Legal structure: some implications - Business Environment

For businesses in the private sector, the choice of legal structure has important implications. Among the factors which the aspiring entrepreneur has to take into account when deciding what form of business enterprise to establish are:

  • the degree of personal liability;
  • the willingness to share decision-making powers and risks;
  • the costs of establishing the business;
  • the legal requirements concerning the provision of public information;
  • the taxation position;
  • commercial needs, including access to capital; and
  • business continuity.

For some, retaining personal control will be the main requirement, even at the risk of facing unlimited personal liability and reducing the opportunities for expansion.For others, the desire to limit personal liability and to provide increased capital for growth will dictate that the owner seeks corporate status, even if this necessitates sharing decision-making powers and may ultimately result in a loss of ownership and/or control of the enterprise.

This link between an organisation’s legal structure and its subsequent operations can be illustrated by examining three important facets of organisational life: the organisation’s objectives, its sources of finance and its stake holders. As the analysis below illustrates, in each of these areas significant differences occur between alternative forms of business organisation, both within the private sector and between the state and non-state sectors of the economy. In some cases, these differences can be attributed directly to the restraints (or opportunities) faced by an organisation as a result of its legal status, suggesting that the legal basis of the enterprise conditions its operations. In other cases operational considerations tend to dictate the organisation’s legal form, indicating that these are as much a cause of its legal status as a result of it a point well illustrated by the workers’ co-operative and the public corporation.

Organisational objectives
All business organisations pursue a range of objectives and these may vary to some degree over time. New private sector businesses, for example, are likely to be concern edinitially with survival and with establishing a position in the marketplace, with profitability and growth seen as less important in the short term. In contrast, most well-established businesses will tend to regard profits and growth as key objectives and may see them as a means towards further ends, including market domination, maximizing sales revenue and/or minimizing operating costs.
Organisational objectives are also conditioned by the firm legal structure. In sole traders, partnerships and some limited companies, control of the enterprise rests in the hands of the entrepreneur(s) and hence organisational goals will tend to coincide with the personal goals of the owner(s), whatever the point in theorganisation life cycle. In public companies, however where ownership tends to be separated from control the goals of the owners (shareholders) may not always correspond with those of the directors and senior managers who run the organisation, particularly when the latter are pursuing personal goals to enhance their own organisational position, status and/or rewards.
It is worth noting that the possibility of goal conflict also occurs where an individual company becomes a subsidiary of another organisation, whether by agreement or as a result of a takeover battle. This parent subsidiary relationship may take the form of a holding company which is specially created to purchase a majority of the shares in other companies, some of which may operate as holding companies themselves. Thus, while the individual subsidiaries may retain their legal and commercial identities and may operate as individual units, they will tend to be controlled by a central organisation which may exercise a considerable degree of influence over the objectives to be pursued by each of its subsidiaries. It is not inconceivable, for example, that some parts of the group maybe required to make a loss on paper, particularly when there are tax advantages to be gained by the group as a whole from doing so.Workers co-operatives and public corporations provide further evidence of the relationship between an organisation legal status and its primary objectives. In the case of the former, the establishment of the enterprise invariably reflects a desire on the part of its members to create an organisation which emphasizes social goals (e.g. democracy, co-operation, job creation, mutual trust) rather than the pursuit of profits hence the choice of the co-operative form. Similarly in the case of the public corporation, a decision by government to establish an entity which operates in the interests of the public at large (or national interest) favours the creation of a state-owned-and-controlled organisation, with goals laid down by politicians and generally couched in social and financial terms (e.g. return on assets, reinvestment, job creation) rather than in terms of profit maximization.
This apparent dichotomy between the profit motive of the private sector and the broader socio-economic goals of public bodies has, however, become less clear-cut over the last decade, as an increasing number of state-owned organisations have been prepared for privatization and successive governments have sought to bring private money into public projects by creating public/private partnerships. Equally, in other parts of the public sector including the health service and local government increasing stress is being laid on best value and on operating within budgetsconcepts which are familiar to businesses in the private sector. While it is not inconceivable that a change in government could reverse this trend, current evidence suggests that a shift in cultural attitudes has occurred and public bodies can no longer rely on unconditional government support for their activities. If this is the case, further convergence is likely to occur between state and privately owned bodies, with the former moving towards the latter rather than vice versa.

Finance
Business organisations finance their activities in a variety of ways and from a range of sources. Methods include reinvesting profits, borrowing, trade credit and issuing shares and debentures. Sources include the banks and other financial institutions, individual investors and governments, as well as contributions from the organisation’s original owners. In the context it is appropriate to make a number of observations about the topic as it relates generally to the business environment:

  1. All organisations tend to fund their activities from both internal (e.g. owner’s capital, reinvested profits) and external sources (e.g. bank borrowing, sale of shares).
  2. Financing may be short term, medium term or longer term, and the methods and sources of funding chosen will reflect the time period concerned (e.g. bank borrowing on overdraft tends to be short term and generally needed for immediate use).
  3. Funds raised from external sources inevitably involve the organisation in certain obligations (e.g. repayment of loans with interest, personal guarantees, paying dividends)and these will act as a constraint on the organisation at some future date.
  4. The relationship between owner’s capital and borrowed funds usually describe das an organisation’sgearing can influence a firm’s activities and prospects in a variety of ways (e.g. high-geared firms with a large element of borrowed funds will be adversely affected if interest rates are high).
  5. Generally speaking, as organisations become larger many more external sources and methods of funding become available and utilizing these can have implications for the structure, ownership and conduct of the organisation.

This latter point is perhaps best illustrated by comparing sole traders and partnerships with limited companies. In the case of the former, as unincorporated entities neither the sole trader nor the partnership can issue shares (or debentures) and hence their access to large amounts of external capital is restricted by law. Companies have no such restrictions other than those which help to differentiate a private company from a public one and consequently they are able to raise larger amounts by inviting individuals (and organisations) to subscribe for shares. Where a company is publicly quoted on the stock market, the amounts raised in this way can be very large indeed and the resultant organisation may have millions of owners who change on a regular basis as shares are traded on the second-hand market.
Organisations which decide to acquire corporate status in order to raise funds for expansion (or for some other purposes) become owned by their shareholders, who may be the original owners or may be individual and institutional investors holding equity predominantly as an investment and with little, if any, long-term commitment to the organisation they own. As indicated above, in the latter case, a separation tends to occur between the roles of owner (shareholder) and controller (director) and this can lead to the possibility of conflicting aims and objectives or differences in opinion over priorities within the enterprise a problem discussed in more detail below under ‘Stakeholders’.A further illustration of the relationship between an organisation’s legal structure and its ability to raise finance is provided by the public corporation. In this case, as a public body accountable to Parliament and the public via government, the public corporation is required to operate within a financial context largely controlled by government and normally conditioned by the government’s overall fiscal policy, including its attitude to the size of the Public Sector Borrowing Requirement (PSBR). One aspect of this context in Britain has been the establishment of external financing limits (EFLs) for each nationalized industry, arrived at by negotiation between government and the board running the public corporation, and used as a means of restraining monetary growth and hence the size of the PSBR.

Unfortunately this has also tended to prevent the more financially sound corporations, such as British Telecom before privatization, from borrowing externally on a scale necessary to develop their business a restriction which tends to disappear when the corporation becomes a fully fledged public company, either through privatization or by some other means.

Stakeholders
All organisations have stakeholders; these are individuals and/or groups who are affected by or affect the performance of the organisation in which they have an interest. Typically they would include employees, managers, creditors, suppliers, shareholders (if appropriate) and society at large. As Table illustrates, an organisation’s stakeholders have a variety of interests which range from the pursuit of private gain to the more nebulous idea of achieving public benefit. Sometimes these interests will clash as, for example, when managers seek to improve the organisation’s cash flow by refusing to pay suppliers’ bills on time. On other occasions, the interests of different stakeholders may coincide, as when managers plan for growth in the organisation and in doing so provide greater job security for employees and enhanced dividends for investors.
The legal structure of an organisation has an impact not only on the type of stakeholders involved but also to a large degree on how their interests are represented.In sole traders, partnerships and smaller private companies, the coincidence of ownership and control limits the number of potential clashes of interest, given that objectives are set by and decisions taken by the firm’s owner-manager(s). In larger companies, and in particular, public limited companies, the division between ownership and control means that the controllers have the responsibility of representing the interests of the organisation’s shareholders and creditors and, as suggested above, their priorities and goals may not always correspond.A similar situation occurs in public sector organisations, where the interest of taxpayers (or ratepayers) is represented both by government and by those individual Legal structure also chosen by government to run the organisation. In this case, it is worth recalling that the broader strategic objectives of the enterprise and the big decisions concerning policy, finance and investment tend to be taken by politicians, operating with advice from their officials (e.g. civil servants, local government officers) and with in the context of the government’s overall economic and social policies. The organisation’s board of management and its senior executives and managers are mainly responsible for the day-to-day operations of the business, although the board and the person chairing it would normally play a key role in shaping overall objectives and decisions, through regular discussions with government and its officials.One important way in which public sector organisations differ from their private sector counterparts is in the sanctions available to particular groups of stakeholders who feel that the organisation is not representing their best interests. Shareholders in a company, for example, could withdraw financial support for a firm whose directors consistently disregard their interests or take decisions which threaten the security and/or value of their investment, and the possibility of such a reaction normally guarantees that the board pays due attention to the needs of this important group of stakeholders. The taxpayer and ratepayer have no equivalent sanction and in the short term must rely heavily on government and its agencies or, if possible, their power as consumers to represent their interest vis-à-vis the organisation. Longer term,of course, the public has the sanction of the ballot box, although it seems highly unlikely that the performance of state enterprises would be a key factor in determining the outcome of general or local elections.

organisational stakeholders

The relative absence of market sanctions facing state-owned organisations has meant that the public has had to rely on a range of formal institutions (e.g. parliamentary scrutiny committees, consumer consultative bodies, the audit authorities)and on the media to protect its interest in areas such as funding, pricing and quality of service provided. As these organisations are returned to the private sector, the expectation is that the sanctions imposed by the free market will once again operate and shareholders in privatized utilities will be protected like any other group of share holders in a privately owned enterprise. To what extent this will occur in practice, of course, is open to question, while the newly privatized public corporations face little, if any, competition. Government, it seems, prefers to hedge its bets on this question, at least in the short term hence the establishment of ‘regulators’ with powers of investigation into performance and some degree of control over pricing.


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