You are a young entrepreneur with a great new idea for widgets and have decided to launch into a profitable, widget-selling business from your bedroom. You make your first widgets by hand and sell them to kids at your school. Boom! You are now a sole proprietorship.
What is a Sole Proprietorship?
Establishing a sole proprietorship does not require filing documents and registering your business. Instead it springs into being as soon as you start acting like a business (i.e., conducting an activity for a profit). The owner of a sole proprietorship keeps all the profits and maintains complete and total control over his or her company. Sounds nice and easy, eh? Not really.
1. Being Personally Liable Sucks
One of the biggest problems with sole proprietorships is that the owner is personally liable to company creditors and in the event of a lawsuit. Say, one of those widgets malfunctions and causes injury to a customer. Then the customer can sue you and your business. That means that not only could the company lose its widget-making equipment and other assets but you could also lose any personal items of value such as your prized baseball card collection and your 2010 Toyota Prius. Even your Cavalier King Charles Spaniel, Missy, can be confiscated.
2. Sole Proprietorships Make Less Money
However, being personally liable is not the only downfall of sole proprietorships. Sole proprietorships also tend to make much less money than incorporated businesses. In his article, How Much Money do Small Business Owner Make?, Scott Shane, Professor of Entrepreneurial Studies at Case Western Reserve University, analyzes IRS Statistics to determine the income of sole proprietorships versus S-corps. Shane found that the average sole proprietorships were making much less than the average S-corps.
According to Shane, in 2007, the average S-corp generated about $100,000 in income on about $1.5 million in sales (keep in mind, business owners are writing off everything from their cars to paper and pens, so the average S-corps owner is likely enjoying far more of that $1.5 million than is represented on their taxes). In 2008, the average nonfarm sole proprietorship had revenues of only $58,256 and net income of only $11,696. Those numbers are staggeringly low, even for a “Great Recession.”
3. Sole Proprietorships Have the Same Identity as Their Owners
Sole proprietorships have the same legal identity as their owners. This means that if the owner becomes disabled, retires or dies, the business does, too. Sole proprietorships do not have a perpetual existence like most business entities.
4. Sole Proprietorships Can’t Get No Respect
Sole proprietorships are not taken seriously. Banks are not likely to lend money to sole proprietors because they are generally considered unstable. Sole proprietorships are also less likely to attract good employees because they typically do not offer employee benefits and have no chance at ownership potential.
5. Sole Proprietorships Have No Skin in the Game
Part of the reason why sole proprietorships are considered unstable is because they appear to have no skin in the game. Sole proprietors generally think small. They plan on being a small operation, think they’ll never have employees, think they’ll never make a great deal of money and they can’t even be bothered to spend a few hundred dollars to incorporate their business and shield their personal assets from liability. Think about it. If you were an investor or lender, would you invest or lend money to someone who doesn’t take their business seriously?
Then Why Are Most Businesses Sole Proprietorships?
Unbelievably, “new businesses are much more likely to be set up as sole proprietorships than as corporations, even though new corporations outperform sole proprietorships on almost every possible measure: speed of business development, access to external capital, survival, sales growth, and profitability.”1 Why? My guess is because it’s free and easy. If you are an entrepreneur, you know by now that nothing about running a successful business is free or easy!
Just because most entrepreneurs are setting themselves up as sole proprietorships doesn’t mean you have to. Remember, most businesses also fail. Therefore, you don’t want your company to be like most businesses. Instead show potential customers, lenders, investors and business partners that you think BIG and take your business seriously by incorporating immediately.
Rachel Rodgers is the owner of Rachel Rodgers Law Office, a law firm dedicated to providing innovative legal counsel to Generation Y entrepreneurs. She is an Under30CEO herself and when she is not practicing law, you find her drinking East African coffee in a bookstore or traveling in a developing country (or drinking East African coffee in a bookstore in a developing country).