BUS Chapter 6: Business Formation

chief executive officer

CEO Instead, again in accordance with corporate bylaws, the board appoints a chief executive officer (CEO) and other corporate officers to manage the company on a daily basis.

Limited Ability to Attract and Maintain Talented Employees

Most sole proprietors are unable to pay the high salaries and substantial perks that highly qualified, experienced employees get when they work for big, well-established companies.

Limits on Types of Firms that Can Form LLCs

Most states do not permit banks, insurance companies, and nonprofit organizations to operate as LLCs.

Permanence

Unless the articles of incorporation specify a limited duration, corporations can continue operating as long as they remain financially viable and the majority of stockholders want the business to continue. Unlike a sole proprietorship or partnership, a general corporation is unaffected by the death or withdrawal of an owner.

Simplicity and Flexibility in Management and Operation

Unlike corporations, LLCs aren't required to hold regular board meetings. Also, LLCs are subject to less paperwork and fewer reporting requirements than corporations.

Disadvantages of General Partnerships

Unlimited Liability Disagreements Lack of Continuity Difficulty in withdrawing from agreement

Complications When Operating in More Than One State

When a business that's incorporated in one state does business in other states, it's called a "domestic corporation" in the state where it's incorporated, and a "foreign corporation" in the other states. A corporation must register (or "qualify") as a foreign corporation in order to do business in any state other than the one in which it incorporated. This typically requires additional paperwork, fees, and taxes. But registration as a foreign corporation is only necessary if the company is involved in substantial business activities within the state. Businesses that only engage in minor business activities typically are exempt from the registration requirement. For example, a firm operating a production facility or maintaining a district office in a state other than its corporate home would need to register as a foreign corporation, but a firm that simply held a bank account or solicited sales to customers in that state through the mail would not be required to do so.

limited liability

meaning they aren't personally responsible for the debts and obligations of their company.

A key to franchise success is

serving fast-growing markets.

Entering into a Franchise Agreement

terms and conditions, fees and other payments, training and support, specific operational requirements, conflict resolution, assigned territory

business format franchises

A broad franchise agreement in which the franchisee pays for the right to use the name, trademark, and business and production methods of the franchisor.

sole proprietorship

A business that is owned, and usually managed, by one person.

acquisition

A corporate restructuring in which one firm buys another.

merger

A corporate restructuring that occurs when two formerly independent business entities combine to form a new organization.

nonprofit corporations

A corporation that does not seek to earn a profit and differs in several fundamental respects from C corporations.

Franchise Disclosure Document (FDD)

A detailed description of all aspects of a franchise that the franchisor must provide to the franchisee at least 14 calendar days before the franchise agreement is signed.

S corporations, statutory close corporations

A form of corporation that avoids double taxation by having its income taxed as if it were a partnership.

franchise

A licensing arrangement under which a franchisor allows franchisees to use its name, trademark, products, business methods, and other property in exchange for monetary payments and other considerations.

Difficulty in Withdrawing from a Partnership

A partner who withdraws from a partnership remains personally liable for any debts or obligations the firm had at the time of withdrawal—even if those obligations were incurred by the actions of other partners.

distributorships

A type of franchising arrangement in which the franchisor makes a product and licenses the franchisee to sell it.

Advantages of General Partnerships

Ability to Pool Financial Resources Ability to Share Responsibilities and Capitalize on Complementary Skills Ease of Formation Possible Tax Advantages

Unlimited Liability

As a general partner, you're not only liable for your own mistakes but also for those of your partners. In fact, all general partners have unlimited liability for the debts and obligations of their business. So, if the assets they've invested in the business aren't sufficient to meet these claims, the personal assets of the partners are at risk. When someone sues a general partnership, the lawsuit can target any individual partner or group of partners. In fact, lawsuits often go after the partners with the deepest pockets, even if they did not personally participate in the act that caused the legal action. In other words, if you have more personal wealth than the other partners, you could lose more than they do even if they were the ones at fault!

Limited liability

As already explained, stockholders are not personally liable for the debts of their company. If a corporation goes bankrupt, the stockholders might find that their stock is worthless, but their other personal assets are protected.

Tax Pass-Through

As mentioned at the beginning of this chapter, for tax purposes the owners of LLCs may elect to have their companies treated as either a corporation or a partnership—or even as a sole proprietorship if owned by a single person. The default tax classification for LLCs with more than one owner—and the one most LLCs choose—is the partnership option. Under this arrangement, there is no separate tax on the earnings of the company. Instead, earnings "pass through" the company and are taxed only as income of the owners. This eliminates the double taxation of profits that is endemic to general corporations. However, there are some cases where it makes sense for LLCs to elect to be taxed as a corporation. For example, the owner of a single-person LLC can avoid paying self-employment taxes by electing to have the LLC treated as a corporation rather than as a sole proprietorship.

Retention of Control

As the only owner of a sole proprietorship, you're in control. You have the ability to manage your business the way you want. If you want to "be your own boss," a sole proprietorship might look very attractive. Nicholas Hollows, sole proprietor of Hollows Leather in Eugene, Oregon, says, "I definitely don't intend to switch my role from a person who makes things to a person who manages people. Being hands on is the whole reason I do this."

Differences in State Laws

As we've already mentioned, LLC laws are still evolving—and their specific requirements vary considerably among the states. In 2006, the National Conference of Commissioners on Uniform State Laws created a Revised Uniform Limited Liability Company Act that could be used as a model by all states. To date, only a few states have adopted this law. Until there is more uniformity in state laws, operating LLCs in more than one state is likely to remain a complex endeavor.

Expense and Complexity of Formation and Operation

As we've already seen, establishing a corporation can be more complex and expensive than forming a sole proprietorship or partnership. Corporations are also subject to more formal operating requirements. For example, they are required to hold regular board meetings and keep accurate minutes.

Easier Access to Funding

Bankers and other lenders may be more willing to lend money if the business is part of an established franchise than if it is a new, unproven business.

Complexity of Formation

Because of the need to file articles of organization and pay filing fees, LLCs can take more time and effort to form than sole proprietorships. In general, forming an LLC is also more difficult than creating a partnership. But as we mentioned earlier, the formation of a partnership requires a "meeting of the minds" of the partners, which isn't always easy to achieve. So in some cases, the formation of a partnership can prove to be every bit as challenging as the formation of an LLC.

Lack of Permanence

Because sole proprietorship are just extensions of their owners, they lack permanence. If the owner dies, retires, or withdraws from the business for some other reason, the company legally ceases to exist. Even if the company continues to operate under new ownership, in the eyes of the law, it becomes a different firm.

Unlimited Liability

Because the law views a sole proprietorship as an extension of its owner, the debts of the firm become the owner's personal debts. The owner of Erie County Farms, a grocery store in Erie, Pennsylvania, never incorporated his business, so the store operated as a sole proprietorship. Accordingly, when Erie County Farms went bankrupt, the bankruptcy court seized the owner's home and personal assets to pay $650,000 in unpaid bills.Footnote Likewise, if someone sues your business and wins, the court can seize your personal possessions—even those that have nothing to do with your business—and sell them to pay the damages. This unlimited personal liability means that operating as a sole proprietorship is a risky endeavor.

Heavy Workload and Responsibilities

Being your own boss can be very rewarding, but it can also mean very long hours and a lot of stress. Sole proprietors—as the ultimate authority in their business—often must perform tasks or make decisions in areas where they lack expertise.

More Paperwork, More Regulation, and Less Secrecy

Corporations are more closely regulated and are required to file more government paperwork than other forms of business. Large, publicly traded corporations are required to send annual statements to all shareholders and to file detailed quarterly and annual reports with the Securities and Exchange Commission (SEC). The annual report filed with the SEC (called a Form 10-K) is often hundreds of pages long and includes a wealth of information about the company's operations and financial condition. Anyone can look at these forms, making it difficult to keep key corporate information secret from competitors.

Ability to Raise Large Amounts of Financial Capital

Corporations can raise large amounts of financial capital by issuing shares of stock or by selling formal IOUs called corporate bonds. The ability to raise money by issuing these securities gives corporations a major financial advantage over most other forms of ownership.

Annual Franchise Tax

Even though they may be exempt from corporate income taxes, many states require LLCs to pay an annual franchise tax.

Disadvantages of C Corporations

Expense and complexity of formation and operation Complications when operating in more than one state Double taxation of earnings and additional taxes More paperwork, more regulation, and less secrecy Possible conflicts of interest

Flexible Ownership

Flexible Ownership: Unlike S corporations, LLCs can have any number of owners. Also unlike S corporations, the owners of LLCs can include foreign investors and other corporations. However, some states do make it difficult to transfer ownership to outsiders.

Less Risk

Franchises offer access to a proven business system and product. The systems and methods offered by franchisors have an established track record. People who are interested in buying a franchise can do research to see how stores in the franchise have performed and can talk to existing franchisees before investing.

Conflict Resolution

How the franchisor and franchisee will handle disputes.

Lack of Continuity

If a current partner withdraws from the partnership, the relationships among the participants will clearly change, potentially ending the partnership. This creates uncertainty about how long a partnership will remain in business.

Potential for Disagreements

If general partners can't agree on how to run the business, the conflict can complicate and delay decision making. A well-drafted partnership agreement usually specifies how disputes will be resolved, but disagreements among partners can create friction and hard feelings that harm morale and undermine the cooperation needed to keep the business on track.

Retention of Profits

If your business is successful, all the profits go to you—minus your personal taxes, of course.

Ease of Formation

In theory, forming a partnership is easy. As we've already noted, it's possible (but not advisable) to establish a partnership based on a simple verbal agreement. But we shouldn't overemphasize this advantage. Working out all of the details of a partnership agreement can sometimes be a complex and time-consuming process.

Ease of Transfer of Ownership

It's easy for stockholders of publicly traded C corporations to withdraw from ownership—they simply sell their shares of stock.

full shield protection

LLP liability protection offered by some states in which partners have limited liability for all claims against their company, except those resulting from their own negligence or malpractice

partial shield protection

LLP liability protection offered by some states where each partner has limited liability for the negligence or malpractice of other partners but still has unlimited liability for any other debts

Ability to Make Use of Specialized Management

Large corporations often find it easier to hire highly qualified professional managers than proprietorships and partnerships. Major corporations can typically offer attractive salaries and benefits, and their permanence and potential for growth offer managers opportunities for career advancement.

Institutional investors

Large organizations - such as pension funds, mutual funds, and insurance companies - that invest their own funds or the funds of others. such as mutual funds, insurance companies, pension funds, and endowment funds, pool money from a large number of individuals and use these funds to buy stocks and other securities.

Foreign Status in Other States

Like corporations, LLCs must register or qualify to operate as "foreign" companies when they do business in states other than the state in which they were organized. This results in additional paperwork, fees, and taxes.

Entrepreneurs thinking about forming sole proprietorships should also be aware of some serious drawbacks:

Limited financial resources Unlimited liability Limited ability to attract and maintain talented employees Heavy workload and responsibilities Lack of permanence

Possible Tax Advantage

No taxes are levied directly on the earnings of sole proprietorships as a business. Instead, the earnings are taxed only as income of the proprietor. As we'll see when we discuss corporations, this avoids the undesirable possibility of double taxation of earnings.

Pride of Ownership

One of the main reasons many people prefer a sole proprietorship is the feeling of pride and the personal satisfaction they gain from owning and running their own business.

Brand Recognition

Operating a franchise gives the franchisee instant brand-name recognition, which can be a big help in attracting customers.

stockholders/shareholders

Ownership of C corporations is represented by shares of stock, so owners are called ___. Common stock represents the basic ownership interest in a corporation, but some firms also issue preferred stock. One key difference between the two types of stock involves voting rights; common stockholders normally have the right to vote in stockholders' meetings, while preferred stockholders do not.

Ability to Share Responsibilities and Capitalize on Complementary Skills

Partners can share the burden of running the business, which can ease the workload. Tasks and jobs can also be divided based on complementary skills, using each partner's talents to best advantage.

Limited Financial Resources

Raising money to finance growth can be tough for sole proprietors. With only one owner responsible for a sole proprietorship's debts, banks and other financial institutions are often reluctant to lend it money. Likewise, suppliers may be unwilling to provide supplies on credit. This leaves sole proprietors dependent on their own wealth plus the money that their firms generate.

Limited Liability

Similar to a corporation, all owners of an LLC have limited liability.

Possible Tax Advantages

Similar to a sole proprietorship, the earnings of a partnership "pass through" the business—untouched by the IRS—and are taxed only as the partners' personal income. Again, this avoids the potential for double taxation endemic to corporations.

Double Taxation of Earnings and Additional Taxes

The IRS considers a C corporation to be a separate legal entity and taxes its earnings accordingly. Then, as shown in Exhibit 6.4, any dividends (earnings the corporation distributes to stockholders) are taxed again as the personal income of the stockholders. This double taxation can take a big bite out of earnings that are distributed to shareholders. But note that corporations often reinvest some or all of their profits back into the business. Shareholders don't pay income taxes on these retained earnings. Many states also impose separate income taxes on corporations. Most states also impose an annual franchise tax on both domestic and foreign corporations that operate within their borders.

franchisor

The business entity in a franchise relationship that allows others to operate its business using resources it supplies in exchange for money and other considerations.

franchise agreement

The contractual arrangement between a franchisor and franchisee that spells out the duties and responsibilities of both parties.

Possible Conflicts of Interest

The corporate officers appointed by the board are supposed to further the interests of stockholders. But some top executives pursue policies that further their own interests (such as prestige, power, job security, high pay, and attractive perks) at the expense of the stockholders. The board of directors has an obligation to protect the interests of stockholders, but in recent years the boards of several major corporations have come under criticism for continuing to approve high compensation packages for top executives, even when their companies performed poorly.

Fees and Other Payments

The fees the franchisee must pay for the right to use the franchisor's products and methods, and when these payments are due.

Terms and Conditions

The franchisee's rights to use the franchisor's trademarks, patents, and signage, and any restrictions on those rights. It also covers how long the agreement will last and under what terms (and at what cost) it can be renewed.

Training and Support

The franchisor normally provides the franchisee with extensive training and support. For example, Subway offers two weeks of training at its headquarters and additional training at meetings. The franchisor also sends out newsletters, provides Internet support, maintains a toll-free number for phone support, and provides on-site evaluations.

Assigned Territory

The geographic area in which the franchisee will operate and whether the franchisee has exclusive rights in that area.

Specific Operational Requirements

The methods and standards established by the franchisor that the franchisee is required to follow.

C corporation

The most common type of corporation, which is a legal business entity that offers limited liability to all of its owners, who are called stockholders

franchisee

The party in a franchise relationship that pays for the right to use resources supplied by the franchisor.

divestiture

The transfer of total or partial ownership of some of a firm's operations to investors or to another company.

Training and Support

The types of training and support the franchisor will provide to the franchisee.

board of directors

When most stockholders don't have the time, management skills, or desire to effectively manage such a complex business enterprise. Thus, in accordance with corporate bylaws, the stockholders elect a board of directors and rely on this board to oversee the operation of their company and protect their interests. The board of directors establishes the corporation's mission and sets its broad objectives. But board members seldom take an active role in the day-to-day management of their company. also sets the level of compensation for these officers and monitors their performance to ensure that they act in a manner consistent with stockholder interests. It also provides advice to these officers on broad policy issues, approves their major proposals, and ensures that the company adheres to major regulatory requirements.

Ability to Pool Financial Resources

With more owners investing in the company, a partnership is likely to have a stronger financial base than a sole proprietorship.

corporation

a business entity created by filing a form (known in most states as the articles of incorporation) with the appropriate state agency, paying the state's incorporation fees, and meeting other requirements.

Limited Liability Company (LLC)

a hybrid form of business ownership that is similar in some respects to a corporation while having other characteristics that are similar to a partnership.

partnership

a voluntary agreement under which two or more people act as co-owners of a business for profit

limited liability partnership (LLP)

another partnership arrangement that is attractive to partners who want to limit their personal risk.

Ease of Formation

compared to the other forms of ownership we'll discuss, the paperwork and costs involved in forming a sole proprietorship are minimal. No special forms must be filed, and no special fees must be paid. Entrepreneurs who are eager to get a business up and running quickly can find this a compelling advantage.

Limitations and Disadvantages of LLC's

complexity of formation, annual franchise tax, foreign status in other states, limits on types of firms that can form LLCs, differences in state laws

Disadvantages of Franchising

costs, lack of control, negative halo effect, growth challenges, restrictions on sale, poor execution

corporate bylaws

detailed rules that govern the way the corporation is organized and managed. Because of these requirements, forming a corporation tends to be more expensive and complex than forming a sole proprietorship or partnership. The requirements, however, vary among the states. Some states are known for their simple forms, inexpensive fees, low corporate tax rates, and "corporation-friendly" laws and court systems.

general partnership

each partner has the right to participate in the company's management and share in profits - but also has unlimited liability for any debts the company incurs.

Advantages of Sole Proprietorship

ease of formation retention of control pride of ownership retention of profits possible tax advantage

limited partnership

is a partnership arrangement that includes at least one general partner and at least one limited partner. - General partners have the right to participate fully in managing their partnership, but they also assume unlimited personal liability for any of its debts—just like the partners in a general partnership. - Limited partners cannot actively participate in its management, but they have the protection of limited liability. This means that, as long as they do not actively participate in managing the company, their personal wealth is not at risk.

Advantages of Franchising

less risk, training and support, brand recognition, easier access to funding

Advantages of C Corporations

limited liability, permanence, ease of transfer of ownership, ability to raise large amounts of financial capital, ability to make use of specialized management

Advantages of LLC's

limited liability, tax pass-through, simplicity and flexibility in management and operation, flexible ownership