considering.
Partnerships are common among professionals like lawyers, accountants and the medical profession, as well the building industry. There are two main types, a general partnership and a limited liability partnership.
Each partner is classed as self-employed and fills in their own tax return. The partnership itself doesn’t pay tax on its profits.
A general partnership is not a legal person in its own right, so can’t own property or employ staff and any contracts entered into are made collectively with each individual partner. Any assets of the partnership belong to the partners equally, and any profits are shared equally. All the partners are responsible for the partnership’s debts and liabilities.
A limited liability partnership is a hybrid between a limited company and a general partnership. Like a company, an LLP is a legal person and can own property and enter into contracts. The individual partners are not liable for the debts of the partnership. An LLP must be formally set up and registered at Companies House, and the partners will enter into a partnership agreement that governs the relationship between them and will contain details like how much of the profit each individual partner will receive.
The advantages and disadvantages of each business structure
Advantages of setting up a limited company
There are different types of limited company, including Community Interest Companies, companies limited by guarantee, and public limited companies. The most common type of company is the private company limited by shares, and so that’s what we’ll focus on here.
A limited partnership is relatively easy to set up, will formalise your business and lend it credibility if you want to borrow money, enter into supply agreements or look for investors.
The main advantage of a private limited company is that your personal assets, like your home or family car, aren’t exposed to any risk because the company is a separate legal body, and it alone will be responsible for any liabilities.
Another advantage of the limited company is that it can own assets like intellectual property rights, and if the business grows and expands the shares will increase in value and can be bought and sold. If one day you decide to go public, your shares can be traded on a stock exchange and bought by members of the public.
A limited company is an ideal vehicle if you plan to grow your business, borrow money or seek investment in return for offering your funders a share in your business in return for the cash.
In addition, the tax regime that applies to companies is more generous than that applicable to sole traders and partners. A limited company will pay corporation tax on its profits, and any money left over will be paid as dividends to its shareholders who will pay tax on them. The directors and other employees pay income tax on their salaries and fees. A company can choose to keep profits within the business and so pay a lower rate of tax overall.
Small private companies can raise money from investors in a tax-advantaged way using a scheme like the Enterprise Investment Scheme or Small Enterprise investment scheme.
A company only needs a single director and shareholder, so a one-person business can be set up as limited company.
Disadvantages of setting up as a limited company
The main disadvantages of a limited company are administration cost and lack of privacy.
A limited company must complete annual accounts and make a corporation tax return to HMRC. It must pay National Insurance Contributions on the salaries of its employees and pay tax and NICs on its employees’ behalf. You also have to register your company at Companies House and provide details about your directors. There are ongoing filing requirements relating to important company decisions and you need to keep registers of current shareholders and those people in your company who have control of its operations.
Because the documents filed at Companies House are public, anyone can look at them, including your competitors.
A further disadvantage of setting up as a limited company is that the shareholders receive profits according to the number of shares they hold, regardless of their individual contribution to the company’s success, unless you create separate classes of shares with preferred dividend rights.
Advantages of setting up as a sole trader
The main advantage of being a sole trader is that you alone control the strategy of your business and are accountable only to yourself. You can buy or sell property, enter into contracts and employ staff. All the profits and all the assets of the business belong to you.
A sole tradership is very flexible and easy to set up, there’s not much red tape to comply with and no fees to pay.
Unlike being an employee, you can deduct your business expenses from your income before you pay income tax on your profits as a self-employed person.
Disadvantages of setting up as a sole trader
The main disadvantage of being a sole trader is that you are personally responsible for the liabilities and debts of the business, meaning you could lose your home if things go badly. In addition, over a certain amount of income, tax rates start to climb so you’ll end up paying more tax than if you set up as a company.
What’s more, if you’re planning to grow your business and have big ambitions, your options are limited. Because a sole trader isn’t a separate legal person from yourself, it has no intrinsic value and can’t be bought and sold, although your business assets like your trade name, premises, customer lists and tools may have their own value. You may find that businesses and banks are less willing to deal with you or offer loans on preferential rates than if you’re set up as a company.
Advantages of setting up a business partnership
The main advantage of a general partnership is that it can be very informal. While we advise you to document your partnership, you can start out as partners just by agreeing to work like this. It’s a very flexible model, and new partners can join, and partners can leave without any formality. You can divide the profits between you as you choose.
The partners are together responsible for decision-making with no external influence from shareholders or constraints on their operations.
Another advantage of the general partnership is that any agreement between you and your partners is private. So you don’t need to file any documents for public inspection.
With a general partnership, you can spread the risk of doing business and the work done by the partnership with your other partners. If one of you is ill, the other can step in and keep your clients happy.
If you set yourself as a limited partnership, the partnership will be a separate legal entity, can own property and employ staff, and the personal assets of the partners are protected from any liabilities of the partnership.
Disadvantages of setting up as a business partnership
In a partnership, each partner is registered as self-employed and pays income tax on the partnership profits they receive, and this may be less tax-advantaged than setting up a limited company. What’s more, in a general partnership, each partner has responsibility for the debts and liabilities of the business. This can be an issue if one partner runs up debts without the knowledge of the others, as you’ll all be equally responsible for them.
Because a general partnership is informal, you can be at risk if a partner leaves or becomes ill as the partnership may dissolve at that point.
If you set up as a limited liability partnership, while you will not be responsible for the partnership’s debts, this comes at cost as you will have to set up a partnership agreement and file accounts at Companies House. This means that the details of your partnership are made public.
While setting up in general partnership is easy, problems can occur if there’s no written agreement. If one person is contributing more than another in terms of workload or brings more to the party, such as a valuable asset, disagreements can occur. Deciding who owns what, and who is entitled to what share of the profits can be problematic, as can be deciding what to do if someone wants to leave or you want to force them out.
How do I choose the right business structure for my start-up?
There is no right or wrong answer to the best business structure, however some structures may be more appropriate than others. Find out more in our article ‘How do I choose the right business structure for my start-up?’