Business basics part 1: structure

In the first of a series on how businesses work, Ricky Ghosh takes a look at structure

One of the most important choices facing any business is which of the wide variety of corporate structures to adopt. Each type of structure has its own advantages and disadvantages, and professional advisers (especially lawyers and accountants) are often involved in tailoring businesses to the most appropriate form.

The most widely used structures today are: sole trader, partnership (including limited liability partnerships or LLP), and company - both private (known as a limited company or Ltd) and public (known as a public listed company or PLC). Complex businesses such as private equity funds usually use a combination of these for commercial efficiency and legal protection.

Sole traders

Sole traders are most commonly found where self-employed people own and operate their own, usually small-scale, businesses. A cornershop owner, builder or independent taxi driver would probably all use this structure. All the assets are owned by the same person who makes all the major decisions, and is also personally liable for all the debts and obligations of the business, without limit. Although this is the most straightforward structure, allowing small businesses to operate free from outside control and with few legal restrictions, these advantages must be balanced against the risk of financial ruin if the business fails.

Partnerships

In partnerships, multiple people run the business as equal owners. Common examples are vet surgeries, dentists and high street solicitors. The assets are jointly owned by the partners, and the profits or losses are divided between them. The partners are liable together for all debts and obligations of the business (although note that some partnerships may include "limited partners" - external investors who are only liable up to the amount of their investment in the business). This feature creates the problem of "rogue partners", who may independently take on financial liabilities in the name of the business for which the innocent partners will be financially responsible. A high level of trust between partners is therefore required, and the "partnership deed" which governs the business will contain many restrictions on partners' ability to enter into transactions. Partnerships are subject to few formalities and public disclosure requirements, making them easy to run, and they have greater economic power than sole traders, but these advantages must once again be set against the financial risks.

Limited company

The most famous corporate structure, the limited company (Ltd) is the way in which most medium to large sized commercial undertakings are organised. The company itself owns and runs the business as a distinct entity - a separate "legal person" - as opposed to "natural persons", that is, like you and me). The shareholders own the company and the directors run it, but the company is separate from both. The use of this concept leads to the most important advantage of companies - limited liability for investors. The company takes on its own debts and legal obligations (for example, to respect the rights of its employees) but the investors (that is, the shareholders) are financially protected because they are only liable up to the amount of their investment in the company and even then only in the event of insolvency. Because of this arrangement, most major businesses operate as companies - they must take on debt to meet current costs, invest and generate future income, but they can protect the people "behind the veil of incorporation" by taking on these debts in the company's name. (However, note that, depending on their bargaining power, the directors and/or shareholders may have to give personal guarantees or other "comfort" to the lenders).

Separate legal personality (and the consequential limited liability) encourages entrepreneurs to take on speculative ventures because they know that their personal assets are protected in the event of failure. However, the people who must deal with the company - investors and trade counterparties (for example, suppliers) - are open to the risk that the other side of any deal they enter into with a company will not be honoured (counterparty risk). In order to protect them, as well as the shareholders, the law imposes many legal requirements on companies. Most importantly the requirements of (i) public disclosure (records including accounts and information on who is behind the company must be annually submitted to Companies House), and (ii) restrictions on how the company may be run. Most of these rules are contained in the Companies Act 2006 - we'll examine these in more detail in next issue's article.

Public company

The largest companies, public companies (PLCs), which have "floated" on the stock market via an initial public offering (IPO) of their shares for sale to investors, are subject to proportionately more legal restrictions. In particular, because they are able to sell shares to the general public they are subject to very onerous disclosure requirements.

Limited liability partnerships

Limited liability partnerships (LLPs) are quite rare, but should be dealt with briefly. They are a hybrid of partnerships and companies, combining certain features of both. The partners can limit their financial risk, but must make more public disclosures and are subject to more legal restrictions. Most of the large professional services firms have adopted this model.

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