This is a common and important question for those potential entrepreneurs who are rather unfamiliar with legal aspects of business entities and their consequences. There have been many responses to this question but here we take a growth/risk/cost perspective to answer it. In another article, we explain some legitimacy challenges to grow a business so you might want to have a look there for non-legal growth barriers. There are numerous legal business entities but here we focus on the most important ones: sole proprietorship, limited partnership and unlimited partnership. As Klapper et al. mention in their 2011 article, Joint Stock Companies are more rigid and usually associated with bigger businesses and hence not suitable for creating a new venture.
Lets first define these entities:
According to Wikipedia “A limited partnership (LP) is a form of partnership similar to a general partnership, except that where a general partnership must have at least two general partners (GPs), a limited partnership must have at least one GP and at least one limited partner.” Limited partnership and general partnership have similar structure so it is similar to partners in a conventional firm like having the management control and sharing the profit. As in a general partnership, the GPs have actual authority, as agents of the firm, to bind the partnership in contracts with third parties that are in the ordinary course of the partnership’s business.
The important aspect of limited partnership is having limited liability like shareholders in a corporation. This means that the limited partners have no management authority, and (unless they obligate themselves by a separate contract such as a guaranty) are not liable for the debts of the partnership.
According to Wikipedia “A sole proprietorship, also known as the sole trader or simply a proprietorship, is a type of business entity that is owned and run by one natural person and in which there is no legal distinction between the owner and the business. The owner is in direct control of all elements and is legally accountable for the finances of such business and this may include debts, loans, loss, etc.” So the owner received directly all the profit and pays no corporate tax. On the other hand, the owner is the sole responsible person for all losses and debts.
From the definition some differences like liability are already clear. Liability is an important aspect to consider because if you have much too debt and fully liable, authorities can come and take your own property. So you have to be vary careful on this point. One difference is that although sole proprietorship does not pay corporate tax, if the business grows above certain income (150 – 200 thousand Euros in the Netherlands; similar levels in the US or elsewhere), the total paid tax would be much more than an incorporation. So if you intend to grow a business it would be better to think of limited partnership.
This point brings us to another difference. To investors and outside stakeholders, a partnership signals growth ambitions of business owners. Basically, limited partnership, in terms of administrative set-up, is much more potent for growth compared to sole proprietorship. This is in terms of ability to hire, tax report and distinguishing between the person and the business. So the business can basically own, buy and sell properties and grow its domain. One advantage of sole proprietorship is its flexibility and easiness to start and run a nascent venture. It is also less costly to set up as well as less administrative costs compared to limited partnerships.
One last point is that, in many countries like the Netherlands, it is possible to switch from sole proprietorship to limited partnership further down the road. It is often not so difficult to switch so you can rest assured that the legal entity is NOT a permanent and unchangeable decision.
Governments made it increasingly easy and less costly to register a company in order to stimulate formal entrepreneurship. Governments also have dramatically reduced (or reducing) the start-up capital needed to register a limited partnership.
In sum, our verdict is that limited liability partnership has several advantages in spite of being more costly and more paper-work. At the end of the day, in an increasing number of countries, there is no risk to start sole proprietorship and change the business entity with little costs to limited partnership if your business really started to take off.