PART ONE
Launching your business
Chapter 1
Setting up your company
Avoid the barriers and traps
You have an idea for your new business. You might even have tested it out, started exploring how youâre going to fund it, and brought some co-founders on board to help you make it a success. Itâs an exciting time.
And yet itâs also the moment at which you might feel a bit stuck. Do you set up a company, and if so what kind? Should you raise investment at the beginning, or wait until later on? Is it a good idea to plan out the finances up front, or to see how things evolve? And out of the myriad things you have to do, what should you focus on first? It can feel overwhelming.
I speak to lots of entrepreneurs who are at this stage, and what I find time and again is that itâs easy to let the technicalities of setting up your business distract you from your main goal: to start creating your product or service and making money from it. I call them the âFour Barriersâ.
The Four Barriers
Barrier #1: worrying about what legal structure to use
Sometimes people spend months researching whether they should create a limited company, a social enterprise structure, or some other kind of entity. Please donât waste time on this. If youâre in any doubt just set up a limited company, and you can always change it later â itâs flexible.
Barrier #2: over-complicating the documentation
Thereâs no need at this stage to over-engineer any legal documentation. In fact, if you think you need highly specialised legal or accounting advice before choosing your business structure, youâre probably complicating things far too much.
Barrier #3: creating a complicated tax optimisation scheme
This is an eye-roller for solicitors and accountants (unless theyâre the kind who love to take your money, of course). As long as youâre not setting up an investment fund or a business that will only work if itâs highly tax-optimised, thereâs no need to even think about using an offshore structure.
The reasons for this are simple. Incorporating a company in a tax haven, such as the Cayman Islands, doesnât in itself mean that the company doesnât have to pay full UK tax. You also have to make sure that itâs owned and managed from the Caymans (generally by the use of a complex trust scheme). That costs a lot of money and is pointless for a start-up that, currently, has no value. Whatâs more, UK investors wonât be eligible for tax relief if they invest in your business, which is a huge disincentive for them. You can worry about offshoring your business later, when you have to spare the ÂŁ50,000 that youâll need.
Barrier #4: getting bogged down in figures
Please donât spend ages creating fiendishly complicated cap tables, with varying predictions of the percentage holdings of shareholders or investors once youâve been through five different investment rounds. At this stage you can spend your time more productively elsewhere. Excessive number crunching wonât help you with the important tasks of setting up your company and making it a reality in the marketplace.
If any of these barriers are holding you back, you have full permission not to worry about them. Just push them to one side for now.
However, there are some elements of setting up a business that are worth thinking about from the beginning. If you donât get them right then they can make your life difficult, deny you future opportunities, and scupper your chances of securing crucial investment. So that you can avoid them, the rest of this chapter will cover:
⢠the vital differences between for-profit and social enterprise structures, and the impact these can have on your businessâ viability;
⢠what it means to create a company, and how to do it without causing future problems for yourself;
⢠how to pay yourself in a sustainable way; and
⢠the low-down on taxes and VAT.
For-profit company or social enterprise?
If your aim is to do good in the world, deciding whether your company should be a for-profit business or a social enterprise can be confusing. However, itâs important that you understand the differences between the two set-ups if youâre not to regret your choice further down the line. So that you can see what I mean, Iâm going to explain what social enterprises are first and then move on to for-profit companies.
Social enterprises
Although you may hear the phrase âsocial enterpriseâ bandied about, itâs not really a legal term but a label that covers three broad types of business:
⢠Pure not-for-profit businesses. Here, all the money made is ploughed back into the business to pay its costs and expand its social purpose.
⢠Businesses that are created to support a social purpose or community, but still return some value to their owners and investors. You can often find these kinds of companies in the education space, for instance, where certain businesses have a core community purpose but still need to attract investment. This is the kind of scheme that Lucio, our fictional entrepreneur, has in mind.
⢠Businesses that are primarily for-profit, but with the aim of trading in an ethical way or promoting a social purpose. Today an increasing number of start-ups are created with this aim, because entrepreneurs are often just as motivated by generating social change as they are by making money.
Does your business idea fall into one of these categories? If so, you may be thinking of setting it up as a formal social enterprise, but Iâd probably advise you not to. To understand the reasons why, you need to know how these companies are structured and what that means for you. There are many different social enterprise structures, but here are the ones that crop up most often in the UK.
Community Interest Company (CIC)
This is the most common type, and is popular for businesses with a specific community purpose. Itâs usually set up in a similar way to a for-profit business (in that it has shareholders who own it), but with one crucial difference: itâs subject to a statutory asset lock. This stops more than a certain amount of the profits (a maximum of 35 percent) being paid to shareholders.
Itâs worth thinking about the implications of this by comparing it to a standard for-profit company. In the latter, if you make ÂŁ100,000 profit you can â in theory â pay out all of it to your shareholders. But with a CIC thereâs an asset lock, so you canât distribute more than ÂŁ35,000. Discovering this limitation can be a major âhead in handsâ moment for some CIC founders, and they often come to regret using this structure. How are they supposed to generate an income that both they and their shareholders can live on? Whatâs more, once a business is structured via a CIC itâs very hard to revert to a for-profit structure.
There is, however, one benefit to CICs, which is that social purpose grants are usually given only to asset-locked businesses. So if you think your funding will mainly come from grant money, a CIC makes absolute sense.
Company limited by guarantee
With guarantee companies, one or more people guarantee the liability of the company up to a certain amount. There are no shareholders or owners, and so no profits can be paid out. The only way to earn any money from such a company is to be a director or employee and be paid a salary. This structure tends to be used for charities and wholly not-for-profit entities.
You can see that a major sticking point with formal social enterprise structures is that there are restrictions on how they return value to their owners and investors. However, thereâs another disadvantage which is also of huge importance: these structures are not optimised to attract investment. The reason for this is a series of tax incentive schemes available to investors in start-ups. Iâll explore them further in Chapter 10, but for now just be aware that the vast majority of UK angel investors use the schemes, and theyâre only applicable to for-profit businesses. Thereâs an equivalent for social enterprises called social impact tax relief (SITR), but relatively few investors are interested in it. This means that being a formal social enterprise can close investment doors to you.
To me, the choice as to whether to use a formal social enterprise or for-profit structure largely comes down to how you expect to gain most of your funding. If it will be from community or social grants then youâll want to go down the social enterprise route, and if it will be from investors then youâll want the for-profit route. If youâre not sure, a for-profit structure is simpler and more flexible (at least in the early stages) because you can run it pretty much how you like and â if itâs important to you â still be socially responsible in the way that you do business. Also, while you can switch to being a social enterprise at a later date, itâs harder to do the same the other way around. If your main aim is to trade ethically or to improve the world in some way, ask yourself whether you can achieve that better via a successful for-profit business.
For-profit businesses
So youâve decided to set up a for-profit business. Your most likely structure will be that of a limited company, but itâs worth understanding two other structures that are relevant: sole tradership and a Limited Liability Partnership (LLP).
Sole trader
When you set up in business as a sole trader, youâre simply trading as yourself. All you need to do is to notify the tax authority, in the UK HMRC, that youâre self-employed, and pay taxes on your profits at the end of the year.
However, the downside is that youâre personally responsible for any losses that you make. So if your business goes bust, your home and assets are on the line and you can be made bankrupt. Just as importantly, if you have ambitions to build a sizeable business, being a sole trader isnât scalable. You canât raise investment, and itâs more complicated to register for value added tax (VAT) and operate as a VAT registered business. We discuss VAT later in this chapter.
Limited Liability Partnership (LLP)
Some people set up LLPs because the owners have limited liability and the structure has certain tax advantages. Instead of the LLP paying tax on its overall profits, as happens with a company, the owners pay income tax on their individual shares of profits each year. However, LLPs are clunky to operate and not easy to scale. Also, investors prefer investing in limited companies because of the tax breaks available to people investing in those kinds of businesses. As a result, LLPs tend to be used only by professionals such as solicitors, accountants, and architects.
Limited company
This is the important one. A limited company is a separate legal âpersonâ, owned by its shareholders. It can enter into contracts, borrow money, employ people, and sell shares in itself to raise money. It can do most of the things that people do, apart from make a mean cup of coffee and come up with cool ideas.
There are a number of advantages to setting up a limited company:
⢠itâs the structure chosen by the UK government for investor tax reliefs, so investors are more inclined to invest in limited companies than they are in any other structure;
⢠the company has limited liability, so if its business goes bust the personal assets of its shareholders are protected;
⢠although the company pays tax on its profits (corporation tax), its shareholders donât pay any personal tax until they take money out of it, or sell their shares in it; and
⢠itâs easy to set up and operate â in fact, ridiculously easy. In the UK you can do it yourself online, and thereâs no minimum sum you have to put in. This is in contrast to some other countries, where you have to invest the equivalent of thousands of pounds just to get a company up and running as well as jump through numerous bureaucratic hoops.
And the downside? Itâs more expensive to operate than if youâre a sole trader. You have to file an annual corporation tax return and accounts with HMRC (which will probably cost you between ÂŁ750 and ÂŁ2,000 in accountancy fees), and lodge an annual confirmation statement with Companies House. Having said that, you can see how itâs the structure youâd choose if you have aspirations for your start-up to be scalable and attractive to investors.
Setting up your company â what country to choose
If youâre planning on incorporating your company in the UK you can skip this, but if youâre thinking of basing it abroad there are some important things you need to know. You wouldnât want to deny yourself valuable opportunities, or saddle yourself with huge legal and accountancy costs for no reason.
Your number one consideration is where your investors are likely to be based, because investors usually prefer to buy into companies in the same jurisdiction as their own. This is when you might tell me youâre planning on snaring some Silicon Valley cash and will therefore set up your company in the US, but you have to be realistic. If your initial customer base is in the UK or Europe, and if your main networks are also there, it makes little sense for you to set up a company thousands of miles away. Also, a UK company can attract UK investo...