In this, the third and final article in a series of three, we will look at the option of setting your new business up as a Private Limited Company.
Many people are under the impression (wrongly), that in order to start their own business, they must first set up a limited company. This can put people off before they even start. As can be seen from the previous articles in this series, it is not necessary to form a limited company if you prefer not to. However, there are numerous reasons as to why someone might prefer to run a business as a ltd company and some of these reasons are detailed below.
HOW DO I SET UP A LIMITED COMPANY?
Out of the three options of sole trader, partnership and ltd company, setting up a limited company requires the most ‘work’ – mostly paperwork. However, don’t be put off – it isn’t as hard or complicated as people often believe.
To form a ltd company from scratch, you can use a solicitor, however there are numerous firms in the UK that specialise in setting up ltd companies or that will sell you an existing company ‘off the shelf’. To find a firm that provides this service, just do a quick Google search for ‘company formations’ or similar.
Most people will opt to set up a private limited company. The company must have at least one director and a secretary. If there is only one director, he/she cannot act as the company secretary as well. The director and secretary will normally also become shareholders – the people that actually own the company.
Your next choice is to decide between an ‘off the shelf’ company and a new company. An off the shelf company is already set up and you simply transfer the shares and directorships to yourself. This is probably the quickest way of obtaining a ltd company, but you are limited to the choice of names of already formed and available companies. Once you have obtained your off the shelf company, you can change the name if you wish.
With a new company, you start from the beginning and form a brand new company, with your choice of name (subject to availability).
Fortunately, whether you decide to set up or purchase your new company using a solicitor, a ltd company transfer service or by dealing with Companies House yourself, you will always have someone to help you with the process and to ensure that you have filled in the various forms correctly.
A limited company is a separate legal entity in itself and this means that ‘it’ – the company, is responsible for its own debts. When a company is formed, the ‘shareholders’ purchase shares in the company and this payment is normally the starting capital that the company uses to establish itself. The shareholders maximum liability is the value of their initial investment for their shares. Regardless of what happens later on with the company, they cannot be called upon to come up with more money to pay off company debts. In addition, the company director’s personal assets cannot be touched to pay off company debts, unless the company has been trading fraudulently. This is known as ‘limited liability’, since the liability of the owners is limited, unlike a partnership or sole trader whose liability for the company debts is unlimited.
Now, before you get excited about the prospect of setting up a company and running up huge debts that you might never have to pay off, read on…..
As I said above, a company is its own entity and as such, it can be valued ‘on its own’. Usually, as a company grows, the directors will retain some of the profits each year to add value to the company balance sheet. This is a bit like the companies savings account – each year that goes by, it saves a little bit more of its profit and so the business value grows. The value of a ltd company is sometimes referred to as its ‘Net Worth’. The net worth of a company is basically the amount of money that would be left if all the company assets were sold and all the company debts were repaid. In the beginning or if every year the directors withdraw all of the profit for themselves, the company may have a very low net worth and as such, minimal value.
Note that the net worth is a snapshot value – it is not necessarily equal to the price that a company would fetch if it were to be sold. The net worth is the value that would be left if the company stopped trading at a point and everything was sold and all debts repaid. When a company is sold, other factors come into play such as the future profitability of the company and the perceived value of any goodwill that has been built up over the time the business has been trading.
If a company has a low net worth, then a prospective lender may, quite rightly, feel uncomfortable about lending the business any money. After all, if you went to the bank for a loan and your only asset was £100 worth of shares, then the amount the bank will lend you would be minimal. For this reason, it is perfectly normal for a lender, especially banks, to ask for company directors to guarantee the debts of the business. Therefore, if the company defaults on a loan, the creditor can require the guarantor to repay the debt instead and may resort to seizing their personal assets if necessary.
Many directors do not like giving guarantees for their companies – when I worked in finance it was something that I often asked for and which regularly caused directors to get a bit upset. My answer was always the same:
‘If you as a director do not have enough confidence to support your own business by way of a guarantee, then why should we support it and lend you any money?’
A bit harsh? Maybe but perfectly true. After all, if you have doubts about risking your own money on your own business, why should anyone else be prepared to risk their money on it?
The good news is that once a business has become more established and has a reasonable net worth, then there is a good chance that you will be able to ask the lender to cancel your personal guarantee and let the company stand on its own two feet.
Tax and NI is a little bit more complicated for ltd companies but don’t worry, once you get your head around it, it is really quite easy to understand the basic principles.
As I said before, the ltd company is a separate legal entity, so even though it is your company, technically you are not classed as being self-employed. As a director of the company, you are in fact an employee of the company – that’s right; you’ve just got yourself another job!
In your employed status, you pay income tax in exactly the same way as if you had a normal job – usually through the PAYE (pay as you earn) system on a monthly basis. In addition, the ltd company has to pay corporation tax on its profits. Don’t worry if that sounds as though you pay tax twice on the same money – you don’t. Your salary will already have been deducted from the profit of the company as an expense; therefore it will not be taxed twice. Take a look at the following, very simplistic example. Note that the following does not take account of tax allowances or any relief that may be available, it is purely to illustrate the above point.
The company will pay corporation tax on the profit of £10,000. In addition, the company director will pay tax on his salary of £20,000.
National Insurance is also slightly different for a ltd company. The employee (company director) makes a contribution and the company also makes a contribution on the employees’ behalf. Clearly if you are the only director and it is your company, then both contributions are indirectly coming out of your pocket.
Yep, you’ve guessed it already – the financial recording keeping rules for ltd companies are a bit more complicated as well!
Limited companies must file a copy of their annual accounts with Companies House, within a set timescale after their year end. Failure to do so can result in penalty fees being incurred. Smaller companies are able to file abbreviated accounts and are not required to have the accounts audited (this means being checked by an accountant to confirm that they give a true and fair view). Larger companies have to file full accounts and are required to have the accounts audited.
In fairness, a larger company is more likely to have several directors and shareholders and it is likely that these shareholders will expect the company to produce audited accounts so that they can see how their investment (their initial input of cash to purchase the shares)is doing.
Unless you are qualified or have some experience in accountancy or book-keeping, I would recommend that you employ a professional to prepare company accounts. At least this way you can be sure that they have been completed correctly and they will be ready before the Companies House deadline. Many small company director’s leave the accounts until the last minute and then either rush to do a whole years worth of figures in one go or just don’t bother and end up being fined. As the old saying goes, a good accountant will earn his fee in saved tax and penalties.
Despite the fact that it is very easy to set up a new ltd company and the fact that it can be done for next to nothing, larger companies often prefer to deal with ltd companies rather than sole traders or partnerships. Personally, I don’t think that credibility alone is a good reason to set up a limited company, unless you absolutely have to in order to deal with other businesses. There are far more important things to take into account, such as accounting requirements and potential tax liability etc.