Part II: Starting a New Business

Selecting a Form Chap

of Business Ownership 5

Introduction to Business 4th, Madura, J. (2007).

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Andrianantenaina Hajanirina, B.A., B.Sc., M.M.

 Learning goals
• Describe the advantages and
disadvantages of:
– a sole proprietorship.
– a partnership.
– a corporation.
• Explain how the potential return and risk
of a business are affected by its form of
ownership.
• Describe methods of owning existing
businesses. 1–2
 Selecting a Form of
Business Ownership
When entrepreneurs establish a business, they must decide on the
form of business ownership.

There are three basic forms of business ownership:

1. sole proprietorship,
2. partnership, and
3. corporation.
The form that is chosen can affect the profitability, risk, and value of the
firm.

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 1-Sole Proprietorship
Definition
Sole proprietorship is a business owned by a single owner (sole
proprietor).

The sole proprietor is obligated to cover any payments resulting

from the loans but does not need to share the business profits with
creditors.

Typical example of proprietorship:

a local restaurant, a local construction firm, a barber shop, a laundry
service, and a local clothing store.

In US 70% of firm are sole proprietorshipbut only contributes 10% of

business revenue.

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 Sole proprietorship (Cont’)
Characteristics of a succesful sole proprietorship
•Sole proprietors must be willing to accept full responsibility for the
firm’s performance
•Selling flexible hours
•They must exhibit strong leadership skills, be well organized, and
communicate well with employees.
•Have experience

Advantages of a Sole Proprietorship

• All Earnings Go to the Sole Proprietor
No other owner, thus all rewards go to the owner.
• Easy Organization
Legal requirements are minimal, registration to the State
Need occupation licence
• Complete Control
Having only one owner with complete control of the firm eliminates
the chance of conflicts during the decision-making process.
• Lower Taxes 1–5
Because considered as personal tax (lower than corporate tax)
 Ethics and CSR
Disadvantages of a Sole Proprietorship
•The Sole Proprietor Incurs all Losses
They are unable to share any losses that the firm incurs
•Unlimited Liability
No limit on the debts for which the owner is liable
•Limited Funds
Limited funds and cannot have large business like aricraft
manufacturing, shipbuilding...
•Limited Skills
A sole proprietor has limited skills and may be unable to control all
parts of the business

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 2-Partnership
Definition
-A business that is co-owned by two or more people is referred to as
a partnership.
-The co-owners of the business are called partners.
-The co-owners must register the partnership with the state and may
need to apply for an occupational license.
-About 10 percent of all firms are partnerships.

Types
general partnership
a partnership in which all partners have unlimited liability
limited partnership
a firm that has some limited partners
limited partners
partners whose liability is limited to the cash or property they
contributed to the partnership
general partners
partners who manage the business, receive a salary, share the profits
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or losses of the business, and have unlimited liability
 Partnership (cont’)
Advantages of a Partnership
•Additional Funding
An obvious advantage of a partnership over a sole proprietorship is the
additional funding that the partner or partners can provide.
Therefore, more money may be available to finance the business
operations (some have 1000 partners)
•Losses Are Shared
Each owner will absorb only a portion of the loss.
•More Specialization
With a partnership, partners can focus on their respective
specializations and serve a wide variety of customers.
For example,
an accounting firm may have one accountant who specializes in
personal taxes for individuals and another who specializes in business
taxes for firms.

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 Partnership (cont’)
Disadvantages of a Partnership
1. Control Is Shared
The decision making in a partnership must be shared.
If the partners disagree about how the business should be run,
business and personal relationships may be destroyed.
Some owners of firms do not have the skills to manage a business.
2. Unlimited Liability
General partners in a partnership are subject to unlimited liability, just
like sole proprietors.
3. Profits Are Shared
Any profits that the partnership generates must be shared among all
partners.
The more partners there are, the smaller the amount of a given level of
profits that will be distributed to any individual partner.

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 Partnership (cont’)
Other form of partnership
S-corporation
A firm that has 100 or fewer owners and satisfies other criteria.
Owners have limited liability
The earnings are distributed to the owners and taxed at the respective
personal income tax rate of each owner.

limited liability company (LLC)

a firm that has all the favorable features of a typical general partnership
but also offers limited liability for the partners
An LLC must be created according to the laws of the state where the
business is located.

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 3-Corporation
Definition
a state-chartered entity that pays taxes and is legally distinct from its
Owners (through share)
Although only about 20 percent of all firms are corporations,
corporations generate almost 90 percent of all business revenue.
charter
a document used to incorporate a business. The charter describes
important aspects of the corporation.
bylaws
general guidelines for managing a firm

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Corporation (cont’)

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 Corporation (Cont’)
Characteristics
How Stockholders Earn a Return
Stockholders can earn a return on their investment in a firm in two
different ways.
First, they may receive dividends from the firm, which are a portion
of the firm’s recent earnings over the last three months that are
distributed to stockholders.
Second, the stock they hold may increase in value. When the firm
becomes more profitable, the value of its stock tends to rise, meaning
that the value of stock held by owners has increased. Thus, they can
benefit by selling that stock for a much higher price than they paid for
it.
Private versus Public Corporations
publicly held
shares can be easily purchased or sold by investors
going public
the act of initially issuing stock to the public 1–13
 Corporation (cont’)
Advantages of a Corporation
Limited Liability
Owners of a corporation have limited liability (as explained earlier),
whereas sole proprietors and general partners typically have unlimited
liability.
Access to Funds
A corporation can easily obtain funds by issuing new stock (as
explained earlier). It allows to grow and to engage in new business
ventures.
Transfer of Ownership
Investors in large, publicly traded companies can normally sell their
stock in minutes by calling their stockbrokers or by selling it online over
the Internet.
Conversely, owners of sole proprietorships or partnerships may have
some difficulty in selling their share of ownership in the business.

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 Corporation (cont’)
Disadvantages of a Corporation
High Organizational Expense
Organizing a corporation is normally more expensive than creating the
other forms of business because of the necessity to create a corporate
charter and file it with the state.
Some expense may also be incurred in establishing bylaws.
Issuing stock to investors also entails substantial expenses.
Financial Disclosure
When the stock of a corporation is traded publicly, the investing public
has the right to inspect the company’s financial data, within certain
limits. As a result, firms may be obligated to publicly disclose more
about their business operations and employee salaries than they
would like.
agency problem
when managers do not act as responsible agents for the shareholders
who own the business
High Taxes
Since the corporation is a separate entity, it is taxed separately from its 1–15

owners
 Corporation (cont’)
Illustration of Double Taxation in a corporation

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 Corporation (cont’)
Tax effect

capital gain
the price received from the sale of
stock minus the price paid for the
stock 1–17
 Corporation (cont’)
Comparing Forms of Business Ownership

No single form of business ownership is ideal for all business

owners. An individual setting up a small business may choose a sole
proprietorship.
Some people who decide to co-own a small business may choose a
partnership.
If they wish to limit their liability, however, they may decide to establish
a privately held corporation.
If this corporation grows substantially over time and needs millions of
dollars to support additional business expansion, it may convert to a
publicly held corporation so that it can obtain funds from stockholders.

How Business Ownership Can Change

It depends on the owner

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4-How Ownership Can Affect Return
and Risk
Impact of Ownership on the Return on Investment
The return on investment in a firm is derived from the firm’s profits (also
called “earnings” or “income”).
As described earlier, when a firm generates earnings, it pays a portion
to the IRS as income taxes.
The remaining (after-tax) earnings represent the return (in dollars) to
the business owners.
However, the dollar value of a firm’s after-tax earnings is not ecessarily
a useful measure of the firm’s performance unless it is adjusted for
the amount of the firm’s equity, which is the total investment by the
firm’s stockholders.
For this reason, business owners prefer to measure a firm’s profitability
by computing its return on equity (ROE), which is the earnings as a
proportion of the equity.
equity
the total investment by the firm’s stockholders
return on equity (ROE) 1–19

earnings as a proportion of the firm’s equity

ROE for Zenmax Company example

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 Risk
Impact of Ownership on Risk
risk
the degree of uncertainty about a firm’s future earnings

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5-Obtaining Ownership of an Existing
Business
Some people become the sole owners without starting the business.
The following are common methods by which people become owners
of existing businesses:
Assuming ownership of a family business
Purchasing an existing business
Franchising

Assuming Ownership of a Family Business

Many people work in a family business and after a period of time
assume the ownership of it.
This can be an ideal way to own a business because its performance
may be somewhat predictable as long as the key employees continue
to work there.

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 Obtaining ownership (cont)
Purchasing an Existing Business
Businesses are for sale on any given day in any city. They are
often advertised in the classified ads section of local newspapers.
Businesses are sold for various reasons, including financial difficulties
and the death or retirementof an owner.

People considering the purchase of an existing business must

determine whether they have the expertise to run the business or
at least properly monitor the managers. Then they must compare the
expected benefits of the business with the initial outlay required to
purchase it.

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 Obtaining ownership (cont)
Franchising
franchise
an arrangement whereby a business owner allows others to use its
trademark, trade name, or copyright, under specific conditions
franchisor
a firm that allows others to use its trade name or copyright, under
specified conditions
franchisee
a firm that is allowed to use the trade name or copyright of a franchise
distributorship
a type of franchise in which a dealer is allowed to sell a product
produced by a manufacturer
chain-style business
a type of franchise in which a firm is allowed to use the trade name
of a company and follows guidelines related to the pricing and sale
of the product
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 Obtaining ownership (cont)
Example of franchise

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 Obtaining ownership (cont)
Advantages of a Franchise
Proven Management Style
Franchisees look to the franchisors for guidance in production and
management.
Example: McDonalds

Thus, the franchise is a less risky venture than a new type of business,
as verified by a much higher failure rate for new businesses.

Name Recognition
Many franchises are nationally known because of advertising by the
franchisor.
This provides the franchisee with name recognition, which can
significantly increase the demand for the product.

Financial Support Some franchisees receive some financial support

from the franchisor, which can ensure sufficient start-up funds for the 1–26
franchisee.
 Obtaining ownership (cont)
Manufacturing arrangement
a type of franchise in which a firm is allowed to manufacture a product
using the formula provided by another company

Disadvantages of a Franchise
Sharing Profits
In return for services provided by the franchisor, the franchisee must
share profits with the franchisor. Annual fees paid by the franchisee
may be 8 percent or more of the annual revenue generated by the
franchise

Less Control
The franchisee must abide by guidelines regarding product production
and pricing, and possibly other guidelines as well. Consequently, the
franchisee’s performance is dependent on these guidelines.

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 Obtaining ownership (cont)
The Popularity of Business-to-Business Franchises
Franchises that serve other businesses (called business-to-business or
B2B franchises) have grown substantially in the last few years.
In particular, many franchises focus on providing hiring services,
consulting services, and training services for firms.
These types of franchises are popular because they normally require a
smaller initial investment than many other franchises such as hotels
and restaurants

Global Business
Ownership of Foreign Businesses
Opportunities in foreign countries have encouraged many
entrepreneurs in the United States to establish foreign businesses
in recent years. A common way for an entrepreneur to establish a
foreign business is to purchase a franchise created by a U.S. firmin a
foreign country. For example,McDonald’s, Pizza Hut, and KFC have
franchises in numerous foreign countries. The potential return on these
franchises may be higher than in the United States if there is less 1–28

competition.
Summary

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 Applications
See the assignment

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