Alternative Forms of Business Organization

There are three main forms of business organization: (1) sole proprietorships. (2) partnerships.  and (3) corporations. plus several hybrid forms. 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. Because most business is conducted by corporations, we will concentrate on them is this book. However it is important to understand the differences among the various forms.

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 businesses 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 non-corporate business. Partnerships many 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 of transferring ownership and (4) difficulty of raising large amounts of capital. The tax treatment of a partnership is similar to that for proprietorships, which 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. The partners of the national accounting firm Laventhol and Horwath, a huge partnership which went bankrupt as a result of suits filed by investors who relied on faulty audit statements about the perils of doing business as a partnership. Thus, a Texas partner who audits a business which 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 capita. 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 amounts of capital 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 which 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 which then went bankrupt, your potential loss on the investment would be limited to your $10.000 investment.²  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 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) Names and addresses of directors. The charter 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 existence³. Then after the corporation is in operation quarterly and annual employment, financial and tax reports must be filed with state and federal authorities.

The bylaws are a set 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 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 the firm’s ability to attract capital. Since 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”. Since an investment in 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.

As we will se later most firms are managed with value maximization in mind and this in turn, has caused most large businesses to be organized as corporations.