Chapter 1: Introduction to Business Law & Practice Flashcards
1 Different legal forms of business
1.1 Introduction to 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.
The business models that you
will need to understand for the SQE are:
- Sole trader
- Partnership
- Limited partnership
- Limited liability partnership (LLP)
- Private and unlisted public companies
The business models that you
will need to understand for the SQE are:
We will consider the following features of each of these business models: costs, risk, structure,
formalities, privacy and finance.
You will learn about the taxation of the different business models in the next section which might
be a consideration for your client when deciding which model is best.
1.1.1 Why businesses are set up
It might be useful background to consider why businesses are set up before we explore the different ways in which they may be set up.
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.
1.1.2 Why do businesses need to raise finance?
It might also be helpful to consider why businesses need to raise finance and how they can raise finance to understand the considerations to be taken into account about which business model might be the best one to choose.
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
lawyers; 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.
1.1.3 How do 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;
* The business may borrow money, for instance, from a bank; and
* 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.
1.2 Business model overview
There are several basic ways in which businesses can be structured. The business model can be
unincorporated and incorporated.
Unincorporated businesses are those run in the main by individuals rather than through a separate legal entity who have full personal liability for the liabilities of the business such as sole traders and partnerships.
1.2 Business model overview
Incorporated businesses exist as legal entities separate from their owners who enjoy limited liability in respect of the debts that are owed by the incorporated business. Perhaps the most widely used are limited companies. We will look at the key considerations for a client when choosing an appropriate business model and apply these to the most common of business models looking at their key features
1.2.1 Factors influencing the choice of business model
As there are several structures within which it is possible to operate a business. It is therefore
important to be able to recognise some of the factors which may affect your client’s choice and these are set out here in overview and will be explored in further detail in later sections and chapters.
Set-up costs and formalities
There may not be any upfront cost in setting up in business as a sole trader or partnership, since
there are no formal incorporation requirements. There may be costs of incurring legal advice and in the case of a partnership seeking advice on the terms of a partnership agreement. There are, however, costs involved in incorporating a company or LLP, and these will be increased by the associated legal fees.
The Economic Crime and Corporate Transparency Bill (ECCTB),
The Economic Crime and Corporate Transparency Bill (ECCTB), which is aimed at preventing abuse of UK corporate structures and addressing economic crime, will impact upon set up (and ongoing costs) for incorporated businesses.
Some of the relevant provisions are set out below:
- It will introduce identity verification requirements for new and existing registered company directors, people with significant control and those delivering documents to the Registrar of Companies (Registrar) such as company secretaries and authorised corporate service
providers such as accountants and legal advisers.
More active gatekeeper
It proposes to give the Registrar wider powers to allow it to become a more active gatekeeper over company creation and a custodian of more reliable data. This includes powers to verify and decline information submitted or already on the register.
Improve financial information
It will also improve financial information in respect of accounts and reports on the register, so it
is more reliable and accurate enabling better business decisions to be made.
Greater protection
It will give greater protection to some personal information provided to Companies House to
limit fraud.
Amendments to current provisions
There will be amendments to the current provisions on company names, the registered office
and members to improve transparency and a requirement to maintain a registered email
address.
Tighten provisions
It will tighten the provisions surrounding limited partnerships.
Ongoing costs
Due to the principle of limited liability (see below), companies (and, to a lesser extent, LLPs) are
subject to greater regulation and disclosure requirements than either sole traders or partnerships.
This increased level of regulation adds to the administrative cost of running a company and an
LLP.
Liability on insolvency
Partners’ and sole traders’ personal assets are at risk if the business loses money or becomes insolvent. Shareholders of limited companies or members of LLPs, however, will only be liable to mcontribute the amount unpaid, if any, on their share capital or capital contribution respectively. Lenders often try to circumvent this principle of limited liability by seeking personal guarantees from shareholders, directors of a company or members of an LLP.
Tradition
Many types of professional businesses, eg architects, accountants and law firms, are traditionally operated as partnerships. This may too influence the client’s choice of business medium.
Raising finance
If loans are being used to raise finance many lenders (often banks) may prefer to lend to companies and LLPs rather than to a sole trader or partnership. This is because a company (and to a lesser extent an LLP) is subject to a higher degree of regulation and disclosure, and therefore the lender may feel comfortable that it has full information against which to measure the risk it is undertaking in lending to a company
Raising finance
You will see that directors of companies also owe duties to
the company and creditors which you will look at in later chapters. In addition, companies and
LLPs are usually able to offer more forms of security for borrowing than individuals or partnerships.
Companies also have more flexibility in raising finance as they usually have the ability to sell shares to investors in addition to through obtaining loans from lenders.
You will consider how companies can obtain finance in more detail in later chapters.
Risk
When establishing a business, it is necessary, from the outset, to appreciate the concept of commercial risk. ‘Risk’ refers to the likelihood of things going wrong.
The role of a lawyer includes advising your client on how to operate its business within the law: ie. to inform it of what is and what is not permitted. An equally important aspect of your role is to help your client address and minimise commercial risk with legal solutions. To do this, it is necessary to understand the risks that clients face in given situations.
Risk
In business, clients constantly face choices as to whether or not to take a given commercial risk. It is necessary for a lawyer to understand the risks, to help a client spot them and to identify the possible liabilities that could confront the client if it fails to address the risks adequately. A client will almost always want to know:
* What the main elements of risk in the current proposed course of action are;
* What the consequences if things do go wrong (ie the potential liabilities) are; and
* What strategies can be employed to reduce or minimise these risks and potential liabilities.
Tax
When choosing the appropriate business structure or model, another key consideration will be how much tax will be payable on the profits of the business. The way in which the profits of a business are taxed depends to a large extent on its business medium, and many clients will want to obtain advice on the potential tax consequences of
operating via different business models when deciding on a business structure
Complex, specialist area
This is a complex, specialist area and as a commercial lawyer you will need an awareness of how tax will impact your client’s choice of business structure, but you will almost certainly seek specialist advice from tax lawyers and accountants. An overview of tax in respect of different business models is dealt with in the next section and more detail about calculating tax for
individuals and companies is set out in later chapters.
Summary
The key considerations when forming a business are:
* Costs: 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?
Summary
Privacy: To what extent is information about the business required to be publicly disclosed?
* Finance: How can the business raise capital?
* Tax: How is this business model taxed? This will be considered in more detail in the next section.
Having set out the considerations to be taken into account when setting up a new business we will now give an introductory overview of the different types of business model that a business can be operated through setting out and summarising their key characteristics. You will look at some of these business models (partnerships, LLPs and companies) in more detail in later chapters.
1.2.2 Sole traders: Key characteristics
- Costs: There are no set up costs –the sole trader can start trading straight away as there are
no formalities to comply with. - Risk: The sole trader has unlimited personal liability meaning 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. - Structure: There is no formal structure required - the individual can choose how they wish to
run their business. A sole trader is not a separate legal entity.
1.2.2 Sole traders: Key characteristics
- Formalities: There are no Companies House filing or procedural requirements for running the business.
- Privacy: There is complete privacy with no need for publicly filed accounts, etc.
- Finance: There is a personal capital injection of cash by the sole trader. Contracts are formed between the individual themselves and third parties, so an individual can take out a personal loan.
1.2.3 Partnership: Formation
Partnerships can be created without any formalities. This is because s1(1) Partnership Act 1890 (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.
1.2.3 Partnership: Formation
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. Evidence of profit sharing will be prima facie evidence of a partnership but not necessarily conclusive evidence. A loan of money by one party to another does not of itself create a partnership.
Does a partnership exist?
No one factor alone will suffice to create a partnership – it is necessary in all cases to consider all the facts. Some examples from the case law follow. If there is an agreement to share losses as well as profits, this makes the existence of a partnership more likely (Northern Sales (1963) Limited v Ministry of National Revenue (1973)).
Does a partnership exist?
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.
The terms of the partnership – PA 1890
Can be formed without formalities
Although a partnership can be formed without any required formalities, it is advisable to have a
partnership agreement drawn up by a solicitor as otherwise the partnership will be governed by
the default provisions of the PA 1890. These include the following:
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. There should therefore be an express provision in the
agreement setting out a profit sharing ratio, otherwise both profits and losses are shared equally.
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 of the partners can do this.
Partnership agreements
Varied by unanimous consent
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
Partnership agreements
Partners will wish to vary the default provisions of PA 1890 as these are not suitable for a modern business. Typically, a partnership agreement will deal with the following key
principles as well as other more practical details:
* 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
Partnerships: Key characteristics
Cost
- Costs: There are no set up costs as there are no formalities. The partnership can start trading
straight away. Partnerships can be formed without any formal agreement or even intention
although it might be advisable for certainty to have a partnership agreement drafted which
may incur costs and take time to agree.
Risk
Risk: Generally 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. For tax purposes each partner is liable to pay tax on their share of the income or gains of the LLP
Structure, Formalities & Privacy
Structure: A partnership is not a separate legal entity.
* Formalities: There are no Companies House filing or procedural requirements for running the business.
* Privacy : There is complete privacy. There is no requirement for publicly filed accounts etc.
Finance
Finance: Contracts are formed between third parties and the partners in the partnership as
individuals. Individual partners can take out personal loans or inject their own cash into the
partnership
Limited Partnerships
Limited partnerships (LP) are quite rare but included here for completeness. An 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). There must be at least one limited partner and one general partner.
The Limited Partnership Act
LPs are governed by the Limited Partnership Act 1907 (as amended). LPs must be registered at Companies House but there is no requirement to file accounts at the moment.
Investment Vehicles
LPs are not commonly used for general business but often used for investment vehicles. They are
popular joint venture business structures where an investor (the limited partner) puts money into a
business run by the general partner.
Investment Vehicles
Note that on 6 April 2017 a new sub-category of limited partnership called a private fund limited partnership was created. These are now commonly used for investment vehicles and will be subject to greater scrutiny as a result of the ECCTB provisions which are aimed at tackling the misuse of limited partnerships through strengthening
transparency and disclosure requirements and enabling them to be deregistered.’ after ‘investment vehicles’
1.2.5 Limited liability partnership (LLP)
- 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’.
Two or more associated persons
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 members have limited liability
All members (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 or membership agreement.
Registration at Companies House
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
The organisational structure of an LLP is very flexible and should be decided between the
members in a formal written partnership or members’ agreement. In the absence of any such
agreement Regulations 7 and 8 of the Limited Liability Partnerships Regulations 2001 (SI
2001/1090) contain default provisions as follows:
Contain default provisions
- 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
Contain default provisions
- 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.
LLPs: Key characteristics:
- Costs: Costs are involved in setting up an LLP including legal fees.
- Risk: All members 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. Many law and accountancy firms are LLPs. For tax purposes it is treated as a partnership or membership so each member is liable to pay tax on their share of the income or gains of the
LLP.
LLPs: Key characteristics:
Structure: An LLP has a separate legal personality and can own property and enter into contracts on its own behalf. In effect it is a hybrid of a traditional partnership and a company. The organisational structure of an LLP is flexible and should be decided between the members in a formal written members’ agreement. In the absence of such an agreement
Regulations 7 and 8 of the Limited Liability Partnerships Regulations 2001 will apply.
Formalities, Privacy, Finance
Formalities: There is a requirement to be registered at Companies House.
* Privacy : LLPs are required to file annual accounts and other information.
* Finance: As it is a separate legal entity, an LLP can borrow in its own name. It can also create floating charges, which are a particular type of security favoured by banks on lending.
Formalities, Privacy, Finance
- Formalities: There is a requirement to be registered at Companies House.
- Privacy : LLPs are required to file annual accounts and other information.
- Finance: As it is a separate legal entity, an LLP can borrow in its own name. It can also create
floating charges, which are a particular type of security favoured by banks on lending.
1.2.6 Companies
Companies are the most popular business model in England and Wales. There were over 4.5
million private limited companies registered with Companies House in 2023. We will consider what
makes companies such a popular business model in later sections and chapters but in the meantime, here is an introductory overview of the basics in respect of companies.
Companies Act 2006 (CA 2006)
The CA 2006 is the key legislation governing companies in England and Wales. This statute replaced the Companies Act 1985 (CA 1985) and brought about many changes in company law. The primary aim of CA 2006 was to simplify the law for private companies. Key changes made include:
Companies Act 2006 (CA 2006)
- The removal of the requirement for private companies to hold Annual General Meetings
- 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)
You will learn more about the requirements of CA 2006 as you progress through these materials.
Constitutional documents
CA 2006 came into force on 1 October 2009. Prior to this, companies were governed by the
principles of the 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.
Constitutional documents
CA 1985 required companies to have two constitutional documents: the Articles of Association
(Articles) and 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)
Formation of a company
A client wishing to start a business through the medium of a company can either incorporate a new company from scratch or purchase and then convert an existing shelf company to conduct its business.
1.2.7 An overview of who’s who in a company
Shareholders (also known as 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 (ie 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.
1.2.8 Shareholders
The owners of a company are its shareholders, otherwise known as its members. Shareholders
invest money (share capital) in the company in return for a share in the ownership of the
company, evidenced by a share certificate. Shareholders’ rights such as voting rights and rights
to a dividend are set out in the Articles (and sometimes also in a shareholders’ agreement. You will
learn more about shareholder agreements later in theses materials).
Beginning of membership
Membership begins when the member’s name is entered in the company’s register of members (s
112(2) CA 2006). The first shareholders of the company are its subscribers under s 8 – so called as
they subscribe to the company’s memorandum of association
Shareholder does not have to be human
A shareholder need not be a human being. A company has a separate legal identity and can,
amongst other things, own property in its own name. A company can therefore own shares in
another company. Where company A owns all the shares in company B, company B will be a
wholly owned subsidiary of company A. If company A owns some, but not all, of the shares in
company B, company B may still be a subsidiary of company A but not a wholly owned
subsidiary. Section 1159 CA 2006 gives the definition of a subsidiary.
Wholly owned subsidiary
A Ltd owns all the shares in B Ltd. A Ltd is therefore described (for certain company law purposes)
as B Ltd’s ‘parent’ or ‘holding’ company. In turn, B Ltd is A Ltd’s (wholly owned) ‘subsidiary’
Forming a group of companies
A Ltd and B Ltd together form a ‘group’ of companies. There is no limit on the number of
companies that can form a group, which means, therefore, that subsidiary companies may have
their own subsidiaries too. This means that B Ltd could have its own subsidiary (eg C Ltd). In
addition, there is no limit on the number of subsidiaries that a company may have, so it would be
possible for either A Ltd or B Ltd to have more than one subsidiary. Group structures are
frequently used to isolate risk and/or mitigate tax liabilities.
1.2.9 Shares
A share is often described as a ‘bundle of rights’. By investing in the share capital of any company, the investor (shareholder or member) becomes a part owner of the company and will often have voting rights in shareholder meetings.
Several different classes of shares
There are several different classes of share that a company may issue to its shareholders. Different classes of shares may carry different rights and entitlements. All rights and entitlements in relation to shares of all classes are set out in the company’s Articles
Most common type = ordinary share
The most common type of
share is known as an ordinary share. An ordinary share will usually entitle its holder to vote at shareholder meetings and to receive a share of the profits and surplus assets of a company after it is wound up (if there are any).
Nominal or par value
Shares in a limited company having a share capital must have a fixed nominal value. Common
nominal values for ordinary shares are 1p, 5p or £1. The nominal (or ‘par’) value of a share is
the minimum subscription price for that share. It represents a unit of ownership rather than the
actual value of the share.
Premium share
A share may not be allotted/issued by a company at a discount to its nominal value. A share
may however be allotted/issued for more than its nominal value, and the excess over nominal
value is known as the ‘premium’. The market value of a share (ie the amount at which a share
may be traded between shareholders) will often be much higher than the nominal value of the
share.
