Sole traders and partnerships are the most popular forms of business organization in most of the countries because it is much easier and cheaper to set up an unincorporated business than an incorporated business.
Almost all of the businesses start very small, often as a sole trader or a small partnership. Then, when a business grows (increases sales revenue, hires more workers, invents new products, opens more shops etc.) the original owners may decide to incorporate – change the type of business ownership to become a private limited company.
Private limited companies, and especially public limited companies, are more complex to set up. They have many more legal controls than unincorporated business, e.g. must produce more detailed financial statements every year.
The owners may decide to incorporate for a number of reasons, such as:
1. To reduce risk to owners. Incorporation has the benefit of separating legal identity between the business and the owners, and providing owners with limited liability. The legal and financial risks are minimized.
2. Business continuity. If one or more owners leave, retire or pass away, then the business is still able to continue operating. Separate legal identity has the benefit of perpetual continuity.
3. Raise large amounts of capital. The original owners may want to raise additional capital to invest in future growth plans of the business. This may be easier to achieve by becoming a limited company and selling shares in the business to other investors.
Finally, when the business aims to become a very large multinational corporation, the owners may decide to ‘go public’ which means changing from a private limited company to a public limited company. They will do so, if they are hoping to raise large amount of capital from selling a part of their business to general public.
Factors to consider when setting up a new business
The choice of which form of business organization the owners will use will depend on several factors:
How quickly the owners want to start operating their business. Unincorporated business organizations including sole traders and partnerships are much quicker to set up. There is not state filing required. Incorporated businesses take longer to establish because they have more complex legal requirements and state filing with more paperwork is required.
Cost of creation and operational requirements. Unincorporated business organizations have no cost of creation and have relatively few or no legal requirements when it comes to start-up capital. Limited liability companies must elect The Board of Directors (BOD), hold regular annual meetings and are required to annually report their final accounts to the authorities (private limited companies) and to general public (public limited companies).
The potential size of the business. Most unincorporated businesses are very small having only one or just few owners. And many will remain so because of factors such as the size of the market, or the owners’ personal choices and preferences. These small businesses are more likely to be set up and remain running forever as sole traders or partnerships. When the number of customers or the market grows, the owners may wish to change the ownership structure into a private limited company.
The number of owners. A sole trader can only have one owner, but he or she can hire employees. If there is more than one owner, then the choice will usually be between a partnership and an incorporated business. The larger the number of owners is, the more likely it is that owners will choose an incorporated business organization.
Duration of existence. Sole proprietorship is dissolved, if a sole trader ceases doing business, retires or passes away. Partnerships dissolve upon death or withdrawal of a partner unless safeguards are specified in a partnership agreement. Incorporated businesses are perpetual meaning that even though shareholders sell their shares or pass away, the business will still exist.
The owners’ role in the management of the business. Some owners may only want to invest in a business and have nothing to do with the running of it. If this is the case, then an incorporated business organization may be a better choice. Limited liability companies are managed by directors who are elected by the shareholders. When it comes to sole traders, they have full control of management and operations. In partnerships, each partner has an equal voice, unless otherwise arranged.
The attitude towards financial risk. If owners do not want to risk their personal wealth (assets), then, they are more likely to set up an incorporated business. Shareholders are typically not personally liable for the debts of the corporation. Sole traders and partners have unlimited liability though.
The ability of raising capital. It is often difficult unless individual sole trader contributes personal funds. In partnerships, contributions can be made from partners, and more partners can be added to raise money. In incorporated businesses, shares of stock are sold to raise capital.
