Whether you’re an aspiring entrepreneur with an amazing business idea or a freelancer who wants more control over your work, one of the first things you need to decide is how you want to carry out your business plan.
Having a plan and choosing the right structure is a vital step in optimizing your business potential. Your decision should involve planning for the future, from attracting external investment, transferability of ownership, and taking advantage of tax benefits. As your business grows, it isn’t always easy to change your structure, so plan ahead and seek advice on which structure will allow you to achieve your business goals.
In Canada, we have three main business structures, Sole Proprietorship, Partnerships, and Corporations. Although Cooperatives form a fourth business structure, they don’t make sense for businesses in the digital tech industry.
This is by no means a thorough explanation nor does it qualify as legal advice. If you have any questions, please don’t hesitate to contact us or get in touch with your accountant.
Sole Proprietorship
The easiest and most common form of business in Canada is the sole proprietorship. Sole proprietors or owners have full control over their business. They are responsible for the day-to-day operation, as well as any profits or losses. Unfortunately, this also means sole and full liability, placing all risks of taking on the business in the owner’s personal income. Any potential lawsuit would be against the owner personally, so if you choose this option, be sure to consider business liability insurance.
Since the business is tied to the owner personally, they can hire employees, but employees won’t be involved in management nor have any monetary stake in the business. The business begins and ends with the owner. This makes transferring or selling the business difficult without making it a separate legal entity through incorporation.
Freelancers who are just starting out, and want to test the waters before fully committing, might consider starting as a sole proprietorship and incorporating later.
Advantages:
- Simple and inexpensive set up
- All profits go to owner
- Tax benefits in earlier stages of business
Disadvantages:
- Sole responsibility and unlimited liability
- Difficult to sell or transfer business
- Difficult to attract investment and funding
Partnership
A Partnership allows two or more like-minded people to pool their resources and skills to start a business together. Like sole proprietorships, partnerships are easier to form than corporations, and similarly entail the assumption of any financial debts and liabilities, though they are now shared between partners.
There are two main types of Partnership sub-structures, General Partnerships and Limited Partnerships, which offer some flexible options for business management and resource sharing.
General Partnerships involve owners who are equally involved in managing the business, and are jointly and severally liable for the business up to the total value of their assets. This means that potentially all partners are liable for the debts, acts, or faults of any other partner.
Limited Partnerships allow a combination of general and limited partners. The difference is general partners are managing partners with several and joint liability, whereas limited partners are solely involved in contributing capital towards the business. Therefore, limited partners are only liable up to the amount they invested in the business, and don’t have to worry about personal liability.
Unfortunately, a major downside involves partner disagreements and fall outs. Since the business is tied to the partnership, any partners walking away could potentially dissolve the business. Another disadvantage is the ability for a partner to legally bind the other to a Third-party agreement without prior approval. Though it cannot create a legal structure to the business, having a well-drafted Partnership Agreement that sets out responsibilities and guidelines between partners will help alleviate some but not all complexities.
A group of like-minded individuals with a stellar working relationship may want to consider a partnership, though they should ensure they have enough initial capital and a Partnership Agreement.
Advantages:
- Inexpensive to set up
- Increased capital pool from partners
- Shared duties and responsibilities
Disadvantages:
- Difficult to establish a business brand
- Potential conflict between partners resulting in business dissolution
- Divided decision-making
Incorporation
Though the most expensive and complex business structure, corporations establish a separate legal entity from the owners. As a distinct entity the business can acquire capital from external investors while allowing for ownership transferability and perpetual existence. This helps negate the problems of business dissolution experienced in sole proprietorships and partnerships. Furthermore, a corporation can borrow money, incur its own liabilities and debts, can sue or be sued, enter into contracts, and own property.
Corporations establish a legal entity by way of formal documents such as the Articles of Incorporation, Corporate By-laws, Director and Shareholder Resolutions, and Shareholder Agreements. Each of these documents set out the rules for governing and operating the company.
Corporations are perfect for long-term planning, offering flexibility in hiring and managing permanent or contract staff. From a tax perspective, corporations are better suited for high revenue generation, and provide different methods to be paid via salary, dividends, or a combination of both. Keep in mind it is best to consult an accountant or tax lawyer to plan how you want to be paid through your corporation to optimize tax benefits, instead of potentially paying double the taxes.
In Canada you have the option of incorporating Federally or Provincially, each with it’s own advantages and disadvantages. For example, it is easier and more cost-effective to incorporate Federally if you plan to carry on business in more than one province or internationally.
Advantages:
- Separate legal entity and limited liability
- Easier to raise capital from investors and financial institutions
- Optimizing tax benefits and the choice of being paid through a salary or receiving dividends
- Perpetual existence and ownership transferability
- Easier to hire and manage employees
Disadvantages:
- Expensive and complex to set up and operation
- Shareholders and directors can be held liable where personal guarantees are required to secure financing
- Dilution of ownership through selling of shares
- Company values and direction may change with ownership
Why Tech Start-Ups Should Incorporate
Having a business structure that allows you to attract initial investment, grow, and eventually sell your business, is valuable for entrepreneurs wanting to bring their ideas to life. Start-ups can be risky and might not always end up being successful. Corporations are resilient and allow the business to better handle risk, take on debt, and attract investment, so that founders can focus on their product.
As a tech start-up, you will likely create your own product and brand which will require copyright, trademark, or patent protections. Corporations provide a perfect distinct legal entity to attach and protect IP rights that can be sold and perpetually exist separately from owners or founders.
Incorporated start-ups also benefit from having federal and provincial funding. The Smartstart Seed Fund in Ontario is one of many government funds that require the business to be incorporated. This is due to corporations offering more transparency and certainty to government grantors, investors, lenders, and banks, who need assurance that the money provided goes directly to the business and is used for its intended purpose. Though it is possible to acquire loans and funding for sole proprietorships and partnerships, they are severely limited in contrast to what is available for corporations. Tech start-ups need as much funding as they can get.
Incorporating is a difficult process, but is worthwhile in the long run. With the right planning and investments, you should be able to hire a team to help with management while you remain dedicated to your vision.
Conclusion
Each business structure offers a different set of advantages and disadvantages. Accordingly, you should plan appropriately to avoid surprises and headaches in the future. Changing your business structure is possible, but it becomes increasingly difficult as you become more established.
Incorporating can also be done on your own, but you want to ensure you’ve accounted for everything. Without proper planning, you might end up making costly mistakes that you won’t realize until later. For that reason, I suggest taking the time to plan appropriately and consider seeking out the advice of a lawyer who understands the digital tech industry.
If you’d like to learn more or want help getting started with your business, feel free to contact us or book a consultation. At AMAR-VR LAW, we’ll guide you through the process so you can focus on what you do best.