‘An idea is only as good as its execution’– a popular saying in the startup ecosystem. When entrepreneurs come up with an idea, rightfully their complete focus is on making that idea work and take the product to the market. Usually, most entrepreneurs are either confused or ignorant about type of entity suitable to take carry out business.
This article presents suggestive chronology of entity types that can help entrepreneurs reduce compliance cost and enhance flexibility.
Tinkering phase: Corporate entity not required
The tinkering phase is a trial-and-error phase. Founders attempt to give physical shape to their idea. They incur some costs but there no revenues in horizon yet. In this phase, entrepreneurs need not form a corporate entity. A simple partnership agreement documenting understanding between the partners is adequate. In case of single entrepreneur, a sole proprietorship is sufficient.
Pros:
Very minimal compliance requirement (except general tax related compliance). Almost no reporting to be made to any regulator (except sector specific regulators, if any). Simplicity in formation and dissolving entity (in case idea cannot be materialized).
Cons:
No corporatization means unlimited liability.
Product development and test phase: Basic corporatization
In the product development and testing phase, business have to extensively interact and transact with vendors and customers. This increases the probability of unforeseen liabilities and in turn the necessity of limited liability. Assuming startup is still bootstrapped and there is no plan to raise equity funding until minimum viable product (MVP) is ready, basic corporatization is advisable. Corporatization would mean that entrepreneurs may convert their partnership to LLP (limited liability partnership). Sole proprietor may choose to form an OPC (one-person company). This will help founders to protect their personal assets in case business goes bankrupt.
Pros:
Lesser compliance and reporting compared to private limited company.
Limited liability meaning protection of personal assets of partners against claims of business creditors.
Streamlined and time-bound incorporation process.
Eligible for various startup related schemes of government.
Cons:
Not suitable to raise seed funding from angel investors or incubation centre.
Annual compliance costs.
Tax rate on LLP is higher than private limited company (but in absence of revenue & profit, this won’t have any impact).
Product introduction and scaling up phase
This is the phase where idea gets transformed into viable business. Product gains traction and business starts generating revenue. Founders may approach investors to raise funds for rapidly scaling up. These investments are made against various securities like equity shares, preference shares, debentures, etc. These securities cannot be issued by an LLP. Before this stage, business must be converted into a private limited company.
Pros:
Company can issue equity shares, preference shares to investors, ESOPs to employees and debentures to lenders.
Lower corporate tax rates.
Suitable for incubation and accelerator programs.
Streamlined and time-bound incorporation process.
Cons:
Enhanced compliance and reporting costs.
Distributed profit (dividend) taxable to shareholders.
IPO phase
IPO means listing of equity shares on stock market. In this phase, most of the initial investors like promoter/founders, anchor investors, venture capital firms, investment funds exit and offload their equity stake to general public. For this, private limited company has to be converted into public limited company.
Pros:
Enables exit of existing investors.
Listing enhances prestige for the company.
Cons:
Extensive reporting and disclosure requirements.
Stringent regulatory supervision.
The evolution of entity type given above are simply indicative based on their pros and cons. Actual choice of entity type will depend on nature of business, stage and pace of product development, prospect of raising external capital and personal preference of the founders.
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Disclaimer: This article is for the purpose of general awareness and does not represent professional opinion of the author.
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