Avoiding common bear traps when incorporating a business

Having made a strategic decision to convert your business to a limited company - whether from being a sole trader or a traditional partnership - there are some potential bear traps to avoid when doing so. Here is our guide to some of the main ones and what you can do to avoid them.

Bear Trap 1 - Not managing changes to your key contracts

The cost of supplied services can increase where a business is a seen as a ‘new customer’. Any entitlement to discounts through loyalty may be lost and access to lower interest rates may no longer be available. Before you incorporate, read the small print and ensure that any potential financial costs for transferring over any service contracts outweigh the benefits of remaining unincorporated.

It is important that liabilities under contracts are correctly transferred to the new limited company to ensure that the original business owner no longer has responsibility for them. Any obligation under an existing contract should be transferred to the new limited company by novation. A novation is a tripartite agreement where the original business owner, the customer or supplier, and the new limited company all agree that the new limited company will replace the original business owner. The novation will also document any changes to the terms of the contract.

To prevent any ambiguity over liability, all stationery, websites, email footers and pro-forma documents must be updated so it is clear to customers that the entity carrying on the business is no longer a ‘person or persons’ but a limited company. A simple solution is to circulate a newsletter or new terms of business which clearly states the new limited company is the provider of the goods or services.

Bear Trap 2 - Not spending enough time on employee matters

On incorporation, existing employees transfer over to, and become the responsibility of, the new limited company. Any transfer under TUPE must strictly follow the regulatory procedures to avoid any potential liabilities. Don’t forget, you must also notify any pension provider of the transfer. Further, employee liability insurers must be notified of the incorporation. Policy conditions may require termination of the original policy and commencement of a new policy.

Bear Trap 3 - Not understanding the role & responsibility of a director

The office of a director in a new limited company can be an onerous one as, once appointed, a director becomes personally subject to laws and regulations that carry criminal liability for non-compliance. Make sure that any individual appointed as a director of your new limited company is fully aware of their statutory duties and the company’s constitutional requirements.

Investing in the right candidates is essential to any successful company but, over time, relationships and circumstances can change. So, however friendly you may be with the directors of your new limited company, it is advisable to have clear lines of separation between personal and business affairs. The best way to do this is ensure all directors are appointed under a written service agreement, which should set out the terms and conditions of engagement. Disputes often arise where the decision-making capabilities of a director were not formalised. Avoid this by clearly listing matters where director autonomy can be exercised.

Bear Trap 4 - Not dealing properly with the trading premises

If the business premises are rented, the lease will need to be assigned to the new limited company. Before incorporation, carefully check the terms of your lease to confirm that assignment is possible and what needs to be done to secure landlord’s consent to the assignment. Important to note that an outgoing tenant will usually be obliged to guarantee the new tenant’s performance of the obligations from which the outgoing tenant is released.

If the business premises are freehold, it may be worth considering retaining ownership and leasing the premises to the new limited company. Please remember, if there is a mortgage, lender consent will be required.

Bear Trap 5 - Not having an effective shareholders’ agreement in place

Even the most successful shareholder relationships can become strained at times. The best way to prevent such tensions affecting the success of the new limited company is to put in place a professionally drafted shareholders’ agreement. This will determine what matters require what level of internal approval, how shares are held and transferred, what happens when the shareholders disagree, who is entitled to be on the board of directors and, importantly, how the company is to be financed and run.

Bear Trap 6 - Not keeping your bank on side

You cannot assume that your bank, or indeed other funders, will consent to your proposed incorporation, so it is vitally important to discuss the implications of it with them early, and certainly before any irreversible action is taken. Your bank may see incorporation as weakening their security for their business lending and may insist on personal guarantees to ensure that directors or shareholders have something to lose if the limited company cannot meet its liabilities. Setting up new business bank accounts and security arrangements will require internal sign off and can take time to arrange so make sure you are properly equipped to answer all the questions your bank may have.

Taking advice from advisers who are experienced in governance matters such as these should prove value for money in the long run.

For further information, please contact Kerry Brooks or call 0151 906 1000.