Merits of Incorporation

Introduction

If you are thinking of setting up a company, either from scratch or by way of incorporating an existing business be it a partnership or a sole trader, there are various issues to bear in mind as set out below. At the end of the day, of course, it will depend on individual circumstances and situations.

So what does running a business as a private limited company mean?

Such a business will be owned and operated by the company itself. The company is recognised in law as having a “personality” which is separate from the person(s) who form the company and/or the directors and shareholders. The division of powers between board meetings (where, generally, directors’ decisions are made) and general meetings (where generally, decisions of shareholders are made) is a fundamental aspect of company law. It imposes on a company a degree of formality, which is absent from running a business by a sole trader or as a partnership.

Liability

The company is responsible for the debts and obligations of the business, so the directors and shareholders cannot generally be required to pay anything towards the debts of the company in the event of the company’s insolvency. Shareholders enjoy the benefit of limited liability, which means that their liability is limited to paying to the company the price they have agreed to pay for their shares. Once their shares have been paid for in full, the shareholder has no further liability. Note, however, that there are a few exceptional circumstances where a director or shareholder can be forced to make a contribution to the company’s assets, in particular in the event of insolvency, or where a director has given a personal guarantee.

Partners and traders, on the other hand, are fully liable for all debts of the business. In the case of a partnership, if one partner does not pay then the others must pay his share.

Management Structure

The only limitation laid down by the Companies Act 1985 (as amended) is that a company is obliged to have one director and one secretary (who may not be the same person). Otherwise the company is entitled to lay down whatever procedures and limitations on its management that it chooses, by incorporating the agreed rules in the Articles of Association (the “Articles”). For further advice on this area, please see paragraph 4.2 below.

The Articles would usually be drafted so as to give the directors the freedom to regulate how they manage the company. However, certain major decisions, for example, incurring borrowings over a certain limit may be reserved to the shareholders , whether this be set out in the Articles or a shareholders’ agreement. For further advice on this area, please see paragraphs 4.2 and 4.3 below. A partnership is at liberty to organise itself in such a way that certain partners exercise management functions and other partners are only consulted on major issues.

Raising Finance

The standard choice for raising finance is between debt (i.e. loans) and equity (i.e. shares). Please see the document entitled “Raising Finance” for a fuller discussion of these alternatives. This discussion is restricted to looking at their relative advantages and disadvantages in the context of incorporation.

Debt

Most lenders of a business will seek security for payment of a loan. Companies, partnerships and sole traders can all create fixed charges (i.e. an interest attaching to a specific item of company property) over their assets as security, however, only a company is able to create a floating charge. A floating charge is an interest in company property created in favour of a creditor to secure an amount owing, such property being circulating assets (such as cash and stock in trade) to which it will not attach until some event causes it to become fixed. Although the floating charge is an inferior form of security compared to a fixed charge, it allows the company to use, for example, its stock-in trade and future assets as security for its borrowing. This means that a company has greater scope than a sole trader or a partnership for raising finance. Please see the document entitled “Raising Finance” for further discussion on fixed and floating charges.

Capital or “Equity”

When a person introduces capital to a limited company in return for shares, the company has the advantage of being able to offer limited liability. A partnership to which a person introduces capital and becomes a partner is asking that person to accept unlimited liability for the debts of the partnership incurred after he becomes a partner.

In the longer term, a company (provided that it is a public limited company) may also make an offer to the public and/or flotation on the London Stock Exchange or the Alternative Investment Market, a route that is denied to sole traders or partnerships. Please see the document entitled “Listing” for further discussion on flotations.

Taxation

The company will pay corporation tax on the profits of the business; the directors and shareholders of the company cannot be made liable for payment of corporation tax. A sole trader, on the other hand, is responsible for paying income tax on all profits of the business.

Running of the Company

Unless it is dissolved a company continues in existence so that it is not affected by the death, bankruptcy, mental disorder or retirement of any of its shareholders. In the case of a partnership, on the other hand, subject to any agreement between the partners the partnership could be dissolved as regards all partners on the occurrence of such an event.

Publicity of Incorporation

The downside of a company is that it must make public a range of information about its affairs and its shareholders by filing returns and documents with the Registrar of Companies.

A partnership, on the other hand, is entitled to maintain privacy with all of its affairs, except that the identity of all partners and an address for service of documents must be made public.