Startups and entrepreneurship are the backbone of an economy and its growth. And economic recessions are breeding grounds for entrepreneurs and startups.
When an entrepreneur enters a market to showcase their unique idea and services, it could either lead to glorious success or an abject failure. This risk-taking sets entrepreneurs apart from the rest of the population.
National Incubation Center Karachi (NICK) held a seminar on the 2nd of June 2021 titled, “Startups As Legal Entities”. NICK invited Mubariz Siddiqui to educate startups and founders about the legal frameworks they should keep in mind.
Mubariz Siddiqui is an influential business lawyer with a history of facilitating early-stage businesses and investors in the tech industry. He got his education from the University of London and has served many companies and organizations that are household names.
He is currently working as an independent legal practitioner.
In his presentation, Mubariz highlighted the different kinds of legal entities you can form as a startup, and their pros and cons. Choosing an unsuitable form of legal entity can spell disaster for a startup.
Here are some of the highlights of the seminar.
Co-Founders’ Relationship:
Trust is the Key:
In the beginning, it is crucial to have a certain level of trust. It will hopefully grow with time and effort, though, and this is the pathway for further growth of any long-term business relationship.
Clearly Defined Roles
When are you starting off, you are very clear about what each of you is looking to get out of this business. Obviously, startups are messy and roles are not very clearly defined. But it’s still a good idea to get clear about the expectations from the very beginning.
Founders can have two kinds of disputes among themselves.
- Founders want different things from the business. For example, one founder might want to serve B2B and the other might want to go for B2C.
These kinds of differences are fine. In fact, they are healthy.
- The bigger issue is when the founders want the same things for themselves. For example, both founders want the CEO position for themselves. These kinds of conflicts can be very difficult to resolve and can cause serious problems.
It’s a good idea to put down a clear and detailed partnership agreement from the get-go. But it is equally important not to overdo it. You don’t even know at this point whether this business will even work out or not.
Another dispute might be about when a partner wants to quit. What will he get from the business? So it’s important to provide for the exit plans beforehand.
Let’s say a partner decides to leave six months into the business. You might decide it’s not very likely to have created much value in six months’ duration. So you decide in advance that any partner wanting to quit in six months will not get anything. Or maybe a very small percentage. On the other hand, what happens if someone wants to leave after, say, three years or so?
So it’s very important for each partner to agree upon the terms and conditions before starting up a business.
Key Concepts of Legal Entities
There are two key concepts that must be understood before deciding on the form of legal entity you want to create.
- Separate Legal Entity:
Your business exists as a separate person in the eyes of the law. That separate entity is capable of owning properties, owning IP’s, making contracts with people, employing people, etc.
- Limited Liability
The liability of the owners is limited to what they have invested in the business. The owner’s personal assets can’t be taken from them.
Types of Organization
There are three main types of legal entities you can form.
Sole Proprietorship:
The business is owned by one person, and there is no legal distinction between the owner and the business. They’re the same entity, and the owner is personally liable to pay off everything the business owes to anyone.
This is the simplest legal form of business and is suitable for most early-stage startups.
Partnership Firm:
The business is owned by two or more people. They run the business according to their partnership agreement. There is no legal distinction between the partners and the business, and they are personally liable to pay everything the business owes to anyone.
The business entity is dissolved whenever a partner leaves or a new partner enters. These events would require a new partnership deed, and a new entity will be created.
This is a little bit more demanding than a sole proprietorship but is still much simpler than a private limited company.
Limited Liability Company / Private Limited Company:
Private Limited Companies are the most involved of these legal entities. There are registration and documentation processes these companies must comply with as required by the law.
Private Limited Companies are separate legal entities. The owners own stocks or shares of the company and are not personally liable for anything the company owes. This basically means that the company’s payables can only be paid off through what the company owns as a legal entity. The shareholders’ (owners) personal assets cannot be used to pay off the company’s liabilities.
Startups usually begin as sole proprietorships and partnerships. They are messy and agile. And they don’t have the time or energy to spend on a lot of paperwork.
Then, as they start growing and need to raise funds from investors, they typically transition into a private limited company. This is almost a customary move to protect both the founders and investors.
However, most startups would be better off staying a sole proprietorship or a partnership firm. They are simpler forms of entities and are easier to maintain as well. Their taxation is also significantly lower than private limited companies.
The key questions to ask are whether your business is likely to be sued, how much security you want to build in your business’s legal structure, and what costs are you willing to pay for it.
Conclusion:
Starting a business can be very challenging. But a little bit of pre-planning can go a long way towards making things clearer and less complicated. So it’s a good idea to sit down with pen and paper and plan out what legal entity would be the best for your startup, if you haven’t done this already.