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There are three main forms of business organization: (1) sole proprietorships, (2)
partnerships, and (3) corporations. In terms of numbers, about 80 percent of businesses
are operated as sole proprietorships, while most of the remainder are divided
equally between partnerships and corporations. Based on dollar value of sales, however,
about 80 percent of all business is conducted by corporations, about 13 percent
by sole proprietorships, and about 7 percent by partnerships and hybrids.
Sole Proprietorship
A sole proprietorship is an unincorporated business owned by one individual. Going
into business as a sole proprietor is easy—one merely begins business operations.
However, even the smallest business normally must be licensed by a governmental
unit.
The proprietorship has three important advantages: (1) It is easily and inexpensively
formed, (2) it is subject to few government regulations, and (3) the business
avoids corporate income taxes.
The proprietorship also has three important limitations: (1) It is difficult for a
proprietorship to obtain large sums of capital; (2) the proprietor has unlimited personal
liability for the business’s debts, which can result in losses that exceed the
money he or she invested in the company; and (3) the life of a business organized as a
proprietorship is limited to the life of the individual who created it. For these three
reasons, sole proprietorships are used primarily for small-business operations. However,
businesses are frequently started as proprietorships and then converted to corporations
when their growth causes the disadvantages of being a proprietorship to
outweigh the advantages.
Partnership
A partnership exists whenever two or more persons associate to conduct a noncorporate
business. Partnerships may operate under different degrees of formality,
ranging from informal, oral understandings to formal agreements filed with the secretary
of the state in which the partnership was formed. The major advantage of a partnership
is its low cost and ease of formation. The disadvantages are similar to those associated
with proprietorships: (1) unlimited liability, (2) limited life of the
organization, (3) difficulty transferring ownership, and (4) difficulty raising large
amounts of capital. The tax treatment of a partnership is similar to that for proprietorships,
but this is often an advantage.
Regarding liability, the partners can potentially lose all of their personal assets,
even assets not invested in the business, because under partnership law, each partner is
liable for the business’s debts. Therefore, if any partner is unable to meet his or her
pro rata liability in the event the partnership goes bankrupt, the remaining partners
must make good on the unsatisfied claims, drawing on their personal assets to the extent
necessary. Today (2002), the partners of the national accounting firm Arthur
Andersen, a huge partnership facing lawsuits filed by investors who relied on faulty
Enron audit statements, are learning all about the perils of doing business as a
partnership. Thus, a Texas partner who audits a business that goes under can bring
ruin to a millionaire New York partner who never went near the client company.
The first three disadvantages—unlimited liability, impermanence of the organization,
and difficulty of transferring ownership—lead to the fourth, the difficulty partnerships
have in attracting substantial amounts of capital. This is generally not a problem
for a slow-growing business, but if a business’s products or services really catch on, and
if it needs to raise large sums of money to capitalize on its opportunities, the difficulty in
attracting capital becomes a real drawback. Thus, growth companies such as Hewlett-
Packard and Microsoft generally begin life as a proprietorship or partnership, but at
some point their founders find it necessary to convert to a corporation.
Corporation
A corporation is a legal entity created by a state, and it is separate and distinct from
its owners and managers. This separateness gives the corporation three major advantages:
(1) Unlimited life. A corporation can continue after its original owners and managers
are deceased. (2) Easy transferability of ownership interest. Ownership interests can
be divided into shares of stock, which, in turn, can be transferred far more easily than
can proprietorship or partnership interests. (3) Limited liability. Losses are limited to
the actual funds invested. To illustrate limited liability, suppose you invested $10,000
in a partnership that then went bankrupt owing $1 million. Because the owners are
liable for the debts of a partnership, you could be assessed for a share of the company’s
debt, and you could be held liable for the entire $1 million if your partners could not
pay their shares. Thus, an investor in a partnership is exposed to unlimited liability.
On the other hand, if you invested $10,000 in the stock of a corporation that then
went bankrupt, your potential loss on the investment would be limited to your
$10,000 investment.1 These three factors—unlimited life, easy transferability of ownership
interest, and limited liability—make it much easier for corporations than for
proprietorships or partnerships to raise money in the capital markets.
The corporate form offers significant advantages over proprietorships and partnerships,
but it also has two disadvantages: (1) Corporate earnings may be subject to
double taxation—the earnings of the corporation are taxed at the corporate level, and
then any earnings paid out as dividends are taxed again as income to the stockholders.
(2) Setting up a corporation, and filing the many required state and federal reports, is
more complex and time-consuming than for a proprietorship or a partnership.
A proprietorship or a partnership can commence operations without much paperwork,
but setting up a corporation requires that the incorporators prepare a charter and a
set of bylaws. Although personal computer software that creates charters and bylaws is
now available, a lawyer is required if the fledgling corporation has any nonstandard features.
The charter includes the following information: (1) name of the proposed corporation,
(2) types of activities it will pursue, (3) amount of capital stock, (4) number of directors,
and (5)namesand addresses of directors.Thecharter is filed with the secretary of
the state in which the firm will be incorporated, and when it is approved, the corporation
is officially in existence.2Then,after the corporation is in operation, quarterlyandannual
employment, financial, and tax reports must be filed with state and federal authorities.
The bylaws are a set of rules drawn up by the founders of the corporation. Included
are such points as (1) how directors are to be elected (all elected each year, or
perhaps one-third each year for three-year terms); (2) whether the existing stockholders
will have the first right to buy any new shares the firm issues; and (3) procedures
for changing the bylaws themselves, should conditions require it.
The value of any business other than a very small one will probably be maximized
if it is organized as a corporation for these three reasons:
1. Limited liability reduces the risks borne by investors, and, other things held constant,
the lower the firm’s risk, the higher its value.
2. A firm’s value depends on its growth opportunities, which, in turn, depend on the
firm’s ability to attract capital. Because corporations can attract capital more easily
than unincorporated businesses, they are better able to take advantage of growth
opportunities.
3. The value of an asset also depends on its liquidity, which means the ease of selling
the asset and converting it to cash at a “fair market value.” Because the stock of a
corporation is much more liquid than a similar investment in a proprietorship or
partnership, this too enhances the value of a corporation.
Most firms are managed with value maximization in
mind, and this, in turn, has caused most large businesses to be organized as corporations.
However, a very serious problem faces the corporation’s stockholders, who are
its owners. What is to prevent managers from acting in their own best interests, rather
than in the best interests of the owners? This is called an agency problem, because
managers are hired as agents to act on behalf of the owners.
Hybrid Forms of Organization
Although the three basic types of organization—proprietorships, partnerships, and
corporations—dominate the business scene, several hybrid forms are gaining popularity.
For example, there are some specialized types of partnerships that have somewhat
different characteristics than the “plain vanilla” kind. First, it is possible to limit the liabilities
of some of the partners by establishing a limited partnership, wherein certain
partners are designated general partners and others limited partners. In a limited
partnership, the limited partners are liable only for the amount of their investment
in the partnership, while the general partners have unlimited liability. However,
the limited partners typically have no control, which rests solely with the general
partners, and their returns are likewise limited. Limited partnerships are common in
real estate, oil, and equipment leasing ventures. However, they are not widely used in
general business situations because no one partner is usually willing to be the general
partner and thus accept the majority of the business’s risk, while the would-be limited
partners are unwilling to give up all control.
The limited liability partnership (LLP), sometimes called a limited liability
company (LLC), is a relatively new type of partnership that is now permitted in many
states. In both regular and limited partnerships, at least one partner is liable for the
debts of the partnership. However, in an LLP, all partners enjoy limited liability with
regard to the business’s liabilities, so in that regard they are similar to shareholders in
a corporation. In effect, the LLP combines the limited liability advantage of a corporation
with the tax advantages of a partnership. Of course, those who do business with
an LLP as opposed to a regular partnership are aware of the situation, which increases
the risk faced by lenders, customers, and others who deal with the LLP.
There are also several different types of corporations. One that is common
among professionals such as doctors, lawyers, and accountants is the professional
corporation (PC), or in some states, the professional association (PA). All 50
states have statutes that prescribe the requirements for such corporations, which
provide most of the benefits of incorporation but do not relieve the participants of
professional (malpractice) liability. Indeed, the primary motivation behind the professional
corporation was to provide a way for groups of professionals to incorporate
and thus avoid certain types of unlimited liability, yet still be held responsible for
professional liability.
Finally, note that if certain requirements are met, particularly with regard to size and
number of stockholders, one (or more) individuals can establish a corporation but elect
to be taxed as if the business were a proprietorship or partnership. Such firms, which differ
not in organizational form but only in how their owners are taxed, are called S corporations.
Although S corporations are similar in many ways to limited liability partnerships,
LLPs frequently offer more flexibility and benefits to their owners, and this is
causing many S corporation businesses to convert to the LLP organizational form. |
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