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Types of Business Entities in India

April 2, 2007 · Posted in Entrepreneurship

So you’ve decided to become an entrepreneur. Congratulations - half your battle is won.

The next half of the battle begins now - starting with the legal aspects and procedures involved in starting a business.

The next step for you would be to form a legal business entity. For doing so, it is important that you are aware of the types of business entities in India so that you can decide which one is most suitable for your needs.

1) Sole Proprietorship:

This is the most common type of business entity. Sole proprietorship means that theres a sole owner who funds and operates the business. It is the simplest form of business entities - relatively formality free, no rules about records you are required to keep, no requirement of having your accounts audited and no requirement of filing financial information to the registrar of companies. In short, there is no legal distinction between you and your business.

Pros:

Very easy to setup and start your business
Relatively formality free. So, less time spent upfront in legal procedures
No public disclosure of your finances required
You keep all the profits - no sharing of profits with others — since there arent any shareholders

Cons:

Personal liability. If you go bankrupt, creditors get the right to your possessions - house, property etc.
Very difficult to get investment from VC’s, angels etc.

2) Partnerships:

Partnership is a type of business entity, where you partner with other individuals to own and run the business. On a higher level, they can be viewed as collection of sole proprietors. By partnering with other individuals, you get access to a bigger pool of capital, skills and other resources to fund and run your business. All partners contribute capital equally, share profits and losses equally and have an equal say in business decisions.

Pros:

Access to larger pool of resources and capital
You do not have the confidence to start the business on your own and need some one to shoulder the responsibility
Access to complementary skills. For example, if you are a geek, you may partner with someone with a marketing/management background to balance out the odds

Cons:

If your partner makes a business mistake, without your knowledge or consent, and it adversely affects your business, you are equally liable to bear the consequences - even though you had no role to play in the mistake
If your partner goes bankrupt, his share in the business can be seized by his creditors. Although you are not liable for his personal debts, your business may be put into jeopardy

Because of the drawbacks related to partnerships, it is very important that you trust the person before considering to make him a business partner. It is generally a good idea to have a legal document that highlights the partnership agreement between partners - the profit sharing, duration of partnership, admitting-expelling additional partners, dissolving the partnership etc.

3) Limited Liability Company:

This type of business entity is most common and preferred type while starting a company. A limited liability company is a separate legal entity from its founders, shareholders and mangers. The liability of the shareholders is limited to the paid-unpaid capital that is issued as part of the company. Thus, in case of bankruptcy, personal assets of the founders/mangers is not affected. A limited liability company needs to keep record of accounts, audit their records and file an annual report on return with the registrar of companies.

Pros:

Founders financial liabilities are limited
Proper structuring of the company management - for example, who will be the managing director etc.
Easy to get funding from VC’s and other sources - by selling a stake (shares) in the company
Additional members / directors can be added to the company structure
Selling the company is a relatively easy (legally) because of the legal incorporation records, financial records, annual returns etc. have already been filed

Cons:

Time and effort required to complete the initial incorporation
Additional overhead of keeping records, having those records audited and filing annual reports
Double taxation (not sure to what extent this is valid in India). So, the revenues that your company earns are taxed at the corporate level and then the individual shareholders are taxed at the personal level for the income they make from the revenue

Note: I’ve tried to be as accurate as possible. If you notice any discrepancy, please let me know and I shall correct it.

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One Response to “Types of Business Entities in India”

Vivek Dhar on July 10th, 2008 4:34 am

We need Bankruptcy policy for start-up owners, till then everything is a disaster until you have lots of money.