Why a Business Should Not Register as a Sole Proprietorship
Many small business owners do get their start as sole proprietors. It makes sense given that this is the simplest and cheapest business entity to establish. And if you're not using a DBA, there is virtually no paperwork involved with starting as a sole proprietor. It's a fast solution to starting a small business. That said, it may not always be the smartest solution when it comes to launching a new endeavor. There are several key drawbacks to establishing a sole proprietorship and operating your company as such. In this article, we look at the disadvantages of registering your business as a sole proprietorship and what that could mean for the company over the long term.
Keep in mind, being a sole proprietor is not necessarily all bad. There are some pros to having a sole proprietorship; as mentioned, it's the simplest type of business to start as well as the least expensive. So if you are in a hurry to get going and get that company off the ground, then it might make sense to begin as a sole proprietorship.
Additionally, unlike with a partnership or in some cases an LLC, you are in total control. Decision making for the business rests completely in your hands. Many entrepreneurs nurturing their ideas through their company do prize this type of autonomy.
Furthermore, when it comes to taxation for a sole proprietor, the process again is quite simple as compared to some other business types. Not to mention, with certain kinds of corporate structures there is the possibility of double taxation. For a sole proprietor, however, the business profits are simply run through their tax returns and are taxed as income.
While the above are some definite advantages to consider, there are also some downsides which might make you think twice about setting up shop as a sole proprietorship…
Personal Assets Are At Risk With A Sole Proprietorship
This is perhaps the main disadvantage of a sole proprietorship. Because the business is not separate from you, because it's not an entity completely different from you personally, this puts your assets at risk. Let's say then for example that a disgruntled client sues the business. If upon going to court, the client gets the judgment they're seeking, this could mean that everything from your retirement accounts, to stocks and bonds, to your car, even being vulnerable. In other words, they can be taken to compensate the plaintiff. In a corporate structure and with LLCs, this is not the case. The company owners' assets are protected from any debts or liabilities that the firm may incur.
Because in a sole proprietorship personal assets are at risk, many business owners who are sole proprietors will get an insurance policy which can in part help to protect some (though not all/) of their assets should the company incur legal troubles or significant debt. The issue with these kinds of policies though is often that what is covered is not enough to account for all damages. In that case, yet again as a sole proprietor your assets, including even your residence may be at stake.
The Owner is the Business
How is this a disadvantage? Essentially, as a sole proprietor, because the business is not its entity, you are the business. And so, when you do pass on, the business dies with you, unless you have planned otherwise. With a corporate structure, the business exists on its own, independent of the owner. So when the owner does die, the shareholders and various directors ensure that the company continues.
Because the business and the owner are essentially the same, it also makes the company less attractive should you want to try and sell it eventually. Any potential buyer is going to see that the primary value is the owner and their relationships with the clients that they've cultivated through the years. Without that owner involved, does the business have any standalone value? Generally speaking, the answer is no. Therefore, selling the company becomes quite difficult.
Raising Money is More Difficult As A Sole Proprietorship
Corporations have a fairly easy path to raising money. They can sell more shares and thereby bring in the capital that way. Yes, they are selling ownership in the company, but again, they can raise money rather quickly. A sole proprietor on the other hand does not have this option when it comes to raising capital. The only way a sole proprietorship could sell shares in the company would be if they changed their business structure altogether.
Certainly, a sole proprietorship can apply for a business loan and thus borrow money to meet their business needs. However, many lenders will give more credence and look more favorably on LLCs and corporations, as these business structures tend to be recognized more formally. In some cases, sole proprietors might use their assets to raise money for the company. From home equity loans to borrowing from their 401ks, they will liquidate what they have to keep the company up and running. There of course is a danger in this approach. If the business falters, they could lose the money they invested and thus jeopardize their future security.
Establishing your company as a sole proprietorship is an easy way to get started. That said, it is critical to keep in mind the risks involved. Setting up an LLC initially, while it requires a bit more paperwork and costs more, can be a smarter way to go depending on the type of business you have—as this offers you more protection and does help with the credibility factor.
First Union Lending is here to help! We work with small business owners getting them the cash they need, when they need it—not weeks or months from now. If you're looking for a short term loan, merchant cash advance, or SBA loan, we have a financing solution for you. Call today!