Reading: Lesson 1 - The Corporate Life Cycle

1.1.A - The Corporate Life Cycle

1. Starting Up as Proprietorship 

1. Proprietorship is an unincorporated business owned by one individual.
2. Starting a business as a proprietor is easy—one merely begins business operations after obtaining any required city or state business licenses. The proprietorship has three important advantages: (1) it is easily and inexpensively formed, (2) it is subject to few government regulations, and (3) its income is not subject to corporate taxation but is taxed as part of the proprietor’s personal income.
   
3. A proprietorship also has three important limitations: (1) It may be difficult for a proprietorship to obtain the capital needed for growth. (2) The proprietor has unlimited personal liability for the business’s debts, which can result in losses that exceed the money invested in the company (creditors may even be able to seize a proprietor’s house or other personal property). (3) The life of a proprietorship is limited to the life of its founder.
   
4. For these three reasons, sole proprietorships are used primarily for small businesses. In fact, proprietorships account for only about 13% of all sales, based on dollar values, even though about 80% of all companies are proprietorships.
   

2. More Than One Owner: Partnership

1. Some companies start with more than one owner, and some proprietors decide to add a partner as the business grows.
   
2. A partnership exists whenever two or more persons or entities associate to conduct a non-corporate business for profit.
   
3. Partnerships may operate under different degrees of formality, ranging from informal, oral understandings to formal agreements filed with the secretary of the state in which the partnership was formed. Partnership agreements define the ways any profits and losses are shared between partners. A partnership’s advantages and disadvantages are generally similar to those of a proprietorship.
4. Regarding liability, the partners potentially can lose all of their personal assets, even assets not invested in the business, because under partnership law, each partner is liable for the business’s debts. Therefore, in the event the partnership goes bankrupt, if any partner is unable to meet his or her pro rata liability, then the remaining partners must make good on the unsatisfied claims, drawing on their personal assets to the extent necessary.
   
5. To avoid this, it is possible to limit the liabilities of some of the partners by establishing a limited partnership, wherein certain partners are designated general partners and others limited partners.
   
6. In a limited partnership, the limited partners can lose only the amount of their investment in the partnership, while the general partners have unlimited liability. However, the limited partners typically have no control—it rests solely with the general partners—and their returns are likewise limited.
   
7. Limited partnerships are common in real estate, oil, equipment leasing ventures, and venture capital. However, they are not widely used in general business situations because usually no partner is willing to be the general partner and thus accept the majority of the business’s risk, and no partners are willing to be limited partners and give up all control.
   
8. In both regular and limited partnerships, at least one partner is liable for the debts of the partnership. However, in a limited liability partnership (LLP), sometimes called a limited liability company (LLC), all partners enjoy limited liability with regard to the business’s liabilities, and their potential losses are limited to their investment in the LLP. Of course, this arrangement increases the risk faced by an LLP’s lenders, customers, and suppliers.
   

3. Many Owners: A Corporation

1. A corporation is a legal entity created under state laws, and it is separate and distinct from its owners and managers.
   
2. This separation gives the corporation three major advantages: (1) unlimited life—a corporation can continue after its original owners and managers are deceased; (2) easy transferability of ownership interest—ownership interests are divided into shares of stock, which can be transferred far more easily than can proprietorship or partnership interests; and (3) limited liability—losses are limited to the actual funds invested.
   
3. The corporate form offers significant advantages over proprietorships and partnerships, but it also has two disadvantages: (1) Corporate earnings may be subject to double taxation—the earnings of the corporation are taxed at the corporate level, and then earnings paid out as dividends are taxed again as income to the stockholders. (2) Setting up a corporation involves preparing a charter, writing a set of bylaws, and filing the many required state and federal reports, which is more complex and time-consuming than creating a proprietorship or a partnership.
   
4. The charter includes the following information: (1) name of the proposed corporation, (2) types of activities it will pursue, (3) amount of capital stock, (4) number of directors, and (5) names and addresses of directors. The charter is filed with the secretary of the state in which the firm will be incorporated, and when it is approved, the corporation is officially in existence.2 After the corporation begins operating, quarterly and annual employment, financial, and tax reports must be filed with state and federal authorities.
   
5. The bylaws are a set of rules drawn up by the founders of the corporation. Included are such points as (1) how directors are to be elected (all elected each year or perhaps one-third each year for 3-year terms); (2) whether the existing stockholders will have the first right to buy any new shares the firm issues; and (3) procedures for changing the bylaws themselves, should conditions require it.
   
6. There are several different types of corporations. Professionals such as doctors, lawyers, and accountants often form a professional corporation (PC) or a professional association (PA). These types of corporations do not relieve the participants of professional (malpractice) liability. Indeed, the primary motivation behind the professional corporation was to provide a way for groups of professionals to incorporate in order to avoid certain types of unlimited liability yet still be held responsible for professional liability.
   
7. If certain requirements are met, particularly with regard to size and number of stockholders, owners can establish a corporation but elect to be taxed as if the business were a proprietorship or partnership. Such firms, which differ not in organizational form but only in how their owners are taxed, are called S corporations.
   

4. Growing and Managing a Corporation

1. When entrepreneurs start a company, they usually provide all the financing from their personal resources, which may include savings, home equity loans, or even credit cards. As the corporation grows, it will need factories, equipment, inventory, and other resources to support its growth.
   
2. In time, the entrepreneurs usually deplete their own resources and must turn to external financing. Many young companies are too risky for banks, so the founders must sell stock to outsiders, including friends, family, private investors (often called angels), or venture capitalists.
   
3. If the corporation continues to grow, it may become successful enough to attract lending from banks, or it may even raise additional funds through an initial public offering (IPO) by selling stock to the public at large. After an IPO, corporations support their growth by borrowing from banks, issuing debt, or selling additional shares of stock. In short, a corporation’s ability to grow depends on its interactions with the financial markets.
   
4. For proprietorships, partnerships, and small corporations, the firm’s owners are also its managers. This is usually not true for a large corporation, which means that large firms’ stockholders, who are its owners, face a serious problem. What is to prevent managers from acting in their own best interests, rather than in the best interests of the stockholder/ owners? This is called an agency problem, because managers are hired as agents to act on behalf of the owners.
   
5. Agency problems can be addressed by a company’s corporate governance, which is the set of rules that control the company’s behavior towards its directors, managers, employees, shareholders, creditors, customers, competitors, and community.