By Harry Dronfield & Sunad Joshi
Posted: 2nd September 2015 10:47Choosing the wrong company – the risks
There are several types of companies which can exist and it is crucial to ensure that the company you form is suitable to the business needs of organisation you intend to run. The consequences of overlooking this can be costly and time consuming. For example we recently assisted a nursery school which (prior to instructing us) had incorrectly incorporated as a private limited company (a company with shareholders). The nursery school was charged substantial business rates as a company with share capital and as a result of setting up a private limited company it was unable to claim charitable rate relief which would entitle it to up to 80% relief.
To avoid this liability in the future, we assisted the nursery school in setting up a new company, this time limited by guarantee. We then applied for and obtained charitable status for the new company. However, the “old” company remained liable for a debt to the council and the process of transferring the assets from the old company to the charitable company was costly and far from straightforward. The situation would have been avoided altogether had the nursery school correctly formed as a company limited by guarantee at the outset.
Choosing the right company
Before forming a company, you should consider the purpose or business of the company. If you are running a not-for-profit organisation, and intend to obtain charitable status for the company, you will generally be required to form a company limited by guarantee. On the other hand, if you intend to trade for profit, you may form a company with share capital and limited (a “private limited company”) or unlimited liability. If you want to offer shares in your company to the public, you may form a public limited company.
Owners (otherwise known as members, shareholders or subscribers) in limited companies are protected to a certain extent as they have limited liability. That is one of the main attractions to forming a company as opposed to running a business as a sole trader or in partnership, or managing an club or society as an unincorporated association.
The rules which apply to the governance of a company are set out in the company’s Articles of Association (the “Articles”). “Model Articles” are available for private limited companies and companies limited by guarantee. The former are suitable for most simple trading companies. The latter are suitable for organisations where there is no requirement to distribute profit. Nevertheless, certain companies will benefit from bespoke Articles, which ensure that shareholders’ rights and obligations are aligned with the company’s objectives. Simply put, the Articles form a contract between each of the shareholders and the company.
Several case studies below illustrate where the company formed, and its Articles, are bespoke to the purpose and function of the company.
The Property Developer
James is a property developer. He wants to obtain investment from individuals to raise funds to purchase and redevelop a property. He decides to form a company with the specific purpose of purchasing the property (i.e. a “Specific Purpose Vehicle” or “SPV”). The most suitable company for an SPV is a private limited company. James will grant shares to the investors in proportion to their investment. The SPV therefore owns the property and James and the investors own the shares.
It is important to use the correct form of Articles for an SPV. For example:
(a) the Articles would ensure that all shareholders are required to consent to the sale of any assets of the company i.e. the property;
(b) the investors may each want the right to appoint a director; and
(c) the investors may wish to reserve certain decision making powers to themselves.
The Amateur Sports Club
Archna is the chair of her local swimming club which her children aged five and eight attend for lessons. The club is run by a committee and is an unincorporated association with a set of rules called a constitution. The committee decide, due to their exposure for any unforeseen liabilities of the club, to form a company. The club has obtained Community Amateur Sports Club (“CASC”) status which gives them certain tax advantages.
The correct form of company would be a company limited by guarantee. This gives the committee and all members of the club protection in the event that a claim is made against the club. The club, once the company is formed, will need to apply for CASC status for the company itself and HMRC will assess the company’s Articles to ensure they meet the criteria.
It is crucial that the Articles are drafted to meet this criteria which includes:
- having clear objectives of promoting and facilitating the participation in the sport of swimming;
- a requirement to use the income of the company solely to achieve the objects of the club and not to distribute the income to any members;
- confirmation that membership is open to all without discrimination and the level of fees payable by members must not preclude open membership; and
- a procedure for the distribution of the assets of the club on the dissolution of the company to confirm that the funds are transferred to another charitable institution for the furtherance of swimming.
The Freehold Property
Hannah, Robert, Ashraf and Susan (the “leaseholders”) each own the leasehold to flats in a converted house, 10 Village Green Grove. John owns the freehold. The leaseholders decide that they want to purchase the freehold from John and form a company for the purposes of holding the freehold interest.
The leaseholders could either form a company limited by guarantee or a company limited by shares. The leaseholders choose to form a company limited by guarantee due to the relative ease of releasing the guarantee when a flat is sold compared with the transfer of a share.
The Articles should ensure that the members of the company are the existing leaseholders, and that there is a mechanism for terminating their membership if they are no longer a leaseholder. The Articles should also include a provision confirming that each leaseholder can appoint a director to the company to ensure that each of their interests are recorded.
The recruitment consultancy
Sandra and Timothy own and run a recruitment consultancy specialising in placing candidates in the finance industry. The business is growing rapidly and as part of their plans to grow, they employ Raj. They wish to give Raj a 5% share of the business on the following conditions:
a) they do not want him to receive the benefit of these shares if he leaves his employment with the business and goes to work for a competitor;
b) they do not want him to be able to sell his shares to a third party; and
c) they want to limit the input Raj can have in relation to making important decisions about the business.
As the business grows, they are also increasingly aware of their potential personal liability for matters relating to the business.
The most suitable structure would be a private company limited by shares which limits Sandra and Timothy’s liability. They can grant shares equivalent to 5% of the total shareholding to Raj, and retain the balance equally. The shares they issue to Raj can be a different class of shares, which do not entitle him to vote as a member of the company.
When forming the company, it is important to set out the existence of the different classes of shares and the particulars of how the classes differ on the Form IN01. It is also crucial to record the nature and rights attaching to the shares in the Articles. The Articles should contain “leaver” provisions, which ensure that if Raj leaves his employment, he does not receive the full “market” value of the shares. The circumstances where Raj is considered to be a “good” or “bad” leaver should be clearly defined and the consequences of his leaving in either scenario must be clearly set out.
The Articles should contain detailed provisions precluding Raj from selling his shares to a third party without first offering his shares to Sandra and Timothy (pre-emption rights). This ensures that the shares in the company remain held by Sandra or Timothy or persons they are willing to allow to become shareholders.
The above sets out examples of where clients benefit from forming companies suited to their business or organisation with bespoke rules.
Harry Dronfield, Associate Solicitor at Rollingsons Solicitors. Harry specialises in Company and Commercial Law and represents mainly London-based SMEs. He is experienced in assisting businesses at their inception and during their growth. His passion is getting to know and understand his client’s business and providing clear, specialist and commercial advice and assistance.
Sunad Joshi, Assistant Solicitor at Rollingsons Solicitors. Sunad specialises in Company and Commercial Law with a focus on Intellectual Property issues which effect businesses. He prides himself on finding practical and commercial solutions to his clients’ legal problems.