Which legal structure is right for your business start-up?

There are pros and cons to every structure, but one is right for your business start-up

South Africa needs entrepreneurs. Business start-ups have been identified by the South African government as a way to stimulate economic growth and help solve our massive unemployment problem. According to the Global Entrepreneurship Monitor 2022/23 Global Report, South Africa ranks 48 out of 49 countries for the rate of established business ownership, defined as the “percentage of adults aged 18–64 who currently own and manage a business that has paid salaries or wages for over 42 months”. A paltry 1.8% of South Africans fall into this category. In terms of total early-stage entrepreneurial activity – the “percentage of adults aged 18–64 who are either starting or running a new business” – a mere 8.5% of South Africans are entrepreneurs. Our track record is particularly dismal when it comes to youth and women, according to Seed Academy, a woman-owned entrepreneur development adviser.  

If you are a budding entrepreneur, South Africa needs you! Before you can do anything you must decide on the legal structure of your business start-up. There are different types of companies, and each has advantages and disadvantages. Some legal structures are more suited to certain types of business than others. Let’s look at them in turn. This article deals with for-profit companies. Different structures apply to not-for-profit entities.

Sole proprietorship

In a sole proprietorship, there is a single founder who owns and runs the business. This is the simplest form of business structure because the business is not a separate legal entity. The owner is the business. This structure is often used by freelancers – e.g., graphic designers, writers, some consultants – individuals who provide a service based on their personal skill and experience. They do not employ anyone, and they are the business. Sole proprietors can use a trading name. They are the only one with authority to make decisions about the business.

A sole proprietorship is simple to set up and the owner has full control of the business. They keep all the profits, but they also suffer all the losses. They carry all the business risk. If a sole proprietor incurs business debt, it’s the same as personal debt, and they are personally liable. 

A sole proprietor can employ someone, but they cannot take on another owner. To do that, they have to dissolve the sole proprietorship and form a new business entity. It’s also not a good idea for a sole proprietor to take on employees under this structure, although it is not prohibited. Employment law is complex and any expansion increases business risk. If a sole proprietorship reaches this stage, it is usually time to set up a limited company.

Partnership

A partnership is just what it sounds like. Two or more co-owners run the business together. Partners pool their money, share specialised skills and resources – often complementary – and share in the ups and downs of business success. Like a sole proprietorship, a partnership is not a separate legal entity. It is legally very similar to a sole proprietorship except that there is a group of owners rather than a single proprietor. Each partner is taxed on their share of the partnership profits.

The graphic designer (for example) who is a sole proprietor may go into partnership with another graphic designer as demand increases, perhaps to serve a different market. They want to partner with a similarly skilled professional and share knowledge and expertise. A partnership allows the expense of running a business to be shared and workload to be spread. 

However, it’s important to choose a partner carefully. All partners are liable for debts incurred by any partner. Decision-making must be shared, and if one partner wants to sell the business, all partners must agree to sell, or buy out the partner who wants to leave, which involves a formal evaluation of the business to determine the value of the exiting partner’s stake.

Partnerships are commonly found in professions such as law, medicine, and accountancy, where all partners are equally qualified and registered with their professional body.

Pty Ltd. – Proprietary limited company

Probably the most common type of structure for a small business is a proprietary limited company, or Pty Ltd. This is a private company and is a separate legal entity, even if there is only one owner. So a sole proprietor may decide to set up a Pty Ltd. because it offers certain advantages over a sole proprietorship structure. The owner or owners of a Pty Ltd. are the shareholders. The business continues to exist if one of the shareholders wants to sell their shares, so it is easier to exit from a Pty Ltd. than from a partnership, though the other shareholders must purchase the shares or accept a new shareholder into the business. Shareholders are not liable for company debts, because the company exists outside of their personal capacities. A private company can make its own decisions about its future without having to consult external shareholders. 

A Pty Ltd. is a popular structure and has many advantages over a sole proprietorship or partnership, but it comes with legal requirements. Two shareholders must be at a meeting, except when the company only has one shareholder, and the financial statements must be audited annually. A private company is not required to hold an AGM, but it may do so by choice or its articles of association may require it. Shares cannot be offered to the public, which can limit the ability to raise capital. Many private companies go public when they reach a stage of growth where they need more investment than they can source privately. They then opt for an initial public offering (IPO) on a stock exchange.

Personal liability company

There is another type of private company – the personal liability company. In this structure, the company’s directors, as well as past directors, are jointly liable, together with the company. They remain liable for any debts and liabilities of the company contracted during their respective periods of service as directors. A personal liability company’s name must end with the word “Incorporated” or “Inc”.

The personal liability company replaced the incorporated/professional companies formed under the Companies Act of 1973. It is used by professionals such as stockbrokers, attorneys and accountants, similar to partnership, where professional rules require these professionals to have personal liability. The personal liability company offers the benefits and convenience of a separate legal entity while complying with these rules. 

A personal liability company is required to have a minimum of one director on the board of directors, but an organisation may alter its memorandum of incorporation to require more than one director on the board. 

This structure is unlikely to be used by a business start-up outside of the professional context mentioned.

Public company

A small business start-up is also unlikely to start life as a public company, but it may go public at a later stage. A public company issues securities through an IPO and trades its shares on at least one stock exchange. Shares are valued in daily trading, which determines the value of the business. Anyone can purchase shares in a public company, though shareholders tend to be large institutions like pension funds. 

The main advantage of a public company structure is the opportunity to raise capital through sale of shares to the public. A stock exchange listing means the business is visible to investors, which can spark interest and create business opportunities. But it also means the business is open to public scrutiny, which can have negative consequences as well as positive. Risk is spread among all shareholders, but so is decision-making, so making decisions can take longer. Annual audited accounts must be published for inspection by the public and an AGM must be held. When company directors opt to go public, they usually retain a 51% majority stake. Without this, they lose control of their company. But even with a majority holding, they must heed the views of all shareholders. Sometimes a director of a public company buys back all shares to take the company back into private ownership, because they want to assert full control over the direction of the company. (This is usually done by a wealthy industrialist like Richard Branson – few other individuals can afford this step.)

Franchising

Franchising can be a great way to start a business. In a franchise, the owner of the business allows third parties to trade under licence. The business owner who purchases the licence, known as the franchisee, has the right to sell goods or services using the business’s name and systems. There is usually a hefty fee associated with the franchise, but the franchisee has access to a recognised brand, customer base, and centralised marketing/advertising. Many well-known South African businesses are franchises, such as Universal Paints, Col’Cacchio Pizzeria, Galito’s Chicken, Just Property, and many more. Many franchises offer training programmes on business management and all offer operational support to grow the business. This is in their interests, as, in addition to the initial franchise fee, the franchisee pays regular royalties for the use of the brand name and operational systems. So the more the franchisee makes, the more the franchise owner makes. 

Franchises come with a long list of rules, regulations, and directives the franchisee must comply with. For this reason, franchising does not tend to appeal to entrepreneurs, who are usually independent, innovative, and ambitious. Most entrepreneurs have a business idea of their own that they want to see succeed. But franchising can be a great way to get into business quickly, provided the aspiring franchisee has sufficient capital for the licence.

State-owned companies

There is one other type of company – the state-owned enterprise, or SOE. An SOE is formed by the government for the purpose of engaging in commercial activities, and government has either full or partial ownership. SOEs are typically approved to engage in specific activities. Eskom, Transnet, and Telkom are examples of SOEs. This structure is not relevant to a small business start-up.

Help with your business

When deciding on the legal structure for your business start-up, it’s important to seek legal advice about the advantages and disadvantages of these different structures, according to your needs and intentions as a business.

As attorneys, we will protect your interests and advise you on the most appropriate legal entity for your business start-up. We’ll help you draw up a business plan, draft articles of association or a memorandum of incorporation, and register your company with the Companies and Intellectual Property Commission (CIPC). Contact Simon on 086 099 5146 or email sdippenaar@sdlaw.co.za to arrange a preliminary discussion.

SD Law

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