How to choose the best legal structure for your startup and protect yourself from bankruptcy

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You have an idea, a concept, you want to develop into a startup or small business that can grow, borrow money or attract funders, employ people, issue shares, and do all the things that a business can do — until you have a company the size of Atlassian, or an app that enables you to do the things you dreamed of doing, apart from working.  

It is a reality that 60% of small businesses cease to trade within three years, with cashflow being the major reason. If you cannot pay your bills, including credit cards, business creditors or small loans, you could be forced into bankruptcy, or choose to declare yourself bankrupt to clean up the debt.

Whilst bankruptcy no longer means a term in debtors prison like Mr Micawber, nor is it a social disgrace, it does have a flow-on effect for your plans to grow your startup. Here in Australia bankruptcy is for a minimum of three years, up to a maximum of eight years. While you are a bankrupt you cannot be a company director, nor can you travel overseas without the permission of your trustee.   

The bankruptcy is recorded for five years on your credit rating and you will be on the National Personal Insolvency Index forever. Thereafter, you could find it very difficult to borrow funds as you will be required to disclose any periods of bankruptcy. Your reputation as a business person could also be affected.

There are various government agendas to change the length of time you are a bankrupt in a move to encourage innovators and entrepreneurs, but those will need to be balanced against people using the system to avoid payment of creditors, employees and taxes — all of which make our society go around.

If you personally own assets, like an apartment or a house or intellectual property, you need to ensure that any creditors you may acquire cannot use those personal assets to repay debts you incur in the course of making your startup viable. You also need to keep an eye on your debts and tax obligations and set up some simple business practices that can help avoid a bankruptcy notice been served on you when you least need it.

You also need to think about the appropriate legal structure structure for your startup — a legal structure that will ensure that you and your assets have the best personal protection if your startup does not take off, and a structure that is tax effective and the best model for expansion.

Which business structure is best for me and my future plans?

There are three basic structures that you should consider. Your lawyer and accountant can help you to tailor a structure most effective for your current situation and business growth plans.

1. Sole trader

The least expensive and most easily unwound business structure is that of a sole trader.

You register your business name and Australian Taxation Office requirements in your own name. You are the entity that your clients, funders, suppliers, creditors, debtors and any staff enter into contracts with. The fortunes and failure of the business are directly connected to your own personal failures and fortunes and there is no protection for your assets such as your home, cash reserves or shares that are in your name.

If the business grows you cannot take on partners or shareholders to share the liabilities and/or profits without creating a different business structure, which could have tax consequences.

2. Partnership

A business partnership can be between two or more people. The agreement between the partners as to how the relationship is going to operate should be in writing. The partners must decide how the partnership will be operated, who is going to be responsible for each aspect of the business, how the profits and loses will be distributed, and most importantly, how each partner can exist or how the business can be wound up when the time comes (that time will arise).

A partnership relies heavily on trust and co-operation.

There is legislation that sets out the fundamentals of a partnership, and the agreement can be tailored to the partners’ specific needs. The partnership owns the business name, a Tax File Number and can claim costs. The partnership cannot own assets, but it can operate a bank account and enter into contracts. Profits and losses are shared between the partners, yet your personal assets could still be exposed in a partnership. Your lawyer or accountant can assist with your personal situation.

The partnership can expand and take on more partners as the need arises and partners can exist the business in a pre-determined manner as personal circumstances change.

3. Proprietary company

A company is a separate legal entity, unlike a sole trader or a partnership, and owns and operates the business in its own right. It offers the best protection for you and your personal assets. Also, many funders, banks and lenders will only lend to a company.

The company owns the business name and any other assets, such as intellectual property and patents. It pays company tax and other ATO requirements; it employs staff, including yourself; and pays superannuation and other legislative requirements, such as workers compensation. It enters into contracts with suppliers, landlords and other business relationships and is liable for any debts incurred. You can also be an employee at the company and receive a wage and other employee benefits (such as paid holidays!).  

You and any others involved in the startup can be directors and/or shareholders of the company, depending on the level of involvement that each person wants.  

If the company is to have shareholders other than you then a Shareholders Agreement should be agreed to. This will set out the entry and exit requirements for shareholders, their rights and responsibilities (such as funding requirements) and how shares can be traded. Of course, initial shareholders will have to agree to the terms and it should have the ability to be varied.

As a shareholder you can receive dividends from time to time and have the right to vote on decisions made by the directors. You can still retain control of the business of the company and as it grows, you can make the decisions about its growth and management without exposing your personal assets.

As a director of the company you have the responsibility to ensure that the company complies with the law, including making responsible business decisions, protecting the value of the shares and assets and other directors’ responsibilities. You could be personally liable for company debts depending on the extent of your liability or if you go guarantor for the company or the company becomes insolvent.

While this may all seem a bit dry, complex and even constricting on your ideas, creating the right legal framework for your startup at the beginning of your venture will save you from having to deal with even more complex problems when you start to engage with funders, founders and the world that you want to change.

Go and see a friendly solicitor who can listen to what you have now and where you want to go in the future.  The advice you get will support you and your ideas.

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