How to Choose the Best Entity Structure for Your Startup? : A Practical Guide
Updated: Sep 4, 2022
Choosing an entity for a startup is one of the toughest challenges early-stage founders face. In my recent interaction, with a number of early-stage founders, I realized, that many founders are still confused as to what entity they should set up at the beginning of their startup journey. While, many think that private limited company is the way to go, some others who want to start alone and want to test the viability of their product/idea, are more inclined towards a sole proprietorship model. While the legal implications of choosing an entity is important, it is also important to marry the same with the long and short-term business goals any startup has. Hence, we bring to you a set of scenarios and what kind of entity suits each scenario the best!
What are the various entities a startup can set up?
Before we move on to discuss the practicalities associated with choosing an entity structure. Let us present in brief what are the various entities you can choose:
Practical Scenarios and the entity structure suited to them.
Let us consider the below scenarios and discuss what entity structure should a startup choose in these situations:
Scenario 1: You have an idea which you want to test. You are a non-tech founder and are looking for a co-founder with whom you can implement your idea and set up an entity.
If you are a founder, who is in the aforementioned situation, then, you can choose between a LLP and a private limited company. You would require more than one person to set up your company and hence, going with an OPC structure or a sole proprietorship is out of question. A partnership would expose you to unlimited liability. Hence, the two structures open to you are LLP and a private limited company. If you just want to test your idea and are not looking to raise funds soon, a LLP would be a better way to begin as compliances are less, costs of formation and closing are also comparatively lower than a private limited company.
Scenario 2: You want to start a service-based startup and want to explore freelance opportunities before you incorporate an entity.
For anyone wanting to operate in this manner, sole proprietorship along with a MSME registration is the best way forward. A sole proprietorship would entail almost no compliances but would give you the opportunity to attach a brand name to your business. You can evaluate the marketability of your services while incurring nil compliance costs and once you think you are ready to take the next step, convert the same into a private limited company or a LLP, depending upon your long term goals.
Scenario 3: You have an idea for a product, you are two people, one tech and one non-tech founder, you need more people to bring your product till the MVP stage but are facing a cash crunch.
In such a situation, you can do the following:
Set up a private limited company and offer ESOPs or sweat equity to the people whom you bring on board. This would enable you to hire more hands at a lesser cost. As only a private limited company can issue ESOPs, it would be imperative that you choose to incorporate your startup as a private limited company.
Set up a private company and look to raise funds or join an incubator or an accelerator. Investors are more likely to invest in a private company than the other entity structures and hence, if you are looking to raise funds, private limited company should be the preferred entity structure.
Your long-term goals (raising funds, becoming a successful bootstrapped startup, expansion etc.) should also feature when you are deciding which entity to choose. If you are strapped for cash and end up spending half your money in incorporation and compliances, you may not have enough left for your core activity that is product development. Hence, choosing an entity structure for a startup, is not a plain vanilla choice but a number of factors need to be brought in before you decide upon the type of entity you want your startup to be.
You can contact us for more information on similar practical scenarios as listed above and for queries related to startup entity structures/documentation, by clicking on the button below. We also have a YouTube video where the legal implications of choosing an entity have been explained in detail, you can find the same here: https://www.youtube.com/watch?v=wPcZDSEOOIc&t=5s
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