From napkin to IPO?

What began life on the back of a paper napkin has become more tangible.  You've had interest from a couple of key industry players and hooked up with an incubator.  The product development itself is progressing well and fingers crossed isn't far off being commercially viable.  Family and friends have tipped in some cash and you're off and running.

Before you go much further, do a little housekeeping and make sure you have the right business structure in place to begin with.  It will save you many headaches down the track, allow you to raise capital more easily and protect you and your business partners effectively as long as you get it right.

So what is the right business structure for a startup?

There are a number of different options available and we can have a brief look at them all before deciding what is right for you. Headline "must haves" for a startup are likely to include:

1. Easy set up; 

2. Low establishment and ongoing costs;

3. Limited liability; 

4. Effective tax arrangements;

5. Attractive to investors and customers; and finally

6. Startup friendly but flexible for when my business grows.

Sole Trader?

First up you have the option of establishing your startup as a sole trader business. This means you will be operating the business in your own name. It is easy to set up and can be established very quickly. A sole trader is very much in charge of their own destiny and has ultimate control over the business.  Profits (and losses) come back to you as the individual owner.

There are some risks however. As an individual you will be taking on all the risks of the business and any liabilities which it incurs.  If the business generates any reasonable income you will quickly find yourself paying tax at the top marginal rate.

If you are a startup with grand plans to conquer the world, expect to grow quickly and likely need the help of others to achieve this, then you may need to consider other options. 

Partnership?

The second option is to establish a partnership.  A partnership is a group of individuals/entities carrying on a business with a view to profit. Like the sole trader option it is easy to establish. Formal documentation can be kept to a minimum although it is advisable to set out the rights and obligations of each of the partners in a partnership deed.

There are some tax "swings and roundabouts" for  partnerships with a mix of advantages and disadvantages alike for partners. Profitable partnerships can push their individual owners into higher tax brackets unless additional structuring advice is sought at the outset. The partnership agreement can vary the allocation of profits and losses depending on the relevant contributions from each of the partners which does provide a measure of flexibility.  

From a startup perspective you will want to be very confident in your choice of partner as partners are jointly and severally liable for the debts of the partnership.  As such each partner's own assets are potentially at risk in a partnership. For a startup whose principal asset moving forward is (hopefully) itsintellectual property assets, partnerships can prove a challenge. Potential investors are keen to ensure "clean" ownership of assets and partnerships can sometimes muddy these waters.

Company

Of all the various options available, setting up as a company provides your startup with the greatest amount of flexibility and options. A company structure sets up a separate legal entity which is able to own assets and enter into contracts directly with third parties. It is separate from its individual shareholder members which limits the liability of these members from any losses the company may incur. This ability to limit liability exposure is one of its main advantages over other structures.

Companies do take a bit more effort to set up.  There are costs associated with incorporating the new entity as well as ongoing compliance costs. Running a company will require that you to become familiar with various tax and legal reporting obligations and requirements.  Whilst this is something your accountant and lawyer can assist with it nevertheless needs to be factored into your planning. 

You have the ability to set out in some detail the rights and obligations of founding shareholders in a shareholder agreement.  This document provides a roadmap for you to follow.  It can deal with member share allocations, decision-making, roles and responsibilities, new investors, sale of the business etc.  It can provide mechanisms for managing disputes and can provide a blueprint for any restructuring activities which may become necessary as the business grows and takes on more investors or expands overseas. 

Companies are subject to different taxation requirements than those applying to you as an individual.  The current company tax rate is 30% which compares favourably to the higher marginal tax rates applying to individuals. As a startup you will have the ability to manage the tax affairs of the company efficiently including the ability to take advantage of favourable tax incentives and grants made available by State and Commonwealth governments. See various grant options available here and here for example. 

A company structure appeals to investors and will allow you to bring on new investors and funders more easily.  This can be done in a variety of ways including by issuing shares to these investors in return for capital or taking funds on through loan arrangements directly with the funder. There are other options available too as arrangements become more sophisticated including via convertible notes etc.

Whilst you are unlikely to be hiring employees right from the get go, as you expand you will want to take on staff directly to supplement your contractor workforce.  A company structure allows this to occur seamlessly without increasing your legal exposure to the increased financial and other obligations associated with employees.

Other options?

There are other structuring options available to you including setting up trust arrangements or establishing a joint venture. There are a number of different "flavours" of trust and joint venture structures all with various advantages and disadvantages. 

Trusts and joint venture arrangements are relatively easy to set up and operate. There are some particular complexities with trusts including legal obligations which will require ongoing advice.  Trust arrangements do have tax benefits worth exploring however. Joint venture arrangements are generally not seen in traditional startup businesses, unless of course you are a junior miner hunting for gold or oil in outback Australia and need a few partners to share the risk!

From a startup perspective we would expect to see most serious startup businesses setting up as a company, perhaps separating out the intellectual property assets from the main operating company and considering to what extent trust arrangements can play in assisting to manage liability and tax issues efficiently for the individuals involved.

For each individual business this will vary depending on the particular circumstances of the business and its founders. It is clear however that if you are serious about your startup business and are prepared to commit to some of the ongoing compliance requirements that go with having a company structure, then a company structure will likely offer you the greatest flexibility as your business moves from napkin, to garage, to boardroom and finally to exit.