Are You Incorporating Too Early?
Entrepreneurs are often afraid to remain sole proprietors, scared of its numerous drawbacks. But you should also be clear about the drawbacks of registering a private limited company too early.
If you use the service Quora often, you’ll quickly realise that a lot of new or soon-to-be entrepreneurs are interested in how to get their businesses started legally. These questions are being asked before anything has been done toward building a business. Given that many small Indian private limited companies don’t even complete their compliances every year, this is very strange.
My takeaway from this is that entrepreneurs are thinking ahead when they have an idea. Surely not all of them will be incorporating early on, but it’s likely that at least a few are, which is reason enough to clear this up once and for all. When should you incorporate? What risks are you taking if you don’t? Let’s find out.
A Sole Proprietorship May Still Do
A sole proprietorship requires no registration, per se. Instead, it is recognised by one of more government registrations, such as the license under Shops & Establishments Act (for all office establishments), Professional Tax (for all employers), Service Tax (for service providers with a turnover of over Rs. 9 lakh in the preceding year), VAT registration (for traders and manufacturers with a turnover of over Rs. 5 lakh), MSME registration (for small- and medium-sized manufacturers and service providers) or an Importer-Exporter Code (if you’re in the import or export business, of course).
Sole Proprietorships have more advantages than disadvantages for nascent businesses. Here’s why:
Very Flexible: There are no requirements placed on a sole proprietor. You can maintain your books of accounts if you please, or not do so, whereas private limited companies must pay at least Rs. 15,000 a year to an auditor to inspect their books; you can even simply pay tax at 8% of your profits (under Rs. 1 crore only) if you wish not to go through the hassle of declaring your income.
No Compliance: Aside from having to file service or VAT returns (as the case may be), there is no need for compliance as a sole proprietor. Compliance alone costs new companies around Rs. 20,000 a year and much more in time, potentially. Fines run into lakhs for non-compliance, by the way.
Easy to Start: Private limited companies take 10 to 15 days to get started, but require much investment of time over the next month to put things in order. They also cost around Rs. 15,000. This is in addition to the time and money you have to spend acquiring a Service Tax or VAT registration, or both, as the case may be. Last we checked start-ups only had time for what’s essential. And when you’re just starting out, only the government registrations are essential.
When To Make The Switch?
The big problem with a sole proprietorship is that its proprietor has unlimited liability. This means that liabilities of a business can be recovered from the personal possessions of its owner. Countless entrepreneurs have burnt their fingers and personal lives by staying sole proprietors. But that shouldn’t mean you incorporate a private limited company on day one. It only means that you should not get into any complicated deals before you do so.
It’s other main drawback, particularly since we’re discussing start-ups, is that there’s no way to raise money. You don’t have shareholders as the entire business just belongs to one individual. Do remember, however, that incorporating too close to the investment date could lead to some tax issues, which is why you should register the business as a company when you start looking for investment, rather than when you raise it.
The ideal time to make the switch, therefore, is when the business is risking more than what is just being pumped in to keep it running or when you need to raise money from an investor.
[Hrishikesh Datar, an alumnus of NLS Bangalore, is the founder of Vakilsearch.com, which helps start-ups, including sole proprietors, with all the legal aspects of their business.]