Startup Basics: The Difference Between Structuring And Incorporation (And Why It Is Important)
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At inception, many startups may be run successfully via a freelancer license or e-trader license, with a founder/CEO who wears multiple hats and oversees all aspects of the operations. However, little beknown to the founder are the key considerations regarding structuring which could potentially be a gamechanger.
Structuring and incorporation have been interchangeably referred to in the startup community; however, the difference is stark and significant. Indeed, some may say these two concepts are critically necessary, in their own right.
As a business grows, so do risks and liability concerns, which is where the evolution of structure is necessary, and change in management style would also be important. For example, startups will most definitely face limitations in scaling up if they have the wrong license, or if they have a license that inhibits hiring employees or having a mainland presence.
Founders/CEOs also need to learn to tighten reigns and give up 100% control, or risk a startup that runs through “management by personality” that makes for risky business. For most companies, the change needs to be made when the business needs hiring employees, or operations start expanding at a significant pace. As such, thank goodness for venture capitalists in a way, in that they force compliance through professional legal or financial advisors, and they tend to force transition to a more “formal” management style without emotion or personality.
Structuring a company comes far before incorporation, where incorporation refers to obtaining the license as a company for your business. When you have thought about a structure, you have considered the foundation of your business.
A popular Chinese proverb comes to mind: “When the roots are strong, there is no reason to fear the wind.” When thinking of how to structure your business, think about your current business activity, and your foreseeable five years’ business activity and how that could impact the business.
Structuring is also important because it’s not about founding a company or getting a license, but about creating a business that you can sell in a few short years, whilst not be restricted with scaling operations, expanding geographies, or being funded. Structure can most definitely confuse entrepreneurs venturing into the startup space, so let’s break down the formal and most common startup structures:
- Sole proprietorship (freelancer license, e-trader license, professional license, civil company) These are popular because they are time and cost-effective when you start up. However, when you operate as a sole proprietorship, you and your business are one entity. Unless the license comes with memorandum and articles of association from a regulator that strictly states liability is not limited, please understand and assume that liability is personal, on you and unlimited, which means you are personally responsible for all actions undertaken through that license as the owner of the business. Sole proprietorships can be converted into limited liability companies.
- Limited liability companies (LLC) This is quite common because it affords superior asset protection for shareholders. Shareholder’s liability is limited to the value of each of his/her/its proportion of share capital, and personal assets cannot be encroached upon.
The reasons people migrate from sole proprietorships to LLCs, is most commonly for the following reasons:
- To limit liability and risk
- Increase chances of getting credit lines from banks or investors by having credibility of a share capital and ability to split it with funders or investors
- To share the venture with partners
- To separate business operations, income and assets from personal ones
Regardless of the structure chosen, it is always advisable to consider limiting risk and liability through either or both, insurance and contracts.
The UAE has over 53 free zones and more than 7 mainland options where one can incorporate a company or obtain a license from. Incorporation is essentially licensing a structure by a regulator to perform commercial activities or trade. It is important to also remember that when you set up a company/LLC you will obtain, in addition to the trade license, memorandum and/or articles of association; however, in the case of sole proprietorships or freelance options, it will most probably be only a license. Free zones also issue share certificates, and some free zones issue certificates of incumbency.
Incorporation usually means you have finalized a structure, identified how you want to scale, confirmed your business activities and are certain of your overall objectives. Here are a few key considerations to keep in mind when incorporating:
- Having a license does not mean you are automatically compliant with the law. You need to actually then start compliance with all necessary regulations and laws. Know and understand the laws applicable to your business activity.
- Understand that majority of the regulators only permit issuance of ordinary share capital that must be fully paid up.
- Review the terms of the memorandum and articles of association before you sign them, correct mistakes and amend any unreasonable terms; as long as you do not contravene the UAE Companies Law or the right applicable laws, you should not be prevented from requesting amendments.
- Ensure you understand the costs, process, and commitment involved in your exit strategy, whether by consent or through dissolution.
- If you are bringing investors or funders in, be clear about how that affects your company, and what documents and processes you need to put into place with respect to your license, memorandum, and/or articles of association.
- Always remember that limited liability company have a maximum permitted 50 shareholder limit.
- Understand the types of equity, anticipate the various stakeholders in your business, and identify each of their impact on the business before you incorporate.
To summarize, choose a structure wisely based on your own objectives as a founder/CEO, and then incorporate the company with the right (impersonal) management style. Follow key considerations whilst incorporating before you get a license. The cheapest jurisdiction isn’t necessarily the right jurisdiction, so, it is advisable to think long term and have a vision. If you have pinned down your structuring and incorporation aspects, it is just rosy and uphill from there.