David Montegriffo, a Senior Associate at Hassans, brings you a series of articles which aims to help anyone who is looking to establish or grow their business in Gibraltar.
Over the next six weeks, The Hassans’ Entrepreneurship Series will look at:
Week 1: Business Structure – Limited Liability vs Unlimited Liability
Week 2: Intellectual Property Rights and Beyond – Practical ways to protect your ideas and creations
Week 3: Shareholder Relationships – Be careful who you get into bed with
Week 4: Rewarding Loyalty and Motivating Employees – Share options plans and other perks
Week 5: Business Contracts
Week 6: Corporate Financing and Third party Investment / Raising Capital.
Limited Liability vs Unlimited liability – Landing on your business structure
Businesses can be structured in various ways. The structure will impact how the business is managed, pays taxes, and deals with its liabilities. Broadly speaking, businesses operate as sole traders, as a form of partnership or through limited companies. Aside from differences in tax treatments and filing obligations, one of the major features distinguishing business structures is the concept of “limited liability” versus “unlimited liability”. In this context, “liability” means liability for the payment of the debts owed by a business at a given moment. When we designate a business structure as having either “limited liability” or “unlimited liability”, this relates to the liability of the owners to settle the business’ debts.
Some business structures, such as an individual operating as a sole trader (or those working together in a partnership), will have “unlimited liability”. This means that the individual will be personally responsible for the debts of their business. In such circumstances, there is no legal separation from their business. Anybody owed money from the business is owed money directly from the individual. Anybody looking to sue the business will be suing the individual.
So, what happens if a sole trader’s business runs out of cash? A common query which is raised (and has become somewhat of a cliché) is “Can they come after my house?”. This is a worst-case scenario, but it is possible. If a creditor demands payment and the creditor cannot be paid by the business, it is the individual’s personal assets which may be at risk. Ultimately, there is a risk of personal bankruptcy arising. It is therefore of paramount importance that a sole trader remains on top of their finances.
On the flip side, the concept of “limited liability” is seen in structures such as private limited companies and LLPs. Where limited liability exists, owners will only be liable for debts up to the value of their investment. In a general sense, once an investor makes their investment, they will not be called upon for further amounts. Where a creditor is owed money, it is against the assets of the company which the creditor will have a claim rather than against the owners’ assets. This is a crucial difference from the unlimited liability model.
The key feature which makes the existence of “limited liability” possible is the law’s recognition of a separate legal personality of companies (and certain other forms of entity). In effect, the company is separate and distinct to its owners. Owners are therefore exempt from personal liability. The company can sue and be sued by parties, own assets and sell assets, pay taxes and accumulate debt, all in its own name. It can enter into contracts with other parties – these contractual obligations will be obligations of the company and not obligations of the owners.
The concept of separate legal personality is a fundamental principle of company law. It is only in rare circumstances that a court will disregard this principle to “pierce the corporate veil”, such as where a company has been incorporated as a façade to dodge pre-existing obligations or in cases where there is some impropriety to conceal liability.
Is limited liability the way to go?
The appropriate structure should be based on the business’ specific circumstances. There are certain responsibilities and fees which come with incorporating a company which may not be appropriate for a sole trader or fledgling business. There is also a privacy consideration in that the company’s information will be publicly available. Notwithstanding, it is not surprising that the limited company is the most popular form of business structure. Company owners are attracted to the notion that, figuratively speaking, upon incorporation a separate “person” is born who can hold assets in their own name and is responsible for their own liabilities. This does not eliminate the risk of business failure but can be a shield against major losses.
Limited liability has been a driver for job creation and entrepreneurship. Even when dealing with risky and speculative investments, an individual willing to invest £5,000 in a company understands that any loss is capped at that £5,000 investment. They would certainly be less willing to invest £5,000 where there is a risk of losing their entire savings in the process! Without the protections of limited liability in place, it would be difficult to imagine modern economic history playing out in the same way.
Part 2 Intellectual Property Rights and Beyond can be viewed here.