Forms of Ownership Chapter 5

Copyright © 2015 Pearson Education, Inc. Learning Objectives Define sole proprietorship and explain the six advantages and six disadvantages of this ownership model Define partnership and explain the six advantages and three disadvantages of this ownership model Define corporation and explain the four advantages and six disadvantages of this ownership model Copyright © 2015 Pearson Education, Inc.

Learning Objectives (cont.) Explain the concept of corporate governance and identify the three groups responsible for ensuring good governance Identify the potential advantages of pursuing mergers and acquisitions as a growth strategy, along with the potential difficulties and risks Copyright © 2015 Pearson Education, Inc.

Learning Objectives (cont.) Define strategic alliance and joint venture and explain why a company would choose these options over a merger or an acquisition Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Sole Proprietorships Sole proprietorship A business owned by a single person Unlimited liability A legal condition under which any damages or debts incurred by a business are the owner’s personal responsibility A sole proprietorship is a business owned by one person (although it may have many employees). Many farms, retail establishments, and small service businesses are sole proprietorships, as are many home-based businesses, such as those operated by caterers, consultants, and freelance writers. Many of the local businesses you frequent around your college campus are likely to be sole proprietorships. In a sole proprietorship, the owner and the business are legally inseparable, which gives the proprietor unlimited liability: Any legal damages or debts incurred by the business are the owner’s personal responsibility. If you aren’t covered by appropriate insurance and run into serious financial or legal difficulty, such as getting sued for an accident that happened on your premises, you could lose not only the business but everything else you own, including your house, your car, and your personal investments. Copyright © 2015 Pearson Education, Inc.

Advantages of Sole Proprietorships Simplicity Single layer of taxation Privacy Flexibility and control Fewer limitations on personal income Personal satisfaction Operating as a sole proprietorship offers six key advantages. Copyright © 2015 Pearson Education, Inc.

Disadvantages of Sole Proprietorships Financial liability Demands on the owner Limited managerial perspective Resource limitations No employee benefits for the owner Finite life span For all its advantages, sole proprietorship also has six significant disadvantages. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Partnerships Partnership An unincorporated company owned by two or more people Limited liability A legal condition in which the maximum amount each owner is liable for is equal to whatever amount each invested in the business A partnership is a company that is owned by two or more people but is not a corporation. The partnership structure is appropriate for firms that need more resources and leadership talent than a sole proprietorship but don’t need the fundraising capabilities or other advantages of a corporation. Many partnerships are small, with just a handful of owners, although a few are very large; the accounting and consulting firm PwC (www.pwc.com), for example, has nearly 10,000 partners. To minimize personal liability exposure, some organizations opt for a limited partnership. Under this type of partnership, one or more persons act as general partners who run the business and have the same unlimited liability as sole proprietors. The remaining owners are limited partners who do not participate in running the business and who have limited liability—the maximum amount they are liable for is whatever amount each invested in the business. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Partnerships (cont.) General partnership A partnership in which all partners have joint authority to make decisions for the firm and joint liability for the firm’s financial obligations Limited partnership A partnership in which one or more persons act as general partners, run the business, and have the same unlimited liability as sole proprietors Partnerships come in two basic flavors. In a general partnership, all partners have joint authority to make decisions for the firm and joint liability for the firm’s financial obligations. If the partnership gets sued or goes bankrupt, all the partners have to dig into their own pockets to pay the bills, just as sole proprietors must. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Partnerships (cont.) Master Limited Partnership (MLP) A partnership that is allowed to raise money by selling units of ownership to general public partnerships and can bring together business professionals with diverse skill sets and perspectives. A master limited partnership (MLP) is allowed to raise money by selling units of ownership to the general public, in the same way corporations sell shares of stock to the public. This gives MLPs the fundraising capabilities of corporations without the double-taxation disadvantage. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Partnerships (cont.) Limited Liability Partnership (LLP) A partnership in which each partner has unlimited liability only for his or her own actions and at least some degree of limited liability for the partnership as a whole The limited liability partnership (LLP) form of business was created to help protect individual partners in certain professions from major mistakes (such as errors that trigger malpractice lawsuits) by other partners in the firm. In an LLP, each partner has unlimited liability only for his or her own actions and at least some degree of limited liability for the partnership as a whole. Restrictions on who can form an LLP—and how much liability protection is offered under this structure—vary from state to state. Copyright © 2015 Pearson Education, Inc.

Advantages of Partnerships Simplicity Single layer of taxation More resources Cost sharing Broader skill and experience base Longevity Partnerships offer two of the same advantages as sole proprietorship plus four more that overcome some important disadvantages of being a sole owner. Copyright © 2015 Pearson Education, Inc.

Disadvantages of Partnerships Unlimited liability Potential for conflict Expansion, succession, and termination issues Anyone considering the partnership structure needs to be aware of three potentially significant disadvantages Copyright © 2015 Pearson Education, Inc.

The Partnership Agreement A partnership agreement should address investment percentages, profit-sharing percentages, management responsibilities and other expectations of each owner, decision-making strategies, succession and exit strategies, criteria for admitting new partners, and dispute-resolution procedures. A carefully written partnership agreement can maximize the advantages of the partnership structure and minimize the potential disadvantages. At a minimum, a partnership agreement should address investment percentages, profit-sharing percentages, management responsibilities and other expectations of each owner, decision-making strategies, succession, and exit strategies (if an owner wants to leave the partnership), criteria for admitting new partners, and dispute-resolution procedures (including dealing with owners who aren’t meeting their responsibilities). Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Corporations Corporation A legal entity, distinct from any individual persons, that has the power to own property and conduct business Shareholders Investors who purchase shares of stock in a corporation A corporation is a legal entity, distinct from any individual persons, that has the power to own property and conduct business. It is owned by shareholders, investors who purchase shares of stock. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Corporations (cont.) Private corporation A corporation in which all the stock is owned by only a few individuals or companies and is not made available for purchase by the public Public corporation A corporation in which stock is sold to anyone who has the means to buy it The stock of a public corporation is sold to anyone who has the means to buy it—individuals, investment companies such as mutual funds, not-for-profit organizations, and other companies. Such corporations are said to be publicly held or publicly traded. In contrast, the stock of a private corporation, also known as a closely held corporation, is owned by only a few individuals or companies and is not made available for purchase by the public. Corporations can change from private to public ownership or from public to private as their financial needs and strategic interests change. Copyright © 2015 Pearson Education, Inc.

Advantages of Corporations Ability to raise capital Liquidity Longevity Limited liability Corporations have become a major economic force because this structure offers four major advantages over sole proprietorships and partnerships. Copyright © 2015 Pearson Education, Inc.

Advantages of Corporations (cont.) Liquidity A measure of how easily and quickly an asset such as corporate stock can be converted into cash by selling it The stock of publicly traded companies has a high degree of liquidity, which means that investors can easily and quickly convert their stock into cash by selling it on the open market. In contrast, liquidating (selling) the assets of a sole proprietorship or a partnership can be slow and difficult. Liquidity helps make corporate stocks an attractive investment, which increases the number of people and institutions willing to invest in such companies. In addition, because shares have value established in the open market, a corporation can use shares of its own stock to acquire other companies. Copyright © 2015 Pearson Education, Inc.

Disadvantages of Corporations Cost and complexity Reporting requirements Managerial demands Possible loss of control Double taxation Short-term orientation of the stock market The advantages of the corporate structure are compelling, but six significant disadvantages must be considered carefully. Copyright © 2015 Pearson Education, Inc.

Special Types of Corporations S Corporation A type of corporation that combines the capital-raising options and limited liability of a corporation with the federal taxation advantages of a partnership An S corporation, or subchapter S corporation, combines the capital-raising options and limited liability of a corporation with the federal taxation advantages of a partnership (although a few states tax S corporations like regular corporations). Corporations seeking “S” status must meet certain criteria, including a maximum of 100 investors, all of whom must be U.S. residents. Copyright © 2015 Pearson Education, Inc.

Special Types of Corporations (cont.) Limited Liability Company (LLC) A structure that combines limited liability with the pass-through taxation benefits of a partnership; the number of shareholders is not restricted, nor is members’ participation in management As its name suggests, the limited liability company (LLC) structure offers the advantages of limited liability, along with the pass-through taxation benefits of a partnership. Furthermore, LLCs are not restricted in the number of shareholders they can have, and members’ participation in management is not restricted as it is in limited partnerships. Given these advantages, the LLC structure is recommended for most small companies that aren’t sole proprietorships. Copyright © 2015 Pearson Education, Inc.

Special Types of Corporations Benefit Corporation A profit-seeking corporation whose charter specifies a social or environmental goal that the company must pursue in addition to profit A benefit corporation has most of the attributes of a regular corporation but adds the legal requirement that the company must also pursue a stated nonfinancial goal, such as hiring workers whose life histories make employment difficult to attain or reducing the environmental impact of particular products. The corporation’s performance toward meeting that goal must be independently verified as well. These requirements offer key advantages to founders and other stakeholders. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Corporate Governance Board of directors A group of professionals elected by shareholders as their representatives, with responsibility for the overall direction of the company and the selection of top executives Although a corporation’s shareholders own the business, few of them are typically involved in managing it, particularly if the corporation is publicly traded. Instead, shareholders who own common stock select a board of directors to represent them, and the directors, in turn, select the corporation’s top officers, who actually run the company. Copyright © 2015 Pearson Education, Inc.

Corporate Governance (cont.) Describes all the policies, procedures, relationships, and systems in place to oversee the successful and legal operation of the enterprise Also refers to the responsibilities and performance of the board of directors specifically The term corporate governance can be used in a broad sense to describe all the policies, procedures, relationships, and systems in place to oversee the successful and legal operation of the enterprise. However, media coverage and public discussion tend to define governance in a more narrow sense, as the responsibilities and performance of the board of directors specifically. Because serious corporate blunders can wreak havoc on employees, investors, and the entire economy, effective corporate governance has become a vital concern for society as a whole, not just for the individual companies themselves. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Corporate Governance (cont.) Exhibit 5.3 Shareholders of a corporation own the business, but their elected representatives on the board of directors hire the corporate officers who run the company and hire other employees to perform the day-to-day work. (Note that corporate officers are also employees.) Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Shareholders Proxy A document that authorizes another person to vote on behalf of a shareholder in a corporation Shareholder activism Activities undertaken by shareholders to influence executive decision making in areas ranging from strategic planning to social responsibility All shareholders who own common stock are invited to an annual meeting where top executives present the previous year’s results and plans for the coming year and shareholders vote on various resolutions that may be before the board. Those who cannot attend the annual meeting in person can vote by proxy, authorizing management to vote on their behalf. Shareholder activism, in which shareholders pressure management on matters ranging from executive pay to corporate social responsibility to overall company performance, has become an increasingly visible factor in corporate governance. Activist shareholders are becoming better organized and more sophisticated in proposals they present, forcing boards to pay more attention to the concerns they raise. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Corporate Officers Corporate Officers The top executives who run a corporation Chief Executive Officer (CEO) The highest-ranking officer of a corporation The third and final group that plays a key role in governance are the corporate officers, the top executives who run the company. Because they implement major board decisions, make numerous other business decisions, ensure compliance with a dizzying range of government regulations, and perform other essential tasks, the executive team is the major influence on a company’s performance and financial health. The highest-ranking officer is the chief executive officer (CEO), and that person is aided by a team of other “C-level” executives, such as the chief financial officer (CFO), chief information officer (CIO), chief technology officer (CTO), and chief operating officer (COO)—titles vary from one corporation to the next. Copyright © 2015 Pearson Education, Inc.

Mergers and Acquisitions An action taken by two companies to combine and perform as a single entity Acquisition An action taken by one company to buy a controlling interest in the voting stock of another company If a company determines that it doesn’t have the right mix of resources and capabilities to achieve its goals and doesn’t have the time or inclination to develop them internally, it can purchase or partner with a firm that has what it needs. Businesses can combine permanently through either mergers or acquisitions. In a merger, two companies join to form a single entity. Companies can merge either by pooling their resources or by one company purchasing the assets of the other. Although not strictly a merger, a consolidation, in which two companies create a new, third entity that then purchases the two original companies, is often lumped together with the other two merger approaches. In an acquisition, one company buys a controlling interest in the voting stock of another company. In most acquisitions, the selling parties agree to be purchased; management is in favor of the deal and encourages shareholders to vote in favor of it as well. Because buyers frequently offer shareholders more than their shares are currently worth, sellers are often motivated to sell. Copyright © 2015 Pearson Education, Inc.

Mergers and Acquisitions (cont.) Hostile takeover Acquisition of another company against the wishes of management Leveraged buyout (LBO) Acquisition of a company’s publicly traded stock, using funds that are primarily borrowed, usually with the intent of using some of the acquired assets to pay back the loans used to acquire the company In some situations, a buyer attempts to acquire a company against the wishes of management. In such a hostile takeover, the buyer tries to convince enough shareholders to go against management and vote to sell. A leveraged buyout (LBO) occurs when someone purchases a company’s publicly traded stock primarily by using borrowed funds, sometimes using the target company’s assets as collateral for these loans. The debt is expected to be repaid with funds generated by the company’s operations and, often, by the sale of some of its assets. An LBO is an aggressive move and can be quite risky if the buyer takes on so much debt that repayment demands deplete the cash the company has for operations and growth. Copyright © 2015 Pearson Education, Inc.

Advantages of Mergers and Acquisitions Increase their buying power as a result of their larger size Increase revenue by cross-selling products to each other’s customers Increase market share by combining product lines Gain access to new expertise, systems, and teams of employees A merger or an acquisition is a rare event for many firms, but some other companies use acquisitions as a strategic tool to expand year after year. Companies pursue mergers and acquisitions for a variety of reasons: They might hope to increase their buying power as a result of their larger size, increase revenue by cross-selling products to each other’s customers, increase market share by combining product lines to provide more comprehensive offerings, or gain access to new expertise, systems, and teams of employees who already know how to work together. Bringing a company under new ownership can also be an opportunity to replace or improve inept management and thereby help a company improve its performance. Copyright © 2015 Pearson Education, Inc.

Disadvantages of Mergers and Acquisitions Executives have to agree on how the merger will be financed Managers need to decide who will be in charge after they join forces Marketing departments need to figure out how to blend product lines, branding strategies, and advertising and sales efforts Companies must often deal with layoffs Although the advantages can be compelling, joining two companies is a complex process because it involves virtually every aspect of both organizations. Copyright © 2015 Pearson Education, Inc.

Strategic Alliances and Joint Ventures A long-term partnership between companies to jointly develop, produce, or sell products Joint venture A separate legal entity established by two or more companies to pursue shared business objectives THE END A strategic alliance is a long-term partnership between companies to jointly develop, produce, or sell products, and a joint venture as a separate legal entity established by the strategic partners. Both of these options can be more attractive than a merger or acquisition in certain situations. Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall