3 Main Forms of Business Organization
A sole proprietorship is the simplest form of business. It 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 has 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.
A partnership exists whenever two or more persons associate to conduct a noncorporate business. Partnerships may 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, as we demonstrate in Chapter 2.
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 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 capital. 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.
A corporation is the complex and biggest form of business. It 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 P10,000 in a partnership that then went bankrupt, owing P1 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 P1 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 P10,000 in the stock of a corporation that then went bankrupt, your potential loss on the investment would be limited to your $10,000 investment. 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 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 document 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 a 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 existence. Then, after the corporation is in operation, quarterly and annual employment, financial, and tax reports must be filed with state and
The bylaws are a set of 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 by laws 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:
- Limited liability reduces the risks borne by investors, and, other things held constant, the lower the firm’s risk, the higher its value.
- 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.
- 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 similar investment in a proprietorship or partnership, this too enhance the value of a corporation.