How to choose an appropriate business structure

One of the most important factors when starting a new business or acquiring an existing business is to ensure that the appropriate business structure is established from a governance, asset protection and taxation perspective. How do you choose an appropriate business structure?

There are several structures to choose from either individually or as part of a larger group when starting, expanding or acquiring a business, including:

  • Sole trader– the most simple structure, giving complete control to the Owner but exposes them to personal risk;
  • Company– more complex, however limits owners liability as the business is a separate legal entity;
  • Partnership– consisting of 2 or more people who distribute all income or losses. Like a sole trade owners have complete control but exposed to personal risk; and
  • Trust– where a trustee is responsible for the operation of the business.

Selecting a structure that effectively meets the requirements of the owners will largely depend upon the size and type of business, complexity of businesses operations, expected future operations (i.e. significant expansion planned) and the risk appetite of the owners. Owners need to consider the advantages/disadvantages of maintaining a more complex structure which can be overly burdensome from a cost perspective especially with the level of risk they are willing to take and expected future operational status of the business.

The key factors to consider when determining the appropriate structure for your business are as follows:

  • Protection of individuals charged with operating the business;
  • Type, size, location(s) and industry of business, now and into the future;
  • Number of people who will share in the profits of the business;
  • Protection of key assets and funding structure into the business;
  • Corporate Governance requirements for the business;
  • Any legal and regulatory requirements; and
  • Tax effective distribution of profits and/or ability to sell assets/business units.

While a business structuring can be altered over time to reflect the changing nature, size and complexity of the business, it is important to get the business structuring correct from the beginning as it can be costly and difficult to unwind in either high growth or distressed circumstances.

Examples of benefits that arise from establishing an effective business structure when the business becomes distressed are outlined in a case study example below:

Private equity-backed contracting business

Situation

  • Private equity owned contracting business acquired with +$5M of funding provided to fund working capital.
  • Funding was provided by a 2nd ranking secured loan facility. Funding provided by Trading Bank had priority.
  • Business experienced rapid expansion through acquisition of a major contract which represented +80% of turnover.
  • Business ultimately failed due to the issues with the major contract due to management skills to manage, working capital requirement, service levels and ultimate profitability.

Outcome

  • Insolvency will see PE firm receiving 20 – 30 cents in the dollar return on the funding injected verses 5 cents in the dollar if the loan was unsecured.

Key learnings

  • Securing loan will achieve a +$3M improvement in return for PE Firm
  • Enables PE Firm to have a significant say in the conduct of the Voluntary Administration
  • Shareholder Loans via loan agreements would have mitigates assets being “at risk” and enabled shareholder to control the insolvency