Topics Covered in this article
Choosing a form of business entity is crucial to a successful organization. It refers to all those steps that need to be undertaken for establishing and maintaining relationship between men, material, and machinery to carry on the business efficiently for earning profits. The choice of a business entity will depend on an object, nature and size of the business of such entity which will be varied from case-to-case basis and will also depend upon the will of the owners of the business entity which they want to accomplish. The main types of business structures are Sole Proprietorship, Partnership, Hindu Undivided Family (HUF), Limited Liability Partnership, Co-operative Societies, Branch Office and Company. A business enterprise can be owned and organized in several forms. Each form of organization has its own merits and demerits. Similarly, in case of Company several factors need to be weighed before opting it as a business structure.
A company is a “legal person” or “legal entity” separate from, and capable of surviving beyond the lives of its members. A company is rather a legal device for the attainment of social and economic end. It is, therefore, a combined political, social, economic and legal institution. Due to its separate legal existence, its shareholders are not held liable for the liabilities of the company. Further, the right choice of the form of the company is very crucial because it determines the power, control, risk and responsibility of the entrepreneur as well as the division of profits and losses. Once a form of company is chosen, it is very difficult to switch over to another form because it needs to go through conversion process, or winding up of the existing organisation ultimately resulting into the waste of time, effort and money.
Demerits Of Company
Difficulty in formation: Alongside the lengthy application process is the amount of time and energy necessary to properly maintain a corporation and adhere to legal requirements. Formation of a company is not an easy task. A number of stages are involved in company formation. Promotion is the first & foremost step in forming a company, it is both expensive and risky. The suitability of a particular type of business is to be decided first. Number of persons required to associate for getting a company incorporated. A lot of legal formalities are required to be performed at the time of registration.
- High costs: It is a crucial factor that is undertaken while choosing a particular form of organisation. From this point of view, sole proprietorships are the easiest and cheapest to form. There is no one specific government regulation. but is guided by various state and central laws to give a valid proof of existence. 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 mandatorily required as a prerequisite since an oral agreement is 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 easy.
Company form of business organisation is comparatively more complicated to form. It can be created by law, wound-up by law, and operates 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.
- 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. Company requires huge investments. Depending on the capital required, they can be set up as public companies or may be in the form of listed companies by raising money from the public and being listed on the stock exchanges. Although the Companies Act, 2013 provides simplified procedure to set-up a small Company or an OPC, they still require more capital as compared to sole proprietorship or partnership.
- Legal formalities: Filing articles, memorandum & number of forms, is overall a long process for incorporating. One has to go through extensive paperwork to properly determine and document the details of the organization and its ownership.
- Ownership v. Management: The owners of a company normally elect a Board of Directors to control the business’s resources for them. On the other hand, in smaller firms, there is generally no difference between the Directors and the Shareholders, they are the same person or people. However, when the share ownership of the business becomes more widespread the original owners of the business sacrifice some of their control. The management may indulge in speculative business activities. There is no direct relationship between efforts and rewards. The profits of the company belong to shareholders and the Board of Directors are paid only a commission. The management does not take personal interest in the working of the company.
- Fraudulent management: The promoters and directors may indulge in fraudulent practices & insider training. The management is in the hands of those persons who have not invested much in the company. The Company Law has devised methods to check fraudulent practices but they have not proved enough to check them completely.
- Right of minority shareholders: It is common to witness abuse of power by majority shareholders. It is so because the ultimate decision-making power is exercised by majority share owners who tend to ignore the interests of minority share owners. Minority shareholders tend not to participate in the decision-making process of public companies with a controlling shareholder, and their voice is rarely heard. Even when they disagree with how the company is being managed, they prefer to express this dissatisfaction through exit, i.e., by selling their shares, rather than by expressing their voice at a shareholder meeting.
- Reporting requirements: Too many periodicals & incident-based reporting requirements create a burden on company. They have to disclose that information which is important to be kept undisclosed due to fear of misuse. Too many experts need to be employed or outsourced & may be a completely new department for the same has to be made by the company, this further adds to the cost & dilution of privileged information. Reporting requirements to Registrar, SEBI, RBI or any other agency (if required) has to be fulfilled & too many reporting discourages a person from incorporating a Companuy.
- Lack of secrecy: The management of companies remains in the hands of many persons. Everything is discussed in the meetings of Board of Directors. The trade secrets cannot be maintained. In case of sole trade and partnership concerns such secrecy is possible because a few persons are involved in management.
- Delay in decision-making: In company form of organization no single individual can make a policy decision. All important decisions are taken either by the Board of Directors and if prescribed resolutions need to be passed in general meetings. Decision-making process is time consuming. If some business opportunity arises and a quick decision is needed, it will not be possible to arrange meetings all of a sudden. So many opportunities may be lost because of a delay in decision-making.
- Concentration of economic power: The company form of organization has helped concentration of economic power in a few hands. Some persons become directors in a number of companies and try to formulate policies which promote their own interests. The shares of a number of companies are purchased to create subsidiary companies. Interlocking of direction-ship and establishment of subsidiary companies have facilitated concentration of economic power in the hands of a few business houses.
- Tax Implications: In smaller entities, such as sole proprietorship or partnership, tax liability is dependent on the extent of profits. However, the liability of the owner is unlimited. In case of companies the liability of shareholders is limited to the value of shares they have purchased. In case of companies or, tax liability could be higher. Companies are taxed on its own income which is separate from its shareholders. In addition to this, dividends & profits passed on to shareholders are also taxed as a part of personal income tax. This amounts to double taxation of corporate income in the hands of shareholders.
- Degree of risk & 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 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 assets. Thus, while a shareholder/member/partner may lose the entire money he puts into or agreed to put into the company, he cannot be forced to contribute additional funds out of his own pocket to satisfy the business debts of the company.
- Use of corporate veil to hide criminal activities: the company is treated as a distinct individual having no role to play in the acts undertaken by human agency. Here, human agency cannot take shield behind the Company being an artificial person, having separate legal entity. When directors, or whosoever in charge of the company, commits frauds, or illegal activities, or does any activities outside scope of the objects, memorandum, articles of the company, the principle of lifting of corporate veil is initiated. It scrutinizes, the human agency behind the scenes of the Company, to determine the real culprit committing such offences. This doctrine works as a watchdog but the authorities often fail to lift the veil due to involvement of reputed persons or inability to detect any wrongdoings. The Company acts as a facade for them, this
- Mergers & amalgamations complexities: Unlike sole-proprietorship & partnership, Corporations involve huge legal as well as financial complexities. They bring numerous challenges across the departments. There are plenty of factors that can further complicate the scenario of business restructuring, including when the company is acquired or merged is in a different country with unique reporting and regulatory requirements.
- Mandatory compliances: A large number of rules and regulations are framed for the working of the companies. The companies have to follow rules for both internal & external working. The government tries to regulate the working of the companies because large public money is involved. The formalities are many and the penalties for their non-compliance are heavy. This often detracts companies from their main objectives for which they have been formed. If a person wants autonomy or independence with little government interference then he must go for sole proprietorship or partnership.
MERITS OF COMPANY
Despite so many demerits, Company is comparatively a much organised & suitable form of business structure nowadays due to following reasons:
- Separate entity: Since the company is created by law, it has separate legal existence as compared to its members. Therefore, the members cannot be personally held responsible for the acts of company and company cannot be held liable for the acts of the members.
- Limited liability: In a limited liability company, the main risk shareholders have is connected to the value of their shares that they hold or were promised.
- Helps generate capital: A company has two forms of obtaining capital: equity, which means raising funds through the public and debt referring to bank loans or other forms of credit. When a company is incorporated, it is considered more reliable; hence it shall be easy to obtain capital. The SEBI and other allied laws require the incorporation of the company to allow sourcing funds in the form of equity. Moreover, if the funds are raised from the public instead of a private group, the company must satisfy the conditions for a public company and be listed on a recognised stock exchange. Hence, it promotes the easy way for capital formation and pooling.
- Perpetual existence: When a corporation has a perpetual existence, it can still exist regardless of what happens to its founders or shareholders. That is because the company is considered a separate entity and its ownership can change hands.
- Transferability of shares: Shares are at equal footing with a movable property and hence freely transferable from one person to another. This aspect provides liquidity to the shareholders. Members are in a position to encash the shares at any time as they will. In a public limited company, the shares can be transferred freely. Whereas, in a private limited company, the share transfer is not frequent due to it being closely-held, but is not prohibited.
- Professional management: This type of management for a business involves directors who are elected by shareholders and have a lot of experience running companies. The directors then hire professional managers, who are in turn responsible for overseeing the day-to-day operations of the business.
- Expansion potential: In a public limited company, there is no limit on the number of shareholders. Companies can expand by offering new shares and use their reserves to expand further.
- The ability to transfer shares: Shareholders can sell their shares for any reason, especially if the company is not as profitable as they’d hoped. Even though shares are changing hands, the business will continue to run.
- Sharing the risk: The whole risk of the business is shared among shareholders based on their number of shares. This is an advantage, especially for small investors.
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. 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.
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.