Most businesses begin in the simplest way available. Someone has a skill, a product or an idea, they start trading, and the legal structure follows whatever was quickest to arrange at the time. In practice that usually means operating as a sole trader, or forming a partnership with people they know and trust.
That arrangement works perfectly well while a business is finding its feet. The question of whether to incorporate tends to arrive later, and it often arrives at a particular moment: when the business needs money it does not currently have.
What a limited company actually changes
A company is, in plain terms, a group of people carrying on a business together. What makes a limited company different is the word in the middle.
In a partnership there is no legal separation between the business and the people running it. If the business cannot pay what it owes, the partners can be pursued for those debts personally, which puts savings, property and other assets on the line.
The alternative took shape during the 19th century, when Parliament accepted the argument that people putting money into a business should be able to fix the maximum they stood to lose. The Limited Liability Act 1855 established the principle.
A limited company is a legal person in its own right, separate from the shareholders who own it and the directors who run it. Its debts belong to it rather than to them. If it fails, it can be wound up, and provided the directors have met their legal duties, they are not usually asked to settle the company’s liabilities from their own funds.
Incorporating, the term used for forming a limited company, brought further advantages as company law developed, including tax treatment that can work in the owners’ favour. It is now a realistic option for businesses of almost any size, from a single tradesperson to an international group.
When the question arises
Picture a business that has outgrown its original arrangements. It might be a family engineering firm, a design studio, a food producer or a couple of retail units. It has traded successfully for several years, and the owners have taken it as far as their own resources allow. The next stage depends on money from outside the business, either investment or borrowing.
Both routes point towards incorporation, but the reasoning behind each is quite different.
Bringing in investment
Someone putting money into a business expects a return, and expects that return to be legally secure.
It is possible to handle this by contract. A solicitor can draft terms setting out what the investor is entitled to and in what circumstances. But agreements of that kind are expensive to prepare and awkward to amend. Businesses move in directions nobody predicted, and every significant change means another round of drafting and negotiation.
Shares deal with the problem more neatly. An investor in a limited company receives a defined stake in the business itself, and with it a set of rights recognised in company law: a share in the profits, a say in certain decisions, and a clear position if the company is later sold or wound up.
Those rights differ between private companies and publicly quoted ones, and a company’s articles of association can adjust them further. The real advantage is familiarity. Investors, accountants and solicitors all understand how shares work, which takes a good deal of friction out of the conversation.
Borrowing to grow
Borrowing raises a different question: who, precisely, is responsible for repaying the money.
The funding might come from a high street bank, a specialist commercial lender, a private equity backer or a public body. Whatever the source, the lender needs a borrower it can hold to the agreement.
A sole trader or partner is that borrower in person. A limited company borrows in its own name. The people who negotiate the facility, sign the paperwork and spend the money are acting as agents of the company rather than on their own account, so if the business later fails, the debt sits with the company.
Where the protection stops
That is the principle, and in many cases it holds. Directors should nonetheless understand its limits.
A recently incorporated company has no trading history, may own no property and cannot point to years of profitability. To a lender it looks like an untested borrower with little to fall back on. The usual response is to seek reassurance elsewhere, in the form of personal guarantees from the directors or shareholders, or security over property they own personally.
Signing a personal guarantee gives away a large part of the protection incorporation provides. If the company defaults, the lender can pursue the guarantor directly, and where the guarantee is supported by security over a family home, that home can be at risk.
This does not mean guarantees should never be given. They are a routine feature of business lending, and refusing outright may simply mean the loan does not happen. It does mean directors should know exactly what they are agreeing to, and should take advice before signing rather than after.
Seeking professional advice
There is no universal answer to when a business should incorporate. Doing it early brings filing obligations and administration a small operation may not yet need. Leaving it too late can hold up an investment round or a loan application at precisely the wrong moment.
In most cases the decision is prompted by one of two things: an opportunity that requires a corporate structure, or a level of personal risk the owners no longer wish to carry. Both are sound reasons to act.
A solicitor and an accountant working together can set out what incorporation would mean for a particular business, including how existing contracts, premises and staff arrangements transfer across, and what directors take on once they are appointed. Where the structure is right, it supports growth and profitability as well as protecting the people behind the business. The important thing is that the choice is made deliberately, rather than under pressure from a deal that is already on the table.
John Roberts is a Partner and Director at Austin Lafferty Solicitors. John has been with the firm for almost 20 years, with experience in all areas of business law.
