CHAPTER 5

How to Form
a Business

McGraw-Hill/Irwin Copyright © 2015 by the McGraw-Hill Companies, Inc. All rights reserved.
 MAJOR FORMS of OWNERSHIP
• Sole Proprietorship -- A business owned, and
usually managed, by one person.

• Partnership -- Two or more people legally

agree to become co-owners of a business.

• Corporation -- A legal entity with authority to

act and have liability apart from its owners.
 FORMS of
BUSINESS OWNERSHIP
 Sole Proprietorship
Advantages Disadvantages

• Ease of starting and • Unlimited liability

ending business • Limited financial
• Being your own boss resources
• Management
• Pride of Ownership
difficulties
• Leaving a legacy • Overwhelming time
• Retention of company commitment
profit • Few fringe benefits
• No special taxes • Limited growth
• Limited life span
 Partnership

Advantages Disadvantages
• More financial • Unlimited liability
resources
• Shared management • Division of profits

• Complementary skills • Disagreements

and knowledge • among partners
• Longer survival
• Difficult to terminate
• No special taxes
 MAJOR TYPES of PARTNERSHIPS
• General Partnership -- All owners share in
operating the business and in assuming liability
for the business’s debts.
• Limited (Silent) Partnership -- An owner who
invests money in the business, but enjoys
limited liability. Limited Liability means that
liability for the debts of the
business is limited to the
amount the limited partner
puts into the company;
personal assets are not at
risk.
 Some Other Types of Partnerships
Secret  active role in managing but identity
is unknown to the public.

Nominal  not actually a partner but lends

their name or reputation so
public believes they are a
partner.

Dormant  neither active in

managing nor known to the
public.
Questions for Your Would-Be Partner
Many partnerships go sour. Entrepreneur Magazine suggests
asking four questions before choosing a partner to help
increase the chances of the partnership surviving.

1) What are the would-be partners’ business concept? A

person needs to find a partner that has the same business
philosophy as they do. If one partner has the philosophy
“if its costs too much, we can’t spend it” and the other
partner has the philosophy “you have to spend money to
make money,” the partners will constantly disagree on how
to run the business.
Questions for Your Would-Be Partner
2) How will we structure ownership? Many make the
mistake of not talking things out and assuming that the
partners will split everything 50-50 or equally among all
partners. The business starts making a profit. One partner
thinks they should get 60% of the profit because they put
more money into the business, and the other partner thinks
they should get 60% of the profit because they put more
time into the business. Houston, we have a problem!
Questions for Your Would-Be Partner
3) Why do we need each other? Many times a person will
choose a good friend or somebody similar to them to be
their partner. Wrong! For example, two accountants have
worked together for 10 years in major accounting firm. An
opportunity comes up to buy a small business, and the two
accountants decide to go into business together. Both of
them will be very good dealing with the accounting and
finance of the business. What do they known about
management and marketing? Entrepreneur recommends a
person choose a partner that compliments
them. If the person is good at accounting
and finance, the person should look for a
partner who is good at management and
marketing.
Questions for Your Would-Be Partner
4) How do our lifestyles differ? Partners need to have similar
lifestyles or problems will arise. For example, two women
have gone into business together. One woman is married
with kids and the other woman is single. The married
woman constantly begins asking the single woman to cover
the business while she picks up the kids from school, take
the kids to soccer practice, take time off to attend a baseball
tournament her kid is playing in, etc. Or the single woman
constantly asks the married woman if she can cover the
business so she can have an active social life. There is a
problem!
 Questions for Your Would-Be Partner

1. What are the would-be partners’ business

concept?

2. How will we structure ownership?

3. Why do we need each other?

4. How do our lifestyles differ?

SOURCE: Entrepreneur
 Articles of Partnership
The judicial system got tired of sour partnerships ending
in court and clogging up the system. So all the states,
except Louisiana, have it now that if a partnership ends up
in court and no Articles of Partnership are in place,
everything is automatically split equally among all
partners. The Articles of Partnership, sometimes called
Articles of Copartnership, is a document that should be
drawn up before the business starts operating. The
document require partners to talk
things out and agree upon a list of
key points about running the business.
The next slide provides a few key
features of the Articles of Partnership.
 Articles of Partnership
Key Features:
Compensation and ratio for sharing profits &
losses
Duties of each partner
Procedures for resolving conflicts
Provision for dissolution
Duration of partnership
Contribution of each partner (money, talent,
equipment, etc.)
 Corporation
Advantages Disadvantages
• Limited liability • Extensive paperwork
• Ability to raise more • Double taxation
money for investment • Two tax returns
• Size • Size
• Perpetual life • Difficulty of
• Ease of ownership termination
• change • Possible conflict with
• Ease of attracting Board of Directors
talented employees and Stockholders
• Separation of • Initial cost
ownership from
management
 WHO CAN INCORPORATE?
• Anyone - truckers, doctors, plumbers, athletes
and small business owners can incorporate.

• Normally stock is not issued to outsiders when

individuals incorporate, so the advantages and
disadvantages are not exactly the same as for
large corporations.

• Major advantages are limited

liability and possible tax benefits.
 INCORPORATION TYPES
• Domestic  Company does business in the state
that it was incorporated.
• Foreign  Company does business in one state,
but chartered in another state.
• Alien  Company does business in the U.S. but
is chartered in another country.

Note: About one-third of all

incorporations are done in
Delaware.
 MERGERS and ACQUISITIONS

• Merger -- The result of two firms agreeing

to join in forming one company.
• Acquisition -- One company’s purchase
of the property and obligations of another
company. Sometimes
can be hostile causing
resistance.
 Types of Mergers

Horizontal

Vertical

Conglomerate No
Relationship
between
companies
 TYPES of MERGERS
• Horizontal Merger -- The joining of two firms in the
same industry. Examples: Bicycle company mergers
with a Tricycle company or a Shoe company mergers
with a Sock company (Footwear Industry).

• Vertical Merger -- The joining of two firms in different

stages of related businesses. Examples: Bicycle
company mergers with Wheel company (need wheels
for bicycles) or a Soup company mergers with a Can
company (need cans for soup).

• Conglomerate Merger -- The joining of firms in

completely unrelated industries. Example: Bicycle
company buys Restaurant chain
 HOSTILE TAKEOVER STRATEGIES
 Tender Offer - Is an offer to purchase
some or all of shareholders' shares in
a corporation. The price offered is
usually above the market price.

 White Knight - is a friendly investor

that buys a corporation with the support
from the corporation's board of directors
and management while it is facing a
hostile acquisition from another potential
acquirer.
 HOSTILE TAKEOVER STRATEGIES
 Poison Pill – a company targeted for a
takeover makes the shares of the
company’s stock look less desirable
or makes the financial position of
the company unattractive to the acquiring firm.

 Golden Parachute - Substantial benefits given

to top executives in the event that the
company is taken over by another firm
and the executives are terminated as a
result of the takeover. This benefits can
be so large that it discourages others from
acquiring the company.
 HOSTILE TAKEOVER STRATEGIES

 Shark Repellent - a company

will make special amendments
to its charter or bylaws that
requires obtaining two-thirds
or three-fourths of the majority
votes instead of a simple
majority to ratify a takeover by
an outsider, which makes the
takeover almost impossible to
achieve.
 Franchises
Advantages Disadvantages

• Management and • Large start-up costs

marketing assistance • Shared profit
• Personal ownership • Management
regulation
• Nationally recognized
or well-known name
• Coattail effects
• Restrictions on selling
• Financial advice and
• Fraudulent franchisors
assistance
• Lower failure rate
 Cost of Some Top 100
Franchises
Average
Average Royalty
Company Franchise
Investment Fee
Fee
CiCi’s Pizza $23,000 $623,000 10%

Denny’s $20,000 $1,668,000 8%

Express Oil
$35,000 $1,765,000 8%
Change

Jani-King $13,000 $25,000 14%

Little Caesars $10,000 $475,000 10%

McDonald’s $45,000 $1,000,000 12%

Source: World Franchising
 SELF CHECK

Answer the following questions

1. Which is usually the easiest form of
business to start and end?

A. Sole proprietorship
B. Limited partnership
C. Corporation
D. Cooperative
E. Franchise
2. Sue operates a sole proprietorship, but she is in
poor health and may be unable to continue running
the business. What would happen if Sue becomes
incapacitated?

A. Her business automatically continues under new

management as a sole proprietorship.
B. Her business automatically converts into a public
corporation with stock sold to interested investors.
C. Her business ceases to exist unless sold or taken
over by Sue's heirs.
D. Her business becomes the property of the most
senior employee who wishes to continue operating
the firm.
E. Her business is taken over by the government.
3. Sheila plans to open a shop. She wants to be
the firm’s only general partner, but she is trying
to get several friends to participate as limited
partners. Which of the following does Sheila
apparently want to do?

A. Limit her personal liability to the amount she

personally invests in the company.
B. Be the only person allowed to share in the firm’s
profits.
C. Obtain a strong financial base for the firm while
maintaining personal control over the firm’s
management.
D. Meet the legal requirements of the Uniform
Partnership Act.
E. Form a strong general partnership.
4. John is a stockholder in Billet Investments, which is
a Corporation. Billet recently lost a major court
decision and will be forced into bankruptcy. In fact,
the damages awarded are so great that, even if all of
its assets are sold and the proceeds are used to pay
its debts, Billet is likely to still owe money to its
creditors. If Billet does go bankrupt, John and the
other stockholders will

A. be personally responsible for all remaining debts.

B. lose their investment but nothing else.
C. be entitled to full reimbursement of any investment
losses.
D. automatically qualify for federal reimbursement for
any losses suffered by the firm.
E. Lose their personal assets to pay off the debt.
5. A _______ is the result of two firms
combining to form a new firm.

A. joint tenancy
B. tenancy in common
C. merger
D. leveraged buyout
E. acquisition
6. A merger involving a commercial
bakery and a grocery retailer would
be an example of which of the
following?

A. Vertical merger
B. Horizontal merger
C. Linear merger
D. Conglomerate merger
E. Diagonal merger
7. Globe Airlines recently looked into a merger
with Royal Airlines, a financially troubled
rival. The firms believe the merger will
create a stronger company that can offer
travelers more flights to a wider variety of
destinations. Which of the following best
describes this proposed merger?

A. Conglomerate merger
B. Leveraged buyout
C. Horizontal merger
D. Joint venture
E. Vertical merger
8. Carl is interested in becoming a franchisee
in Bob’s Delights, a very successful fast
food chain specializing in food dishes from
the U.S. east coast. Which of the following
problems is Carl most likely to encounter if
he agrees to become a franchisee?

A. High initial costs and fees

B. Poor name recognition and visibility
C. Lack of financing
D. Lack of managerial assistance
E. High failure rate
9. Sue has decided to become a partner
in John’s business. She will have an
active role in managing but her
identity will be unknown to the public.
What type of partnership was formed?

A. Silent
B. General
C. Dormant
D. Nominal
E. Secret
10. Which of the following situations would be the best
opportunity for a partnership to succeed?

A. Young single female and married with children female

starting a daycare center.
B. Joe believes in a saving money philosophy and Tony
believes in a spending money philosophy starting a
restaurant.
C. Any, who likes to party, and Mary, who likes to work,
deciding to start a bakery store.
D. Henry, who knows accounting/finance and Sam, who
knows management/marketing, starting a dry cleaning
store.
E. Adam, who believes in a 60-40 partnership split, and
Eve, who believes in a 60-40 partnership split, starting a
bookkeeping service without talking to each other.
 SELF CHECK ANSWERS
1. A
2. C
3. C
4. B
5. C
6. A
7. C
8. A
9. E
10. D