Reading: Lesson 6 - Corporate Forms of Business Ownership

5.6.A - Corporate Forms of Business Ownership

1. THE STRUCTURE OF CORPORATIONS

1. Corporations are towers on the business landscape. Although proprietorships are many in number, they are generally small in size. In comparison, corporations are few in number, but generally large in size. Because corporations tend to be large, they play a powerful role in this and other countries. For example, corporations employ millions of people, have many layers of management, and provide consumers with many of the goods and services they use daily. In a recent year, corporate sales of goods and services were more than 20 times greater than sales from proprietorships, and more than 6 times greater than sales from partnerships in the United States.
   
2. Not all corporations are large. Corporations such as Ford, Apple, and Walmart are known to almost everyone, but many small corporations also exist. Small corporations are popular for reasons discussed later in this lesson. Because the corporation plays a vital role in business, we need to understand its basic features as well as management implications. To gain knowledge of the basic features of the corporation, we can follow York, Burton, and Chan as they consider incorporating their fast-growing food store partnership.
   
3. Elena Morales, a lawyer, helped York, Burton, and Chan prepare the partnership agreement under which they now operate. The partners asked Elena to describe a corporation to them. She stated that a corporation is a business owned by a group of people and authorized by the state in which it is located to act as though it were a single person, separate from its owners. To get permission to form a corporation, organizers must obtain a charter. A charter (often called a certificate of incorporation) is the official document through which a state grants the power to operate as a corporation.
   
4. A corporation is, in a sense, an artificial person created by the laws of a state. A corporation can make contracts, borrow money, own property, and sue or be sued in its own name. Any act performed for the corporation by an authorized person, such as an employee, is done in the name of the business. For example, the treasurer of a corporation has the power to borrow money for the business. An unauthorized employee, such as a receptionist who was hired to answer the phone and greet visitors, could not borrow money for the corporation. Elena further explained the important roles played by three key types of people in corporations: (1) stockholders, (2) directors, and (3) officers.
   
5. Stockholders - The owners of a corporation are stockholders. Ownership is divided into parts called shares. A person who buys one share becomes a stockholder, or shareholder. Therefore, thousands of people can own a corporation. Each stockholder receives a physical or an electronic certificate from the corporation, which shows the number of shares owned. Stockholders have a number of basic rights. Stockholders can:
   
   • Transfer ownership of shares to others.
   • Vote for members of the ruling body of the corporation and on other special matters that may be brought before the stockholders.
   • Receive dividends (profits that are distributed to stockholders on a per share basis) when authorized by the ruling body of the corporation.
   • Buy new shares of stock in proportion to one’s present investment should the corporation issue more shares.
   • Receive some net proceeds (cash received from the sale of all assets less the payment of all debts) should the corporation go out of business.
   
   A stockholder does not have the same financial responsibility as a partner; that is, there is no liability beyond the extent of the stockholder’s ownership. If the corporation fails, a stockholder can lose only the money used to buy the shares of stock. Creditors cannot collect anything further from the stockholder.
   
   
6. Directors - The board of directors (often shortened to directors or the board) is the ruling body of a corporation. The stockholders elect directors, who collectively have the management oversight responsibilities to develop plans and policies to guide the corporation as well as appoint officers to carry out the plans. If the corporation is performing well, the board is content to deal with policy issues and review the progress of the company. However, if the corporation’s profits fall, or if it experiences other serious difficulties, the board often steps in and takes an active role in the operational management of the business. In large firms, boards generally consist of 10 to 25 directors. A few directors are top executives from within the corporation. The remaining directors are from outside the corporation and are usually executives from other businesses or nonprofit organizations. Often, directors are stockholders who hold many shares, but directors need not be stockholders. Sometimes people who hold few or no shares are elected to the board because they have valuable knowledge needed by the board to make sound decisions. In some countries, such as Sweden, France, and China, at least one current employee is required to be on the board of directors.
   
7. Officers - An officer of a corporation is a top executive who is hired to manage the business. The board of directors appoints officers. In a larger corporation, the titles of these officers are often shortened to letters. For example, the top officer is frequently called a CEO (chief executive officer) and the head financial officer is the CFO (chief financial officer). In addition, large corporations may have vice presidents in charge of major areas, such as marketing, sales, and manufacturing. The officers of a small corporation often consist of a president, a secretary, and a treasurer.
   
8. A close corporation (also called a closely held corporation) is one that does not offer its shares of stock for public sale. Just a few stockholders own it; some of them may help run the business in the same manner that partners operate a business. York, Burton, and Chan could form a close corporation. The three former partners would then own all the stock and operate the business as well. In most states, a close corporation does not need to make its financial activities known to the public, as the stock is not offered for general sale. It must, however, prepare reports for the state from which it obtained its charter. In addition, it must prepare reports for tax purposes for all states in which it operates.
   
9. An open corporation (also called a publicly owned corporation) is one that offers its shares of stock for public sale. One way to announce the sale of common stock to the public is with an advertisement in the newspaper or online with an investment bank. The corporation must file a registration statement with the Securities and Exchange Commission (SEC) containing extensive details about the corporation and the proposed issue of stock. A condensed version of this registration statement, called a prospectus, must be furnished to each prospective buyer of newly offered stocks (or bonds). The prospectus is a formal summary of the chief features of the business and its stock offering. Potential buyers can find information in the prospectus that will help them decide if they want to buy shares of the corporation.
   

2. FORMATION OF CORPORATIONS

1. Over several months, York, Burton, and Chan asked their attorney, Elena Morales, many questions. After careful thought, the partners decided to form a corporation and name it York, Burton, and Chan, Inc. Morales explained that there were three basic steps involved. First, a series of management decisions had to be made about how the corporation would be organized. Second, the proper legal forms had to be prepared and sent to the state office that handled such matters. Third, the state would review the incorporation papers and issue a charter if approved.
   
2. Each state has its own laws for forming corporations. No federal law controls this process across the nation. To incorporate a business, it is necessary in most states to file a certificate of incorporation with the appropriate state office. The certificate of incorporation calls for basic information about the business. In addition to the firm name, purpose, and capital stock, it requires information about the organizers.
   
3. Naming the Business - A business is usually required by law to have a name that indicates clearly that a corporation has been formed. Words or abbreviations such as Corporation, Corp., Incorporated, or Inc. are used. The organizers have decided to name their corporation York, Burton, and Chan, Inc.
   
4. Stating the Purpose of the Business - A certificate of incorporation requires a corporation to describe its purpose clearly. In the case of York, Burton, and Chan, Inc., the purpose is simple: to operate a retail food business. It allows the corporation to expand into new food lines, but it does not allow the corporation to start nonfood operations. For major changes in purpose, a new request must be submitted and approved by the state.
   
5. Investing in the Business - The certificate of incorporation could not be completed until York, Burton, and Chan decided how to invest their partnership holdings in the corporation. They agreed that the assets and debts of the partnership should be taken over by the corporation. They further agreed that shares were valued at $100 each at the time of incorporation. There were 10,000 shares in all ($1,000,000 divided by $100 equals 10,000). York, Burton, and Chan each agreed to receive 2,217 shares. The 3,349 unissued shares (the difference between the 10,000 authorized shares and the 6,651 shares received by the organizers) can be sold later to raise more funds to expand the business.
   
6. Paying Incorporation Costs - Usually a new corporation must pay an organization tax, based on the amount of its capital stock. In addition, a new corporation usually pays a filing fee before the state will issue a charter entitling the business to operate as a corporation. In some states, the existence of the corporation begins when the application or certificate of incorporation has been filed with the appropriate state agency.
   
7. One of the first steps in getting the new corporation under way is to prepare a balance sheet or statement of financial position. The new corporation’s balance sheet appears in the Figure below. The ownership of the corporation is in the same hands as the ownership of the partnership was. The ownership of the corporation, however, is evidenced by the issued capital stock. The former partners each received a stock certificate indicating ownership of 2,217 shares of stock with a value of $100 a share. 
   

   
   

8. The three stockholders own the business and elect themselves directors. The new directors select officers. York is appointed president; Burton, vice president; and Chan, secretary and treasurer. The Figure below illustrates the organization chart of the new corporation. 
   

   
   

9. Handling Voting Rights - The owners agreed that each owner will have 2,217 votes on matters arising in stockholders’ meetings. Voting stockholders usually have one vote for each share owned. However, if Chan, for instance, sold 1,200 of his shares to Burton, Burton would own 3,417 shares, or more than 50 percent of the total 6,651 shares of stock that have been issued. Burton would have more votes than York and Chan combined. He would effectively control the corporation; that is, York and Chan would lose if Burton voted differently from them on any issue. Their lawyer told the officers of the corporation that they must send each stockholder notices of all stockholders’ meetings to be held. Even stockholders with just one share must receive notices of meetings. If stockholders cannot attend the meetings personally, they can be represented through proxy vote instructions that can be submitted by Internet, phone, or mail. A proxy is a written authorization for someone to vote on behalf of the person signing the proxy. Corporations often enclose a proxy form with the letter that announces a stockholders’ meeting.
   

1. The corporation can help to solve some of the management issues found with proprietorships and partnerships. At the same time, corporations have their own management issues.
   
2. Sources of Capital - A corporation can obtain money from several sources. One of those sources is the sale of shares to stockholders. Because corporations are regulated closely, people usually invest more willingly than in proprietorships and partnerships. In addition, corporations usually find borrowing large sums of money less of a problem than do proprietorships or partnerships.
   
3. Limited Liability - Except in a few situations, the owners (stockholders), directors, and managers are not legally liable for the debts of the corporation beyond their investment in the stock shares purchased. Stockholders are more willing to invest in a corporation when there is no possibility of incurring a liability beyond their original investment. At the same time, directors and managers may be more willing to work with a corporation when they cannot be found personally liable for debts of the corporation.
   
4. Permanence of Existence - The corporation is a more permanent type of organization than the proprietorship or the partnership. It can continue to operate indefinitely, or only as long as the term stated in the charter. The death or withdrawal of an owner (stockholder) does not end the corporation. Directors and managers can change over time without affecting the operation or ownership of a corporation.
   
5. Ease in Transferring Ownership - It is easy to transfer ownership in a corporation. A stockholder may sell stock to another person and transfer the stock certificate, which represents ownership, to the new owner. When shares are transferred, the transfer of ownership is indicated in the records of the corporation. A new certificate—paper or electronic—is issued in the name of the new stockholder. Billions of shares are bought and sold every day.
   
6. Taxation - The corporation is usually subject to more taxes than are imposed on the proprietorship and the partnership. Some taxes that are unique to the corporation are a filing fee, which is payable on application for a charter; an organization tax, which is based on the amount of authorized capital stock; an annual state tax, based on the profits; and a federal income tax. Another tax disadvantage for corporations is that profits distributed to stockholders as dividends are taxed twice. This double taxation occurs in two steps. The corporation itself first pays corporation-specific taxes on its profits. Then it distributes some of these profits to shareholders as dividends, and the shareholders pay individual taxes on the dividends they receive.
   
7. Government Regulations and Reports - A corporation cannot do business wherever it pleases. To form a corporation, an application for a charter must be submitted to the appropriate state official, usually the secretary of state. York, Burton, and Chan, Inc., has permission to conduct business only in the state of New York. Should it wish to conduct business in other states, each state will likely require the corporation to obtain a license and pay a fee to do business in that state. State incorporation fees are not very expensive. The attorney’s fee accounts for the major costs of incorporating. Each state has different laws that govern the formation of corporations. The regulation of corporations by various governments is extensive. Managers must ensure that the corporation files special reports with the state from which it received its charter as well as with other states where it conducts business. The federal government requires firms whose stock is publicly traded to publish financial data. As a result, there is a greater need for detailed financial records and reports.
   
8. Stockholders' Records - Corporations that have many stockholders have added problems— and expenses—in communicating with stockholders and in handling stockholders’ records. By law, stockholders must be informed of corporate matters, notified of meetings, and given the right to vote on important matters. Letters and reports must be sent to stockholders on a regular basis. In addition, each time a share of stock is bought or sold and whenever a dividend is paid, detailed records must be kept. Keeping records for the millions of stockholders of Microsoft, for example, is a task Microsoft pays another business to handle.
   
9. Charter Restrictions - A corporation is allowed to engage only in those activities that are stated in its charter. Should York, Burton, and Chan, Inc., wish to sell hardware, the organizers would have to go to the state to obtain a new charter or change the old one. As a partnership, they could have added the other line of merchandise without government approval. 
   
10. Agency Dilemma - An agency dilemma can occur when an agent, or someone who works for another, pursues his or her own interest over the employer’s interest. For example, in large corporations where stock ownership is broadly spread over a large number of stockholders, managers may look to their own interests over stockholders by making purchases that benefit only managers. Managers could try to persuade the board of directors to increase management pay, diminishing returns to stockholders. Corporate boards must ensure that managers perform their duties for the benefit of the corporation owners, the stockholders.