Some entrepreneurs dream of creating a huge company, employing hundreds.
Others would rather be a “one-person show” as a sole proprietor.
A sole proprietorship is owned and run by one individual who receives all profits. It has the benefit of being relatively easy and inexpensive to establish.
Of course, that only tells part of the story. There are several disadvantages to sole proprietorship to be aware of and guard against as well.
My name is Sam Mollaei, and as a Business Lawyers for Entrepreneurs, I can help you decide what type of business organization – including sole proprietorship – might be right for you.
And of course, if you have any questions about your unique situation, feel free to email me.
By the end of this post, you’ll know what the disadvantages of sole proprietorship are so you can make an informed decision as to whether this business structure is right for you.
1. Your Liability Is Unlimited
The most serious disadvantage of being a sole proprietor is unlimited exposure to liabilities and lawsuits.
In a corporate business structure, the corporation is treated as a separate legal entity from its owner. That means when someone sues the business, they only have access to the business assets, protecting the owner’s assets.
In a sole proprietorship, on the other hand, there is no separation between business assets and personal assets. If someone sues the business or it was to go bankrupt, the owner’s cash, bank accounts, car, or even their home may be seized in addition to the assets of the business.
And the owner has to deal with these problems alone, compared to a corporation where there is a team of professionals to offer expertise and help carry the load.
2. Your Capacity to Raise Capital is Limited
Even if a business idea is sound, an owner may find him or herself short of cash at a crucial time in the company’s development and growth.
Without partners or outside investors, it can be challenging for business owners to come up with the large amounts of capital needed to start and sustain a company.
Corporations, by contrast, have many ways to raise money, including selling additional shares of stock, issuing bonds, and taking out relatively low interest business loans.
By contrast, a sole proprietorship cannot sell ownership in the company without changing its business structure and doesn’t have the ability to issue bonds.
Of course, they may borrow money just like any other business structure. But sole proprietors may have difficulty securing loans or finding investors since the venture may appear riskier than a business with an executive team and hundreds of employees.
And if they do get a bank loan, they may be required to use their personal assets for collateral, putting them in jeopardy if they were to default on loan payments.
3. There Can Be a Lack of Financial Controls
The less formalized structure of a sole proprietorship doesn’t require the same regular financial statements and company minutes as a corporation.
The lack of strictly managed accounting controls can result in the owner being uninformed about financial matters, mixing business and personal expenses, and missing important deadlines.
This could result in their falling behind on their payments or not getting paid on time, negatively affecting cash flow.
4. Taxes are Typically Higher
Another downside to sole proprietorship is the need to pay taxes personally.
And because the business and the owner are one and the same, the owner has to pay self-employment taxes on business income in addition to personal income tax.
Even if the name of the business is different from the owner’s name, or he or she is operating under a DBA, the funds for paying taxes will still come from the business owner.
In addition, many corporate tax advantages and write-offs are not available to sole proprietors.
And if the business owner dies, the business becomes part of the owner’s estate and subject to steep inheritance taxes on the beneficiaries.
5. The Life of the Business is Limited
Courts do not recognize any difference between a sole proprietorship and its owner.
In a corporation, the business is said to have “perpetual existence,” meaning it will continue until its owners, directors, and shareholders formally decide to end it.
In a sole proprietorship, when the owner passes away, the business ends as well and will be dissolved, unless the owner made an estate plan which allowed the business to continue.
However, when the assets of the business become part of the estate, creditors can make claims against it for payment of debts.
This often means the deceased’s heirs must often sell business assets to satisfy creditor claims. If there are multiple heirs, assets may have to be liquidated to distribute the business’ value among them.
And if the heirs want to take over the business and continue operation, they must create a new business in their own names. However, there is no guarantee they will have the capital or business knowledge to continue operations successfully.
If you have any questions about forming a sole proprietorship or a company, email me directly so I can help.
6. You’re the Sole Decision Maker
Starting a new business is an exciting time in which the owner makes all the decisions and does most of the work him or herself.
However, the responsibility for making day-to-day business decisions becomes more difficult as the business grows.
As employees and new products or services are added, there are many more decisions to be made.
The problems encountered in growing a business can be complex. And since it is your baby, there is the risk that you may be unable to be totally objective, or you simply may not have the experience and knowledge necessary to make good decisions in all situations.
It helps to be able to brainstorm with a diverse team of executives, each with their own unique viewpoint and expertise.
7. Striking a Work-Life Balance is Challenging
A hidden cost of a sole proprietorship is increased pressure and time demands.
An owner may feel the need to think about the business 24/7 and his or her personal life, relationships, and health may suffer as a result.
Sole proprietors often find it difficult to go on vacations, since they may feel – rightly or wrongly – that the business will fall apart without them.
And even when the owner happens to get away from work for a time, he or she may still feel the need to check in and stay involved, never really getting a rest.
8. Finding and Retaining Good Employees Can Be Difficult
A sole proprietor can choose to have employees or not, and the structure of the business is somewhat flexible.
For example, the owner could decide to pay employees a higher wage but not offer certain benefits, such as health insurance.
Or they could, instead, decide to only work with independent contractors. Bonuses and incentives are up to the owner’s discretion as well.
However, owners of sole proprietorships may find it difficult to attract top workers because they can’t match the pay, benefits, prestige, and networking opportunities offered by large companies.
9. Sole Proprietorships Can Be Less Business-Like in Appearance
When compared with a corporation or a partnership, a sole proprietorship may appear to some to be less business-like or professional.
In part, this is due to the fact that it is not a legal entity that has undergone the rigid procedures required to form corporations and partnerships.
And depending on how it presents itself to the public and customers, the business structure could even appear a bit informal.
What To Do Next
Setting up a business as a sole proprietorship is attractive because it costs very little and doesn’t require much documentation.
However, you should carefully consider the disadvantages of unlimited liability and other factors, which will only become more serious as a business grows.
If you’re trying to decide if you should set up your business as a sole proprietorship, or as a corporation or partnership instead, you need to consider the pros and cons.
As a Business Lawyer for Entrepreneurs, I’ve assisted hundreds of non-US clients just like you start their U.S. business and I can definitely help you start yours.
The first step is to email me at firstname.lastname@example.org to discuss the options with you.
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