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Chapter 4 Choosing a Form of Business Ownership

LEARNING OBJECTIVES

4-1 Describe the advantages and disadvantages of sole proprietorships.

4-2 Explain the different types of partners and the importance of partnership agreements.

4-3 Describe the advantages and disadvantages of partnerships.

4-4 Summarize how a corporation is formed.

4-5 Describe the advantages and disadvantages of a corporation.

4-6 Examine special types of businesses, including S corporations, limited-liability companies, and not-for-profit corporations.

4-7 Discuss the purpose of a joint venture and syndicate.

4-8 Explain how growth from within and growth through mergers can enable a business to expand.

Sole Proprietorships

Sole proprietorship – a business that is owned (and usually operated) by one person

Although a few sole proprietorships are large and have many employees, most are small.

Some of today’s largest corporations, including Walmart and JCPenney, started out as sole proprietorships.

Sole proprietorships are the most popular form of ownership when compared to partnerships and corporations, but they rank last in sales revenues.

FIGURE 4-1 Relative Percentages of Sole Proprietorships, Partnerships, and Corporations in the United States

FIGURE 4-2 Total Sales Receipts of Sole Proprietorships, Partnerships, and Corporations in the United States

Advantages of Sole Proprietorships

Ease of start-up and closure

Sole proprietorship is the simplest way to start a business.

Pride of ownership

Retention of all profits

All profits become the personal earnings of the owner.

No special taxes

Profits earned by a sole proprietorship are taxed as the personal income of the owner.

Flexibility of being your own boss

Disadvantages of Sole Proprietorships

Unlimited liability – a legal concept that holds a business owner personally responsible for all the debts of the business

Lack of continuity

If the owner retires, dies, or is declared legally incompetent, the business essentially ceases to exist.

Lack of money

Banks, suppliers, and other lenders usually are often unwilling to lend large sums of money to sole proprietorships.

Limited management skills

The sole proprietor must have expertise in a number of different areas (sales, buying, accounting, etc.).

Difficulty in hiring employees

Partnerships

Partnership – a voluntary association of two or more persons to act as co-owners of a business for profit

Example: Before becoming incorporated, Procter & Gamble was formed as a partnership.

This form of ownership is much less common than the sole proprietorship or the corporation, representing only about 10 percent of all American businesses.

There is no legal maximum on the number of partners a partnership may have.

Types of Partners

General partner – a person who assumes full or shared responsibility for operating a business

Limited partner – a person who invests money in a business but has no management responsibility or responsibility or liability for losses beyond the amount he or she invested in the partnership

The Partnership Agreement

Articles of partnership – an agreement listing and explaining the terms of the partnership

The partnership agreement should state:

Who will make the final decisions

What each partner’s duties will be

The investment each partner will make

How much profit or loss each partner receives or is responsible for

What happens if a partner wants to dissolve the partnership or dies

FIGURE 4-3 Articles of Partnership

Advantages of Partnerships

Ease of start-up

Availability of capital and credit

Because partners can pool their funds, a partnership usually has more capital available than a sole proprietorship does.

Personal interest

Combined business skills and knowledge

Partners often have complementary skills; the weakness of one partner may be offset by another partner’s strength in that area.

Retention of profits

All profits belong to the owners of the partnership.

No special taxes

Disadvantages of Partnerships

Unlimited liability

Each general partner is legally and personally responsible for the debts, taxes, and actions of any other partner conducting partnership business, even if that partner did not incur those debts or do anything wrong.

Limited partners risk only their original investment.

Many states allow partners to form a limited-liability partnership (LLP), in which a partner may have limited-liability protection from legal action resulting from the malpractice or negligence of the other partners.

Management disagreements

Lack of continuity

Partnerships are terminated if any one of the general partners dies, withdraws, or is declared legally incompetent; however, the remaining partners can purchase that partner’s ownership share.

Frozen investment

Corporations

Corporation – an artificial person created by law with most of the legal rights of a real person, including the rights to start and operate a business, to buy or sell property, to borrow money, to sue or be sued, and to enter into binding contracts

Unlike a real person, a corporation exists only on paper.

Corporations comprise about 18 percent of all businesses, but they account for 82 percent of sales revenues.

Corporate Ownership

Stock – the shares of ownership of a corporation

Stockholder – a person who owns a corporation’s stock

Closed corporation – a corporation whose stock is owned by relatively few people and is not sold to the general public

Example: Mars

Open corporation – a corporation whose stock can be bought and sold by any individual

Examples: General Electric, Microsoft, Nike

TABLE 4-1 Ten Aspects of Business That May Require Legal Help

Choosing either the sole proprietorship, partnership, corporate, or some special form of ownership

Constructing a partnership agreement

Incorporating a business

Registering a corporation’s stock

Obtaining a trademark, patent, or copyright

Filing for licenses or permits at the local, state, and federal levels

Purchasing an existing business or real estate

Creating valid contracts

Hiring employees and independent contractors

Extending credit and collecting debts

Forming a Corporation (slide 1 of 6)

Where to Incorporate

A business is allowed to incorporate in any state that it chooses.

Most small- and medium-sized businesses are incorporated in the state where they do the most business.

The decision on where to incorporate usually is based on two factors:

The cost of incorporating in one state compared with the cost in another state

The advantages and disadvantages of each state’s corporate laws and tax structure

Forming a Corporation (slide 2 of 6)

Where to Incorporate (continued)

Domestic corporation – a corporation in the state in which it is incorporated

Foreign corporation – a corporation in any state in which it does business except the one in which it is incorporated

Example: Sears Holding Corporation, the parent company of Sears and Kmart, is incorporated in Delaware, where it is a domestic corporation, but is a foreign corporation in the remaining 49 states.

Alien corporation – a corporation chartered by a foreign government and conducting business in the United States

Examples: Volkswagen AG, Samsung Corporation

Forming a Corporation (slide 3 of 6)

The Corporate Charter

Articles of incorporation – a contract between a corporation and the state in which the state recognizes the formation of the artificial person that is the corporation (often called a corporate charter)

Usually, the articles of incorporation include the following information:

The firm’s name and address

The incorporators’ names and addresses

The purpose of the corporation

The maximum amount of stock and types of stock to be issued

The rights and privileges of stockholders

The length of time the corporation is to exist

Forming a Corporation (slide 4 of 6)

Stockholders’ Rights

There are two basic types of stock.

1. Common stock – stock owned by individuals or firms who may vote on corporate matters but whose claims on profits and assets are subordinate to the claims of others

2. Preferred stock – stock owned by individuals or firms who usually do not have voting rights but whose claims on dividends are paid before those of common-stock owners

Generally, smaller corporations issue only common stock.

Forming a Corporation (slide 5 of 6)

Stockholders’ Rights (continued)

Perhaps the most important right of owners of both common and preferred stock is to share in the profit earned by the corporation through the payment of dividends.

Dividend – a distribution of earnings to the stockholders of a corporation

Other rights include:

Receiving information about the corporation

Voting on changes to the corporate charter

Attending the corporation’s annual stockholders’ meeting

Proxy – a legal form listing issues to be decided at a stockholders’ meeting and enabling stockholders to transfer their voting rights to some other individual or individuals

Forming a Corporation (slide 6 of 6)

Organizational Meeting

As the last step in forming a corporation, the incorporators and original stockholders meet to adopt corporate bylaws and elect a board of directors.

The board members are directly responsible to the stockholders for the way they operate the firm.

Corporate Structure

In a corporation, both the board of directors and the corporate officers are involved in management.

Board of directors – the top governing body of a corporation, the members of which are elected by the stockholders

Board members can be chosen from within the corporation or from outside it.

Their major responsibilities are to set company goals, develop general plans (or strategies) for meeting those goals, oversee the firm’s overall operation, and appoint corporate officers.

Corporate officers – the chairman of the board, president, executive vice presidents, corporate secretary, treasurer, and any other top executive appointed by the board of directors

They help the board to make plans, carry out strategies established by the board, hire employees, and manage day-to-day business activities.

FIGURE 4-4 Hierarchy of Corporate Structure

Advantages of Corporations

Limited liability – a feature of corporate ownership that limits each owner’s financial liability to the amount of money that he or she has paid for the corporation’s stock

Ease of raising capital

Corporations can not only borrow money but also raise additional sums of money by selling stock.

Ease of transfer of ownership

Perpetual life

Since it is essentially a legal “person,” a corporation exists independently of its owners and survives them.

Specialized management

Typically, corporations are able to recruit more skilled, knowledgeable, and talented managers than proprietorships and partnerships.

Disadvantages of Corporations

Difficulty and expense of formation

Government regulation and increased paperwork

A corporation must register and meet various government standards before it can sell its stock to the public.

Conflict within the corporation

Double taxation

Corporate profits are taxed twice—once as corporate income and a second time as the personal income of stockholders.

Lack of secrecy

Because open corporations are required to submit detailed reports to government agencies and to stockholders, competitors can use this information to compete more effectively.

TABLE 4-2 Some Advantages and Disadvantages of a Sole Proprietorship, Partnership, and Corporation

	Sole Proprietorship	General Partnership	Regular C-Corporation
Protecting against liability for debts	Difficult	Difficult	Easy
Raising money	Difficult	Difficult	Easy
Ownership transfer	Difficult	Difficult	Easy
Preserving continuity	Difficult	Difficult	Easy
Government regulations	Few	Few	Many
Formation	Easy	Easy	Difficult
Income taxation	Once	Once	Twice

S Corporations

S corporation – a corporation that is taxed as though it were a partnership

In other words, the corporation’s income is taxed only as the personal income of its stockholders.

S corporation criteria:

No more than 100 stockholders are allowed.

Stockholders must be individuals, estates, or certain trusts.

The corporation has no nonresident, alien shareholders.

There can be only one class of outstanding stock.

The firm must be a domestic corporation eligible to file for S corporation status.

All stockholders must agree to the decision to form an S corporation.

Becoming an S corporation can be an effective way to avoid double taxation while retaining the corporation’s legal benefit of limited liability.

Limited-Liability Companies

Limited-liability company (LLC) – a form of business ownership that combines the benefits of a corporation and a partnership while avoiding some of the restrictions and disadvantages of those forms of ownership

Example: BMW of North America

Advantages:

Avoids double taxation of a corporation

Retains the corporation’s legal benefit of limited liability

Provides more management flexibility and fewer restrictions than corporations

The difference between an S corporation and an LLC is that an LLC is not restricted to 100 stockholders.

TABLE 4-3 Some Advantages and Disadvantages of a Regular Corporation, an S Corporation, and a Limited-Liability Company

	Regular C-Corporation	S Corporation	Limited- Liability Company
Double taxation	Yes	No	No
Limited liability and personal asset protection	Yes	Yes	Yes
Management flexibility	No	No	Yes
Restrictions on the number of owners/ stockholders	No	Yes	No
Internal Revenue Service tax regulations	Many	Many	Fewer

Not-for-Profit Corporations

Not-for-profit corporation – a corporation organized to provide a social, educational, religious, or other service rather than to earn a profit

Various charities, museums, private schools, colleges, and charitable organizations are organized in this way, primarily to ensure limited liability.

Joint Ventures

Joint venture – an agreement between two or more groups to form a business entity in order to achieve a specific goal or to operate for a specific period of time

Example: To take advantage of the production and marketing expertise of General Mills and the worldwide presence of Nestle, the two companies formed a joint venture called Cereal Partners Worldwide.

Once the goal is reached, the period of time elapses, or the project is completed, the joint venture is dissolved.

Syndicates

Syndicate – a temporary association of individuals or firms organized to perform a specific task that requires a large amount of capital

Example: A syndicate consisting of Goldman Sachs & Company, Morgan Stanley, J.P. Morgan, and other Wall Street firms helped U.S. Foods Holdings, a company that markets and distributes fresh, frozen, and dry food and nonfood products to consumers in the United States, sell stock to investors. With the syndicate’s help, U.S. Foods raised over $1 billion through its initial public offering and used the money to improve its cash balance and fund growth and expansion.

Like a joint venture, a syndicate is dissolved as soon as its purpose has been accomplished.

Growth from Within

Most corporations grow by expanding their present operations.

Some introduce and sell new but related products.

Others expand the sale of present products to new geographic markets or to new groups of consumers in geographic markets already served.

Example: Walmart was started by Sam Walton in 1962 with one discount store. Today, Walmart has nearly 11,500 stores in the United States and 27 other countries.

Growth Through Mergers and Acquisitions (slide 1 of 2)

Merger – the combining of two corporations or other business entities to form one business

An acquisition is essentially the same thing as a merger, but the term generally is used in reference to a large corporation’s purchases of other corporations.

To pay for an acquisition, a leveraged buyout may be used.

Leveraged buyout – a financing method that uses borrowed money to pay for the company that is being taken over

Although most mergers and acquisitions are often friendly, hostile takeovers also occur.

Hostile takeover – a situation in which the management and board of directors of a firm targeted for acquisition disapprove of the merger

Growth Through Mergers and Acquisitions (slide 2 of 2)

Classifications of mergers:

Horizontal merger – a merger between firms that make and sell similar products or services in similar markets

Vertical merger – a merger between firms that operate at different but related levels in the production and marketing of a product

Conglomerate merger – a merger between firms in completely different industries

FIGURE 4-5 Three Types of Growth by Merger

Merger and Acquisition Trends for the Future (slide 1 of 2)

The issue of whether mergers and acquisitions are good for the economy and companies is still hotly debated.

Takeover advocates argue that:

For companies that have been taken over, the purchasers have been able to make the company more profitable and productive by installing a new top-management team, reducing expenses, and forcing the company to concentrate on the firm’s most important business activities.

Takeover opponents argue that:

Takeovers do nothing to enhance corporate profitability or productivity.

The only people who benefit from takeovers are investment bankers, brokerage firms, and takeover “artists,” who receive financial rewards by manipulating corporations rather than by producing tangible products or services.

Merger and Acquisition Trends for the Future (slide 2 of 2)

Most experts predict future mergers and acquisitions will be the result of cash-rich companies looking to acquire businesses that will enhance their position in the marketplace or an industry.

Analysts also anticipate more mergers that involve companies or investors from other countries.

Future mergers and acquisitions will be driven by solid business logic and the desire to compete in the international marketplace.