The vast majority of businesses in the UK are structured as sole traders, partnerships or as companies.
1 Sole traders
A sole trader is the only owner of a business. A sole trader benefits from all the profits made by the business but at the same time is responsible for all of the business’ liabilities.
Where a business is run through a partnership, it is owned and managed by more than one individual (i.e. the partners). Any profits made by the partnership are shared between the partners according to the partnership agreement but each partner is jointly and severally responsible for all the business’ liabilities. This means that if a creditor or lender cannot obtain payment from the partnership, it can seek payment of all of the amount due from any of the partners.
Note: There is a type of partnership called a Limited Liability Partnership, which provides financial protection to the investors in the partnership. This operates in a similar way to the limited liability status of companies which is described below.
Unlike sole traders or partnerships, companies separate the ownership of the business from its management between:
- Shareholders who own the business and benefit from the profits made by the business and suffer the losses it may make; and
- Directors who manage the business on the shareholders’ behalf (note that in most companies directors will also be shareholders in the business)
A further difference between companies and sole traders/partnerships is that a company has its own legal existence (often referred to as the company being “a separate legal entity”). If you buy an item from a sole trader or partnership you are actually purchasing the item from the owner(s) of the business but this is not the case with a company. If you enter into a contract with a company you are doing so with the company itself, not the company’s shareholders (i.e. its owners).
Useful characteristics of companies
Companies have been used in the UK as business structures for centuries. They possess certain characteristics that made them well suited for many types of businesses.
Limited liability status
The vast majority of companies in the UK have “limited liability status”. What this means is that if the company is unable to pay its liabilities, the company’s lenders and creditors will not be able to demand that the the company’s shareholders pay any shortfall. The shareholders will simply lose their investment in the company but their loss is restricted to the value of their investment.
This is different from sole traders or partnerships (other than limited liability partnerships) as if these types of businesses cannot pay their liabilities, the lenders and creditors can force the owner(s) to use their own private assets to pay the amounts owed.
This is a significant advantage to investors as it reduces the risk of investing money in a company. It should be noted however, that some lenders or creditors commonly demand some additional security from the shareholders and/or directors of a company before they will offer a loan or credit terms.
For example, if a small company applies for a bank loan, the bank will often ask the directors to provide personal guarantee to cover some or all of the loan amount in case the company is unable to repay the loan. The advantage of limited liability status in this case is reduced but it will still apply to other lenders/creditors of the company.
No upper limit to the number of owners
There is no legal limit to the number of shareholders that a company can have which is particularly useful where large numbers of investors are required in order to fund a project. This does not mean that sole trader or partnership businesses cannot be large but it is worth noting that the largest businesses in the UK are usually run as companies.
Buying and selling an investment is relatively easy
It is generally quicker and easier for an investor to buy or sell shares in company than it would be to buy or sell a sole trader business or a share of a partnership. It is therefore attractive to any investor who wishes to invest for a fixed period of time or who might want to cash-in their investment quickly.
This advantage is maximized when we are dealing with a company whose shares are listed on a stock-market as an investor will then be able to buy or sell a company’s shares almost immediately.
Separation of ownership and management
Many investors have little or no interest in being involved in the day-to-day management of a business in which they hold an investment. A company structure is useful for these investors as the business will be managed by directors appointed by the shareholders.
There are often tax advantages to be gained in the UK by structuring a business as a company, particularly where the company retains a significant portion of the profits it makes rather than paying them out to its shareholders as dividends. It is important to note however, that the UK tax regime is very complex and there can be circumstances where is this is not the case and that the tax advantages of using a company have been reduced in the past several years.
Administration of companies
Whilst there can be advantages in running a business through a company, there are additional administrative burdens that a company must deal with. These burdens have reduced over the past few decades but there are still a number of requirements that companies must meet that are not an issue for sole traders or partnerships.
Companies have officers, of which there are two types:
Directors who run the business and are collectively referred to as the Board of Directors, or alternatively, the Board. The directors have a fiduciary duty towards the company which means they must act in the best interests of the company and not (where there is a conflict) in their own best interests. A private company must have at least one director whereas a public company must have at least two.
Company Secretaries are the chief administrators of companies and play an important role in the governance of companies (i.e., ensuring the company is run in a proper and legal fashion). There was a time when every company needed to appoint a company secretary but this only applies to public limited companies now and as a result many private companies do without them.
Filing company information at Companies House
All UK companies must provide information to Companies House (a Government department). Information to be provided includes the following:
- Details of the company’s officers (i.e. its directors and company secretary)
- The company’s registered office (i.e. its “official” address)
- Company accounts or financial statements (note that there a small number of exemptions to this rule)
The majority of this information is made publicly available (see https://www.gov.uk/government/organisations/companies-house)
These filing requirements have advantages for anyone who deals with the company. For example, a supplier who has been asked by a company to provide a line of credit will will be able to view the records of that company at Companies House. They will then be better informed about the company and will hopefully be able to make a better decision.
Large companies and public limited companies are required to have their financial statements audited. A large company is defined as a company where two out of the following three criteria applies:
- Its turnover is greater than £10.2m
- Its net assets are worth more than £5.1m
- It has more than 50 employees on average
Audits involve appointing a external firm of auditors to review the company’s financial systems and processes as well as the information contained in the financial statements to ensure that those financial statements show a true and fair view of the company.
An audit can be a lengthy and expensive process and for this reason many smaller companies (who have the option of not being audited) choose to do without one.
Which two of the following are characteristics of UK companies with limited liability status?
a) Should the company fail the losses incurred by its shareholders will be restricted to the value of their investment in the company
b) A company can have up to a maximum of 20 owners
c) All companies are required to have their financial statements audited
d) Companies should file their financial statements with Companies House
Click to reveal the answer
The answers are (a) and (d).
b) is incorrect as companies do not have a maximum number of owners and (c) is incorrect as smaller companies are not legally required to have their financial statements audited