GBS151- Ch 5

limited partnership

has one or more general partners and one or more limited partners.

S corporation

is a unique government creation that looks like a corporation but is taxed like sole proprietorships and partnerships. (The name comes from the fact that the rules governing them are in Subchapter S of Chapter 1 of the Internal Revenue Code.) The paperwork and details of S corporations are similar to those of conventional (C) corporations. S corporations have shareholders, directors, and employees, and the benefit of limited liability, but their profits are taxed only as the personal income of the shareholders—thus avoiding the double taxation of C corporations.

general partner

is an owner (partner) who has unlimited liability and is active in managing the firm. Every partnership must have at least one general partner.

limited partner

is an owner who invests money in the business but does not have any management responsibility or liability for losses beyond his or her investment.

limited liability

means that the limited partners' liability for the debts of the business is limited to the amount they put into the company; their personal assets are not at risk.

A vertical merger joins two firms operating in different stages of related businesses.

A horizontal merger joins two firms in the same industry and allows them to diversify or expand their products.

Rather than merge or sell to another company, some corporations decide to maintain, or in some cases regain, control of a firm internally. By taking a firm private, management or a group of stockholders obtain all the firm's stock for themselves by buying it back from the other stockholders.

A leveraged buyout (LBO) is an attempt by employees, management, or a group of private investors to buy out the stockholders in a company, primarily by borrowing the necessary funds.

Another type of partnership was created to limit the disadvantage of unlimited liability.

A limited liability partnership (LLP) limits partners' risk of losing their personal assets to the outcomes of only their own acts and omissions and those of people under their supervision. If you are a limited partner in an LLP, you can operate without the fear that one of your partners might commit an act of malpractice resulting in a judgment that takes away your house, car, retirement plan, even your collection of vintage Star Wars action figures, as would be the case in a general partnership.

A merger is the result of two firms joining to form one company. It is similar to a marriage, joining two individuals as one family.

An acquisition is one company's purchase of the property and obligations of another company.

Advantages of Sole Proprietorships

Ease of starting and ending the business. All you have to do to start a sole proprietorship is buy or lease the needed equipment (a saw, a laptop, a tractor, a lawn mower) and put up some announcements saying you are in business. You may have to get a permit or license from the local government, but often that is no problem. It is just as easy to get out of business; you simply stop. There is no one to consult or disagree with about such decisions. Being your own boss. Working for others simply does not have the same excitement as working for yourself—at least, that's the way sole proprietors feel. You may make mistakes, but they are your mistakes—and so are the many small victories each day. Pride of ownership. People who own and manage their own businesses are rightfully proud of their work. They deserve all the credit for taking the risks and providing needed goods or services. Leaving a legacy. Owners can leave an ongoing business for future generations. Retention of company profits. Owners not only keep the profits earned but also benefit from the increasing value as the business grows. No special taxes. All the profits of a sole proprietorship are taxed as the personal income of the owner, and the owner pays the normal income tax on that money. However, owners do have to pay the self-employment tax (for Social Security and Medicare). They also have to estimate their taxes and make quarterly payments to the government or suffer penalties for nonpayment.

Disadvantages of Corporations

Initial cost. Incorporation may cost thousands of dollars and require expensive lawyers and accountants. There are less expensive ways of incorporating in certain states (see the following subsection), but many people do not have the time or confidence to go through this procedure without the help of a potentially expensive lawyer. Extensive paperwork. The paperwork needed to start a corporation is just the beginning. A sole proprietor or partnership may keep rather broad accounting records. A corporation, in contrast, must keep detailed financial records, the minutes of meetings, and more. As noted in Figure 5.4, many firms incorporate in Delaware or Nevada because these states' business-oriented laws make the process easier than it is in other states. Double taxation. Corporate income is taxed twice. First the corporation pays tax on its income before it can distribute any, as dividends, to stockholders. Then the stockholders pay income tax on the dividends they receive. States often tax corporations more heavily than other enterprises, and some special taxes apply only to corporations.12 Two tax returns. An individual who incorporates must file both a corporate tax return and an individual tax return. Depending on the size of the corporation, a corporate return can be quite complex and require the assistance of a certified public accountant (CPA). Size. Size may be one advantage of corporations, but it can be a disadvantage as well. Large corporations sometimes become too inflexible and tied down in red tape to respond quickly to market changes, and their profitability can suffer. Difficulty of termination. Once a corporation has started, it's relatively hard to end. Possible conflict with stockholders and board of directors. Conflict may brew if the stockholders elect a board of directors who disagree with management.13 Since the board of directors chooses the company's officers, entrepreneurs serving as managers can find themselves forced out of the very company they founded. This happened to Tom Freston, one of the founders of MTV, and Steve Jobs, a founder of Apple Computer (Jobs of course returned to the company later).

Advantages of Corporations

Limited liability. A major advantage of corporations is the limited liability of their owners. Remember, limited liability means that the owners of a business are responsible for its losses only up to the amount they invest in it. EX: Burton Baskin and Irvine Robbins ran their ice cream businesses separately for two years. Once they had succeeded apart, Baskin and Robbins became partners and were able to avoid many of the pitfalls of starting a new business from scratch. They flipped a coin to see whose name would come first. What factors besides the partners' individual success do you think contributed to their long-lasting partnership? Ability to raise more money for investment. To raise money, a corporation can sell shares of its stock to anyone who is interested. This means that millions of people can own part of major companies like IBM, Apple, and Coca-Cola, and smaller corporations as well. If a company sells 10 million shares of stock for $50 a share, it will have $500 million available to build plants, buy materials, hire people, manufacture products, and so on. Such a large amount of money would be difficult to raise any other way. Corporations can also borrow money by obtaining loans from financial institutions like banks. They can also borrow from individual investors by issuing bonds, which involve paying investors interest until the bonds are repaid sometime in the future.10 You can read about how corporations raise funds through the sale of stocks and bonds in Chapter 17. Size. "Size" summarizes many of the advantages of some corporations. Because they can raise large amounts of money to work with, big corporations can build modern factories or software development facilities with the latest equipment. They can hire experts or specialists in all areas of operation. They can buy other corporations in different fields to diversify their business risks. In short, a large corporation with numerous resources can take advantage of opportunities anywhere in the world. But corporations do not have to be large to enjoy the benefits of incorporating. Many doctors, lawyers, and individuals, as well as partners in a variety of businesses, have incorporated. The vast majority of corporations in the United States are small businesses. Page 129Perpetual life. Because corporations are separate from those who own them, the death of one or more owners does not terminate the corporation. Ease of ownership change. It is easy to change the owners of a corporation. All that is necessary is to sell the stock to someone else. Ease of attracting talented employees. Corporations can attract skilled employees by offering such benefits as stock options (the right to purchase shares of the corporation for a fixed price). Separation of ownership from management. Corporations are able to raise money from many different owners/stockholders without getting them involved in management. The corporate hierarchy in Figure 5.5 shows how the owners/stockholders are separate from the managers and employees. The owners/stockholders elect a board of directors, who hire the officers of the corporation and oversee major policy issues. The owners/stockholders thus have some say in who runs the corporation but have no real control over the daily operations

Advantages of Franchises

Lower failure rate. Historically, the failure rate for franchises has been lower than that of other business ventures. However, franchising has grown so rapidly that many weak franchises have entered the field, so you need to be careful and invest wisely

Advantages of Partnerships

More financial resources. When two or more people pool their money and credit, it is easier to pay the rent, utilities, and other bills incurred by a business. A limited partnership is specially designed to help raise money. As mentioned earlier, a limited partner invests money in the business but cannot legally have management responsibility and has limited liability. Shared management and pooled/complementary skills and knowledge. It is simply much easier to manage the day-to-day activities of a business with carefully chosen partners. Partners give each other free time from the business and provide different skills and perspectives. Some people find that the best Page 125partner is a spouse. Many husband-and-wife teams manage restaurants, service shops, and other businesses.7 Longer survival. Partnerships are more likely to succeed than sole proprietorships because being watched by a partner can help a businessperson become more disciplined.8 No special taxes. As with sole proprietorships, all profits of partnerships are taxed as the personal income of the owners, who pay the normal income tax on that money. Similarly, partners must estimate their taxes and make quarterly payments or suffer penalties for nonpayment.

A franchise agreement is an arrangement whereby someone with a good idea for a business (the franchisor) sells the rights to use the business name and sell a product or service (the franchise) to others (the franchisees) in a given territory.

The most popular businesses for franchising are restaurants (fast food and full service) and gas stations with convenience stores. McDonald's, the largest restaurant chain in the United States in terms of sales, is often considered the gold standard of franchising. Retail stores, financial services, health clubs, hotels and motels, and automotive parts and service centers are also popular franchised businesses.

Disadvantages of Partnerships

Unlimited liability. Each general partner is liable for the debts of the firm, no matter who was responsible for causing them. You are liable for your partners' mistakes as well as your own. Like sole proprietors, general partners can lose their homes, cars, and everything else they own if the business loses a lawsuit or goes bankrupt. Division of profits. Sharing risk means sharing profits, and that can cause conflicts. There is no set system for dividing profits in a partnership, and they are not always divided evenly. For example, if one partner puts in more money and the other puts in more hours, each may feel justified in asking for a bigger share of the profits. Disagreements among partners. Disagreements over money are just one example of potential conflict in a partnership. Who has final authority over employees? Who hires and fires employees? Who works what hours? What if one partner wants to buy expensive equipment for the firm and the other partner disagrees? All terms of the partnership should be spelled out in writing to protect all parties and minimize misunderstandings.9 The Making Ethical Decisions box offers an example of a difference of opinions between partners. Difficulty of termination. Once you have committed yourself to a partnership, it is not easy to get out of it. Sure, you can just quit. However, questions about who gets what and what happens next are often difficult to resolve when the partnership ends. Surprisingly, law firms often have faulty partnership agreements and find that breaking up is hard to do. How do you get rid of a partner you don't like? It is best to decide such questions up front in the partnership agreement. Figure 5.3 gives you ideas about what to include in partnership agreements.

Disadvantages of Sole Proprietorships

Unlimited liability—the risk of personal losses. When you work for others, it is their problem if the business is not profitable. When you own your own business, you and the business are considered one. You have unlimited liability; that is, any debts or damages incurred by the business are your debts and you must pay them, even if it means selling your home, your car, or whatever else you own. This is a serious risk, and undertaking it requires not only thought but also discussion with a lawyer, an insurance agent, an accountant, and others. EX: Being the sole proprietor of a company, like a dog-walking service, means making a major time commitment to run the business, including constantly seeking out new customers and looking for reliable employees when the time comes to grow. If you were a sole proprietor, what would you need to do if you wanted to take a week's vacation? Limited financial resources. Funds available to the business are limited to what the one owner can gather. Since there are serious limits to how much money one person can raise, partnerships and corporations have a greater probability of obtaining the financial backing needed to start and equip a business and keep it going. Management difficulties. All businesses need management; someone must keep inventory, accounting, and tax records. Many people skilled at selling things or providing a service are not so skilled at keeping records. Sole proprietors often find it difficult to attract qualified employees to help run the business because often they cannot compete with the salary and benefits offered by larger companies. Overwhelming time commitment. Though sole proprietors say they set their own hours, it's hard to own a business, manage it, train people, and have time for anything else in life when there is no one with whom to share the burden. The owner of a store, for example, may put in 12 hours a day at least six days a week—almost twice the hours worked by a nonsupervisory employee in a large company. Imagine how this time commitment affects the sole proprietor's family life. Many sole proprietors will tell you, "It's not a job, it's not a career, it's a way of life."4 Few fringe benefits. If you are your own boss, you lose the fringe benefits that often come with working for others. You have no paid health insurance, no paid disability insurance, no pension plan, no sick leave, and no vacation pay. These and other benefits may add up to 30 percent or more of a worker's compensation. Limited growth. Expansion is often slow since a sole proprietorship relies on its owner for most of its creativity, business know-how, and funding. Limited life span. If the sole proprietor dies, is incapacitated, or retires, the business no longer exists (unless it is sold or taken over by the sole proprietor's heirs).

General Partnership

all owners share in operating the business and in assuming liability for the business's debts.