Selecting a Form of Business Ownership

Introduction A. The Learning Goals of this chapter are to: 1. Describe the advantages and disadvantages of a sole proprietorship. 2. Describe the advantages and disadvantages of a partnership. 3. Desribe the advantages and disadvantages of a corporation. 4. Explain how the potential return and risk of a business are affected by its form of ownership. 5. Describe methods of owning existing businesses. B. One of the most important decisions an entrepreneur must make when establishing a new business is the form of ownership.

This chapter examines the major forms of business ownership and identifies ways investors can become owners of existing businesses. I. Sole Proprietorship A sole proprietorship is a business owned by a single owner. The owner is called the sole proprietor. About 70 percent of all firms in the United States are organized as sole proprietorships. However, since most sole proprietorships are small, they generate less than 10 percent of all business revenue. A. Characteristics of Successful Sole Proprietors 1. They are willing to accept sole responsibility for the firm’s performance.

The success or failure of the firm rests squarely on the shoulders of the sole proprietor. 2. They are willing to work long hours. The owner must often work more than the typical work day put in by employees. They are on call at all times, and may have to fill in for a sick worker. 3. Most successful sole proprietors also have strong organizational skills, leadership skills, and communication skills 4. Many successful sole proprietors have had previous experience working in the industry in which they are competing. This experience gives them an edge in understanding the competition and the wants and needs of their customers.

B. Advantages of a Sole Proprietorship 1. Since there is only one owner, all earnings go to the sole proprietor. 2. Although the owner must register the name of the business with the state, and may have to obtain an occupational license, the legal requirements of establishing a sole proprietorship are minimal. This ease of formation is an attractive advantage of a sole proprietorship. 3. The sole proprietor is his or her own boss and has complete control over the way the firm is run. This eliminates the chance that disagreements among owners will create conflicts and delay decision making.

4. Earnings of a sole proprietorship are considered personal income and may be subject to lower taxes than the earnings of other forms of business. C. Disadvantages of a Sole Proprietorship 1. Just as the owner enjoys all profits, the sole proprietor also incurs all losses. There are no other owners to share this burden. 2. There is no limit on the amount of debts for which a sole proprietor is liable. For example, if the business is sued, the owner is personally liable for the entire judgment. This unlimited liability is a major drawback of owning a sole proprietorship.

3. A sole proprietor often has very limited access to funds. This means that businesses that require heavy initial investments are seldom operated as sole proprietorships. 4. Sole proprietors may have limited skills. They may find themselves forced to make decisions in areas of business operations where they lack expertise. II. Partnership A partnership is a business that is co-owned by two or more people. The owners of the business are called partners. About 10 percent of all firms are organized as partnerships. A. Types of Partnership 1.

In a general partnership, all partners have unlimited liability. They are personally liable for all obligations of the firm. 2. In a limited partnership, some of the partners have limited liability. These limited partners share in the firm’s profits or losses, but do not take an active role in managing the company. However, a limited partnership must have at least one general partner who accepts unlimited liability. The general partner manages the company, receives a salary, and participates in the firm’s profits or losses. B. Advantages of a Partnership 1.

Additional funding: The presence of more than one owner means that more than one person is providing funding for the business. 2. Shared losses: Any losses are absorbed by more than one owner. 3. Ability to specialize: Unlike a sole proprietorship, where the single owner must be a “jack of all trades,” a partnership allows partners to focus on areas of specialization. This can improve efficiency. C. Disadvantages of Partnerships 1. Shared control: With more than one owner, the possibility exists that owners can disagree about how the business should be run.

This can delay decision making and create ill will among the partners. 2. Unlimited liability: All general partners have unlimited liability. If the partnership is sued or encounters severe financial difficulty, the owners can lose much more than the amount they have invested in the company. 3. Shared profits: Any profits earned by the partnership must be shared among all partners. D. Some small companies with 100 or fewer owners that satisfy certain criteria can avoid the problem of unlimited liability by forming an S-corporation.

This type of business provides owners with limited liability, but is taxed like a partnership. E. Another type of partnership that has become increasingly popular in recent years is the limited liability company (LLC). An LLC is a company that has all of the regular features of a general partnership, but also offers limited liability to the partners. It typically protects a partner’s personal assets from the negligence of other partners. The precise rules governing the liability protection offered by an LLC vary from state to state. III. Corporation A.

A corporation is a state-chartered business entity that pays taxes and is legally distinct from its owners. The people who form a corporation must adopt a corporate charter and file it with the state government. They must also establish general guidelines for managing the firm, which are called the corporation’s bylaws. B. Only about 20 percent of all firms are corporations, but these corporations generate almost 90 percent of all business revenue. Exhibit 5. 1 compares the percentage of firms organized as sole proprietorships, partnerships, and corporations and the percentage of business revenue generated by each form of ownership. C.

The owners of a corporation are called shareholders. Since the corporation is legally distinct from its owners, shareholders have limited liability for the debts of the company. The shareholders elect a board of directors, who are then responsible for establishing the general policies of the corporation and appointing the president and other key officers of the corporation. D. Owners of a corporation can earn a return on their investment in two ways. 1.

Stockholders may receive dividends, which are a distribution of some portion of the firm’s recent earnings to the stockholders. 2. The second type of return is in the form of an increase in the market value of the stock. The stockholders can benefit by selling the stock at a higher price than they paid for it. E. Many small corporations are privately held, meaning that ownership is held by a small number of investors and the stock is not readily available to other investors. Most large corporations are publicly held, meaning that shares of stock can be easily purchased or sold by investors.

F. Advantages of a Corporation 1. Limited liability: Unlike sole proprietors or general partners in a partnership, shareholders of corporations have limited liability. 2. Easier access to funds: The ability to issue additional stock provides corporations with a means of raising additional funds that is not available to sole proprietorships and partnerships. 3. Transfer of ownership: Stockholders in publicly held corporations can normally sell their stock by simply calling a stockbroker. Owners of sole proprietorships and partnerships may have a difficult time selling their business interests.

G. Disadvantages of a Corporation 1. Additional organizational expense: A corporation must create a corporate charter and file it with the state government. This process results in expenses that other forms of business do not incur. 2. Financial disclosure: When the stock of a company is publicly traded, investors have the right to examine the firm’s financial data, within certain limits. This may force the firm to disclose more about its operations and financial status than it would like. 3. Agency problems: Publicly held corporations are normally run by professional managers.

Unfortunately, sometimes the interests of managers conflict with the interests of owners. 4. High taxes: The earnings of corporations are subject to double taxation. Any earnings of the corporation are first taxed as income to the corporation. Then, if the corporation pays dividends to stockholders, the earnings are taxed again as the personal income of the owners of the corporation. The text includes a detailed numerical example of double taxation. Exhibit 5. 2 provides a diagram to show how the earnings a corporation distributes to stockholders are taxed twice, and Exhibit 5.

3 illustrates the difference between the way the earnings of corporations and sole proprietorships are taxed. The text also points out that owners are subject to a capital gains tax if they sell their shares of stock for more than they paid for them. H. Comparison of Forms of Business Ownership: Each form of ownership has its own advantages and disadvantages. No single form is ideal for all situations. An individual who wants to start a business with the least amount of hassle and expense, and who relishes the prospect of being in control, might favor the sole proprietorship.

A group of people who want to start a business together so they can pool their financial assets and specialize in different areas may find a partnership attractive. Others may find privately held corporations, with their limited liability, the most attractive form of ownership. Finally, a company that desires to grow rapidly and needs access to substantial amounts of financial capital may find that a publicly held corporation is the best form of ownership. I. How Business Ownership Can Change: Over time, the type of business ownership that is appropriate for a firm can change. IV.

How Ownership Can Affect Return and Risk A. The potential return and risk from investing in a business are influenced by the form of ownership. B. Return on equity (ROE) measures the return owners receive on their investment. It is computed by dividing the firm’s after-tax earnings by the firm’s equity, which is the total amount invested by the firm’s owners. C. Risk refers to the degree of uncertainty about the firm’s future earnings. Earnings are the difference between revenues and expenses, so lower than expected revenues or higher than expected expenses (or both) could cause a firm to experience losses.

Some sources of risk (such as bad weather or natural disasters) are beyond the control of the firm. But the firm’s owners must be aware of the factors that can affect revenue and cost in order to realistically assess the degree of risk. D. Relationship between risk and return: Generally there is an inverse relationship between risk and return. Potential owners (and creditors) will invest in a high-risk business only if the expected return is high enough to compensate for the risk. E.

Risk of small businesses: Small businesses tend to be riskier than large businesses because they often have limited funds to expand and diversify their businesses. Businesses can reduce their risk by making trade-offs between the form of ownership and access to funds. Generally speaking, the greater the number of people investing in a business, the greater the amount of funds available. Thus, a sole proprietorship could convert to a partnership and a partnership could convert to a corporation so that more funds can be accessed and risk reduced. V. Obtaining Ownership of an Existing Business.

A. Assuming Ownership of a Family Business: Many people work in a family business and eventually assume ownership of it. This type of situation is often desirable since the owner is already familiar with the business. If the business is stable, and key employees remain after the change in ownership, the main function of the new owner may be to ensure that the existing operations continue to function efficiently. If the business is struggling, the new owner may have to make substantial changes in the company’s management, marketing, and financial policies.

B. Purchasing an Existing Business: Existing businesses are sold to new owners for a variety of reasons, including financial difficulties or the death or retirement of the owner. Before buying an existing business, the new owner should carefully examine whether the potential benefits of ownership are great enough to justify the purchase price. The prospective purchaser should also make sure he or she has the expertise to manage the firm or at least the ability to properly oversee the managers who will run the business. C.

Franchising: A franchise is an arrangement whereby a business owner (called the franchisor) allows others (called franchisees) to use its trademark, trade name, or copyright, under specified conditions. Each individual franchise operates as an independent business and is typically owned by a sole proprietor. There are currently over five hundred thousand franchises operating in the United States, generating over $800 billion in annual revenue. D. Types of Franchises 1. A distributorship is an arrangement in which a firm is allowed to sell a product produced by a manufacturer.

Automobile dealerships are an example of this type of franchise. 2. A chain-style business is a firm that is allowed to use the trade name of a company and follows guidelines related to the pricing and sale of the product. Pizza Hut, Subway, and Holiday Inn are examples. 3. A manufacturing arrangement allows a firm to manufacture a product using formulas or methods provided by another company. For example, Microsoft may allow a company located in a foreign country to produce and distribute its software in that country. E.

Advantages of Franchises: 1. Proven management style: Franchisors often provide franchisees with guidance in production and management methods that have a track record of proven success. 2. Name recognition: Obtaining a franchise from a well-known franchisor can provide franchises with a recognized name that can greatly increase the demand for their product. Franchisors often support their brands with extensive advertising. 3. Financial support: Franchisors sometimes are willing to provide financial support to help franchisees get started.

In many franchise arrangements, the franchisee can purchase materials and supplies from the franchisor on credit, which can be a significant source of short-term financing. F. Disadvantages of Franchises 1. Shared profits: Franchisees typically have to pay fees and share profits with the franchisor in exchange for the benefits of operating the franchise. Annual payments can amount to 8 percent or more of the franchise’s annual revenue. 2. Less control: Because the franchisee must agree to abide by guidelines set by the franchisor, the owner of a franchise loses a certain amount of independence and flexibility.