2 - Entity Selection, Formation, and Governance

Learning Objectives

1. Compare the advantages and disadvantages taken on by the owner of a sole proprietorship.

2. Identify the elements that constitute a general partnership, as well as the advantages and disadvantages of a general partnership.

3. Differentiate between a limited and general partnership and list the advantages and disadvantages of a limited partnership.

4. Describe the characteristics of a corporations and the benefits derived from choosing a corporation as a form of business.

5. Explain how a corporation is formed and describe the groups that constitute the organization of most corporations.

6. List and describe the financial tools used by corporations.

7. Summarize the basic purpose and function of a limited liability company as compared to a traditional corporation.

8. Separate franchises by category and explain how different kinds of franchises function.

9. Describe the legal protections that assist franchisees in franchise relationships.

2.2Small Business Structures

David Parker, J.D. discussing Small Business Structures

Types of Business Structures

One of the earliest decisions an entrepreneur starting a new business needs to make is under what form should the business operate: sole proprietorship, partnership, corporation, or some specific form of one of them. Each has benefits and disadvantages. We will take a look at each.

Sole Proprietorship

A sole proprietorship, sometimes simply called a proprietorship, is the simplest form of business entity, and is one where the business is owned and managed by one individual. It is the most common form of U.S. business. This makes sense because of the advantages a sole proprietorship has over other business entities.

Advantages of Sole Proprietorship

1. A sole proprietorship is very easy to set up from a regulatory point of view. Usually, there is no government approval or documentation required, except perhaps for a local business license.

2. The cost of setting up a sole proprietorship is very minimal. If a sole proprietor is doing business in a name other than his or her own, he or she may have to publish in the newspaper, at minimal cost, a fictitious business name statement, or a d/b/a statement “doing business as” statement to alert the public and creditors that he or she is running the business under another name. For example, Tom owns a restaurant named Jade Palace. Jade Palace is his fictitious business name.

3. Another advantage of the sole proprietorship is the flexibility or ease with which the business may be managed. That is not that to say that conducting the business is easy, but rather the formal requirements of the day-to-day business are limited. The proprietor is free to operate the business according to his or her discretion without having to answer to a partner, a board of directors, or shareholders.

4. The proprietor is the sole owner of the assets of the business.

5. A sole proprietorship is easy to terminate.

6. The sole proprietor pays only personal taxes, so the tax calculations for sole proprietorships are usually straightforward and easy to calculate.

7. Finally, the assets of a sole proprietorship are easy to transfer to another person.

Disadvantages of Sole Proprietorship

The sole proprietorship is often the best choice for a beginning or small business, but sometimes when a business starts to grow the disadvantages of the sole proprietorship begin to show.

1. Under a sole proprietorship, there is no legal distinction between the owner of the business and the business itself. That means the owner bears 100 percent of liability for tort claims against the business, and that liability is personal. A successful claimant in a tort lawsuit against the business could attach for payment of the judgment the sole proprietor’s personal assets, like a home or a car.

2. The sole proprietor is personally responsible for all contracts into which he or she enters.

3. If the owner dies, the business usually dies as well.

4. Finally, the only access to capital the proprietor has is what he or she can develop on his or her own through personal funds or loans from others.

2.3General Partnerships

Konrad Lee, J.D. discussing General Partnerships

The general partnership form of business enterprise is characterized by two or more persons agreeing to bind themselves to each other by contract – the partnership agreement – for a common business purpose.

Essential Elements of a General Partnership

The three essential elements of a general partnership include the sharing of losses and profits, an equal right to engage in the management of the business, and joint ownership of partnership assets.

Sharing of Losses and Profits

The profits and losses pass through to the partners in accord with the partnership agreement. Therefore, in Partnership A&B, A may be entitled to 60 percent of the profits and liable for 30 percent of the losses.

Konrad Lee, J.D. discussing Partnerships

Equal Right to Manage the Business

At common law, a partnership was treated as a collection of separate individuals and did not have a separate legal status. The modern view is the opposite, and a partnership is now considered in most states as a legal entity. This means that the partnership may own property in the name of the partnership, and sue, or be sued, as a partnership.

Joint Ownership of Partnership Assets

Additionally, unlike a typical agency relationship or a simple contract relationship, partners in a general partnership are equal owners of the assets of the business. As such they stand together in a fiduciary relationship. That is, each owes the other due care in actions associated with the partnership, including just reporting, avoiding conflicts of interest, and not usurping a partnership opportunity. If the object of the partnership may not be completed within one year, the partnership agreement must be in writing.

Advantages of a General Partnership

Like a sole proprietorship, a general partnership is easily formed at little cost and may easily operate across states. Its management is at the discretion of the partners, and it is often easy to dissolve. Partnerships, although a legal entity, are not taxed directly, rather, the individual partners are taxed at the individual rate that applies to each.

Disadvantages of a General Partnership

Perhaps the biggest disadvantage of a general partnership is that each partner is joint and severally liable for the torts and other claims against the partnership. Therefore, if in the Partnership A&B, A commits a tort against C while acting to further the partnership interests, C may sue A, or sue B, or sue A&B together. Moreover, under the agency relationship which partners share, A may bind B, and vice versa, to terms of contracts entered into as long as A or B do not contract outside the scope and mission of the partnership.

2.4Limited Partnerships

A limited partnership is an agreement between two or more partners to conduct business, but where only one of the partners is responsible for the day-to-day management of the business. The managing partner is known as the general partner and the other partners as the limited partners. This kind of partnership is a creation of state statute, as virtually all states have adopted some version of the Uniform Limited Partnership Act (ULPA), which governs limited partnerships.

Advantages of a Limited Partnership

The key advantage of the limited partnership is that it allows limited partners to escape the joint and several liability that exists in a general partnership. If a limited partner’s contribution to the limited partner enterprise is solely financial, with some small administrative involvement, then the limited partner gets the benefit of partnership while avoiding liability for torts, contract claims, or debt of the partnership. If a limited partner becomes too involved in the management of the business, he or she may lose limited liability status. A limited partner has the right to access the partnership books and may expect, just like in a general partnership, a duty of loyalty from the general partner.

Disadvantages of a Limited Partnership

Because of the risks associated with the formation of a limited partnership, and the fact that it is a creation of state statute, it is much more difficult to form than a general partnership. The partners must sign a certificate of limited partnership – a document that describes the partnership, its purpose, and members - and files it with the appropriate state agency. The certificate of limited partnership becomes a public document open to scrutiny.

While the limited partners are shielded from liability beyond the amount of the investment contribution, general partners are personally liable for the obligations and claims against the partnership. Sometimes, general partners seek to avoid this problem by setting up a corporation, which does have limited liability, to act as the general partner.

Terminating a Partnership

In both a general and a limited partnership, the partnership may be terminated by agreement, by judicial decree—bankruptcy, by death or incompetence of a partner, by destruction of the object of the partnership, or by impracticability of the project. In the event that a limited partnership is terminated, the limited partners receive back any capital contribution or profit in priority to the general partner.

2.5Introduction to Corporations

Konrad Lee, J.D. discussing Corporations

Characteristics of a Corporation

The corporation is a form of business where the ownership is divided into shares and is authorized by state statute to act as a single legal entity. Having been in existence for many hundreds of years, the corporation has several unique characteristics which make it a favorable business form for many enterprises.

1. A corporation is a legal person under the law. Therefore, a corporation can sue and be sued, own property, and enter into contracts. Also, as a legal person a corporation has some limited protections under the Constitution.

2. The shareholders of the corporation have limited liability for the torts, debt obligations, and contracts claims, only up to the amount of the value of the shares owned – capital contribution.

3. Shares in a corporation are easily transferrable. Indeed, with the right online account, a party could buy or sell corporation shares in the time it took this author to write this sentence.

4. A corporation has infinite duration. For example, the Hudson’s Bay Company, a Canadian department store chain, was incorporated in 1670 in London and is still going strong.

Types of Corporations

So-called subchapter s corporations are those having few shareholders, where the Internal Revenue Service allows for the passing of corporate profits directly to shareholders so as to avoid the double tax associated with corporations. Corporations that are formed within a state are called domestic corporations. Those who are operating in a particular state, but were formed in another state are called foreign corporations. For example, the Ford Motor Company, incorporated in Delaware, is a domestic corporation in Delaware and a foreign corporation in the other 49 states in which it distributes vehicles. Alien corporations are those formed outside of the U.S. Some corporations are created to conduct a charitable or other humanitarian purposes, and because they do not exist to make money for shareholders are called non-profit or not-for-profit corporations. That is not to say that the employees of such organizations are not paid. For example, the commissioner of the National Football League, a not-for-profit corporation, was paid upward of $40 million in 2013. A publicly held corporation is one where there are many shareholders extant in the world, while a closely held corporation is where just a few persons own its shares, like S.C. Johnson. Some corporations are created to assist doctors, lawyers, accountants, and so on, and are called professional corporations. Usually, in these types of corporations, the agents of the corporation may not subject the corporation to liability, but the professional him or herself is subject to malpractice claims. Most corporations are privately owned, but a public corporation may be formed by the government to achieve some social good, like the Public Broadcasting Corporation.

2.6Corporate Formation and Management

Formation of the Corporation

Once a business has decided on using the corporate form, it must determine which state will be the state of incorporation. Many large businesses have incorporated in the state of Delaware because it has laws favorable to corporations; however, many businesses choose the state where it will be doing business for incorporation. Upon selection of a suitable name, the incorporators – those persons seeking to establish the business – file Articles of Incorporation with the state. These articles provide the corporate name and address, number of shares to be issued, the agent of service and, usually, the name and address of each incorporator.

The identification of an agent is important because the corporation has legal status and, therefore, there must be some person empowered to accept service of process from creditors or others who may have a claim against it. The Articles also provide information about the nature of the business of the corporation. Traditionally, the law required a detailed description of all business activities in which the corporation planned to engage. In times past, if a corporation exceeded its stated purpose it would have been said to have engaged in an ultra vires act, outside its authority, which could be challenged by shareholders as improper. A corporation could be committing an ultra vires act if it makes loans that are prohibited by law or makes excessive contributions to charities. Over time, that strict rule has lessened.

Once the incorporators or promoters complete the formation of the corporation, they will quickly execute new contracts, called novations, with any party with whom they have had dealings related to the creation of the contract. This is done so that the corporation takes over the contract and the third party releases a promoter. The promoter will now be shielded from liability, one of the primary purposes of forming the corporation in the first place.

Management of the Corporation

There are three actors in the management of the corporation: shareholders, the board of directors, and executives. Often these groups are overlapping in their rights and responsibilities.

Shareholders

The shareholders are the owners of the corporation. As owners, shareholders, by voting rights, have power to elect a board of directors which then governs the corporation by determining strategy and hiring executive officers to manage the day-to-day affairs of the firm. Shareholders also have the right to amend the Articles of Incorporation or the bylaws and to approve mergers or corporate dissolutions or the sale of substantial assets. They do not have responsibility for management of the business.

Board of Directors

The board of directors has a high duty of care to the shareholders and may not engage in any activity which would indicate disloyalty or a conflict of interest. Sometimes, the board of directors will make a decision which results in losses to the corporation. Under the business judgement rule, as long as the directors acted in a reasonable and prudent way, directors will not be subject to lawsuit from shareholders on a breach of duty claim.

Executives

The executives in a corporation are those officers charged with carrying out the daily operations of the corporation according to the direction provided by the board of directors and the wishes of the shareholders. The executives are subject to the same duty of care in carrying out the purposes of the corporation as are the board of directors. Usually the members of the top management team are also members of the board of directors and shareholders. The executives are tasked to see that the business runs according to the Articles of Incorporation and the Bylaws. The Bylaws are the detailed rules governing the management of the firm and sets the requirements for annual meetings, the process for approving major corporate decisions, stock issues, and shareholder voting rights.

Finally, a major shareholder who comingles his or her funds with the corporation, or uses it solely for his or her personal benefit, will lose the limited liability protection of the corporate form under the doctrine known as piercing the corporate veil.

2.7Corporate Financing and Termination

Financing of the Corporation

Stocks

A primary advantage of corporations over other business forms is the ability of the firm to raise capital through the issuance of stocks. Stocks represent an equity interest, or ownership share, of the corporation. Some small businesses issue stocks to employees as a way to compensate them when money is tight. This is what Comer Cottrell, one of the most successful African-American entrepreneurs and now worth over a $1 billon, did to keep his employees loyal during the early days of his Pro-Line hair care business.

Common Stock

The most fundamental equity interest a shareholder has in a corporation is common stock. This stock provides the owner with an interest in the control, assets, and earnings of the corporation in proportion to that stock's value. That is, one share equals one vote. Common stock shareholders generally have preemptive rights. This is the right to purchase newly issued stocks over other parties in order to maintain the percent of stock owned.

Preferred Stock

Some stockholders own preferred stocks. These are stocks that generally cost more to purchase, but carry a preference for the payment of dividends, a priority right to purchase other stock offered, and priority for payment when the corporation is dissolved.

Dividends

A dividend is a distribution of corporate profits to the shareholders as ordered by the directors. Normally, there is no requirement that the directors order dividends, but stocks which regularly pay dividends are seen as more favorable to investors. Sometimes a corporation will be required to declare a dividend payment to shareholders when retained earnings - undistributed profits – get too high, or the Articles of Incorporation or Bylaws demand it.

Bonds

Another way a corporation finances its activities is through bonds. A bond is a debt security sold to investors. The collateral is the credibility of the firm and its ability to repay the loan. Sometimes the physical assets are used as collateral on the bond. A corporation needs to have some regular earnings, or earnings potential, to be able to offer a bond to the public at a favorable rate. The higher a company's perceived credit quality, the easier it becomes to issue debt at low rates and issue higher amounts of debt.

Termination of the Corporation

Dissolution of the corporation may occur when the board of directors and shareholders vote to end it. It may also be terminated by bankruptcy, court decree, or legislative action.

2.8Limited Liability Entities

David Parker, J.D. discussing Limited Liability Entities

The partnership carries specific tax advantages to the partners because tax is paid not on the partnership profits, but upon the individual partner’s personal financial circumstances. A corporation carries with it other advantages in terms of protection from liability, but the corporation pays a separate corporate tax, and thus shareholders are taxed twice. In an effort to obtain the best of both business forms for entrepreneurs – limited liability and only one taxing event – many states have enacted laws that create the limited liability company (LLC). Limited liability company owners are called members. In the LLC, the company may elect to be taxed as either a partnership or a corporation. If taxed as a partnership, income from the business passes through to the individual members in the company. Additionally, unlike a traditional corporation which retains all losses, in the LLC losses may be passed through to the individual members just like profits. This allows a member, when needed, to declare a loss to offset gains in other areas for tax purposes. Perhaps even more importantly, the losses of an LLC do not have to be distributed evenly among members. That means the LLC can manage which members receive profits and losses.

Because it is a creation of state statute, the formation of the LLC is very similar to that of a corporation. Moreover, its management may either be by a management group or by all the members. Under either scenario, the members of an LLC owe each other a duty of due care and loyalty and may not engage in activities that would damage the LLC or its members' interests.

If a member of an LLC wishes to extract him or herself from the company, that member will immediately lose the right to manage the affairs of the LLC and, while a duty of loyalty no longer exits, the member must continue to exercise due care so as not to harm the interest of the other members. The exiting member has no authority to dissolve the LLC, but may force the other members to a buyout.

2.9Franchises

Konrad Lee, J.D. discussing Franchises

Basics of Franchises

Another kind of business is a franchise, which may be operated under any business form. Franchises are businesses where the owner of a trademark, trade name, proprietary manufacturing process, or intellectual property licenses that asset to a third-party business person. The creator of the franchise is called a franchisor and the purchaser is named the franchisee. Franchises are successful because they offer advantages to all parties. For the franchisor, the franchising process allows him or her to sell a proven concept to another and capture revenue from the sale, from ongoing training and supplies, and from taking a percentage of the franchise profits. For the franchisee, he or she is assured a business which has a proven name recognition and a success rubric. For the consumer, a franchise offers certainty, uniformity of price, and quality.

Types of Franchises

Manufacturing or Plant-Processing Franchise

There are at least three types of franchises. The first is known as the manufacturing or plant-processing franchise. This is where, in Coke for example, the secret formula is sent from Atlanta to bottling facilities all over the world, where is it is added to water and rendered into Coke. The independent bottlers are franchisees.

Chain-Style Franchise

The second kind of franchise, the chain-style franchise, was made famous by Ray Kroc, the former CEO of McDonald's. In the chain-style franchise, the franchisor licenses the franchisee to sell or make its products. In these types of relationships, the franchisee may be required to purchase the product, uniforms, or advertising from the franchisor.

Distributorship Franchise

The distributorship is the last kind of franchise. A distributorship model is a franchise where a manufacturer licenses the franchisee to sell a product within a specific geographic area. Car dealerships are the best example of distributorship franchises.

Legal Protections for Franchises

The franchisor and the franchisee have a complicated relationship because they are separate legal entities but are bound together by the franchise relationship and the goal of success. Over the years, because they have the better bargaining position, franchisors have taken advantage of franchisees by 1) overcharging for products which must be purchased from them, 2) arbitrarily increasing the percentage of profits taken under the franchise agreement, or 3) terminating the franchise agreement without notice or cause. To address these problems both the federal government and state legislatures have acted to protect franchisees. These protections include prohibiting the franchisor from setting unrealistic sales goals, setting conditions for when a franchise may be lawfully terminated, requiring transparency on financial data, and giving the franchisee proper notice. The Federal Trade Commission has established the Franchise Rule which requires the franchisor to provide written notice to the franchisee of facts relating to the representations made, data collected, earnings projected, and terms of the franchise contract.