Chapter 6: BUSINESS FORMATION
Choosing the Form that Fits
© 2009 South-Western, a division of Cengage Learning
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CHOICES, CHOICES, CHOICES
Form of ownership affects:
• Operation
• Start-up Costs
The form of ownership
• Profit Distribution
of a business is a
• Taxes
big decision.
The “Big Three” is Becoming
the “Big Four”:
• Sole Proprietorship
• Partnership
• Corporation
• Limited Liability Company
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SOLE PROPRIETORSHIP:
BUSINESS AT ITS MOST BASIC
• Advantages:
– Ease of Formation
– Retention of Control
– Pride of Ownership
– Retention of Profits
– Possible Tax
Advantages
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• Disadvantages:
– Limited Financial
Resources
– Unlimited Liability
– Limited ability to
attract and maintain
talented employees
– Lack of Permanence
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MOST COMMON TYPES OF
SOLE PROPRIETORSHIPS
Category
Examples
Number of
Proprietorships
(thousands)
Professional, Technical,
and Scientific Services
Law firms, accountants, architects,
computer system designers, consultants
2,752
Construction
Residential construction, commercial
construction, specialty contractors
2,491
Retail Trade
Car dealerships, restaurants, clothing
stores, home & garden stores
2,416
Other Services
Automobile repair and body shops,
laundries, personal services
1,995
Health Care
Physicians, dentists, chiropractors,
psychologists, psychiatrists
1,762
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Source for Table: “Sole Proprietorship Returns”, by Kevin Pierce Statistics of Income Bulletin, Summer, 2005, Figure A, p.9; website: http://www.irs.gov/pub/irs-soi/03solp.pdf )
BUSINESS FORMS: COMPARING
THE NUMBERS
Total Number of Businesses by Form of
Ownership (Millions)
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Total Net Income by Form of Ownership
($Billions)
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PARTNERSHIPS: TWO HEADS
CAN BE BETTER THAN ONE
• Advantages:
– Pooled Financial
Resources
– Shared
Responsibilities
• Disadvantages:
– Unlimited Liability
– Disagreements
– Ease of Formation
– Difficulty in
withdrawing from
agreement
– Tax Advantages
– Lack of Continuity
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LIMITED PARTNERSHIPS
Limited Partnership –
includes at least one
general partner and at
least one limited partner
Limited partners have
limited liability.
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Limited Liability Partnership –
All partners are actively
involved but they have some
form of limited liability. The
amount of liability differs
per state.
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GENERAL VS LIMITED
PARTNERSHIPS
• General Partnerships
– All partners have the right to participate in
the management of the firm and share in
any profits/losses.
• Limited Partnerships
– All partners contribute financially and share
in the profits but the limited partner(s)
cannot actively participate in management.
© 2009 South-Western, a division of Cengage Learning
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CORPORATIONS: AN
ARTIFICIAL REALITY
• A corporation is a legal entity, separate and
distinct from its owners.
• Corporations are owned by stockholders.
• The Board of Directors establishes the mission
and objectives.
• The Board is elected by the stockholders to
represent their interests.
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CORPORATIONS
• Advantages:
– Limited Liability
– Permanence
– Easy to Transfer
Ownership
– Ability to Raise Capital
• Disadvantages:
– Expense/complexity of
formation and operation
– Double Taxation
– Paperwork and
Regulation
– Conflicts of Interest
– Specialized Management
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Duties of the Board
• Provide continuity for the organization
• Select and appoint a chief executive
• Govern the organization by broad
policies and objectives
• Acquire sufficient resources for the
organization's operations
• Account to the public for the products
and services of the organization and
expenditures
Board FAQ’s
• The average size of boards is 16
• Most boards pay members:
– Stock options
– Travel reimbursement
– Cash stipends
• Directors of top 250 companies average
$238,000 - $261,000 (over $1,000 per
hour) Source: Steven Hall & Associates 2008 study
FAQ’s
• Most Boards organized into committees
(i.e. compensation committee)
• Many Boards have term limits and
evaluations of performance
• Boards generally meet every quarter
• http://www.businessweek.com/managin
g/content/sep2008/ca2008099_190182.
htm?campaign_id=rss_daily
• http://www.thecocacolacompany.com/ourcompany/board.ht
ml
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OTHER TYPES OF CORPORATIONS:
SAME BUT DIFFERENT
• S Corporation
• Closed Corporation
• Non-profit Corporation
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COMPARING TYPES OF
CORPORATIONS
TYPE
S Corp.
Statutory
Close
Corp.
KEY ADVANTAGE
• IRS does not tax earnings
separately.
• Stockholders have limited liability.
• No more than 100 stockholders
• Stockholders must be US citizens
or permanent residents
• Not require to have a board or hold
annual meetings.
• Owners can participate in
management while maintaining
limited liability.
• Limited number of stockholders.
• Stockholders must offer shares to
owner first before selling publicly
• Not all states allow this
corporation type
• Earnings are exempt from federal
and state income taxes.
• Members/directors have limited
liability
• Contributions made by individuals
© 2009 South-Western, a division of Cengage Learning
are tax-deductible
Nonprofit
Corp.
LIMITATIONS
• May have dues paying members
but no stockholders.
• Can’t distribute dividends.
• Can’t make political donations.
• Must keep accurate records
16 to
document tax-exemption.
LIMITED LIABILITY COMPANY:
THE NEW KID ON THE BLOCK
• Advantages:
• Disadvantages:
– Limited Liability
– Franchise Taxes
– Tax Pass-Through
– Foreign Status in
other States
– Simplified
Management and
Operation
– Flexible Ownership
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– State Law
Differences
– Limited to Select
Industries
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COMPARING BUSINESS
FORMS
HIGH
DEGREE OF PERSONAL LIABILITY
Sole
Proprietorships
LOW
Partnerships
LOW
Corporations
DEGREE OF COMPLEXITY AND PERPETUITY
© 2009 South-Western, a division of Cengage Learning
HIGH
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CORPORATE RESTRUCTURING
Mergers – two
companies agree to a
combination of equals.
Acquisitions – when
one firm buys another.
Corporations look for:
– Growth opportunities
– Operational efficiencies
– Competitive advantages
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TYPES OF MERGERS AND
ACQUISITIONS
Type of
Merger
Horizontal
Vertical
Conglomerate
Definition
Objective
Example
Combine firms in
same industry.
• Increase size
• Increase market power
• Gain efficiency
AT&T and
SBC
Combine companies • Provide tighter
with buyer-seller
integration and
relationship.
increase control
Combination of
unrelated
companies.
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• Increase company’s
diversity.
Time Warner
and Turner
Broadcasting
GE acquiring
RCA
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FRANCHISING: PROVEN
METHODS FOR A PRICE
• Not a form of ownership but an operation
option.
–
–
–
–
Subway
Jiffy Lube
7-Eleven
McDonalds
• The franchisee uses the brand name,
trademark and practices of the franchisor.
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FRANCHISING
• Advantages:
• Disadvantages:
– Less Risk
– Costs
– Training and Support
– Lack of Control
– Brand Recognition
– Negative Halo Effect
– Access to Funding
– Growth Challenges
Ben & Jerry franchises its
PartnerShops to non-profit
corporations.
© 2009 South-Western, a division of Cengage Learning
– Restriction on Sale
– Poor Execution
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LOOKING BACK
•
What are the pros and cons of operating a business as a sole
proprietorship?
•
What are the basic features of general partnerships, limited
partnerships, and limited liability partnerships?
•
Why have corporations become the dominant form of business
ownership?
•
How do S corporations, statutory closed corporations and nonprofit
corporations differ from general corporations, and from each other?
•
How does a corporation restructure through mergers and
acquisitions?
•
Why have limited liability companies become increasingly popular?
•
What are the advantages and disadvantages of franchising?
© 2009 South-Western, a division of Cengage Learning
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