Forms of Business Organization - Financial Management

Most businesses are organized as either a sole proprietorship, a partnership, or a corporation.

Sole Proprietorship

A sole proprietorship is a business owned by one person. One of the major advantages of the sole proprietorship business form is that it is easy and inexpensive to establish. A major disadvantage of a sole proprietorship is that the owner of the firm has unlimited personal liability for all debts and other obligations incurred by the firm.

Sole proprietorships have another disadvantage in that their owners often have difficulty raising funds to finance growth. Thus, sole proprietorships are generally small. Although approximately 75 percent of all businesses in the United States are of this type, their revenue amounts to less than 6 percent of the total U.S. business revenue.2 Sole proprietorships are especially important in the retail trade, service, construction, and agriculture industries.

Partnership

A partnership is a business organization in which two or more co -owners form a business, normally with the intention of making a profit. Each partner agrees to provide a certain percentage of the funds necessary to run the business and/or agrees to do some portion of the necessary work. In return, the partners share in the profits (or losses) of the business. Partnerships may be either general or limited. In a general partnership, each partner has unlimited liability for all of the obligations of the business. Thus, general partnerships have the same major disadvantage as sole proprietorships. Even so, approximately 90 percent of all partnerships in the United States are of this type.

A limited partnership usually involves one or more general partners and one or more limited partners. Although the limited partners may limit their liability, the extent of this liability can vary and is set forth in the partnership agreement. Limited partnerships are common in real estate ventures. During the 1980s some corporations, such as Mesa Petroleum, restructured themselves as master limited partnerships, where the partnership units trade just like shares of stock.

The primary motivation for master limited partnerships was to avoid the double taxation of the firm’s income that occurs in a corporation. Tax code changes in 1987 largely eliminated the tax motivation for master limited partnerships. Partnerships have been relatively important in the agriculture, mining, oil and gas, finance, insurance, real estate, and services industries. Overall, partnerships account for about 7 percent of all U.S. business firms and less than 5 percent of total business revenues. Partnerships are relatively easy to form, but they must be re -formed when there is a change in the makeup of the general partners. Partnerships have a greater capacity to raise capital than sole proprietorships, but they lack the tremendous capital attraction ability of corporations.

Corporation

A corporation is a “legal person” composed of one or more actual individuals or legal entities. It is considered separate and distinct from those individuals or entities.Money contributed to start a corporation is called capital stock and is divided into shares; the owners of the corporation are called stockholders or shareholders.

Corporations account for less than 20 percent of all U.S. business firms but about 90 percent of U.S. business revenues and approximately 70 percent of U.S. business profits.5 The corporate form of business organization has four major advantages over both sole proprietorships and partnerships.

  • Limited liability Once stockholders have paid for their shares, they are not liable for any obligations or debts the corporation may incur. They are liable only to the extent of their investment in the shares.
  • Permanency The legal existence of a corporation is not affected by whether stockholders sell their shares, which makes it a more permanent form of business organization.
  • Flexibility A change of ownership within a corporation is easily accomplished when one individual merely sells shares to another. Even when shares of stock are sold, the corporation continues to exist in its original form.
  • Ability to raise capital Due to the limited liability of its owners and the easy marketability of its shares of ownership, a corporation is able to raise large amounts of capital, which makes large -scale growth possible.

However, the ability to raise capital comes with a cost. In the typical large corporation, ownership is separated from management. This gives rise to potential conflicts of goals and certain costs, called agency costs, which will be discussed later. However, the ability to raise large amounts of capital at relatively low cost is such a large advantage of the corporate form over sole proprietorships and partnerships that a certain level of agency costs is tolerated.

As a “legal person, ” a corporation can purchase and own assets, borrow money, sue, and be sued. Its officers are considered to be agents of the corporation and are authorized to act on the corporation’s behalf. For example, only an officer, such as the treasurer, can sign an agreement to repay a bank loan for the corporation.

Corporate Organization and Governance In most corporations, the stockholders elect a board of directors, which, in theory, is responsible for managing the corporation. In practice, however, the board of directors usually deals only with broad policy matters, leaving the day-to-day operations of the business to the officers, who are elected by the board. Corporate officers normally include a chairman of the board, chief executive officer (CEO), chief operating officer (COO), chief financial officer (CFO), president, vice president(s), treasurer, and secretary.

In some corporations, one person holds more than one office; for instance, many small corporations have a person who serves as secretary -treasurer. In most corporations, the president and various other officers are also members of the board of directors. These officers are called “inside” board members, whereas other board members are called “outside” or independent board members. A corporation’s board of directors usually contains at least three members.

Corporate Securities In return for the use of their funds, investors in a corporation are issued certificates, or securities. Corporate securities represent claims against the assets and future earnings of the firm.

There are two types of corporate securities. Investors who lend money to the corporation are issued debt securities; these investors expect periodic interest payments, as well as the eventual return of their principal. Owners of the corporation are issued equity securities. Equity securities take the form of either common stock or preferred stock. Common stock is a residual form of ownership; that is, the claims of common stockholders on the firm’s earnings and assets are considered only after all other claims —such as those of the government, debt holders, and preferred stockholders -have been met.Common stockholders are considered to be true owners of the corporation. Common stockholders possess certain rights or claims, including dividend rights, asset rights, voting rights, and preemptive rights.

Preferred stockholders have priority over common stockholders with regard to the firm’s earnings and assets. They are paid cash dividends before common stockholders. In addition, if a corporation enters bankruptcy, is reorganized, or is dissolved, preferred stockholders have priority over common stockholders in the distribution of the corporation’s assets. However, preferred stockholders are second in line behind the firm’s creditors.

Because of the advantages of limited liability, permanency, and flexibility and because ownership shares in corporations tend to be more liquid (and hence relatively more valuable) than ownership interests in proprietorships and partnerships, it is easy to see why the majority of business conducted in the United States is done under the corporate form of organization.

Other Types of Business Organizations

Though sole proprietorships, partnerships, and corporations are the three basic forms of business organization, there are other types or organizations sometimes referred to as hybrid organizations, that have features of each of these basic forms.

The subchapter S corporation is one such example. The Internal Revenue Code permits companies with 75 or fewer domestic stockholders, and that meet certain other requirements, to register as an S corporation.With the S corporation, stockholders avoid the double taxation of earnings and pay taxes similar to partnerships. The S corporation, however, preserves the other benefits of the corporate setup, including limited liability. In recent years, there has been an increase in the number of firms registering as S corporations for tax purposes.

An increasingly popular form of hybrid organization is the limited liability company (LLC). Like the S corporation, the earnings of the LLC flow through to the owners (called members) and are taxed at the individual level. Also, like the corporation, the LLC members have the benefit of limited liability. The LLC has fewer restrictions than the S corporation in terms of who can qualify as owners and greater flexibility in terms of accounting requirements. For example, the members need not be domestic, and from an accounting perspective no annual reports need to be filed.An example of an LLC is Lazard LLC, a prestigious investment banking firm formerly known as Lazard Freres & Co.

The limited liability partnership (LLP) is another type of business organization where all partners have limited liability. LLPs are taxed like any other partnership; thus, they share the tax advantage of regular partnerships and sole proprietorships. A form of LLP is the professional limited liability partnership (PLLP), which is a partnership formed to render specific professional services such as legal, accounting, or medical services.

Examples of LLPs include Baker and Botts LLP (legal practice) and Price Waterhouse Coopers LLP (accounting and other management services). Goldman Sachs, a well -known investment banking firm, used to be a limited partnership until May 1999, when it converted to the corporate form in order to have better access to capital to finance growth, enable broad employee ownership of the firm, and enable the firm to engage in strategic acquisitions.


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