Let's discuss the pros and cons of the sole proprietorship designation of your business.
You have a business idea. Now you find yourself asking, "Should my business be a sole proprietorship?"
The simple answer is: Maybe. Many professionals often choose this option when starting up because a sole proprietorship is simple to start, and allows them to test the waters without undertaking a large scale financial responsibility like some corporate entities do.
One of the most common business structures, and the simplest out of all the other structures to form, a “sole proprietorship” is a business that is owned by only one person. Many people are confused to what that title belongs-- Is it the business itself or the owner of the business? Actually, it refers to both: the business and the owner since, in this type of structure, there is no legal distinction between the owner and the business.
To understand the concept better, let's discuss the basic features of the sole proprietorship (“SP”):
A SP is owned and run by one person, where the person often runs the business under their own name.
A SP is not a separate legal entity. The owner of the business owns all the assets of the business, but also bears all the risks and debts of the business.
Still not clear? Here are a few pros and cons of a sole proprietorship:
1. Easy setup/formation.
The SP is easy to form, because it doesn’t the formal creation of a business organization. This means there is very little paperwork to worry about, which is the opposite of forming a corporation or partnership. Unlike other entities, a separate trade name for the business is not needed, but is encouraged.
2. Low start up costs.
There are less startup costs with a sole proprietorship; fees tend to be limited to permits, licenses and registration, since there are no operating agreements or articles of incorporation to draft and file.
One of the reasons you are opening your own business is probably to "be your own boss." Since you want to be the decision maker, being a SP allows you to have complete control over all business decisions. You will not have aboard of directors (like with a corporation) or need partner consent (partnerships). There is clearly an added benefit here since it expedites your decision making process and the implementation of that decision.
There is also less government control with a SP. A quick discussion with your business lawyer will reveal you need to register with your local business or tax office, and likely your state department of revenue. After that, you will not be required by most regulatory agencies to submit much paperwork for your business, depending of course on the nature of your business.
You may be thinking, "well this sounds great! I get all the control and the profits!" But while there are benefits to being a SP, there are also cons.
CONS OF A SOLE PROPRIETORSHIP
1. Unlimited personal liability.
Sure, you may be the one enjoying all the profits, but you are also the only one shouldering the liabilities, debts and losses. Businesses that are separate legal entities offer liability protection to their incorporators or shareholders, to varying extents, from the debts and actions of the business. These individuals will only be liable up to the extent of their investment in stocks or shareholdings in the business, and their personal assets remain theirs.
As a sole proprietorship, you retain all the liability for the business.
The sole proprietor does not have any protection from liability, since the debts and obligations of the business are also personal debts and obligations. In the event that the business has incurred major losses and is unable to pay its debts, the creditors can go after the business owner's personal assets, including your car, properties, and other real and personal assets. Even your savings accounts can become fair game to creditors and anyone else that the business owes. In other words, sole proprietors are at risk of losing practically everything if their business does not succeed.
The same is true when someone files lawsuit against the business or the business owner. Since the business and the business owner are one unit, their exposure to legal action is the same. In the event your business loses the case, you, the owner, will be personally liable, meaning the your personal assets can also be targeted.
2. Uncertain Growth Opportunities.
Continuity of the business is an issue when it comes to sole proprietorships. Since the owner and the business are one single unit, the death or retirement of the owner would in turn necessitate the closure of the business. Yes, it is easy to dissolve, but this also causes uncertainty in the existence and continuity of the business. Those businesses that want to grow, have multiple employees, and expand in location or product choices, will be better served with a separate legal entity that can adapt to those needs and survive the death, disability or retirement of the owner/creator of the business; at the very least, a discussion with a business lawyer can address this concern if becoming a SP is the ultimate goal.
3. Difficulty in raising capital.
This is one of the biggest disadvantages of a sole proprietorship. You are setting the business up with the intention of being the only one in control. Naturally, raising the capital you need is entirely up to you. This is why most sole proprietorships use their own money when starting their business. The working capital of the business will be limited to the funds of the sole proprietor, and other funds that it can obtain through loans. This has a direct impact on your personal credit as you and the business are the same.
Banks, lending and financing institutions often look into the stability of a business as a going concern and its assets, which is often less than a corporation or a partnership with more individuals pooling their resources together. For this reason, sole proprietorships are not attractive prospects for investors and lenders.
At Dudai Legal, we work with businesses and business owners from the ground up, so that you are as protected as you can be, so as to prevent legal action wherever foreseeable.
Are you a sole proprietor? Have you faced any of these issues? How do you accomodate your plans for growth despite liability exposure personally? Comment below!