CHAPTER 5

How to Form a
Business

McGraw-Hill/Irwin Copyright © 2015 by the McGraw-Hill Companies, Inc. All rights reserved.
 LEARNING OBJECTIVES

1. Compare the advantages and disadvantages of sole

proprietorships.

2. Describe the differences between general and

limited partners, and compare the advantages and
disadvantages of partnerships.

3. Compare the advantages and disadvantages of

corporations and summarize the differences
between C corporations, S corporations and limited
liability companies.
5-2
 LEARNING OBJECTIVES

4. Define and give examples of three types of corporate

mergers, and explain the role of leveraged buyouts
and taking a firm private.

5. Outline the advantages and disadvantages of

franchises, and discuss the opportunities for diversity
in franchising and the challenges of global
franchising.

6. Explain the role of cooperatives.

5-3
ANNE BEILER
Auntie Anne’s

• Started selling pretzels when

her family was living paycheck
to paycheck.
• Now Auntie Anne’s has over
1,200 locations and brings in
over $410 million!
• Beiler sold the company in
2005 to start focusing on
charity work.
5-4
 NAME that COMPANY

In 2013, this company became the largest firm in

terms of revenue to be taken private through a
leveraged buyout. After closing the $25 million
deal, the founder now controls a 75% stake of
the company he started in his dorm room.

Name that company!

5-5
 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.

5-6
 FORMS of
BUSINESS OWNERSHIP

5-7
 ETHNIC BUSINESS CENTERS
Cities with the Most Minority-Run Firms

1. Atlanta, GA

2. Baltimore, MD

3. Nashville, TN

4. Houston, TX

5. Miami - Ft.
Lauderdale, FL Photo Credit: James Rintamaki

Source: Forbes, www.forbes.com, accessed November 2014. 5-8

 MAJOR BENEFITS of SOLE LO 4-1

PROPRIETORSHIP

1) Ease of starting and

ending the business
2) Being your own boss
3) Pride of ownership
4) Leaving a legacy
5) Retention of company
profit
6) No special taxes
5-9
 DISADVANTAGES of SOLE LO 4-1

PROPRIETORSHIPS

1) Unlimited Liability -- Any debts or damages

incurred by the business are your debts, even if it
means selling your home, car or anything else.
2) Limited financial resources
3) Management difficulties
4) Overwhelming time commitment
5) Few fringe benefits
6) Limited growth
7) Limited life span 5-10
 WORK-LIFE BALANCING ACT

% of small business owners

Work over 80 hours per week Work over 40 hours per week

Source: Inc., www.inc.com, accessed November 2014. 5-11

 TEST PREP

• Most people who start businesses in the U.S. are

sole proprietors. What are the advantages and
disadvantages of sole proprietorships?

• Why would unlimited liability be considered a

major drawback to sole proprietorships?

5-12
 LO 4-2
MAJOR TYPES of PARTNERSHIPS

• General Partnership -- All owners share in

operating the business and in assuming liability for
the business’s debts.

• Limited Partnership --
A partnership with one or
more general partners and
one or more limited
partners.

5-13
 LO 4-2
TYPES OF PARTNERS

• General Partner -- An owner (partner) who has

unlimited liability and is active in managing the firm.

• Limited Partner -- 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.

5-14
 OTHER FORMS of LO 4-2

PARTNERSHIPS

• Master Limited Partnership -- A partnership that

looks much like a corporation, but is taxed like a
partnership and thus avoids the corporate income
tax.

• Limited Liability Partnership -- Limits partners’

risk of losing their personal assets to the outcomes of
only their own acts and omissions and those of
people under their supervision.

5-15
 ADVANTAGES of LO 4-2

PARTNERSHIPS

• More financial
resources

• Shared
management and
pooled/complementa
ry skills and
knowledge

• Longer survival

• No special taxes
5-16
 DISADVANTAGES of LO 4-2

PARTNERSHIPS

• Unlimited liability
• Division of profits
• Disagreements among
partners
• Difficult to terminate

5-17
 LO 4-2
PICKING YOUR PARTNER

There is no such thing as a perfect partner but

ask these questions when you try to find your
best match:
• Do you share the same goals?
• Do you share the same vision for the company?
• What skills does he/she have? Are yours the same?
• What can he/she bring to the business?
• What type of decision maker is he/she?
• Do you trust each other?
• How does he/she problem solve?
5-18
 GOOD BUSINESS,
BAD KARMA?

Imagine you and your partner own a construction

company. You receive a subcontractor’s bid you
know is 20% too low. This could potentially put
the subcontractor out of business. Accepting the
bid will improve your chances of getting a big job.
Your partner wants to take the bid:

• What do you think you should do?

• What will be the consequences of your decision?

5-19
 TEST PREP

• What’s the difference between a limited partner

and a general partner?

• What are some of the advantages and

disadvantages of partnerships?

5-20
 CONVENTIONAL LO 4-3

CORPORATIONS

• Conventional (C)
Corporation -- A state-
chartered legal entity with
authority to act and have
liability separate from its
owners (its stockholders).

5-21
 ADVANTAGES of LO 4-3

CORPORATIONS

• Limited liability
• Ability to raise more money for investment
• Size
• Perpetual life
• Ease of ownership change
• Ease of attracting talented employees
• Separation of ownership from management
5-22
HOW OWNERS AFFECT LO 4-3

MANAGEMENT

5-23
 The BIG BOYS of BUSINESS LO 4-3

America’s Largest Corporations

1. Walmart

2. Exxon Mobil

3. Chevron

4. Berkshire
Hathaway Photo Credit: Walmart Stores

5. Apple

Source: Fortune, www.fortune.com, accessed November 2014. 5-24

 PRIVACY PLEASE LO 4-3

The Ten Largest Private Corporations in the U.S.

Source: Forbes, www.forbes.com, accessed November 2014. 5-25

 DISADVANTAGES of LO 4-3

CORPORATIONS

• Initial cost
• Extensive paperwork
• Double taxation
• Two tax returns
• Size
• Difficulty of termination
• Possible conflict with
stockholders and board of
directors 5-26
 EVEN the BIG GUYS LO 4-3

MAKE MISTAKES

Source: Bloomberg Businessweek, www.businessweek.com, accessed November 2014. 5-27

 B CORPORATIONS LET
SUSTAINABILITY SET SAIL

• Michael Dimin saw tons of

fish were left to rot after
fishermen caught too much.

• Registered his company,

Sea2Table as a benefit
corporation.

• B-corporations are judged on

how they meet their own set
of socially or environmentally
beneficial goals.
5-28
 LO 4-3
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.

5-29
OLDIES BUT GOODIES LO 4-3

America’s Oldest Corporations

5-30
 LO 4-3
S CORPORATIONS

• S Corporation -- A unique government creation that

looks like a corporation, but is taxed like sole
proprietorships and partnerships.

• S corporations have shareholders, directors and

employees, plus the benefit of limited liability.

• Profits are taxed only as the personal income of

the shareholder.

5-31
 WHO CAN FORM LO 4-3

S CORPORATIONS?

• Qualifications for S Corporations:

- Have no more than 100 shareholders.
- Have shareholders that are individuals or estates
and are citizens or permanent residents of the U.S.
- Have only one class of stock.
- Derive no more than 25% of income from passive
sources.

• If an S corporation loses its S status, it may not

operate under it again for at least 5 years.
5-32
 LO 4-3
LIMITED LIABILITY COMPANIES

• Limited Liability Company (LLC) -- Similar to an

S corporation, but without the eligibility requirements.

• Advantages of LLCs:
1. Limited liability
2. Choice of taxation
3. Flexible ownership rules
4. Flexible distribution of profits and losses
5. Operating flexibility
5-33
 LO 4-3
DISADVANTAGES of LLCs

1. No stock, therefore
ownership is
nontransferable
2. Limited life span
3. Fewer incentives
4. Taxes
5. Paperwork

5-34
 TEST PREP

• What are the major advantages and disadvantages

of incorporating a business?

• What’s the role of owners (stockholders) in the

corporate hierarchy?

• If you buy stock in a corporation and someone gets

injured by one of the corporation’s products, can
you be sued? Why or why not?

• Why are so many new businesses choosing a

limited liability company (LLC) form of ownership?
5-35
 LO 4-4
MERGERS and ACQUISITIONS

• Merger -- The result of two firms joining to form one

company.

• Acquisition --
One company’s
purchase of the
property and
obligations of
another company.

5-36
 LO 4-4
TYPES of MERGERS

• Vertical Merger -- The joining of two firms in

different stages of related businesses.

• Horizontal Merger -- The joining of two firms in the

same.

• Conglomerate Merger -- The joining of firms in

completely unrelated industries.

5-37
 LO 4-4
LEVERAGED BUYOUTS

• Leveraged Buyout (LBO) -- An attempt by

employees, management or a group of investors to
buy out the stockholders in a company.

• LBOs have ranged in size from $50 million to $34

billion and have involved everything from small
businesses to giant corporations.

• In 2012, foreign investors poured $166 billion into

U.S. companies.
5-38
 LO 4-5
FRANCHISING

• Franchise Agreement -- An arrangement whereby

someone with a good idea for a business (franchisor)
sells the rights to use the business name and sell a
product or service (franchise) to others (franchisees)
in a given territory.

• More than 770,000 franchised businesses

operate in the U.S., employing approximately 8.5
million people.

5-39
MAKE WAY for the NEWBIES LO 4-5

Top New Franchises

Source: Entrepreneur, www.entrepreneur.com, accessed November 2014. 5-40

 LO 4-5
ADVANTAGES of FRANCHISING

1. Management and
marketing assistance
2. Personal ownership
3. Nationally recognized
name
4. Financial advice and
assistance
5. Lower failure rate

5-41
 DISADVANTAGES of LO 4-5

FRANCHISING

1. Large start-up costs

2. Shared profit
3. Management regulation
4. Coattail effects
5. Restrictions on selling
6. Fraudulent franchisors

5-42
 THE BUILDING BLOCKS of
FRANCHISING

• Bricks 4 Kidz was created as

a way to help kids
understand engineering and
construction.

• Since the business was low

cost and easily reproduced,
this led to over 200
franchises in the U.S. and 11
other countries.
5-43
 LO 4-5
WOMEN in FRANCHISING

• Women own about half of U.S. companies, yet

ownership of franchises is about 21%.

• More women are

becoming
franchisors. Auntie
Anne’s and
Jazzercise and are
owned by women.

5-44
 MINORITY-OWNED LO 4-5

FRANCHISES

• DiversityFran is an initiative to
build awareness of
franchising opportunities
within minority communities.
• Domino’s Pizza launched a
minority franchise recruitment
program called Delivering the
Dream.
Photo Credit: Tom Magliery

• Over 20% of franchises are

minority-owned.
5-45
 LO 4-5
HOME-BASED FRANCHISES

Advantages:
• Relief from
commuting stress
• Extra family time
• Low overhead
expenses

Main Disadvantages:
• Isolation
• Long hours 5-46
 HOME SWEET HOME LO 4-5

Top Home-Based Franchises

Source: Entrepreneur, www.entrepreneur.com, accessed November 2014. 5-47

 E-COMMERCE LO 4-5

in FRANCHISHING

• Most brick-and-mortar franchises have expanded

online.

• Many franchisors prohibit franchisee-sponsored

sites because conflicts can erupt.

• Sometimes “reverse royalties” are sent to

franchisees who believe their sales were hurt by
the franchisor’s site.

• Other franchises are solely based online.

5-48
GIVING ENTREPRENEURS OPTIONS
with DIGITAL FRANCHISING

• Chris Jeffrey created OrderUp shortly after

graduating college.
• OrderUp links up restaurants with hungry patrons
and allows people to order online while OrderUp
takes a small commission.
• For a startup fee of
$42,000 franchisees
receive software and
training to launch OrderUp
in their area.
5-49
 LO 4-5
GLOBAL FRANCHISING

• Canada is the most popular target for U.S.-based

franchises.

• China, South Africa, the Philippines and the

Middle East are becoming popular despite high
cost.

• International franchising goes both ways – some

foreign franchises have come to the U.S.

5-50
 WHAT to CHOOSE? LO 4-5

Picking Franchises that May Survive a Recession

• Focus on tried-and-true name brands.

• Stick to core goods and services.
• Be choosy about the site.
• Don’t pinch pennies.
• Have a fallback choice.
• Don’t assume the franchise will pay off.

5-51
Source: Richard Gibson, Wall Street Journal, www.wsj.com, accessed November 2014.
 HIGH FLYERS LO 4-5

Ten High-Performing Franchises

1. Anytime Fitness
2. Hampton Hotels
3. Subway
4. Supercuts
5. Jimmy John’s
6. 7-Eleven
7. Servpro
8. Denny’s Photo Credit: Innisfree Hotels

9. Pizza Hut
10. Dunkin Donuts
Source: Entrepreneur, www.entrepreneur,com, accessed November 2014. 5-52
 LO 4-6
COOPERATIVES

• Cooperatives -- Businesses owned and controlled

by the people who use them– producers, consumers,
or workers with similar needs who pool their
resources for mutual gain.

• Worldwide, co-ops serve one billion members!

• Members democratically control the business by

electing a board of directors that hires
professional management.

5-53
 TEST PREP

• What are some of the factors to consider before

buying a franchise?

• What opportunities are available for starting a

global franchise?

• What is a cooperative?

5-54