© 2009 South-Western, a division of Cengage Learning 1 Chapter 6: BUSINESS FORMATION Choosing the...

© 2009 South-Western, a division of Cengage Learning 1

Chapter 6: BUSINESS FORMATION

Choosing the Form that Fits

© 2009 South-Western, a division of Cengage Learning2

CHOICES, CHOICES, CHOICES

The form of ownership of a business is a

big decision.

Form of ownership affects:

• Operation• Start-up Costs• Profit Distribution• Taxes

The “Big Three” is Becoming the “Big Four”:

• Sole Proprietorship• Partnership• Corporation• Limited Liability Company


SOLE PROPRIETORSHIP: BUSINESS AT ITS MOST BASIC

• Advantages:– Ease of Formation

– Retention of Control

– Pride of Ownership

– Retention of Profits

– Possible Tax Advantages

• Disadvantages:– Limited Financial

Resources

– Unlimited Liability

– Limited ability to attract and maintain talented employees

– Lack of Permanence


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

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)

Total Net Income by Form of Ownership ($Billions)


PARTNERSHIPS: TWO HEADS CAN BE BETTER THAN ONE

• Advantages:– Pooled Financial

Resources

– Shared Responsibilities

– Ease of Formation

– Tax Advantages

• Disadvantages:– Unlimited Liability

– Disagreements

– Difficulty in withdrawing from agreement

– Lack of Continuity


LIMITED PARTNERSHIPS

Limited Partnership – includes at least one

general partner and at least one limited partner

Limited Liability Partnership – All partners are actively

involved but they have some form of limited liability. The

amount of liability differs per state.

Limited partners have limited liability.


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.


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.


CORPORATIONS

• Advantages:– Limited Liability

– Permanence

– Easy to Transfer Ownership

– Ability to Raise Capital

– Specialized Management

• Disadvantages:– Expense/complexity of

formation and operation

– Double Taxation

– Paperwork and Regulation

– Conflicts of Interest

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/managing/content/sep2008/ca2008099_190182.htm?campaign_id=rss_daily

• http://www.thecoca-colacompany.com/ourcompany/board.html



OTHER TYPES OF CORPORATIONS: SAME BUT DIFFERENT

• S Corporation

• Closed Corporation

• Non-profit Corporation


COMPARING TYPES OF CORPORATIONS

TYPETYPE KEY ADVANTAGEKEY ADVANTAGE LIMITATIONSLIMITATIONS

S Corp. • IRS does not tax earnings separately.

• Stockholders have limited liability.

• No more than 100 stockholders

• Stockholders must be US citizens or permanent residents

Statutory Close Corp.

• 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

Nonprofit Corp.

• Earnings are exempt from federal and state income taxes.

• Members/directors have limited liability

• Contributions made by individuals are tax-deductible

• May have dues paying members but no stockholders.

• Can’t distribute dividends.

• Can’t make political donations.

• Must keep accurate records to document tax-exemption.


LIMITED LIABILITY COMPANY: THE NEW KID ON THE BLOCK

• Advantages:– Limited Liability

– Tax Pass-Through

– Simplified Management and Operation

– Flexible Ownership

• Disadvantages:– Franchise Taxes

– Foreign Status in other States

– State Law Differences

– Limited to Select Industries


COMPARING BUSINESS FORMS

Sole

ProprietorshipsPartnerships Corporations

LOW HIGHDEGREE OF COMPLEXITY AND PERPETUITY

HIGH LOWDEGREE OF PERSONAL LIABILITY


CORPORATE RESTRUCTURING

Corporations look for:– Growth opportunities– Operational efficiencies– Competitive advantages

Mergers – two companies agree to a combination of equals.

Acquisitions – when one firm buys another.


TYPES OF MERGERS AND ACQUISITIONS

Type of Merger

Definition Objective Example

Horizontal Combine firms in same industry.

• Increase size• Increase market power• Gain efficiency

AT&T and SBC

Vertical Combine companies with buyer-seller

relationship.

• Provide tighter integration and increase control

Time Warner and Turner

Broadcasting

Conglomerate Combination of unrelated

companies.

• Increase company’s diversity.

GE acquiring RCA


FRANCHISING: PROVEN METHODS FOR A PRICE

• Not a form of ownership but an operation option.– SubwaySubway– Jiffy LubeJiffy Lube– 7-Eleven7-Eleven– McDonaldsMcDonalds

• The franchisee uses the brand name, trademark and practices of the franchisor.


FRANCHISING

• Advantages:– Less Risk

– Training and Support

– Brand Recognition

– Access to Funding

• Disadvantages:– Costs

– Lack of Control

– Negative Halo Effect

– Growth Challenges

– Restriction on Sale

– Poor Execution

Ben & Jerry franchises its PartnerShops to non-profit corporations.


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?

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