The most common problem which startups or new ventures face while starting their business is whether to form a proprietorship or a Company.
Sole Proprietorship, being the most traditional form of business is still one of the most common types of business entity in India. The easy formation procedure and minimum compliance requirements in a Sole Proprietorship make it a ready option to start a business.
However, there are various disadvantages of a proprietorship which startups fail to understand at the initial stage.
A review of a number of factors which make a Private Limited Company or LLP a much better option than a Sole Proprietorship are stated as under:
Unlimited Liability: In a sole proprietorship, there is no distinction between the proprietor and his business. The proprietorship firm does not have a separate legal entity of its own but runs on the merit of the proprietor. The assets and liabilities of the firm and the proprietor are considered one and the same. This means that the proprietor’s personal assets can be used to dispose of any outstanding liability of his firm. Thus, the liability is both unlimited and personal.
On the other hand, a LLP or Private Limited Company or One Person Company have the advantage of limited liability and separate legal entity which gives it an identity of its own with separate assets and liabilities, distinct from that of its promoters or directors. This ensures the credibility of the company, as a separate entity.
Limited Capital: In a sole proprietorship firm, there is no option but to rely on the proprietor’s funds for raising capital. Bank Loans can also be obtained but only after a thorough due-diligence as there is no distinction between the assets of the business and the assets of the proprietor. There are no partners or co-promoters to pool in any capital. Moreover, the feature of unlimited liability makes it a very risky affair for investors to put in money in a proprietorship form of business.
Therefore, the fund raising ability of a proprietorship firm is severely limited. In a LLP or a Private Limited Company, partners’ capital or equity capital can always be raised easily.
Difficulty in Raising Capital: It is a known fact that Private Equity firms, Angel Investors and Venture Capitalists always prefer investing in a corporate form of business having an organized structure and a good team rather than a proprietorship, which is mostly run single handedly.
Banks and Financial Institutions are also reluctant in sanctioning proprietorship business loans compared to corporate loans as it involves more screening about the credibility of the proprietor. Hence, a proprietor is left with extremely limited choices for raising funds. This creates difficulties as the business grows and the requirement for capital increases.
Limited Growth Prospects: A sole Proprietorship form of business fails to grow in the long term due to constraints of capital and human resource. Lack of skilled employees and proper working space due to limited capital makes it difficult to run the business as it grows. The burden of business promotion, work delivery as well as back office lie on the Sole Proprietor leaving him out of capacity many a times. Unlike LLP and Private Companies, a Proprietorship fails to get the support of co-partners or directors running the business simultaneously. Thus, due to lack of pooled in skills and resources, a proprietorship often lags behind in making a successful business model. Hence, startups usually covert into LLP or Private Company soon after starting their business as a proprietorship, to overcome barriers of team work and resources.
Business Continuity: A proprietorship firm is, for all practical purposes, totally dependent on the proprietor. If for any reason the proprietor is unavailable, the business suffers to a great extent. There is no substitute of the proprietor. Moreover, the legal entity of the proprietorship firm comes to an end with the death or incapacitation of the proprietor. The goodwill earned by the firm is associated with its proprietor and holds no value later on. However, in a corporate form of business, the goodwill earned is that of the company and holds value even if the company is taken over or there is a change in the promoters. Therefore, the business continuity or duration of a sole proprietorship firm is limited unlike a LLP, Private Limited Company or One Person Company.
The reasons cited above clearly explain why a Sole Proprietorship form of business is not suitable for a budding business in the contemporary scenario. Although, many startups wish to start as a Proprietorship and later convert into a company, it is recommended that “the sooner – the better”. Having an organized and transparent business structure from the very beginning increases credibility, investor confidence, ensures better internal controls and finally helps in scaling up quickly.
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