Chapter 1: Different business models and introduction to companies Flashcards
1 Different legal forms of business
This section covers the main legal characteristics of the following forms of business:
* Sole trader
* Partnership
* Limited partnership
* Limited liability partnership
You will look at the main characteristics of public and private companies in the next section.
1.1 Introduction
Businesses are generally set up to make a profit. A business generates income by selling products and/or services. In order to sell the products and/or services the business will incur certain expenses.
Provided the income generated exceeds the expenses of the business, it will make a profit. Once a business has made a profit, a proportion of that profit is likely to be given to the owners of the business, and the rest will be retained in the business in order to help it grow.
1.2 Raising finance
1.2.1 Why businesses raise finance
A business is likely to need to raise finance for a number of reasons including the following:
- To purchase premises from which to operate, plant and machinery, stock or raw materials,
computer hardware and software in order to be able to manufacture and sell goods, or provide
a service; - To employ staff to make the goods and/or provide the services to customers;
- To obtain the advice of professional advisers from time to time, particularly accountants; and
- To expand and grow, which it may do by acquiring other businesses, carrying out marketing
activities eg advertising and investing in new premises and equipment.
1.2.2 How businesses raise finance
There are four basic ways in which a business can raise money:
- The owners of the business may invest in it by making contributions of capital to the business;
- Outside investors may be prepared to make a capital contribution to the business in order to share in its future profits
- As already mentioned, a proportion of the profit that the business has generated is likely to be retained within the business to help it grow, rather than being distributed to the owners and
investors in the business.
1.3 Business models
In practice, lawyers may have to advise clients on the most appropriate business model for their business. In order to do this, you need to be aware of the different possible business models and the key considerations when forming a business and choosing a business model.
In order for you to understand the significance of companies, it is helpful to first consider the
features of alternative business structures. This will enable you to put into context the advantages
and disadvantages that the company structure offers for businesses.
1.4 Key considerations when forming a business
Cost: How much does this business model cost to set up?
Risk: Will the participants in the business have personal liability for debts of the business?
Structure: Does the business model provide a clear organisational structure? Is this
flexible?
Formalities: Are there legal formalities that must be followed in running the business?
How flexible is this business model regarding formalities?
Privacy: To what extent is information about the business required to be publicly
disclosed?
Finance: How can the business raise capital?
1.5 Sole traders – Key characteristics
- No set up costs – there are no formalities, the sole trader can start trading straight away.
- A sole trader is not a separate legal entity – contracts are formed between the individual
themselves and third parties. - Unlimited personal liability – the sole trader’s personal assets such as their home and cars are
potentially liable to be sold to meet the debts of the business. - No formal structure - the individual can choose how they wish to run their business.
- No Companies House filing or procedural requirements for running the business.
- Complete privacy – no need for publicly filed accounts etc.
1.6 Partnerships – Key characteristics
- No set up costs – there are no formalities, the partnership can start trading straight away.
Partnerships can be formed without any formal agreement or even intention. See the next
page for more detail on formation of partnerships. - A partnership is not a separate legal entity. Contracts are formed between third parties and
the partners in the partnership as individuals. - Unlimited personal liability - partners have unlimited joint (in contract) or joint and several (in
tort) liability for the debts and obligations of the partnership incurred while they are partners.
This means that their personal assets such as their houses may need to be sold to meet the
debts of the business. - There are no Companies House filing or procedural requirements for running the business.
- Complete privacy – there is no requirement for publicly filed accounts etc.
- Partnerships are governed by the provisions of the Partnership Act 1890 (PA 1890).
1.7 Partnership - Formation
Partnerships can be created without any formalities. This is because s1(1) PA 1890 defines a
partnership as: ‘…the relation which subsists between persons carrying on a business in common
with a view to profit’
There does not need to be any intention to form a partnership – two or more people working
together with a view to profit automatically form a partnership.
Section 2 PA 1890 contains a list of rules for determining the existence of a partnership. Factors to consider include whether profits and/or losses are shared, whether a loan is made from one
partner to another, whether property is held jointly.
1.7.1 Does a partnership exist?
(Northern Sales (1963) Limited v Ministry of National Revenue (1973)
Case law has also held that if the person is not being ‘held out’ as a partner this makes the
existence of a partnership less likely. In Walker v Hirsch [1884] a clerk lent money to the
partnership, was paid a fixed salary and took 1/8th of the profits and of the losses, but was never
held out as a partner. No partnership was found to exist.
1.8 The terms of the partnership – PA 1890
- Section 24(1) Profits and losses: Partners are entitled to share equally in the profits of the
business, and must share equally in the losses of the business, even where the parties have
contributed to the capital unequally. - Section 24(6) Remuneration: Partners are not entitled to a salary.
- Section 24(8) Decision Making: Decisions arising during the ordinary course of the business
are decided by a majority, except for any change to the nature of the partnership business
which requires unanimity. - Section 25 Expulsion: A partner cannot be expelled by majority vote unless all of the partners
have previously expressly agreed that a majority can do this.
1.9 Partnership Agreements
The partners’ mutual rights and obligations can be varied at any time by their unanimous consent
(s 19 PA 1890). This means that partners can themselves draw up a partnership agreement setting
out how they wish their partnership to run. It is important in a modern partnership that partners seek legal advice and enter into a binding partnership agreement governing the terms of their relationship.
1.9 Partnership Agreements
- Profit sharing ratio
- Salaries
- Decision making – eg are certain partners able to make decisions on particular issues alone or
in small committees? - What happens when a partner leaves the partnership
- How new partners may be appointed and how partners may be removed
1.10 Limited Partnerships (LP) – Key characteristics
- A LP has two different types of partners:
- Limited partners who have limited liability. These limited partners must not be involved in
the management of the business (they are often called ‘sleeping partners’ eg passive investors). If they do become involved in management, they lose their limited status and
become general partners with unlimited personal liability. - General partners who run the business and have unlimited liability (as in a traditional
partnership). - LPs are governed by the Limited Partnership Act 1907 (as amended). LPs must be registered at
Companies House but have no requirement to file accounts. - LPs are not commonly used for general business but often used for investment vehicles. They are popular joint venture business structures where an investor (limited partner) puts money into a business run by the general partner.
1.11 Limited Liability Partnership (LLP) – Key characteristics
- LLPs were introduced by the Limited Liability Partnership Act 2000 (LLPA 2000).
- The key difference between LLPs and sole traders, partnerships or LPs is that an LLP has a separate legal personality – it can own property and enter into contracts on its own behalf. However, for tax purposes it is treated as a partnership and the members are taxed as partners, each being liable to pay tax on their shares of the income or gains of the LLP. This is
referred to as ‘tax transparency’. - Section 2(1)(a) LLPA 2000 states that two or more persons associated for carrying on a lawful business with a view to profit can incorporate an LLP. A ‘person’ in this context can be a
company as well as an individual. - All partners in an LLP have limited liability. Their liability to third parties is limited to the amount that they have agreed to pay under the terms of their partnership agreement.
- LLPs are registered at Companies House in the same way as companies and are required to file annual accounts and other information. LLPs are in effect a hybrid between a traditional partnership (with procedural flexibility) and a company (with limited liability). Many law and accountancy firms are LLPs
Organisational structure of an LLP
- Members share equally in capital and profits.
- An LLP must indemnify its members for payments made and personal liabilities incurred by
them in the ordinary and proper conduct of the business of the LLP. - Every member may take part in management but no member is entitled to remuneration for
managing the LLP. - No person can become a member or assign their membership without the consent of all existing members.
- Ordinary decision making may be by the majority of the members. Any proposed change to the nature of the business requires the consent of all the members.
- There is no implied power of expulsion of a member by the majority unless the members have
expressly provided for such a power in a Members’ Agreement.
1.12 Summary
- Key considerations in choosing a business model include costs, risk, structure, formalities, privacy and finance.
- Possible business models include the sole trader, partnership, limited partnership, limited liability partnership, private limited company and public limited company.
- Consider the key characteristics of sole traders, partnerships, limited partnerships and limited liability partnerships.
- Careful consideration should be given to the advantages and disadvantages of different models based on the features and requirements of the particular business. Clients will also
need to carefully consider financial issues of choosing a particular business model such as the tax implications.
- Introduction to companies
2.1 Companies – Key characteristics
- The key point is that a company is a separate legal entity – companies are distinct from their owners (known as shareholders or members). This means that the company owns property,
enters into contracts and can sue and be sued in its own name. Profits and losses belong to the company and not the shareholders and it is the company that is therefore liable for its own debts, not the shareholders. - Limited liability – the liability of shareholders is limited to the amount unpaid on their shares (if any). This protects shareholders and facilitates investment.
- Companies are governed by the Companies Act 2006 (which superseded the Companies Act
1985) which contains detailed requirements regulating how companies are run and the filings
and disclosures that must be made by all companies at Companies House. - However, these formal procedural requirements can be onerous, especially for small private companies where the shareholders and directors are often the same individuals.
2.2 Companies – Who’s who
Shareholders/ Members
- Owners of the company
- Invest money in return for shares and possibility of dividends
- Not involved in day-to-day management but usually have voting rights and control key decisions
Subscribers
*The name given to the first shareholders in a company who invest in the company when it is initially set up (incorporated)
Directors
- Officers / managers of the company
- Involved in day to day running of the company
- Collectively known as the Board
- In small private companies, directors are often also shareholders
Persons with Significant Control
Details of PSCs must be provided to Companies House. In general, PSCs
are shareholders with over 25% of shares.
Other stakeholders
Other stakeholders include anyone interested in the company, such as
employees, creditors etc
2.3 Companies Act 2006 (CA 2006)
CA 2006 is the key legislation governing companies in England and Wales. This statute replaced the Companies Act 1985 and brought about many changes in company law. The primary aim of
CA 2006 was to simplify the law for private companies:
- The removal of the requirement for private companies to hold Annual General Meetings or submit Annual Returns (this has been replaced with a simpler annual Confirmation Statement)
- Codification of directors’ duties so that directors of small private companies can more easily
understand their obligations - Allowing private companies to pass shareholder resolutions in writing, dispensing with the
requirement for meetings of shareholders (known as General Meetings)
2.4 Different types of company
Private Limited Company
Section 4(1) CA 2006 states that ‘a private company is any
company that is not a public company’. Private companies’ names end with the word ‘Limited’ or ‘Ltd’ (s 59(1)). The vast majority of
companies in England and Wales are private companies, and it is this type of company that this module focuses on.
Private companies limited by shares (Ltd)
Most common type of
company. No minimum share capital requirements. Prohibited from offering shares to the public
Can be formed by one person
Private companies limited by guarantee
No share capital
Liability of members is limited
to the amount that they
agreed to contribute in the
event of a winding up
Membership is not
transferable
These companies are
relatively rare
Unlimited companies
The liability of the members is
unlimited; These companies are rare
2.4.2 Public companies
Public limited company (plc): Section 4(2) CA 2006 states that a ‘public company is a company […] whose certificate of incorporation states that it is a public company. A public company’s name ends with the words ‘Public Limited Company’ or ‘plc’ (s 58(1)).
For practical purposes, the main difference between a public and a private company is that generally only public companies can offer their shares to the public, eg through public listing on a recognised stock exchange such as the London Stock Exchange, therefore permitting trading to take place in its shares.
Public companies are also subject to more onerous regulatory requirements (eg public companies are not able to pass shareholder resolutions by written resolution – you will explore this later in the module).
Public companies limited by shares
(plc)
Can offer their shares to the public
Need a minimum of two directors
Minimum share capital requirement of £50,000 (s 763 CA 2006)
Requires a trading certificate before it can trade (s 761 CA 2006)
Listed Companies
Only public companies can be listed.
Not all public companies are listed.
‘Listed’ means admitted on a regulated investment exchange such as the London Stock Exchange
2.5 Reasons to list a company
To enable a company to raise greater funds by offering shares to the public at large, a private
company’s shareholders may decide to convert the company into a public limited company (plc).
After converting to plc status, a company may seek a listing of its shares on a stock exchange.
Companies whose shares are listed on the London Stock Exchange are known as ‘listed companies’ (but note that it is not the company that is listed, but its shares). You should not therefore assume that a company whose name ends in ‘plc’ is a listed company.
2.6 Principal differences between a private and a public company
2.6.1 Name
As already mentioned, the name of a private company will end in ‘Limited’ or ‘Ltd’ and the name
of a public company will end in ‘Public Limited Company’ or ‘plc’.
2.6.2 Share capital
There is no requirement for a private company to have any specified minimum amount of share
capital. A private company could be incorporated with just one share of 1p. In practice many companies are incorporated with a share capital of £1, that is with one share that has a nominal value of £1. A public company must have a share capital with a nominal value of at least £50,000 (or the euro equivalent), of which at least one quarter must be paid up (this means paid at the time of purchase) (s 586 and s 763 CA 2006).
2.6.3 Number of directors
A private company need only have one director, and a public company must have a minimum of two directors (s 154 CA 2006).
2.6.4 Company Secretary
A private company may choose to have a company secretary but it is not obliged to have one (s
270(1) CA 2006). If a private company does not have a company secretary, the directors (or any
person the directors authorise) may do anything that the secretary is required or authorised to do
(s 270(3)(b) CA 2006).
A public company must have a company secretary (s 271 CA 2006), and the person appointed to
that post must have the requisite knowledge and experience and hold one of the qualifications
specified in s 273(2) CA 2006.
2.6.5 Annual general-meetings
A public company is required to have one annual general meeting (AGM) each year (s 336 CA
2006). Private companies are no longer required to hold an AGM, although they may do so if they
wish. An AGM provides members who are not directors with an opportunity to question directors,
particularly on the issue of a company’s finances.
2.6.6 Regulation
Public companies are potentially able to offer their shares to the public. For this reason they are
subject to a higher level of regulation than private companies. As well as the requirements of the
CA 2006, further legislation governs public companies.
2.8 Summary
- In this element you have looked at the features of private limited companies, public limited
companies and listed companies. - Private limited companies are the most popular business model. A key advantage of this business model is limited liability. You will learn more about this as you progress through the module.
- The majority of companies in England and Wales are private limited companies.
- Public limited companies are able to offer shares to the public and can also seek a listing of their shares on a recognised stock exchange. They have more stringent regulatory
requirements than private companies. - Listed companies are a small subset of public limited companies, being those that have their
shares listed on a recognised stock exchange.
- The company’s constitution
3.1 Constitutional documents
CA 2006 came into force on 1 October 2009. Prior to this, companies were governed by the
principles of the Companies Act 1985 (CA 1985). In practice you will deal with many companies
incorporated prior to CA 2006 therefore it is important to understand some of the provisions of CA 1985 which still affect those companies.
CA 1985 required companies to have two constitutional documents: the Articles of Association
and the Memorandum
The Memorandum
Under s 17 CA 2006 the memorandum no longer forms part of the company’s constitution - it is
only required as part of the procedure to register a company at Companies House. The memorandum of a company incorporated under CA 2006 simply amounts to a declaration on the
part of the company’s subscribers ie that the first members of the company wish to form a
company and agree to become members of that company (s 8 CA 2006).
3.2 Memorandum
Companies could set out constitutional restrictions in
their memorandum and were required to include an objects clause setting out the purposes for
which the company has been formed. Acting outside of this purpose was described as acting
ultra vires or outside the company’s capacity.
3.2 Memorandum
Companies formed under CA 2006 have unrestricted objects (s 31 CA 2006) unless the objects are specifically restricted in the company’s Articles. So the ultra vires rule is not applicable to a
2006 Act company unless it has chosen to insert an objects clause into its Articles. You will learn
more about this in the next Topic.
3.2 Memorandum
For older companies that were incorporated under the CA 1985, s 28 CA 2006 provides that any
provisions in a memorandum must be treated as provisions of the company’s Articles. This includes the objects clauses included in the memoranda of all CA 1985-incorporated companies.
Under CA 2006, therefore, the objects clause of an older company continues in force, operating
as a limitation on that company’s capacity unless and until the Articles of that company are
amended to remove its objects clause.
3.3 Articles of association
All companies must have articles of association (Articles) (s 18 CA 2006). Under CA 2006, the Articles form the main constitutional document of a company. The purpose of the Articles is to regulate the relationship between the shareholders, the directors and the company.
Types of provisions which are included in the Articles of the Company
- The number of directors required to transact business (both to form a quorum at board
meetings and to take decisions at board meetings); - The method of appointment of directors;
- The powers of directors;
- How board meetings are to be conducted;
- Any special rights attaching to shares;
- How shareholder meetings are to be conducted; and
- How and to whom shareholders may transfer their shares.
3.3.1 Relationship between CA 2006 and the Articles (The Legality Test)
A company’s Articles must be interpreted in the light of relevant legislation. There is considerable
scope for overlap between the procedures set out in CA 2006 and those that may also be contained in the company’s Articles.
The Articles must comply with the minimum provisions of CA 2006 (this is known as the Legality Test). A company may in certain circumstances provide a procedure in its Articles which is more onerous than that contained in CA 2006.
Three choices as to the form of its Articles:
(a) Model Articles (MA)/Table A
The Secretary of State has prescribed MA for different types of company (under s 19 CA
2006). If a new company does not register Articles at Companies House, s 20(1) CA 2006
provides that the relevant MA will constitute the company’s Articles in default.
(b) Amended MA: Not all of the provisions contained in the MA are suitable for all companies. Many companies therefore choose to adopt the MA as their Articles, but elect to exclude, or modify the effect
of, some of its provisions.
(c) Tailor made Articles
The third option available to a client is to instruct a solicitor to draft Articles which are tailormade for the particular company concerned. Law firms often have a precedent form of Articles that can be adapted for this purpose.
However, generally this is a very timeconsuming process and therefore costly for the client, although the end product can often be more useful to them in the long run. Most small companies will prefer to adopt MA, subject to
certain amendments.
3.4 Amending the Articles
Once a company has adopted Articles, it is able to alter them at any future date by special
resolution (s 21(1) CA 2006). A special resolution is a decision of the shareholders. You will consider
the different types of shareholder resolutions later in this module. Entrenched Articles can nevertheless always be amended by the agreement of all of the members, or by a court order (s 22(3) CA 2006).
There is a great deal of case law relating to the alteration of a company’s Articles. The basic rule
is that, to be valid, any alteration must be made bona fide in the interests of the company as a
whole (Allen v Gold Reefs [1900] 1 Ch 656). In Shuttleworth v Cox [1927] 2 KB 9 the court held that an amendment to the Articles is not valid if no reasonable man could consider it to be for the benefit of the company.
Sidebottom v Kershaw, Leese & Co Ltd [1920] 1 Ch 154 (Court of
Appeal)
The defendant company had altered its articles by introducing a provision which gave the directors power to buy out, at a fair price, the shareholding of any member who competed with the company’s business. The plaintiffs, who were minority shareholders and who carried on a competing business, unsuccessfully challenged the validity of the alteration. The Court of Appeal found that the alteration was initiated in good faith and bona fide in the interests of the company
and therefore allowed this to stand to protect the company.
Key case: Re Charterhouse Capital Ltd [2015] EWCA Civ 536 (Court of Appeal)
The amendment of a company’s articles to permit the shares of a minority shareholder to be
compulsorily acquired under a takeover offer was held to be valid as it was consistent with the
terms of a shareholders’ agreement. It was not open to challenge on other grounds such as unfair
prejudice.
The Court of Appeal held that the amendment was no more than a ‘tidying up exercise’ which had been consistent with the initial bargain of the founding members, which included the appellant himself. In the absence of any finding of bad faith, improper motive or irrationality, there was no basis for the challenge to the validity of the amendment.
3.5 Legal effect of the Articles
The nature of the contract established by the Articles of a company is set out in s 33(1) CA 2006, which provides that the provisions in the company’s Articles bind the company and its members to the same extent as if there were covenants on the part of the company and each member to
observe those provisions.
Predecessor to s 33(1) CA 2006
The predecessor to s 33(1) CA 2006 (namely s 14 CA 1985) has been the subject of a large amount
of case law. The generally established rule is that the Articles evidence a contract between the
company and its members in their capacity as members and with respect to their rights and
obligations as members (Hickman v Kent or Romney Marsh Sheep-Breeders’ Association [1915] 1
Ch 881 (Ch)).
