1.1 FORMS OF BUSINESS ORGANIZATION
The key aspects of financial management are the same for all businesses, large or small, regardless of how they are organized. Still, its legal structure does affect some aspects of a firm’s operations and thus must be recognized. 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. However, based on the dollar value of sales, about 80 percent of all business is done by corporations, about 13 percent by sole proprietorships, and about 7 percent by partnerships. Because corporations conduct the most business, and because most successful proprietor- them in this book. Still, it is important to understand the differences among the three types of firms.
A proprietorship is an unincorporated business owned by one individual. Going into business as a sole proprietor is easy—merely begin business operations. Proprietorships have three important advantages: (1) They are easily and inexpensively formed, (2) they are subject to few government regulations, and (3) they are subject to lower income taxes than corporations. However, proprietorships also have three important limitations: (1) Proprietors have unlimited personal liability for the business’s debts, which can result in losses that exceed the money they have invested in the company; (2) it is difficult for proprietorships to obtain large sums of capital; and (3) the life of a business organized as a proprietorship is limited to the life of the individual who created it. For these reasons, sole proprietorships are used primarily for small businesses. 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. A partnership is a legal arrangement between two or more people who decide to do business together. Partnerships are similar to proprietorships in that they can be established easily and inexpensively, and they are not subject to the corporate income tax. They also have the disadvantages associated with proprietorships: unlimited personal liability, difficulty raising capital, and limited lives. The liability issue is especially important, 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 and the partnership goes bankrupt, then the remaining partners are personally responsible for making good on the unsatisfied claims. The partners of a national accounting firm, Laventhol and Horvath, a huge partnership that went bankrupt as a result of suits filed by investors who
relied on faulty audit statements, learned all about the perils of doing business as a partnership. Another major accounting firm, Arthur Andersen, suffered a similar fate because the partners who worked with Enron, WorldCom, and a few other clients broke the law and led to the firm’s demise. Thus, a Texas partner who audits a business that goes under can bring ruin to a millionaire New York partner who never even went near the client company.3
4 Part 1 Introduction to Financial Management
Proprietorship
An unincorporated business owned by one individual.
3 There are actually a number of types of partnerships, but we focus on “plain vanilla partnerships” and leave the variations to courses on business law. We note, though, that the variations are generally designed to limit the liabilities of some of the partners. For example, a “limited partnership” has a general partner, who has unlimited liability, and limited partners, whose liability is limited to their investment. This sounds great from the standpoint of the limited partners, but they have to cede sole and absolute authority to the general partner, which means that they have no say in the way the firm conducts its business. With a corporation, the owners (stockholders) have limited liability, but they also have the right to vote and thus influence management.
Partnership
An unincorporated business owned by two or more persons.
A corporation is a legal entity created by a state, and it is separate and distinct from its owners and managers. Corporations have unlimited lives, their owners are not subject to losses beyond the amount they have invested in the business, and it is easier to transfer one’s ownership interest (stock) in a corpora- tion than one’s interest in a non incorporated business. These three factors make it much easier for corporations to raise the capital necessary to operate large businesses. Thus, growth companies such as Hewlett-Packard and Microsoft generally begin life as proprietorships or partnerships, but at some point find it advantageous to convert to the corporate form. The biggest drawback to incorporation is taxes: Corporate earnings are generally subject to double taxation the earnings of the corporation are taxed at the corporate level, and then, when after-tax earnings are paid out as dividends, those earnings are taxed again as personal income to the stockholders. However, as an aid to small businesses Congress created S corporations and allowed them to be taxed as if they were proprietorships or partnerships and thus exempt from the corporate income tax. The S designation is based on the section of the Tax Code that deals with S corporations, though it could stand for “small.” Larger corporations are known as C corporations. S corporations can have no more than 75 stockholders, which limits their use to relatively small, privately owned firms. The vast majority of small firms elect S status and retain that status until they decide to sell stock to the public and thus expand their ownership beyond 75 stockholders.
In deciding on a form of organization, firms must trade off the advantages of incorporation against a possibly higher tax burden. However, the value of any business other than a very small one will probably be maximized if it is organized as a corporation for the following 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 is dependent on its growth opportunities, which, in turn, are dependent on its ability to attract capital. Because corporations can attract capital more easily than can 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 an investment in the stock of a corporation is much easier to transfer to another investor than are proprietorship or partnership interests, a corporate investment is more liquid than a similar investment in a proprietorship or partnership, and this too enhances the value of a corporation.
As we just discussed, most firms are managed with value maximization in mind, and that, in turn, has caused most large businesses to be organized as corporations.
What are the key differences between sole proprietorships, partnerships, and corporations?
How do some firms get to enjoy the benefits of the corporate form of organization yet avoid corporate income taxes? Why don’t all firms—for example, IBM or GE—do this?
Why is the value of a business other than a small one generally maximized if it is organized as a corporation?
