Built on Rock

The busy entrepreneur's legal guide to start-up success

Michael Buckworth

• Publisher: Practical Inspiration Publishing
• Year: 2021
• Print ISBN: 9781788603072
• eBook ISBN: 9781788603065
• Topic: Business
• Subtopic: Business Law
• Index: Business

***BUSINESS BOOK AWARDS 2022 SHORTLISTED TITLE***

Starting a business is one of the most exciting things you can do. It's also one of the most daunting. There's so much that can go right, and so much that can go wrong.

That's why you need to understand and minimise the legal and commercial risks involved. When your new business is built on rock, you can relax in the knowledge that you won't lose access to life-changing opportunities or waste time and energy on fighting legal challenges. Instead, you're free to get on with what you do best — coming up with fresh ideas, finding ways to make them a reality, and selling your products or services to an ever-expanding customer base.

This book makes the complicated aspects of start-up law simple. In everyday language, it walks you through the key legal and commercial considerations.

• Setting up your corporate structure for maximum advantage
• Discovering your risks and how to minimise them
• Finding out the best sources of investment
• Learning how to value your company
• Negotiating with investors for long-term success

MICHAEL BUCKWORTH is a qualified solicitor of the Supreme Court of England and Wales, and the founder of Buckworths ( www.buckworths.com ), the only law firm in the UK working exclusively with start-ups and high-growth businesses. He has a passion for entrepreneurialism, and has advised countless start-ups over the last ten years. He's been 'entrepreneur in residence' at London South Bank University and University College, London, for several years, and is a regular speaker at industry events.

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 you’re going to fund it, and brought some co-founders on board to help you make it a success. It’s an exciting time.

And yet it’s 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 it’s 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 ‘Four Barriers’.

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 don’t waste time on this. If you’re in any doubt just set up a limited company, and you can always change it later – it’s flexible.

Barrier #2: over-complicating the documentation

There’s 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, you’re probably complicating things far too much.

Barrier #3: creating a complicated tax optimisation scheme

This is an eye-roller for solicitors and accountants (unless they’re the kind who love to take your money, of course). As long as you’re not setting up an investment fund or a business that will only work if it’s highly tax-optimised, there’s 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, doesn’t in itself mean that the company doesn’t have to pay full UK tax. You also have to make sure that it’s 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. What’s more, UK investors won’t 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 £50,000 that you’ll need.

Barrier #4: getting bogged down in figures

Please don’t spend ages creating fiendishly complicated cap tables, with varying predictions of the percentage holdings of shareholders or investors once you’ve been through five different investment rounds. At this stage you can spend your time more productively elsewhere. Excessive number crunching won’t 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 don’t 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 business’ 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, it’s important that you understand the differences between the two set-ups if you’re not to regret your choice further down the line. So that you can see what I mean, I’m going to explain what social enterprises are first and then move on to for-profit companies.

Social enterprises

Although you may hear the phrase ‘social enterprise’ bandied about, it’s 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 I’d 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. It’s 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: it’s 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.

It’s worth thinking about the implications of this by comparing it to a standard for-profit company. In the latter, if you make £100,000 profit you can – in theory – pay out all of it to your shareholders. But with a CIC there’s an asset lock, so you can’t distribute more than £35,000. Discovering this limitation can be a major ‘head in hands’ 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? What’s more, once a business is structured via a CIC it’s 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, there’s 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. I’ll explore them further in Chapter 10, but for now just be aware that the vast majority of UK angel investors use the schemes, and they’re only applicable to for-profit businesses. There’s 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 you’ll want to go down the social enterprise route, and if it will be from investors then you’ll want the for-profit route. If you’re 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 – if it’s important to you – 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, it’s 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 you’ve decided to set up a for-profit business. Your most likely structure will be that of a limited company, but it’s 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, you’re simply trading as yourself. All you need to do is to notify the tax authority, in the UK HMRC, that you’re self-employed, and pay taxes on your profits at the end of the year.

However, the downside is that you’re 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 isn’t scalable. You can’t raise investment, and it’s 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 ‘person’, 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:

• it’s 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 don’t pay any personal tax until they take money out of it, or sell their shares in it; and

• it’s easy to set up and operate – in fact, ridiculously easy. In the UK you can do it yourself online, and there’s 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? It’s more expensive to operate than if you’re a sole trader. You have to file an annual corporation tax return and accounts with HMRC (which will probably cost you between £750 and £2,000 in accountancy fees), and lodge an annual confirmation statement with Companies House. Having said that, you can see how it’s the structure you’d choose if you have aspirations for your start-up to be scalable and attractive to investors.

Setting up your company – what country to choose

If you’re planning on incorporating your company in the UK you can skip this, but if you’re thinking of basing it abroad there are some important things you need to know. You wouldn’t 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 you’re 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...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Building your start-up on rock
• Meet Lucio
• Part One: Launching your business
• Part Two: Raising investment
• Solid foundations
• Start-up checklist
• The author
• Acknowledgements