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Points to Consider Before Selecting a Form of Business Organisation

A business organization refers to all the necessary arrangements required to conduct business in a customized manner. It refers to all the steps that need to be taken to establish and maintain a relationship between men, material, and machinery to carry on the business efficiently for profit. This can be called the process of planning and organizing which are an integral part of business management. The system that follows this process of organizing the necessary factors to start and carry on a business is called a business undertaking or organization.

Choosing a form of the business unit is important for a successful organization. A business unit option will depend on an object, nature, and size of the business of such entity which will differ from case to case basis and will also depend on the will of the owners of the business unit they wish to fulfill.

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The main types of business units in India are sole proprietorship, partnership, Hindu undivided family,

(HUF) Business, Limited Liability Partnership (LLP), Co-operative Societies, Branch Offices, and Companies Which can be any type of company including one person company (OPC), private limited company, public Limited company, guarantee company, subsidiary company, statutory company, an insurance company or unlimited company. Further, the company was formed under section 8 or section 25 of the Companies Act, 2013.

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Essentially, companies could be either private limited or public limited companies. Public limited companies could be unlisted or listed. Each entity must sit down and carefully consider all the advantages and disadvantages of each type of entity before choosing one of the forms of business entity that suited best to the nature and size of the business which the entrepreneur/business owner desires to undertake.

A business enterprise can be owned and organized in several forms. Each form of organization has its own merits and demerits. The ultimate choice of the form of business depends upon the balancing of the advantages and disadvantages of the various forms of business. The right choice of the form of the business is very crucial because it determines the power, control, risk and responsibility of the entrepreneur as well as the division of profits and losses. Being a long-term commitment, the choice of the form of business should be made after considerable thought and deliberation. The selection of a suitable form of business organiszation is an important entrepreneurial decision because it influences the success and growth of a business — e.g., it determines the division or distribution of profits, the risk associated with business, and so on.

Once a form of business organisation is chosen, it is very difficult to switch over to another form because it needs the winding up, dissolution of the existing organisation which may be treated as a case which is raised by oneself to face with the complex issues and procedures which ultimately results into the waste of time, effort and money. Further, closure of business will entail loss of business opportunity, capital and employment. The volume of risks and liabilities as well as the willingness of the owners to bear it, is also an important consideration in choosing the right business entity.

Therefore, the form of business organisation must be chosen after giving the due thought and consideration in respect of all the sides of the glorious coin of each form of business entity and its suitability to the business ideas of an entrepreneur. There are several factors to be considered while selecting an appropriate form of business organisation.

As discussed earlier, the different forms of private ownership organisation differ from each other in respect of division of profit, control, risk, legal formalities, flexibility, etc.

Therefore, a thoughtful consideration should be given to this aspect of planning and only that form of organisation which most suited to the style of business should be chosen. Since the need for the selection of business organisation arises both initially, while starting a business, and at a later stage for meeting the needs of its growth and expansion, it is desirable to address this issue at both these levels.

FACTORS GOVERNING THE DECISIONS FOR SUITABLE FORM OF ORGANISATION

For a new or proposed business, the selection of a suitable form of a business organisation is generally governed by the following factors:

  1. Nature of business activity

This is an important factor having a direct bearing on the choice of a form of ownership. In small trading businesses, professions, and rendering of personal services, sole-proprietorship is predominant.

Examples are Laundromats, beauty parlors, repair shops, consulting agencies, small retail stores, medicine stores, dentists, accounting concerns, boarding-house, restaurants, specialty shops, jobbing builders, painters, decorators, bakers, confectioners, tailoring shops, small scale shoe repairers and manufacturers, etc.

The partnership is suitable in all those cases where sole proprietorship is suitable, provided the business is to be carried on a slightly bigger scale with the help of one or more partners (owner).

Besides, the partnership is also advantageous in the case of manufacturing activities on a modest scale. The finance, trading, and real estate industries (on a smaller scale) seem to be suited to partnership form of organization. Some of the financial businesses that find this form advantageous are tax, accounting, stock brokerage firms, and consulting agencies, etc.

Service enterprises like hotels and lodging places; trading enterprises, such as wholesale trade, retail houses; small scale manufacturing enterprises, small drug manufacturers, etc. can be undertaken in the form of partnership. Similarly, the business lines such as carrying on large chain stores, multiple shops, super-bazaars, engineering industrial activities with high capital and working capital requirements and software industrial activities are generally in the form of companies.

Where the persons intending to start a business wish to launch a business organization clothed with a legal entity and incorporate form with a feature of having their sole ownership and control thereon, they may decide to form a One-Person Company (OPC). OPC is a new concept in India and a hybrid of Sole-Proprietor and Company form of business. The concept opens spectacular possibilities for sole proprietors and entrepreneurs as, such companies retain the character of a Sole Proprietorship, provides limited liability feature to the sole proprietor and is clothed with a legal entity distinct from its owner.

An alternative form of organisation where two or more persons are involved in starting the business organisation is the Limited Liability Partnership (‘LLP’) under the Limited Liability Partnership Act, 2008. Such entities have also gained popularity nowadays. A major advantage of such an entity is that the liabilities (if any), of the LLP lies with the entity and does not fall on the individual partners unlike the partnership form of business organisation under the Indian Partnership Act, 1932, where the joint and several liabilities of the parter(s) is one of the features.

In an LLP form, the liability of the Partner is limited to the extent of his contribution towards the LLP, except in case of intentional fraud or wrongful act of omission or commission by the partner himself. What is at stake for the partner is what he has put into the business along with any personal guarantees he would have furnished. However, such forms of business organisation are suitable generally in the service industry and where there is no dependence on large amounts of financing from outside sources.

A One-Person Company (OPC), LLP and limited company exist as a separate business entity in the eyes of law and this creates a wall between the personal assets of the investor and that of the business. Thus, in these form of business organisations the personal property of the owner(s) is protected and this gives the owner(s) the ability to build the business credit, get loans and raise capital.

  1. Scale of operations

The second factor that affects the form of business organisation is the scale of operations. If the scale of operations of business activities is small, sole proprietorship or a One Person Company (OPC) is suitable; if the scale of operations is modest — neither too small nor too large — partnership or limited liability partnership (LLP) is preferable; whereas, in case of large scale of operations, the company form is advantageous.

The scale of business operations depends upon the size of the market area served, which, in turn, depends upon the size of demand for goods and services. If the market area is small, local, sole-proprietorship, OPC or partnership is opted. If the demand originates from a large area, partnership including LLP or Company may be adopted.

  1. Capital requirements

Capital is one of the most crucial factors affecting the choice of a particular form of ownership organisation. Requirement of capital is closely related to the type of business and scale of operations. Enterprises requiring heavy investment (like iron and steel plants, large scale infrastructure projects, etc.) should be organised as companies. Depending on the capital required, they can be set up as public companies and in some cases, may be in the form of listed companies by raising money from the public and being listed on the stock exchanges.

Enterprises requiring small investment (like retail business stores, personal service enterprises, etc.) can be best organised as sole proprietorships or even as Partnerships. Apart from the initial capital required to start a business, the future capital requirements—to meet modernisation, expansion, and diversification plans —also affect the choice of form of organisation.

In sole proprietorship, the owner may raise additional capital by borrowing, by purchasing on credit, and by investing additional amounts himself. Banks and suppliers, however, will look closely at the proprietor’s individual financial resources before sanctioning any loans or advances.

Partnerships can often raise funds with greater ease, since the resources and credit of all partners are combined in a single enterprise. Companies are usually best able to attract capital because investors are assured that their liability will be limited, their operations are in public domain in the transparent manner, easily accessible and the ownership can be transferred to other investors.

  1. Managerial Ability

It is difficult for a sole proprietor to have expertise in all functional areas of business. Further, the size of the business may not permit engagement of professional management.

In other forms of organizations like partnership and company, there is division of work among the partners which allows the partners to specialize in specific areas, leading to better outputs and decision making. However, this may sometimes lead to conflicts due to differences of opinion. Company form of organization is a better alternative if the operations are far flung, complex in nature and require professional management at various levels.

  1. Degree of control and management

The degree of control and management that an entrepreneur desires to have over business affects the choice of form of organisation. In sole proprietorship and OPC, ownership, management, and control are completely fused, and therefore, an entrepreneur has complete control over his business. In partnership, management and control of business is jointly shared by the partners and their specific rights, duties and responsibilities would be documented through incorporating various clauses in this regard in the partnership deed.

They have equal voice in the management of partnership business except where they agree to divide among themselves the business responsibilities in a different manner. Even then, they are legally accountable to each other. In a company, however, there is divergence between ownership and management, the management and control of the company business is entrusted to the Board, who are generally the elected representatives of shareholders.

Thus, a person wishing to have complete and direct control of business prefers proprietary organisation rather than partnership or company. If he is prepared to share it with others, he will choose partnership. But, if the activities are large, professional managers are required to handle the day to day affairs and there is need for corporate structure and management, he will prefer the company form of organisation.

  1. Degree of risk and liability

The size of risk and the willingness of owners to bear it, is an important consideration in the selection of a form of business organisation. The amount of risk involved in a business depends, among other factors like, on the nature and size of business. Smaller the size of business, smaller the amount of risk.

Thus, a sole proprietary business carries small amount of risk with it as compared to partnership or company. However, the sole proprietor is personally liable for all the debts of the business to the extent of his entire property. Likewise, in partnership, partners are individually and jointly responsible for the liabilities of the partnership firm.

Companies and LLPs have a real advantage, as far as the risk is concerned, over the other forms of business organisation. Creditors can force payment of their claims only to the limit of the company’s and LLPs assets. Thus, while a shareholder/member/partner may lose the entire money he puts into or agreed to put into the company and LLP, he cannot be forced to contribute additional funds out of his own pocket to satisfy the business debts of the company and LLP.

  1. Stability of business

Stability of business is another factor that governs the choice of an ownership organisation. A stable business is preferred by the owners in so far as it helps him in attracting suppliers of capital who look for safety of investment and regular return, and also helps in getting competent workers and managers who look for security of service and opportunities of advancement. From this point of view, sole proprietorships are not stable, although no time limit is placed on them by law.

The illness of owner may derange the business and his death cause the demise of the business. Partnerships are also unstable, since they are terminated by the death, insolvency, insanity, retirement, admission, expulsion or withdrawal of/ by one of the partners. Companies and LLPs have the most business stability due to its feature or perpetuity being an artificial or legal person. The life of the company and LLP is not dependent upon the life of its members/partners. Members/partners may come, members/partners may go, but the company/LLP goes on forever unless and until it being wound up.

  1. Flexibility of administration

As far as possible, the form of organisation chosen should allow flexibility of administration. The flexibility of administration is closely related to the internal organisation of a business, i.e., the manner in which organisational activities are structured into departments, sections, and units with a clear definition of authority and responsibility.

The internal organisation of a sole proprietary business, for instance, is very simple, and therefore, any change in its administration can be effected with least inconvenience and loss. To the large extent, the case is the same in a partnership business also. While, in case of company, administration is not that flexible because its activities are conducted on a large scale and they are quite rigidly structured.

Any substantial change in the existing line of business activity — say from cotton textiles to sugar manufacturing — may not be permitted by law if such a provision is not made in the ‘objects clause’ of the Memorandum of Association of the company. Thus, from flexibility point of view, sole proprietorship has a distinct edge over other forms.

  1. Division of profit

Profit is the guiding force of private business and it has a tremendous influence on the selection of a particular form of business organisation. An entrepreneur desiring to pocket all the profits of business will naturally prefer sole proprietorship.

Of course, in sole proprietorship, the personal liability is also unlimited.

But, if he is willing to share the profits, partnership form of organisation would be preferred. In company organisation, however, the profits (whenever the Board of Directors decides) are distributed among shareholders in proportion to their shareholding, but the liability of the shareholders is also limited. The rate at which dividend is to be distributed is decided by the Board, though approved by the shareholders. Companies may also reward shareholders by issue of bonus shares. In case of listed companies, the equity shares are tradeable on the stock exchanges, enabling the shareholders to exit the company at any time as per their own discretion.

  1. Costs, procedure, and government regulation

This is also an important factor that should be taken into account while choosing a particular form of organisation. Different forms of organisation involve different procedure for establishment and are governed by different laws which affect the immediate and long-term functioning of a business enterprise. From this point of view, sole proprietorships are the easiest and cheapest to get started. There is no government regulation. What is necessary is the technical competence and the business acumen of the owner and the requirement of meeting tax liabilities.

Partnerships are also quite simple to be initiated. Even a written document is not necessarily a prerequisite since an oral agreement can be equally effective. However, in actual practice, written partnership deed is usually entered into, as it is needed for registration of the firm and for tax authorities. The procedure for dissolution of partnership is also, relatively simple.

Company form of business organisation is more complicated to form. It can be created by law, dissolved by law, and operate under the express provisions of the law. In the formation of a company, a number of legal formalities have to be gone through which entails, at times, quite a substantial amount of expenditure. Further, various formalities have to be complied with for closure of companies. Non – payment of dues may land the company into insolvency or liquidation.

For example, the cost incurred on the drafting of the Memorandum of Association, the Articles of Association, the Prospectus, issuing of share capital, etc. can be quite high. This cost is however, small in case of private companies. Besides, companies are subjected to a large number of anti-monopoly and other economic laws so that they do not hamper the public interest.

  1. Tax implication

In the choice of the form of business organization, tax implication plays an important factor. In smaller entities, such as sole proprietorship or partnership, tax liability is dependent on the extent of profits. However, the liability of the owner(s) is unlimited. In case of companies or LLPs the liability of shareholders is limited to the value of shares they have purchased. In case of companies or LLPs, tax liability could be higher.

  1. Geographical mobility

The extent to which the product or service is proposed to be manufactured or made available also plays a vital role in choosing the type of business organisation. If a concern deals with local market, a seasonal product or perishable goods, or is meant to cater to a specific city or locality, then sole proprietorship or partnership form of business may be suitable. If it is proposed to market the product or service all over India (which may also entail providing customer support services), a company form of organisation may be preferred.

  1. Transferability of ownership

Sole proprietorship, being a one-person entity does not lend itself to transferability of ownership as the owner himself enjoys the profits and suffers the losses in his business. Partnership form of organisation is one where two or more partners share the profits and/or losses in the agreed proportion. If a partner exits, the partnership, may decide to induct a new partner with benefits of ownership and share of profits or losses. In the company form of organisation, transfer of ownership is possible by transfer of shareholding by any person or group of persons in favour of another person or group of persons.

  1. Managerial Needs

Managerial and administrative requirements also affect the decision about the form of organisation. When the concern is small and it caters to local needs only then one person will be enough to manage the business. Sole – proprietorship form of organisation will be suitable for such a business. If business caters to more areas, then more persons will be needed to look after various business functions in various areas. When a business is run on a large – scale basis, it will require the services of specialists to manage various departments. The company form of organisation will be suitable for such concerns.

  1. Secrecy

Secrecy is of supreme importance, particularly in small business concerns. Accordingly, the entrepreneur would select the sole proprietorship for that reason. In case, he has partners, he will have to carefully weigh whether other partners will be able to maintain the secrecy. He will have to exercise great care in taking partners. In case of a company, secrecy may be restricted to the manufacturing process or the manner in which business is conducted. However, certain aspects of their business such as their board of directors, shareholding, financial statements and other information which are statutorily required to be placed in public domain are accessible to any person.

  1. Independence

The company is subject to strict government regulations. So, if the entrepreneur wants to have freedom in business with little governmental interference, he has to go for either sole proprietorship or partnership.

CONCLUSION

The consideration of the various factors listed above clearly shows that:

(a) These factors do not exist in isolation, but are interdependent, and all these factors are important in their own right. Nevertheless, the factors of nature of business and scale of operations are the most basic ones in the selection of a form of ownership for setting up of a business organisation.

All other factors are dependent on these basic considerations. For instance, the financial requirements of a business will depend on the nature of business and the scale of operations planned. To take an example, if a business wants to set up a trading enterprise (say, a retail store) on a small scale, his financial requirements will be small.

(b) The various factors listed above are only major factors, and in no case they constitute an exhaustive list. Depending upon the requirements of the business, the demands of the situation and sometimes even the personal preference of the owner, the choice of a form of ownership is made.

(c) The problem in choosing the best form of business organisation is one of the analysing and weighing relative advantages and disadvantages to find the one that will yield the highest net advantage. And for that, weights may be assigned to different factors depending upon their importance in each form of organisation, and the type of organisation that obtains the maximum weights may be ultimately selected.

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TaxClue Teamhttp://taxclue.in
Taxclue is an online news portal for reporting all news, articles, judgments, Circulars, orders, and notifications relating to various corporate and tax laws in India. We use the tagline ‘Simplifying Laws’. Our mission is to Simplify the Laws and make people aware of their rights and duties in relation to tax matters in order to equip them to participate in nation-building.

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