To incorporate or not to incorporate...that is the question
· July 30th, 2008
If you operate a small business, you might have spent a night tossing and turning, wondering if you have done all you can to protect the business you’ve built. If so, you’re certainly not alone. Let’s take a look at a typical business owner — I’ll call him Matt.
Matt runs his own contracting business. He has two employees, some very loyal customers and has built up a strong business. After paying his employees and his other expenses, the profits from the business are his and his alone. Why would Matt want to incorporate a company to carry on business?
The first reason might be to protect his personal assets. As a sole proprietor, Matt is personally responsible for the debts and liabilities of the business. These range from paying employee salaries to—in a worst-case scenario—having to pay damages if he or an employee commits some wrongdoing in the course of business that injures someone else. Potentially, these expenses could bankrupt Matt as there is no limit to how much he might have to pay. An unfavourable court award might mean that he would have to sell his house, his boat, or other assets to raise the necessary cash.
Matt wants to grow his business by purchasing new equipment. Rather than taking out a loan, Matt has friends who want to invest in his business. They have indicated they want “a piece of the action” but are not willing to simply give him the money without some security. Matt also has a great employee whom he would like to reward for his long-term service.
In addition, Matt has just proposed to his girlfriend. He wants to ensure that his business continues and will provide for his new family’s future. Matt is aware that, as a sole proprietor, if something happens to him, his business would come to an immediate standstill.
Incorporating his business as a company (rather than continuing as a sole proprietor) could solve Matt’s challenges. Setting up a company will allow Matt to separate his personal assets from his business assets. Companies are separate legal entities from their owners and as such, their owners are not typically responsible for the debts of the company. A company can own property, carry on a business and have rights and liabilities in the same way a person does.
In practice what Matt can do is hire an attorney to incorporate his company and see to the legal formalities. Initially, he will become the company’s sole shareholder or owner. At the time of incorporation, Matt will pay a small cash amount for the shares of the company. He will likely transfer the tools of his business and any contracts he has with suppliers, customers and employees into the name of the company. He and his employees will then be employed by the company. When Matt services his customers, he will do so through the company.
By structuring his affairs in this way, Matt has limited his future liability to the amount of the assets he has transferred to the company in exchange for the shares he was issued. If in the future, the company’s expenses exceed its assets and revenues, Matt will lose only what he has invested in the company and not any of his other personal assets. Creditors will not be able to come after him personally.
There is no limit to the number of owners of a company. If Matt decides to involve his friends in the business, he can increase the number of shares his company has and sell them to his friends. He could also let his prized employee purchase shares at a minimal investment. The money received for these shares is paid to the company and can be used to pursue company activities, including buying that new equipment.
Matt, his friends and employee will have to negotiate the price of the shares and how many will be available. A company is controlled by its shareholders so Matt will want to ensure that he always holds the majority of the shares so he can control its activities. The shareholders, collectively, share in the profits of the company.
A company is a legal entity independent of its owners so Matt’s company will continue to exist even if something happens to him or if one of his friends decides to no longer participate. Company shares are transferable and can be left in a will to Matt’s next of kin who, if they so choose, can continue the business with minimal disruption. Matt’s friends can, in the future, sell their shares to another investor or back to Matt if they no longer want to be involved in the business.
Incorporating a company is relatively inexpensive. Legal and government costs amount to approximately $3500. Once incorporated, the company must maintain books and records and make certain annual filings with the Registrar of Companies in Bermuda. An attorney can advise you of the actual mechanics of the process should you decide to incorporate your business.