If you’ve decided to start a business, you’re probably aware that there are different types of companies. Common companies include a Limited Liability Company, a sole proprietorship or a partnership. Limited liability companies are by far the most common, but it can be important to explore why you would opt for the others. This article will briefly walk you through what you need to know about sole proprietorships.
A sole proprietorship is effectively a legal right to use another name. It is the formalization of an individual as a business. The owner and the business are considered to be the same entity with different names. So why would an entrepreneur start a business that is an extension of themselves?
Potential Reasons to not start Sole Proprietorships
The primary reason why most people don’t start sole proprietorships is that you become responsible for all the business’ debt. Businesses almost always need debt to grow as it’s more cost-effective than investment, but in a limited liability company, the responsibility that people have for their debts are limited.
This means that if the business declares bankruptcy, the investors lose their money, but that’s it. If a business has 10 million dollars’ worth of debt, but only 10 thousand dollars have been invested into the company (an unlikely situation but useful for the example), the only money that the business owners lose is that 10 thousand dollars. Their liability stops there, which is why the company is called a limited liability company.
In sole proprietorships, all liability falls on the owners. This puts owners in a precarious situation, even if they don’t have a bad cash to debt balance. This puts the business owners at risk to market events — for example, if you own a store that sells gold jewelery, and one day the price of gold plummets, you may lose money for a short period as your entire stock devalues.
If you can’t pay the bills one month, you may take out debt to help you recover. If the price of gold crashes even more, or if you get a hike in specific expenses and you can’t pay off your debt by the agreed contractual date, you may return home to find the bank writing you a letter to tell you your home is foreclosed. You could fight this in court, but the stakes are much higher than with a limited liability company.
Potential Reasons for Sole Proprietorships
There are some reasons people opt for sole proprietorships, however. Here are some of them:
- You don’t have to answer to anybody – your company consists of just you and you don’t have to worry about shareholders (and never have to deal with deadlock), partners or anybody else. The only person that can control your company is yourself. You get to be your own boss.
- The business is small and stable – businesses that are small and stable, unlikely to be impacted by market events, suit sole proprietorships best. However, as the recent global crisis has revealed, even businesses that seem immune to market events like affordable neighbourhood restaurants can be impacted by unprecedented forces and rely on state/federal help.
- The business owner keeps al the profit – if you own a sole proprietorship, you don’t need to worry about dividend payments to shareholders; you get to keep all the money you make after tax and can pay yourself without the restrictions that are imposed on Limited liability companies in the form of dividend regulations.
- Freedom – a sole proprietorship is free to do anything it wants as long as it falls within the boundaries of the law and keeps making money (and even if it doesn’t, providing you have deep pockets). This means you are free to pivot if you want to, and it means you can make political statements and decisions without worrying about shareholders pulling investment from the business.
- You don’t need to report your accounts – with a sole proprietorship, you don’t need to prepare an annual report to show shareholders, you don’t need to prepare for external audits of your business accounts (though the IRS can still audit you personally) and you don’t have any obligation to report your earnings to anybody. You enjoy a level of business privacy that few can contest.
- If things aren’t going well, you can just shut down without the litany of liquidation paperwork and legal holes to jump though. You can just cease to operate.
There are distinct pros and cons to starting a sole proprietorship, but in general, they suit small businesses where the business owner is self-employed and has a community role. A small barbershop is a perfect example of a business that leverages a community role to protect against market shocks.
Check out my guide on how to start your business right with tons of useful tips I learned by successfully starting, building, and selling multiple companies.