CHAPTER THREE

3. CHOOSING THE LEGAL FORM OF BUSINESS OWNERSHIP

3.1. Forms of Ownership and Legal Requirement
3.1.1. Legal Forms of Business Organization
1. Proprietorship,
2. Partnership,
3. Corporations, and
4. Cooperatives
3.1.2. The Sole Proprietorship Option
The best way to begin to understand the significance of "becoming" a corporation, or
partnership is to understand the implications of doing business as a "sole
proprietorship." A sole proprietor is simply a person who is engaged in business as
an individual. Sometimes the individual uses his own name in the name of the
business e.g. "Jones Auto Repair." However, in many cases, the sole proprietor will
want to use an "assumed name" such as "Brandon Auto Repair."
While doing business as a sole proprietor may seem fairly simple, there is one very
serious adverse consequence, especially if the business involves products which
could cause harm or injury to other persons. As a sole proprietor, you are personally
liable for any and all debts and liabilities of the business. Whether a claim is made
against your business by a customer, an employee, a competitor, or a trade creditor,
you will be personally "on the hook" for any such claim. As a result, all of your
personal assets, home, motor vehicles, savings accounts, jewelry, household goods,
etc; will be subject to the claims of all such creditors. While certain jointly owned
property (e.g. a residence) of a husband and wife may be exempt from liability to the
creditors of only one of the spouses, even these joint assets may be jeopardized if
both the husband and wife are involved in the operation of the business.

Advantages of Sole Proprietorship

a. Ease of starting and ending the business- All you need is a permit from the local
government.
b. Being your own boss- Working for you is exciting. Freedom and promptness of
action
c. Pride of ownership- Sole proprietors have taken the risk and deserve the credit.
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 d. Leaving a legacy behind for future generations.
e. Retention of company profits- You don’t have to share profits with anyone.
f. No special taxes- Profits of the business are taxed as the personal income of the
owner.

Disadvantages of Sole proprietorship

a. Unlimited liability is the responsibility of business owners for all of the debts of the
business.
b. Limited financial resources. Funds available are limited to the funds that the sole
owner can gather.
c. Management difficulties. Many owners are not skilled at record keeping.
d. Overwhelming time commitment. The owner has no one with whom to share the
burden.
e. Few fringe benefits. Fringe benefits can add up to 30% of a workers income.
f. Difficulty in hiring and keeping high achievement employees.
3.1.3. The Partnership Option
A partnership occurs when two or more persons combine to operate a business. Normally,
the allocation of profits and losses, management and operation of the partnership is set forth
in a written "partnership agreement" which is signed by all of the partners.
3.1.3.1. Characteristics of Partnership
a. Formation
This form of business requires the existence of two or more persons entering in to
contractual relationships. The agreement between the parties is desirable to be written and
signed, to prevent misunderstanding among the parties. This contract is called memorandum
of association, articles of partnership deed or partnership contract. Partner's rights and duties
should be explicitly in written articles of partnership. The memorandum of association lies
down the terms and conditions of partnership and rights, duties, and obligations of partners.
According to the 1960 commercial code of Ethiopia article 284, the memorandum of
association contains the following:
1. The name, address and nationality of each partner;
2. The head office and branches, if any;
3. The business purpose of the firm;
4. The contributions of each partner, their value and their method of valuation;
5. The service required from persons contributing skill;
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 6. The share of each partner in the profits and losses, and the agreed procedures for
allocation;
7. The managers and agents of the firm;
8. The period of time for which the partnership has been established.

In addition to this the articles of partnership may include

1. Partners' rights, if any for withdrawals of funds for personal use.
2. Provision for accounting records and their accessibility to partners.
3. Specific duties of each partner.
4. Provision for dissolution and for sharing the net assets.
5. Restraint on partners' assumption of special obligations, such as endorsing the note
of another.
6. Provision for protection of surviving partners, descendant' estate, and so forth.

Unless specified otherwise in the articles, a partner is generally recognized as having certain
implicit rights. For example, partner: share profits or losses equally if they have not agreed
on a profit and-loss sharing ratio. As part of the formation procedure, this type of business is
required to be made known to the outside parties to the public.

b. Management
Each partner is entitled to an equal voice in management. But to avoid possible problems,
many partnership agreements define the management voice of each partner. For example, a
partnership composed of A, B, C, & D might provide the following management divisions.
1. A- is in charge of purchasing
2. B- is in charge of marketing
3. C- is in charge of accounting & personnel
4. D- is in charge of paper clips and office neatness
5. Any other areas are governed by a vote.
c. Other legal characters.
Unlimited liability
Utmost good faith.
No separate entity.
3.1.3.2. Kinds of Partners

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  A general partner: assumes unlimited liability and is usually active in managing the
business. Most partners are general partners.
 A limited or special partner: assumes limited liability, risking only his/her
investment in the business. Limited partners may not be active in management, and
their names are not used in the name of the business a secret partner - takes an active
role in managing a Partnership but whose identities are unknown to the public, i.e.,
the general public does not know of this person's partnership status. .
 A silent partner: as opposed to a secret partner, silent partner, his identities and
involvement is known to the general public, but is inactive in managing the
partnership business.
 A dormant or sleeping partner: is neither known to the general public nor active in
management.
 Senior partners: assume major roles in management because of their long tenure,
amount of investment in the partnership, or age. They normally receive large shares
of the partnership's profits. .
 Junior partners: are generally younger partners in tenure, have only a small
investment in the firm, and are not expected to make major decision. They assume
limited role in the partnership's management and receive a smaller share of the
partnership's profits.

Advantages of partnership
 Ease of starting
 Increased sources of capital and credit
 Combined managerial skills (improved decision making potential)
 Definite legal status
 Personal supervision
 Reduced risk
 Motivation of important employees
 Tax advantages

Disadvantages of Partnership
 Risk of implied authority
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  Lack of harmony
 Lack of continuity (instability)
 Limited capital availability,(size limitations}
 Investment withdrawal difficulty (frozen investment)
3.1.4. The Corporation Option
 Is essentially an “artificial person” created and operated with the permission of the state
where it is incorporated. It is a person but only “on paper”.
 Is brought to life as a regular C corporation, by filing a form with a state, known as
articles of incorporation.
 Actually owns and operates the business on behalf of the shareholder, under the
shareholder’s total control.
 Protects the owners by absorbing the liability if something goes wrong. When debt is
incurred in the company name, owners are not personally liable and their assets cannot be
taken to settle company obligations.
 Allows owners to hire themselves as employees and then participate in company funded
employee plans like medical insurance.

3.1.4.1. Characteristics of Corporation

 Separate legal entity
 Limited liability
 Transferability of shares
 Perpetual life: The death of one or more owners does not terminate the corporation.
 Separation of ownership from management
 Written constitution
The Corporate Charter
In most states, three or more persons are required to apply to the secretary of state for
permission to incorporate. After preliminary steps, including required- publicity and
payment of the incorporation fee and initial franchise tax, the written application is approved
by the secretary of the state and becomes the corporation's charter. A corporation charter
typically provides for the following:
1. Name of the company
2. Formal statement of its formation
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 3. Purposes and powers- that is, type of business
4. Location of principal office in the state of incorporation
5. Duration (perpetual existence, 50-year life and renewable charter, etc.)
6. Voting privileges of each class of stock
7. Names and addresses of incorporators and first year's directors.
8. Names and addresses of, and amounts subscribed by, each subscribe to capital stock.
9. Statement of alterations of directors' powers, if any, from the general corporation law
of the state

3.1.4.2. Structure of Company Management

I. Share Holders
Preemptive right- ownership of stock typically carries the right to buy new shares, in
proportion to stock already owned, before the new stock is offered for public sale.

II. Board of Directors

The board also makes further recommendations of dividends. The board is empowered to
declare stock dividends. .

III. The Officers or Chief Executives

These include president, chief managing director, or chief executive officer, vice presidents,
and secretary.

III.1.4.3. Advantages of a Corporation

The principal advantages of corporation are:
 Financial strength
 Limited liability
 Scope of expansion
 Managerial efficiency
 Ease in transferring ownership
 Legal-entity status
III.1.4.4. Disadvantages of a Corporation
 Difficulty of formation
 Lack of owner's personal interest.
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  Delay in decision making
 Oligarchy and fraudulent management
 Lack of secrecy
III.1.5. Cooperatives
A COOPERATIVE is a business owned and controlled by the people who use it—
producers, consumers, or workers with similar needs who pool their resources for mutual
gain. A type of company that is owned partially or wholly by its employees, customers,
or tenants. Abbreviation: co-op.
There are 47,000 cooperatives in the U.S.

Members democratically control these businesses by electing a board of directors that

hires professional management.
The FARM COOPERATIVE started with farmers joining together to get better prices
for their food products. The organizations expanded so that farm cooperatives now buy
and sell other products needed on the farm.
In spite of debt and mergers, cooperatives are still a major force in agriculture today.

Proprietorships, partnerships, and corporations are by far the most popular forms of
business organizations. There is yet another form of organization that is small in number but
which serves a very useful purpose. This particular type of business is called a cooperative
(co-op) and is some-what like a corporation.
A Cooperative is a business owned and operated by its user members for the purpose of
supplying themselves with goods and services it is an organization owned by members
/customers who pay an annual membership fee and share in any profits (if it is profit making
organization). Owners, managers, workers, and customers are all the same people.

3.1.6 Other Forms of Business

Franchises an increasingly popular form of business, particularly with those who are less
entrepreneurial, is taking up a franchise. A franchise is a business in which the owner of the
name or method of doing business (called the franchisor) allows a local operator (called the
franchisee) to set up a business under that name. In exchange for an initial fee and a royalty
on sales, the franchisor lays down a blue print of how the business is to be run, content and
nature of products/services on offer, prices and performance standards.

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The difference to a management buy-out is in the position of the purchaser: in the case of a
buy-out, they are already working for the company. In the case of a buy-in, however, the
manager or management team is from another source.

A form of a buyout that incorporates characteristics of both a management buyout and a

management buy-in. A corporate action in which an outside manager or management team
purchases an ownership stake in the first company and replaces the existing management
team. This type of action can occur due to a company appearing undervalued or having a
poor management team. 
Management buy-outs and buy-ins
In recent years the traditional separation of shareholders and management has been eroded
by the growing popularity of management buy-outs'. This is where a group of managers pool
their resources to buy the business they have been running, usually from a larger, parent
company. A management 'buy-in' is where a group of managers buys into an existing firm,
usually replacing those who have been running it. In legal form these are just limited
companies.
Financial supporters can also come from some unusual sources. For example- suppliers or
customers with a strong interest in maintaining an out let or source of supply for their own
products can sometimes be persuaded to provide funds.
It would seem that managers of existing businesses have a good start in setting up a small
business. They already have knowledge of the product and the market, and, since the
business has an established track record, they will probably find obtaining capital for the
buy-out that much easier than the newly formed small business.

3.1.7 Criteria for Choosing the Ownership Form

1. Organizational costs
2. Limited versus unlimited liability
3. Continuity
4. Transferability of ownership
5. Control
6. Raising new equity capital

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