Pride/Hughes/Kapoor Business, 10th Edition

Audio Review Transcript
Chapter 4 Choosing a Form of Business Ownership

1. Describe the advantages and disadvantages of sole proprietorships

How does a business organize itself? Whether it is an e-business or a more traditional business, there are actually three primary forms of business ownership—the sole proprietorship, the partnership, and the corporation. There are also several special-purpose forms of ownership.
Let’s start by talking about sole proprietorships. A sole proprietorship is a business that is owned, and usually operated, by one person. It is the simplest form of ownership and the easiest to start. In fact, ease of start-up is one of the five advantages of the sole proprietorship. Most of the businesses in the United States are sole proprietorships. The second advantage is pride of ownership. The third is that the owner retains all the profits, since those profits are his or her personal earnings. The fourth advantage is flexibility. The owner makes all decisions and so can make changes immediately to profit from market conditions. The fifth advantage relates to taxes. Since the profits of a sole proprietorship are taxed only as personal income to the owner, they are not subject to the double taxation of corporations.
Of course, there are some disadvantages to the sole proprietorship as well. The first of the five disadvantages is unlimited liability, which is a legal concept that holds a business owner personally responsible for all the debts of the business. This means that if the business fails or is involved in a lawsuit and loses, the owner’s personal property can be sold to pay creditors. The second disadvantage is a lack of continuity. If the owner dies or is declared legally incompetent, the businesses no longer exists. The third disadvantage is a lack of money. Banks, suppliers, and other lenders are often unwilling to lend large amounts to sole proprietorships. The fourth disadvantage is the limited management skills that most businesspeople possess. Even an experienced business owner is unlikely to have sufficient skills in all the areas necessary to successfully run a business. Finally, the fifth disadvantage is a difficulty finding and hiring competent employees, since there is rarely room for advancement and a limit on the salary that can be offered. (LO 1 ends)

2. Explain the different types of partners and the importance of partnership agreements

In order to reduce some of the disadvantages, some business owners turn to the partnership. A partnership is a voluntary association of two or more persons to act as co-owners of a business for profit. Though most partnerships have two owners, there is no legal limit on the number of partners that may be involved in a business. In fact, there are two different types of partners and three types of partnerships. One type of partner is a general partner, a person who assumes full or shared responsibility for operating a business. As a result, a general partnership is a business co-owned by two or more general partners who are liable for everything the business does. The second type is the limited partner, who contributes capital to a business but has no management responsibility or liability for losses beyond the amount he or she invested in the partnership. A limited partnership, then, is a business co-owned by one or more general partners who manage the business and limited partners who invest money in it. The third type of partnership is called a master limited partnership. The master limited partnership, or MLP, is a business partnership that is owned and managed like a corporation but taxed like a partnership. This means that shares in MLPs can be traded on organized security exchanges, which increase the available capital, but profits are only taxed as personal income.
Before entering into business, the partners must draft a document called articles of partnership. This agreement explains the legal terms of the partnership, including decision making, contributions, duties, and the percentage of profit and loss each is entitled to or responsible for. (LO 2 ends)

3. Describe the advantages and disadvantages of partnerships

There are six advantages to partnerships. (1) Partnerships are easy to start up. (2) There is greater availability of capital and credit because partners can pool their funds. (3) The owners of the partnership retain all profits. (4) There is increased personal interest by the general partners. (5) The ability to combine business skills and knowledge means that strengths can offset weaknesses. And (6) tax advantages, meaning that business income is taxed only once. Of course, partnerships have disadvantages as well. (1) Like sole proprietorships, general partners in partnerships have unlimited liability. (2) If one partner dies, withdraws, or is declared legally incompetent, there is a lack of continuity. Unlike a sole proprietorship, though, the other partner or partners can buy out the share of the one who is no longer involved. (3) The effect of management disagreements cannot be overlooked. Egos, ambition, and money can lead to irreconcilable friction. And finally (4), investment money is frozen or more difficult to get out of a partnership.  (LO 3 ends)

4. Summarize how a corporation is formed

A corporation is an artificial person created by law, with most of the legal rights of a real person, including the rights to start and operate a business, to buy or sell property, to borrow money, to sue or be sued, and to enter into binding contracts. Corporations make up about 20% of all businesses but they account for almost 85% of all sales revenues. Corporations are quite unlike either of the other two forms of business. Let’s start with a short vocabulary lesson. The shares of ownership in a corporation are called stock, and a person who owns a corporation’s stock is called a stockholder. A corporation whose stock is owned by relatively few people and is not available to the public is called a closed corporation. In contrast, a corporation whose stock is bought and sold on security exchanges and can be purchased by any individual is an open corporation. The process of forming a corporation is called incorporation. A business can incorporate in any state. In the state in which it is incorporated it is called a domestic corporation. In any other state where it does business it's called a foreign corporation. Finally, a corporation chartered by a foreign government that does business in the United States is an alien corporation.
A new corporation begins life in its chosen state by submitting its articles of incorporation to the secretary of state. When these articles are approved, they become the company’s corporate charter, a contract between the corporation and the state in which the state recognizes the formation of the artificial person that is the corporation. The articles of incorporation include such information as the names and addresses of the firm, and the purpose of the corporation, the maximum amount and types of stock to be issued, the rights and privileges of stockholders, and the length of time the corporation is to exist, which is generally forever. A corporation may issue two types of stock—common and preferred. Common stock is owned by individuals or firms who may vote on corporate matters, but whose claims on profit and assets are subordinate to the claims of others. Preferred stock is owned by individuals or firms who usually do not have voting rights, but whose claims on dividends are paid before those of common-stock owners. Both common and preferred stockholders have the right to share in the distribution of earnings of the corporation through dividends. All stockholders also have the right to attend the corporation’s annual meeting. If a stockholder cannot attend, he or she may vote by proxy, which is a legal form listing the issues to be decided at the stockholders’ meeting and enabling the stockholders to transfer their voting rights to some other individual or individuals. The final step in setting up a corporation is an organization meeting to elect the first board of directors, the governing body of a corporation elected by the stockholders. The board is responsible for setting company goals and developing general strategies for reaching those goals. Corporate officers are appointed by the board of directors. Corporate officers consist of the chairman of the board, the president, executive vice presidents, corporate secretary and treasurer, or any other top executive appointed by the board. (LO 4 ends)

5. Describe the advantages and disadvantages of a corporation

There are several major advantages and relative disadvantages for a corporation. The five advantages include the following. (1) A corporation enjoys limited liability, which limits each owner’s financial liability to the amount of money he or she has paid for the corporation’s stock. (2) It is far easier to raise capital, primarily due to the ability to sell stock. (3) It is easy to transfer ownership, simply by selling stock. (4) A corporation has perpetual life, since it does not depend on the life or competency of a sole owner or partner. And finally, (5) a corporation can recruit specialized, talented management and offer larger salaries and opportunity for advancement. Of course, to offset these advantages, the five disadvantages include (1) the difficulty and expense of formation, (2) government regulation, (3) conflict within the organization, especially in competitive markets, (4) double taxation, since both the corporation (as its corporate income tax) as well as the owners (based on their dividends) are taxed on its earnings, and (5) a lack of secrecy. (LO 5 ends)

6. Examine special types of corporations including S-Corporations, Limited-Liability Companies, Government-Owned Corporations, and Not-For-Profit Corporations

In addition to the three types of organizations we have just discussed, several others are used for special purposes. One is the S-corporation, which is a corporation that is taxed as though it were a partnership. Another is a limited-liability company, or LLC, which provides limited-liability protection and is taxed like a partnership. LLCs are similar in many ways to S-corporations. A third type is a government-owned corporation, such as NASA or the FDIC, which is owned and operated by a local, state, or federal government. A fourth type is the not-for-profit corporation, which is organized to provide a social, educational, religious, or other service, rather than to earn a profit, such as certain charities, museums, and colleges.  (LO 6 ends)

7. Discuss the purpose of a cooperative, joint venture, and syndicate

Yet another type of special organization is a cooperative, such as Ocean Spray Cranberries, which is an association of individuals or firms whose purpose is to perform some business function for its members. A sixth type is a joint venture. This is an agreement between two or more groups to form a business entity in order to achieve a specific goal or to operate for a specific period of time. Once the goal is reached or the period of time elapses, the joint venture is dissolved. Finally, we have a syndicate, which is a temporary association of individuals or firms organized to perform a specific task that requires a large amount of capital. Syndicates are often formed to underwrite large insurance policies. (LO 7 ends)

8. Explain how growth from within and growth through mergers can enable a business to expand

Since most corporations tend to be big, how can they grow? Generally, growth is accomplished two ways, from within or through mergers and acquisitions. Growth from within involves expanding product lines and introducing new products and services. Mergers are the purchase of one corporation by another. Sometimes this is done in a friendly manner, other times it is hostile. In the case of a hostile takeover, a situation in which the management and board of directors of the firm targeted for acquisition disapprove of the merger, another company may make a tender offer, which is an offer to purchase the stock of a targeted firm at a price just high enough to tempt stockholders to sell their shares. Another strategy to avoid a hostile takeover is a proxy fight, a technique used by another company to gather enough stockholder votes to control the targeted company. Whether successful or not, mergers are generally one of three types: horizontal, between firms that make and sell similar products; vertical, between firms that operate at different levels in the production and marketing of a product; or conglomerate, which is between firms in completely unrelated industries. Often mergers involve a change in top management.
So what is the future of mergers? Most experts now predict that mergers and acquisitions will result from cash-rich companies looking to enhance their position in the marketplace.  Another trend is mergers driven by business logic and the desire to compete in the international marketplace. Other experts predict more leveraged buyouts, or LBOs, for the future. An LBO is a purchase arrangement that allows a firm’s managers and employees or a group of investors to purchase the company. The bottom line is that no one knows for sure, which makes this an exciting time to be in business—no matter how it is organized. (LO 8 ends)