Business Law for the Entrepreneur
and Manager
Chapter 7 – Business Organizations
Frank Cavico and Bahaudin G. Mujtaba
© Cavico & Mujtaba, 2008
Chapter Topics
• Business Organizations In The United States
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Sole Proprietorship
Partnership
Joint Venture
Limited Partnership
Limited Liability Partnership
Corporation: Introduction, Nature, Formation, and Powers
Rights and Responsibilities of Corporate Directors and Officers
Rights and Responsibilities of Shareholders
Basic Corporate Finance
Fundamental Corporate Change and Corporate Termination
Limited Liability Company
Franchise
Summary
© Cavico & Mujtaba, 2008
Business Organizations in the United
States- Sole Proprietorship
• The sole proprietorship is the most basic
form of business organization, as the owner
of the business is in essence the business.
Any person who does business individually
without utilizing any of the other forms of
business organization is doing business as a
sole proprietorship.
© Cavico & Mujtaba, 2008
Partnership
• It is important to point out that in the U.S. there is no federal
partnership law per se, but rather a series of state partnership statutes
based on, though not necessarily identical to, the Uniform Partnership
Act (UPA)
• The prudent business person is well-advised to check the individual
state version of the UPA where he or she is contemplating doing
business as a partnership
• A partnership is an association of two or more persons to carry on as
co-owners a business for profit. “Business” includes every trade,
occupation, or profession; and thus the object of a partnership can
literally be any and all business transactions
• a partnership need not have a fixed term, in which case it is called a
“partnership at will,” which means that it can be dissolved at any time
by any partner without violating the partnership agreement
• The ownership element to a partnership is critical. Ownership entails
the power of ultimate control and the concomitant right to make
management decisions
© Cavico & Mujtaba, 2008
• “Partnership by estoppel” holds that one, who by words or conduct,
represents himself or herself as a partner, or consents to another
person representing him or her as a partner, may be deemed liable as
a partner
• Typically, though, a partnership is based on contract, and thus is a
consensual relationship
• Together with the “intention” and “control” factors, the sharing of
profits and losses of a business is an essential element of every
partnership
• Partnership property can consist of any property – real or personal,
tangible or intangible - that be privately owned
• In addition to the right to manage the business, the property rights of
a partner are designated in Section 24 of the UPA as rights in specific
partnership property and the partner’s interest in the partnership
• contract of partnership usually (and most advisedly) will specify the
rights, duties, and liabilities of the parties between or among
themselves
© Cavico & Mujtaba, 2008
• It is quite common in partnership practice to concentrate all
management authority in one partner or a small committee
• The sharing of profits and losses in the partnership is governed by UPA
Section 18(a)
• The relationship of the partners to each other and to the partnership is a
fiduciary one
• Section 13 of the UPA, holds that the partnership is bound by any
wrongful act or omission of any partner acting in the ordinary course of
business of the partnership which causes injury or loss to a third party
• There are four key concepts that must be learned. The first is
“dissolution”, the second concept is a dissolution which leads to the
continuation of the business in an altered form, the third concept is a
dissolution which leads to the liquidation of the partnership, and the
fourth concept is when all partnership affairs are settled, which
ultimately leads to its termination
© Cavico & Mujtaba, 2008
Joint Venture
• A joint venture is a type of business relationship
where two or more persons combine their
knowledge, labor, and property to achieve a single
undertaking
• The precise point of division between a
partnership and a joint venture is very blurred
• Today, the joint venture is primarily used in
transnational business alliances in order to achieve
some specific purpose
© Cavico & Mujtaba, 2008
Limited Partnership
• The limited partnership is a business entity that did not exist
at common law; it was created by statute, specifically the
Uniform Limited Partnership Act (ULPA) which most states
in the United States have adopted
• A limited partnership is defined by the Act as one formed by
two or more persons, and having as its members one or
more general partners and one or more limited partners
• The formation of a limited partnership is patterned after the
ULPA, but with one important exception; that is, the limited
partnership requires the filing of a detailed registration
statement, called a certificate, containing many formalities,
with the appropriate state authority
• in 1976 the ULPA was revised by the Revised Uniform
Limited Partnership Act (RULPA) in an attempt to further
encourage its use as a business form
© Cavico & Mujtaba, 2008
Limited Liability Partnership (LLPs)
• One key aspect to the LLP way of doing business is that this form does
not have to have a general partner who is personally liable for the debts
and obligations of the partnership
• LLPs enjoy "flow-through" tax advantages as do the other types of
partnership. No tax thus is paid at the partnership level
• There are two important points regarding LLP law: 1) In most states,
LLPs are restricted to certain types of professionals, such as
accountants and lawyers; and 2) Most states require LLPs to carry a
minimum of $1 million in liability insurance to cover negligence,
wrongful acts, and misconduct by partners or employees of the LLP
• Partnership assets, of course, are subject to all partnership liabilities,
including malpractice claims
© Cavico & Mujtaba, 2008
Corporation: Introduction, Nature,
Formation, and Powers
• The corporate charter is granted by the state, and on one can conduct
business as a corporation without such a grant from the state
• The states can regulate the incorporation of a business as well as the
activities of the corporation
• Corporate existence begins on the date of filing as indorsed on the
charter
• Most states have four types of corporate statutes: 1) general business
corporate statutes, 2) non-profit corporation statutes; and 3)
professional corporation statutes designed for attorneys, physicians,
and accountants; and 4) small, “close,” or “closely held” corporation
statutes
• A corporation is defined as an artificial legal entity, independent of its
owners-investors, created by the state, pursuant to a corporate charter,
with powers conferred upon it by the state
© Cavico & Mujtaba, 2008
• A “domestic” corporation is one formed under the laws of
the particular state; and a “foreign” corporation refers to all
other corporations
• “Publicly held” corporations are those whose outstanding
shares are held by a large number of people, whose shares
are traded on national or international security exchanges,
whose stock prices are published, or whose activities are
regulated by the Securities and Exchange Commission
(SEC)
• A “closely held” corporation is one with relatively few
shareholders, usually less than 35, where all or most of the
shareholders participate in management
© Cavico & Mujtaba, 2008
• The corporation is a separate legal entity, distinct from its shareholders;
that is, it is an artificial legal person
• The corporation is unlimitedly liable, but the shareholders are not
personally liable for the debts of the corporation. The shareholder’s
liability is limited to the amount of his or her investment
• If a shareholder or director dies, or if a shareholder sells or transfers his
or her shares, the corporate continues to exist as a separate entity
• Other advantages of the corporate form are transferability of ownership
• The major disadvantage of the corporation in the U.S. is double
taxation
• there is a specialized corporate form, called a “sub-chapter S” (S)
corporation from the pertinent section in the Internal Revenue Code,
whereby the corporation can be taxed as a partnership
© Cavico & Mujtaba, 2008
• To form a corporation is mandatory, the filing of a document with the
appropriate state official, usually the Secretary of State of the state,
along with the payment of a filing fee. The document is most typically
called an “articles of incorporation”
• Incorporators are the person(s) who execute and sign the articles of
incorporation
• The “articles of incorporation” is an agreement among the incorporators
concerning the organizational details of the corporation
• An act beyond the powers or purposes of the corporation is known as an
ultra vires act, which can be enjoined by the state or by a shareholder
lawsuit, and also which can be the basis of a corporate action to recover
damages against the directors and/or officers who committed the ultra
vires act
• Every corporation is also required to have a registered office and a
registered agent at that office
• A pre-incorporation transaction is one on behalf of the corporation or in
the corporation’s name which occurs before the articles are filed, and
thus before there is any official corporate status
• There are two main types of pre-incorporation transactions: 1)
subscriptions for shares and 2) contracts by promoters
© Cavico & Mujtaba, 2008
• There are three legal doctrines that apply to the defective
formation of a corporation: 1) de jure corporate status, 2)
de facto corporate statue, and 3) corporation by estoppel
• “Piercing the corporate veil” occurs when a court is able
to disregard the corporate entity regardless of the
corporation’s de jure status
• When the subsidiary is a mere “conduit” for the parent,
akin to a department or division, the subsidiary is “thinly”
capitalized, the operations and assets too commingled, or
the representations or advertising confuses the identities of
the two, the corporate entity of the subsidiary can be
disregarded
© Cavico & Mujtaba, 2008
Rights and Responsibilities
of Corporate Directors and Officers
• Directors are the governing body of the corporation, while
officers are “merely” administrative and executive officials
• Directors may delegate management of the day-to-day
business of the corporation to executive officials
• The election, resignation, and removal of directors are areas
that are regulated in detail by state corporate law
• Most states have an age requirement of 18 years of age, and
some states require that the director must be a resident of the
state and/or a shareholder of the corporation
© Cavico & Mujtaba, 2008
• A fundamental principle of corporate law is that for the directors to act
and to legally bind the corporation, the directors must act collectively as
a board
• The fiduciary status and duties of directors are very important corporate
law principles. They are regarded as fiduciaries of the corporation and
serve in a relationship of trust, confidence, honesty, and loyalty
• Directors are protected from “bad” decisions by a significant corporate
rule, called the “Business Judgment Rule.” This rule holds that if a
director acts in a reasonable, prudent, good faith, and informed manner,
but nonetheless makes an honest mistake in judgment or a poor business
decision, and the corporation suffers thereby, the director is not liable to
the corporation for damages
© Cavico & Mujtaba, 2008
Rights and Responsibilities of
Shareholders
• Shareholders are the human ownership component of the corporation
• One may become a shareholder by an original purchase of shares or by
transfer of another person’s shares
• The shareholder retains his or her status and relationship until there is a
transfer of shares registered on the corporate books
• a share of stock is regarded as property (of the intangible kind) and
gives the shareholder an ownership interest in the corporation . This
interest is the right to participate in profits and, upon dissolution and
termination, the right to share in any distribution of assets
• Annual meetings must be held; the place and time is usually fixed in
the bylaws
© Cavico & Mujtaba, 2008
• The chief purpose of the annual meeting is the election of directors.
The power to elect directors is vested in the shareholders at the annual
meeting; and the corporation cannot divest shareholders of that vital
right and power
• An interesting and important shareholder voting right is called
“cumulative voting.” Cumulative voting means that a shareholder is
entitled to vote one vote for each share in the shareholder’s name; and
at the election for directors the shareholder may “cumulate” his or her
votes
• Other voting mechanisms for shareholder to exercise their authority
are the “pooling agreement” and the “voting trust.”
• Shareholders also can impose restrictions on the transfer of shares
• The three most common means of restricting the transferability of
shares are the option, the buy-sell agreement, and the right-of-firstrefusal
© Cavico & Mujtaba, 2008
Basic Corporate Finance
• Dividends are the share of corporate profits to be apportioned among
the shareholders as a return on their investment
• Once dividends are declared, that portion of the profits declared as
dividends becomes the property of the shareholders
• Dividends can be paid in cash, property, or stock
• A stock dividend is the payment of stock to the shareholder from the
corporation’s own authorized but un-issued
• If the directors make an improper payment of dividends they may be
held personally liable to the corporation and its creditors for the
amount
• If the directors make an improper payment of dividends they may be
held personally liable to the corporation and its creditors for the
amount
© Cavico & Mujtaba, 2008
• A corporation is allowed to have a variety of preferences or
priorities as to dividends and asset distribution; and these
preferences must be stated in the articles
• Three corporate finance terms are fundamental: 1) par value,
2) stated capital, and 3) capital surplus
• States have rules for the quality and amount of consideration
to be paid for shares
• The purpose of preemptive rights is to protect shareholders
proportionate interests in event of issue of additional shares.
Preemptive rights are defined as the right to preempt, or to
purchase before others, a new issue of shares in proportion to
the shareholder’s present interest in the corporation
© Cavico & Mujtaba, 2008
Fundamental Corporate Change and
Corporate Termination
• The major types of change to consider are as follows:
1) amending the articles of incorporation,
2) merging corporations
3) consolidating corporations
4) purchasing corporate assets
5) purchasing controlling shares of stock of a corporation
6) dissolving and terminating corporations
• The purchase and sale of assets and the purchase and sale of stock may
rise to the level of fundamental corporate change
• An acquiring corporation is not liable for the obligations of the selling
corporation unless there is an express or implied assumption of the
selling corporation’s liabilities, the sale is really a merger (a de facto
merger), or the acquiring corporation continues the selling
corporation’s business and retains its same personnel
© Cavico & Mujtaba, 2008
• Dissolution is the cessation of corporate business, except
for winding up, which leads to the termination and legal
“death” of the artificial corporate person
• Liquidation or winding up is the process by which
corporate assets are converted to cash and distributed
among the creditors and shareholders
• In most states a designated number of shareholders must
join the petition for judicial dissolution, usually 1/3rd of the
shareholders, but only one in a small, closely-held
corporation
© Cavico & Mujtaba, 2008
Limited Liability Company
• The LLC is formed pursuant to an “articles of organization”; it is an
unincorporated business entity that combines the most favorable
attributes of a general partnership, limited partnership, and corporation
• Make sure to consult the relevant state’s LLC statute when contemplating
the LLC way of doing business
• An LLC may be organized by one or more persons; and if only one
member, a sole proprietor can obtain the LLC benefit of limited liability
• The articles of organization can be amended at any time by filing an
“articles of amendment.”
• A general partnership, limited partnership, as well as a corporation may
be converted to an LLC
© Cavico & Mujtaba, 2008
• As to compensation and reimbursement, a non-manager
LLC member is not entitled to remuneration for services
performed to the LLC
• Concerning lawsuits by a member, a member of an LLC can
bring a direct lawsuit against the LLC to enforce a
member’s rights under the articles of organization, operating
agreement, state LLC law, and other federal, state, and local
law
• There is a limited duty of care owed to the LLC
• LLC laws typically (but not exclusively) use the term
"disassociation" in place of “dissolution."
© Cavico & Mujtaba, 2008
Franchise
• Generally speaking, a franchise is a method of conducting business
that combines the advantages of a recognized, proven, centralized, and
unique way of doing business with the capital, initiative, ambition, and
“hands-on” management provided by a local and independent business
entrepreneur, with the goal of leveraging that business person’s success
far beyond his or her typically limited resource potential
• The critical franchise factor is the commonality of the economic
situations and legal rights the parties have to contend with in their
business
• The term “franchise” is defined by a variety of state laws, some of
which require registration of franchise offerings and/or disclosure to
prospective franchises, as well as others which do not require
registration or disclosure, but which do regulate the relationship
between the franchisor and franchisee
© Cavico & Mujtaba, 2008
• The essence of a franchise is the franchise agreement
between the franchisor and franchisee. The franchise
relationship is thus a contractual one
• One of the main statutory protections afforded to the
franchisee stems from a Federal Trade Commission rule
that requires the franchisor to provide sufficient accurate
information to a prospective franchisee so that one can
make an informed business decision
• Even if the franchisor has the technical legal right to
terminate or to not renew, the covenant of good faith may
prevent the franchisor from so acting
© Cavico & Mujtaba, 2008
Summary
• Establishing a business can be complex and
cumbersome. Opening a business requires
understanding the national and local laws
• The chapter outlined some of the risks and
benefits associated with each type of organization
so the entrepreneur can decide which format best
fits his/her purpose for the business
• The sole proprietorship is the most basic form of
business organization, as the owner of the business
is in essence the business
© Cavico & Mujtaba, 2008
Reference
1.
2.
Cavico, F. & Mujtaba, B. G., (2008). Business Law for the Entrepreneur
and Manager. ILEAD Academy Publications; Davie, Florida, USA. ISBN:
978-0-9774-2115-2.
Cavico, F. and Mujtaba, B. G. (2008). Legal Challenges for the Global
Manager and Entrepreneur. Kendal Hunt Publishing; United States.
© Cavico & Mujtaba, 2008