If you have a brilliant business idea and are busy planning how to turn your dream into a reality, one of the many things you need to consider is the legal structure of your business.

As a start-up business in the UK you have four choices of legal structure, all with different advantages and disadvantages. So how do you decide which legal structure will work best for you?

Lawyers and accountants will usually talk about complex issues of legal status, statutory reporting requirements and limitations of liability – but in my experience for most entrepreneurs starting small businesses it comes down to an assessment of three basic questions.

1. If the business falls into debt, is my house at risk?
2. How much paperwork is involved?
3. Which structure will minimise my tax bill?

​Looking at the four options – operating as a Sole Trader, Partnership, Limited Company or Limited Liability Partnership – through the lens of these questions will hopefully help you in your structural deliberations.
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Is my house at risk?

As a Sole Trader there is no legal distinction between you as an individual and the business. This means that the risks and rewards of the business are borne by you personally. If your business owes money and cannot afford to pay, your creditors are able to claim against your personal assets. In other words, your house is at risk if you chose this structure.

A Partnership is essentially the same as a Sole Trader in this respect, the only difference being you are only responsible for your share of any debts, along with your Business Partner.

By incorporating your business as either a Limited Company (Ltd), or Limited Liability Partnership (LLP), your business takes on a separate legal entity of its own. This means that even if you are a Director or sole (100%) shareholder in the company you are not personally liable for the company’s debts unless you have offered personal guarantees. This limitation of liability is the biggest benefit of incorporation and the main reason why the majority of businesses in the UK take the Ltd form.

If limiting your liability is the main priority for you consider Ltd or LLP structures over becoming a Sole Trader or Partnership.

 
How much paperwork is involved?

Sole Traders have to file a Self-Assessment tax return every year. But they don’t have to file their accounts publicly - so, because your tax return is not on the public record, your business’s figures are kept private.

A Partnership must not only file a partnership tax return, but also each partner must file an individual one - so there will be at least three tax returns to file each year. Like a Sole Trader, Partnerships are not required to publicly file their accounts.

An LLP must file accounts every year with Companies House, and a document called an annual return which lists the partners (or “members” for an LLP). This means your accounts will be available on the public record, so anyone can buy a copy of them for a couple of pounds. In addition an LLP must complete the same tax returns as a Partnership, meaning it must be registered with HMRC and each partner must register and file individual returns, as well as a partnership return each year.

An Ltd structure has similar disclosure and reporting requirements to an LLP, with each Director completing a self-assessment return and being named on the public record at Companies House. In addition Directors have legal obligations, for example they must not let the company keep trading if it can’t pay its debts.

The level of administrative burden for Ltd or LLP businesses will normally require professional support, so be sure to factor fees for an accountant into your business plan if you structure your business in this way.

If limiting the amount of paperwork you will need to complete and the minimising the amount of disclosure you will have to provide is the main priority for you consider Sole Trader or Partnership structures over incorporation as Ltd or LLP.

 
Which structure will minimise my tax bill?

This question is the least straightforward of the three since tax implications always depend on individual circumstances. But to generalise the situation you need to consider two different scenarios – where the business is generating profit, and where the business is generating a loss.

If the business is generating a profit, a Ltd structure gives the most flexibility for tax planning as you have three options for your business profits: pay them to yourself as wages, pay them to yourself as dividends, or leave them in the business to extract at a later date that may be more advantageous for tax purposes.

You need to carefully consider the impact that the differing rates and bandings of income tax will have on the tax payable on any wages and dividends, and be sure not to forget the impact of national insurance in your calculations.

Setting up as a Sole Trader, Partnership or LLP provide far less flexibility as all profit from the business is taxed as if self-employed. This does not always mean you will pay more tax under these structures, but do have less flexibility.

If the business is generating a loss, then the situation may be reversed. This is because losses incurred from a Sole Trader, Partnership or LLP can be offset against any other personal income straight away, carried over or carried back as loss relief.

In an Ltd on the other hand, losses must remain in the business until they can be offset against future business profits which may or may not come about.

As you can see, tax can get pretty complicated!

The best way of determining an accurate answer for your specific circumstances is to do some Tax Scenario Planning. The example below shows how this could work, by looking at Luke’s proposed business selling replica Lightsabers that is planning to make a profit of £50,000 in 2016. Luke is deliberating over whether to structure his business as a Sole Trader or Ltd. By optimising the balance between wages and dividends from an Ltd structure, Luke can end up taking home an additional £2,658 over what she could from a Sole Trader structure.

In any entrepreneurial endeavour you are faced with decisions every day – big decisions with big consequences. Should you hire more people, should you make a change to your product, should you invest in your systems? Every decision you make will have a direct impact on the growth you can achieve and the sustainability of your business for the future.

But it is impossible to make the right call every time. You will make mistakes.
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So given this, how do you ensure you are learning from your mistakes, heading in the right direction and making progress in your business?

The answer lies in Innovation Accounting – taking a disciplined systematic approach to measuring the impact of your decisions against your business plan.

What is Innovation Accounting?

The concept of Innovation Accounting comes from one of my favourite books of the last few years called The Lean Startup by Eric Ries.

The basic contention of the book is that constant innovation and iteration are the best ways to create successful and sustainable businesses. In other words experiment as much as you can to learn what works best for your business.

However, constantly meddling with your business can be counter-productive if you fail to learn the lessons from each and every tweak you make. Only if you really understand the impact of changes you make will you know which were right and which were wrong, which set the business back and which propelled it forward.

This is where accounting comes in.

People generally think of accounting as dry and boring, all about annual financial statements and tax filings. But the real value of accounting is as a framework to consistently and systematically measure business performance. With today’s tools and technology this can increasingly be done dynamically in real-time, delivering insights and learnings back to entrepreneurs quicker and more effectively than ever before.

Using accounting in this way propels businesses forward to test, experiment, ideate, learn and develop in a constant cycle of improvement. This is Innovation Accounting.
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How do I start Innovation Accounting?

Software such as Xero provides a great platform for real-time monitoring of key financial metrics, whilst services such as Google Analytics are an incredible engine to measure and test the digital drivers of your business. These days cost-effective, easy-to-use accounting tools are readily available to businesses of all shapes and sizes.

But creating the technical architecture to deliver Innovation Accounting is the easy part.

Before you can start properly leveraging the power of this technique you need to confront two big questions. Answering them thoughtfully is the key to successfully adopting Innovation Accounting in your business.

First, what should I be measuring? And second, what results do I want to see?

For the answers to both questions look back at your original business plan and model. That model provides assumptions about what the business will look like at a successful time in the future. If it was thoroughly thought through, it will also indicate what the key drivers of business growth are.

Let’s take a simple business selling hand-made Christmas decorations online as an example. The business plan calls for the profits from sales of goods to be reinvested in marketing and promotions, in order to gain new customers and drive growth.

In that model the rate of growth depends on three key metrics: the profitability of each customer, the cost of acquiring new customers, and the repeat purchase rate of existing customers. If these three metrics are improving the business is improving.

If the business is well set up to measure and track these three inputs it can easily follow how decisions impact the long-term base-line of average performance, and also track how much progress is being made towards the ideal-state original business plan. Completing this exercise systematically provides an authoritative and objective evaluation of progress.

Innovation Accounting is a really powerful tool. To successfully apply it to your business you first need to carefully measure and track the impact of your decisions on the drivers of growth, and secondly review how the metrics around those drivers compare to both your base-line performance and original business plan. If you can successfully build this process into your business operations you are in great shape to grow.

The first question when planning any new business venture should always be ‘is there a market for my product?’. If no one wants what you are selling, however wonderful you think it may be, you will not have a business.

But all too often entrepreneurs that answer that first question positively get ahead of themselves and race to develop the business in a rush of excitement without asking the critical follow-up.

‘How big is the market for my product?’

Only once you have answered this question will you know whether the payoff from your new venture is worth the toil, sweat and tears.

A model for market sizing – TAM, SAM, SOM

Answering the all important question of market size is not easy. It generally takes a lot of research from a number of sources to even begin to make meaningful assumptions about how many people out there could want to buy your product. Industry-analyst reports, market research reports, competitors' press releases and general internet research are all useful. But how do you turn these disparate sources into a hypothesis of your market size?

Start big and segment your market down. A top-down approach.

First, calculate your Total Addressable Market – this is an estimate of the total number of people in the universe that your product might appeal to and might be prepared to pay for it.

However, you will have constraints on the number of those people you can reach, either in terms of logistics or marketing reach. Therefore, you need to build in assumptions to reduce the TAM down to estimate your Serviceable Addressable Market – this is the segment of the TAM targeted by your product which is within your reach.

But it is extremely unlikely you will ever be able to sell to 100% of this segment as other entrepreneurs and businesses will compete with you. Therefore, you need to plan for how much market share of the SAM it is realistic to expect to achieve. This is called your Serviceable Obtainable Market – the size of the market you can reasonably initially target.

By following this thought process, you will end up not only with a sound estimation of your business’ immediate potential (your SOM), but also an outline of future growth potential (your SAM and TAM).
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To illustrate the methodology let’s look at a simplified example for Alfred’s new proposed business selling fairy cakes with a twist – they include local superfood watercress – from his shop in Winchester.

Having sized his market Alfred is now in a position to decide whether an annual obtainable market of £300k fits with his wider business plan and whether there is enough potential in his chosen market to justify his investment.

Finding money to start a business is always challenging. The bank won’t lend you a penny without putting your house at risk and government grants are few and far between. Maxing out credit cards is not a sustainable plan and you don’t want to put your family in a tricky spot by asking them for cash. Your best bet is to convince private investors to back you with their money.

The good news is that the government have a fantastic scheme in place to help you attract just that kind of investment to your start-up business – it is called the Seed Enterprise Investment Scheme (‘SEIS’), and it is such a good initiative it is staggering that so few people are aware of it!

The scheme is designed to help small, early-stage companies to raise equity finance by offering a range of tax reliefs to individual investors who purchase new shares in those companies. If you need to raise no more than £150,000, have traded for less than two years and have fewer than 25 employees it is likely your business will qualify.

So how do you take advantage of the scheme?

Firstly, you need to make sure investors qualify for SEIS relief by submitting your company’s funding and structure plans to HMRC before the shares are issued. The only pre-requisites to this are that you must have registered at Companies House, and have a business bank account. You do not need to have started trading so, as long as you are clear about what your intended qualifying trade is, you can wait to see if you will qualify for SEIS before making definite decisions about your final business plan.

The Small Companies Enterprise Centre (SCEC) can issue a certificate confirming SEIS eligibility to show to potential investors. This process can take eight weeks or more, so make sure you start well in advance.

Benefits for investors

Once you have been SEIS approved you are in a great position to attract investors.
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As an individual investor you get 50pc tax relief against the cost of shares in qualifying businesses in any tax year. This means half the amount invested will be deducted from the investor’s tax bill straight away.

To give a practical example of the power of this relief: Helen invests £10,000 in SEIS shares of her friend Clare’s business. The relief available is £5,000 (£10,000 at 50%). The amount of income tax owed for the year (before relief) is £15,000 which Helen can reduce to £10,000 as a result of her investment.

And if that is not generous enough to elicit an investment there is no capital gains tax to pay if you do eventually sell the shares, whether the gain is in the pennies or millions of pounds, and no inheritance tax liabilities either. Should the business fail, further loss relief is available enabling any investor to recoup up to a potential total of 70% of her investment overall. Great upside, significantly reduced downside – the only stipulation is that the shares must be held a minimum of three years.

The government certainly doesn’t do everything right when it comes to encouraging entrepreneurs and small business – but when it comes to SEIS it has, in our opinion, done a pretty good job.

Cash flow should be the number one concern for all businesses with ambitions to grow.

Focussing on turning a profit is of course important, but even profitable businesses can run out of cash – especially if they are growing fast. If you do run out of cash, finding funds to invest in growth is not impossible as they can be bought. This is the main purpose of external funding such as bank loans or equity injections. But such cash can be hard to find and always comes at a cost, be it payment of interest or worse a dilution of ownership.

A preferable approach is to strike the proper balance between generating cash and consuming it through business operations – in other words optimising the cash flow from your operations.

By understanding and then optimising the operating cash cycle in your business you can self-finance a level of growth and create a more flexible, secure and dynamic operation in the process. The keys to adopting this approach are to recognise the three levers available to maximise cash, and then to understand the rate of growth achievable using the optimum combination of these levers in your business.

The Operating Cash Cycle

Every business has an operating cash cycle. This is the length of time between receiving inventory (or providing a service) and eventually getting paid for it by your customers. For most OCC’s cash is tied up for a significant proportion of the cycle where you have to pay suppliers before you receive cash from customers. The cash required to fund this period is known as working capital.
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Some businesses have a positive cycle, where they receive cash from customers before they have to pay anything out to suppliers. These businesses are extremely lucky as they should never be short of cash! Retail businesses like supermarkets that take cash payment from customers, but negotiate lengthy payment terms with suppliers are a classic example.

Businesses that provide a service, architects or solicitors being good examples, are often cited as having a positive cycle as well. It is perceived that they do not have to pay suppliers, instead internally generating the service they are selling. However, it is important to carefully consider what the real cost of a sale includes. For most service businesses employee wages and advertising costs are normally a direct cost of sales, and they must normally be borne before a service can be delivered. In such circumstances they should be considered a part of the OCC.

Whatever your business it is critical to carefully consider and understand your OCC. Only then can you target ways of reducing its length and improving your cash flow.

The Three Levers

So what options are available for improving the amount of cash in your business?

Excluding taking out costly loans and selling equity or assets there are just three levers you can use to boost cash.

Lever 1: Speeding Cash Flow

Our favourite! By reducing the components of your OCC you will free up cash for your business at a faster rate. Target extending the terms on which you pay suppliers and shortening the terms you give to your customers to minimise the period over which cash is tied up.

Lever 2: Reducing Costs

A tough one! By performing a careful review of costs in your business and challenging suppliers to reduce them wherever possible you will create more profit, which will flow through into cash.

Lever 3: Raising Prices

The toughest one! On the other side of the equation are the prices you charge your customers. If your customers, or maybe just a segment of your customers, will accept a price rise and you can achieve this at little or no extra cost you will create more profit, which will flow through into cash.

Optimising the levers

But which lever, or combination of levers, should you target? And what will the impact of any change be on the cash in your business? Which option gives you the best return for your efforts?

The best way to answer these questions is to model different scenarios and compare the output self-financeable growth rates. 
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The SFG is calculated by looking at three factors:

• The length of the operating cash cycle
• The amount of cash needed to finance each £ of sales
• The amount of cash generated by each £ of sales

You can combine these factors to understand how much growth is sustainable. By comparing how many additional sales can be funded by the excess cash generated from existing sales you can calculate how much growth your working capital can sustain. By multiplying this value by the number of cycles in a year you can calculate the annual growth rate achievable without running out of cash. The higher you can get your SFG % the more flexibility and security your business has, and the more ability you have to grow without resorting to costly loans, dilutions to your equity, or selling your house and car!