Intro to Business - Ch 6: Business Formation: Choosing the Form that Fits

The Role of the Board of Directors (6-4c)

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 individuals who are elected by stockholders of a corporation to represent 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. 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 Partnerships (6-3d)

Two other types of partnerships allow some partners to limit their personal liability to some extent, although each comes with particular requirements. The first of these, known as a limited partnership (a partnership that includes at least one general partner who actively manages the company and accepts unlimited liability and one limited partner who gives up the right to actively manage the company in exchange for limited liability) But in other respects they play different roles: - 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.

Disadvantages of General Partnerships (6-3c)

Well-written partnership agreements can usually avoid these risks, but these major setbacks are still possible to occur: 1. 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. 2. 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. 3. Lack of Continuity: If a current partner withdraws from the partnership, the relationships among the participants will clearly change, potentially ending the partnership. 4. 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.

Horizontal merger (6-4g)

the combination of two or more firms competing in the same market with the same good or service

Franchising in Today's Economy (6-6a)

- Expansion into foreign markets is greater because competition is less intense and less saturated - Business methods must be adjusted because of differences in culture and other factors - Women own about 45 percent of all franchises - Minority participation in franchises has been relatively low

Advantages of LLC (6-5b)

- Limited liability: Similar to a corporation - Tax pass-through: 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. - Simplicity and flexibility in management and operation: Unlike corporations, LLCs aren't required to hold regular board meetings, less paperwork is involved, and fewer reporting requirements than corporations too. - 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.

Other Types of Corporations: Same but Different (6-4f)

- S corporations - statutory close corporations - nonprofit corporations

Types of mergers and acquisitions (6-4g)

-horizontal merger -vertical merger -conglomerate merger

The vast majority of businesses in the United States are owned and organized under one of the four forms (6-1 heading):

1. Sole proprietorship 2. Partnership 3. Corporation

Corporate Restructuring (6-4g)

A change in the organization's structure to improve efficiency and firm performance, including such activities as realigning divisions in the firm, reducing the amount of cash under the discretion of senior executives, and acquiring or divesting business units.

Carve-out (6-4g)

A type of divestiture the firm converts a particular unit or division into a separate company and issues stock in the newly related corporation (sells stock to outside investors) However, instead of distributing the new stock to its current stockholders, it sells the stock to outside investors, thus raising additional financial capital.

Advantages of General Partnerships (6-3b)

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. 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. Ease of formation: In theory, forming a partnership is easy. It's possible (but not advisable) to establish a partnership based on a simple verbal agreement. This advantage should not be overemphasized whatsoever, a good amount of preparation needs to be done for this to be effective. Possible tax advantages: SImilar to a sole proprietorship, the earnings of a partnership "pass through" business--untouched by the IRS--and are taxed only as the partner's personal income. Again, this avoids the potential for double taxation endemic to corporations.

Mergers and Acquisitions (6-4g)

Acquisition: a corporate restructuring in which one firm buys another The firm making the purchase is called the "acquiring firm", and the firm being purchased is called the "target firm". After the acquisition, the target firm ceases to exist as an independent entity while the purchasing firm continues in operation, and its stock is still traded. In a merger, instead of one firm buying the other, the two companies agree to a combination of equals, joining together to form a new company out of the two previously independent firms.

Advantages and Disadvantages of Sole Proprietorships (6-2 heading)

Advantages (6-2a) - sole proprietorships offer some very attractive advantages to people starting a business: - Ease of formation: No special forms must be filed, and no special fees must be paid. - 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. - Pride of ownership: The feeling of pride and the personal satisfaction they gain from owning and running their own business. - Retention of profits: If your business is successful, all the profits go to you--minus your personal taxes, of course. - 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 (this avoids the undesirable possibility of double taxation of earnings).

Forming a C-Corporation (6-4a)

As mentioned earlier, the formation of a corporation requires filing articles of incorporation and paying filing fees. It also requires the adoption of corporate bylaws, which are 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.

The Limited Liability Company: The New Kid on the Block

As the newest form of business ownership, state laws concerning the legal status and formation of LLCs are still evolving. Several states have recently revised their statutes to make forming LLCs simpler and to make transfer of ownership easier.

Advantages of Franchising (6-6b)

Both the franchisee and the franchisor must believe they'll benefit from the franchise arrangement; otherwise, they wouldn't participate. The advantages of franchising for the franchisor are fairly obvious. It allows the franchisor to expand the business and bring in additional revenue (in the form of franchising feeds and royalties) without investing its own capital. From the franchisee's perspective, franchising offers several advantages: - Less risk: Franchises offer access to a proven business system and product. The systems and methods offered by franchisors have an established track record. - 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. - Brand recognition: Operating a franchise gives the franchisee instant brand-name recognition - Easier access to funding: Bankers and other lenders may be more willing to lend money.

Limitations and Disadvantages of LLCs

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. Annual franchise tax: Even though they may be exempt from corporate income taxes, many states require LLCs to pay an annual franchise tax. Foreign status in other states: Like corporations, LLCs must register or quality to operate as "foreign" companies when the do business in states other than the state in which they were organized. This results in additional paperwork, fees, and taxes. Limits on types of firms that can form LLCs: Most states do not permit banks, insurance companies, and nonprofit organizations to operate as LLCs. Differences in state laws: LLCs laws are still evolving--and their specific requirements vary considerably among the states.

Advantages of C-Corporation (6-4d)

Corporations have become the dominant form of business ownership for several reasons: - Limited liability: 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 own personal assets are protected. - Permanence - Ease of Transfer of Ownership: Simply sell shares of stock to transfer ownership. - 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. - 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 development.

Disadvantages (6-2b)

Entrepreneurs thinking about forming sole proprietorships should also be aware of some serious drawbacks: - 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. - 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. - Limited Ability to Attract and Maintain Talented Employees: Most 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. - 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. - Lack of Permanence: Because sole proprietorships 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.

Franchising: Proven Methods for a Price (6-6 heading)

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 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 Franchisee: the party in a franchise relationship that pays for the right to use resources supplied by the franchisor Franchising has become a very popular way to operate a business and an important source of employment and income.

Disadvantages of Franchising (6-6c)

From the franchisor's perspective, operating a business with perhaps thousands of semi-independent owner-operators can be complex and challenging. Franchisees are also likely to find some disadvantages: - Costs: The typical franchise agreement requires franchisees to pay an initial franchise fee when they enter into the franchise agreement and an ongoing royalty (usually a percentage of monthly sales revenues) to the franchisor. - Lack of Control: The franchise agreement usually requires the franchisee to follow the franchisor's procedures to the letter. - Negative Halo Effect: The irresponsible or incompetent behavior of a few franchisees can create a negative perception that adversely affects not only the franchise as a whole but also the success of other franchisees. - Growth Challenges: While growth and expansion are definitely possible in franchising (many franchisees own multiple outlets), strings are attached. Franchise agreements usually limit the franchisee's territory and require franchisor approval before expanding into other areas. - Restrictions on Sale: Franchise agreements normally prevent franchisees from selling their franchises to other investors without prior approval from the franchisor. - Poor Execution: Not all franchisors live up to their promises. Sometimes the training and support are of poor quality, and sometimes the company does a poor job of screening franchisees.

Disadvantages of C-Corporations (6-4e)

In addition to their significant benefits, C corporations have a number of drawbacks: - Expense and Complexity of Formation and Operation: 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. - 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. - 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 corporate information secret from competitors. - 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). 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.

Business Ownership Options: The Big Four (6-1)

One of the most important decisions entrepreneurs make when starting a new business is the form of ownership they'll use. The form they choose affects virtually every aspect of establishing and operating their firm, including the initial cost of setting up the business, the way the profits are distributed, the types of taxes (if any) the business must pay, and the types of regulations it must follow. Choice of ownership also determines the degree to which each owner is personally liable for the firm's debts and the sources of funds available to the firm to finance future expansion. Finally, choosing the right business form helps entrepreneurs battle the steep odds against survival. Eighty percent of new business close within five years, and even 37% of large, established, and highly successful Fortune 500 and S&P 500 firms can be expected to fail every five years.

Ownership of C-Corporations (6-4b)

Ownership of C corporations is represented by shares of stock, so owners are called "stockholders" (or "shareholders"): An owner of a corporation. 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. Stock in large corporations is usually publically traded, meaning that anyone with the money and inclination to do so can buy shares--and that anyone who owns shares is free to sell them. But many smaller corporations are owned by just a handful of stockholders who don't actively trade their stock. It's even possible for individuals to incorporate their business and be the sole shareholder in their corporation. Stockholders don't have to be individuals. Individual investors (an organization that pools contributions from investors, clients, or depositors and uses these funds to buy stocks and other securities), 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.

Total Number of Businesses by Form of Ownership (6-1)

Partnerships - 3.61 million (10.77%) Corporations - 5.84 million (17.42%) Sole proprietorships - 24.07 million (71.81%)

Exhibit 6.2 - Total Revenue and Net Income by Form of Ownership (6-1)

Read pg. 95 for image.

Characteristics of S, Statutory Close, and Nonprofit Corporations (6-4f)

See image

Corporations: The Advantages and Disadvantages of Being an Artificial Person (6-4 heading)

There are several types of corporations. The most common is called a 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). Three other types of corporations exist: - S corporations - statutory close (or closed) corporations - nonprofit corporations

Partnerships: Two Heads (and Bankrolls) Can Be Better Than One (6-3 heading)

There are several types of partnerships, each with its own specific characteristics.

Formation of General Partnerships (6-3a)

There is no limit on the number of partners who can participate in a general partnership, but almost partnerships consist of only a few partners--often just two. The partnership is formed when the partners enter into a voluntary partnership agreement. It is legally possible to start a partnership on the basis of a verbal agreement, but doing so is often a recipe for disaster. It's much safer to get everything in writing and to seek expert legal assistance when drawing up the agreement. A typical partnership agreement spells out details, such as the initial financial contributions each partner will make, the specific duties and responsibilities each will assume, how they will share profits (and losses), how they will settle disagreements, and how they will deal with the death or withdrawal of one of the partners.

Entering into a Franchise Agreement (6-6d)

To obtain a franchise, the franchisee must sign a franchise agreement (the contractual agreement between a franchisor and franchisee that spells out the duties and responsibilities of both parties). There's no standard form for the contract, but some of the key items normally covered including the following: - 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. - 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. - Training and Support: The types of training and support the franchisor will provide to the franchisee. - Specific Operational Requirements: The methods and standards established by the franchisor that the franchisee is required to follow. - Conflict Resolution: How the franchisor and franchisee will handle disputes. - Assigned Territory: The geographic area in which the franchisee will operate and whether the franchisee has exclusive rights in that area.

Conglomerate merger (6-4g)

a combination of two firms that are in unrelated industries

Nonprofit corporations (6-4f)

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

Statutory close corporations (6-4f)

a corporation with a limited number of owners that operates under simpler, less formal rules than a C corporation

Franchise Disclosure Document (FDD) (6-6d)

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 The FDD must provide contact information for at least 100 current franchisees (if the franchisor has fewer than 100 current franchisees, it must list all of them.) Also, the FTC requires the FDD to be written in "plain English" rather than in the complex legal jargon that often characterizes such documents. A careful study of the FDD can go a long way toward ensuring that the franchisee makes an informed decision. It's a good idea to have a lawyer who is knowledgeable about franchise law review. You have to pay for any legal advice, but entering into a franchise agreement can be a lot more expensive (and stressful) than a lawyer's fees.

Corporation

a form of business ownership in which the business is considered a legal entity that is separate and distinct from its owners articles of incorporation: the document filed with a state government to establish the existence of a new corporation. In many ways, a corporation is like an artificial person. It can legally engage in virtually any business activity a natural person can pursue. For example, a corporation can enter into binding contracts, borrow money, own property, pay taxes, and initiate actions (such as lawsuits) in its own name. It can even be a partner in a partnership or an owner of another corporation. Because of a corporation's status as a separate legal entity, the owners of a corporation have limited liability (when owners are not personally liable for claims against their firm. Owners with limited liability may lose their investment in the company, but their other personal assets are protected).

limited liability company (LLC)

a form of business ownership that offers both limited liability to its owners and flexible tax treatment 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. Similar to a corporation, an LLC is considered a legal entity separate from its owners. It offers more flexibility than a corporation in terms of tax treatment (its owners can elect to have their business taxed either as a corporation or a partnership). Many states even allow LLCs to be taxed as if they were sole proprietorships.

Sole proprietorship

a form of business ownership with a single owner who usually actively manages the company As far as the law is concerned, a sole proprietorship is simply and extension of the owner. Company earnings are treated just like the owner's income, likewise, any debts the company incurs are considered to be the owner's personal debts.

S corporations (6-4f)

a form of corporation that avoids double taxation by having its income taxed as if it were a partnership Advantages/Limitations: - The IRS does not tax earnings of 5 corporations separately, it can have no more than 100 stockholders - Stockholders have limited liability, with only rare exceptions, each stockholder must U.S citizen or permanent resident of the United States

Limited Liability Partnerships (LLP) (6-3e)

a form of partnership in which all partners have the right to participate in management and have limited liability for company debts Attractive to partners who want to limit their personal risk. It is similar to a limited partnership in some ways. The amount of liability protection offered by LLPs varies among states. In some states, LLPs offer "full-shield" protection, meaning that partners have limited liability for all claims against their company, except those resulting from their own negligence or malpractice.

Distributorships (6-6 heading)

a type of franchising arrangement in which the franchisor makes a product and licenses the franchisee to sell it The most common example of this type of franchise is the arrangement between automakers and the dealerships that sell their cars. E.g. Wendy's, Supercuts, Jiffy Lube, and Massage Envy

Partnership

a voluntary agreement under which two or more people act as co-owners of a business for profit In its most basic form, known as a general proprietorship (a partnership in which all partners can take an active role in managing the business and have unlimited liability for any claims against the firm), 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.

Vertical merger (6-4g)

combination of firms that are at different stages in the production of a good or service, creating a buyer-seller relationship

Divestiture (6-4g)

occurs when the transfer of total or partial ownership of some of a firm's operations to investors or to another company Firms often use divestitures to rid themselves of a part of their company that no longer fits well with their strategic plans. This allows them to streamline their operations and focus on their core businesses. In many (but not all cases), divestitures involve the sale of assets to outsiders, which raises financial capital for the firm. One common type of divestiture, called a "spin-off," occurs when a company issues stock in one of its own divisions or operating units and sets it up as a separate company--complete with its own board of directors and corporate officers.