Understanding the structure of a business is crucial because the legal form affects a firm’s operations and how it is ultimately valued.
The goal of financial management is to maximize shareholder wealth, which means maximizing the firm’s long-run, true intrinsic value. The form of organization influences how easily a firm can raise capital, which is a major determinant of its ability to grow and maximize value.
Here is a detailed summary of the main forms of business organization:
1. Proprietorship
A proprietorship is an unincorporated business owned by one individual.
| Feature | Description |
|---|---|
| Establishment | Easy and inexpensive to form. A person simply begins business operations. |
| Taxation | Subject to lower income taxes than corporations. |
| Liability | The proprietor has unlimited personal liability for the business’ debts, meaning they can lose more than the amount initially invested. |
| Life Span | Limited to the life of the individual who created it. Bringing in new equity requires a change in the structure. |
| Capital | Has difficulty obtaining large sums of capital, so it is used primarily for small businesses. |
| Conversion | Businesses often start as proprietorships and convert to corporations when growth makes the disadvantages outweigh the advantages. |
2. Partnership
A partnership is a legal arrangement between two or more people who decide to do business together.
| Feature | Description |
|---|---|
| Establishment | Relatively easy and inexpensive to establish. |
| Taxation | The firm’s income is allocated to the partners on a pro rata basis and taxed as individual income, avoiding the corporate income tax. |
| Liability | Generally, all partners are subject to unlimited personal liability. If one partner is unable to meet their share of liabilities in bankruptcy, the remaining partners are responsible for the unsatisfied claims. Variations exist, such as a limited partnership (which has one general partner with unlimited liability and limited partners whose liability is capped by their investment). |
| Capital | Unlimited liability makes it difficult for partnerships to raise large amounts of capital. |
3. Corporation (C Corporation)
A corporation is a legal entity created by a state that is separate and distinct from its owners (stockholders) and managers.
| Feature | Description |
|---|---|
| Establishment | More complicated to form than a proprietorship or partnership. |
| Taxation | The major drawback is double taxation. The corporation’s earnings are taxed, and then any after-tax earnings paid out as dividends are taxed again as personal income to the stockholders. |
| Liability | Limited liability is a key advantage. Stockholders’ losses are limited to the amount they invested in the firm. This reduces the risks borne by investors, generally leading to a higher firm value. |
| Life Span | Corporations have unlimited lives. |
| Capital | It is much easier for corporations to transfer shares and raise the large amounts of capital necessary to operate big businesses, which is critical for taking advantage of growth opportunities. |
| Dominance | More than 80% of all business (by dollar value of sales) is done by corporations, and this book focuses on them because most successful businesses eventually convert to this form. |
4. Limited Liability Companies (LLCs) and Partnerships (LLPs)
These forms are popular hybrids combining features of partnerships and corporations.
| Feature | Description |
|---|---|
| Structure | LLCs are generally used by other businesses, while LLPs are used for professional firms (accounting, law, architecture). |
| Liability | They provide the limited liability protection of a corporation. |
| Taxation | They are taxed as partnerships. |
| Control | Unlike limited partnerships, investors in an LLC or LLP have votes in proportion to their ownership interest. |
| Capital | Large companies still typically find it more advantageous to be C corporations due to the benefits in raising capital to support growth. |
A special type of corporation, the S Corporation, is taxed like a proprietorship or partnership (avoiding corporate income tax) but must meet limits (no more than 100 stockholders). This limits their use to relatively small, privately owned firms.
The value of any business other than a relatively small one will likely be maximized when organized as a corporation due to its ability to attract capital more easily and the limited liability it offers investors.
Carlo's Notes 