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INTRODUCTION TO BUSINESS

Yavuz Karazeybek

Resource: Jeff Madura-Introduction to Business (2006)

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CHAPTER 5 Selecting a Form of Business Ownership

A sole proprietorship is a business owned by a single owner

A sole proprietor the owner of a sole proprietorship

Sole Proprietorship

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CHAPTER 5 Selecting a Form of Business Ownership

Sole Proprietorship

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A sole proprietor may obtain loans from creditors to help finance the firm’s operations, but these loans do not represent ownership. The sole proprietor is obligated to cover any payments resulting from the loans but does not need to share the business profits with creditors

Local restaurant, local construction firm, barber shop, laundry shop

They pay income taxes not corporate taxes

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CHAPTER 5 Selecting a Form of Business Ownership

Sole Proprietorship

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Characteristics of Successful Sole Proprietors

Sole proprietors must be willing to accept full responsibility for the firm’s performance. The pressure of this responsibility can be much greater than any employee’s responsibility.

Sole proprietors must also be willing to work flexible hours. They are on call at all times and may even have to substitute for a sick employee. Their responsibility for the success of the business encourages them to continually monitor business operations.

strong leadership

well organized

good communication skills

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CHAPTER 5 Selecting a Form of Business Ownership

Advantages of a Sole Proprietorship

All Earnings Go to the Sole Proprietor: owner does not have to share the earnings

Easy Organization: legal requirements are minimal, not separate entity,

Complete Control: no conflicts during decision making process (prices, menu, salaries..)

Lower Taxes: personal income tax

Sole Proprietorship

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CHAPTER 5 Selecting a Form of Business Ownership

Sole Proprietorship

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Disadvantages of a Sole Proprietorship

The Sole Proprietor Incurs All Losses: do not share losses, liable for all debt

Unlimited Liability: personally liable for any debt

Limited Funds: difficulty in engaging new sectors or expansion

Limited Skills: one person may not have all of the skills required

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CHAPTER 5 Selecting a Form of Business Ownership

Sole Proprietorship

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Reading (p.161)

Deciding on the Sole Proprietor Form of Business

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CHAPTER 5 Selecting a Form of Business Ownership

Partnership

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A business that is co-owned by two or more people is referred to as a partnership.

In a general partnership, all partners have unlimited liability. The partners are personally liable for all obligations of the firm.

In a limited partnership, partners whose liability is limited to the cash or property they contributed to the partnership.

Limited partners are only investors in the partnership and do not participate in its management, but because they have invested in the business, they share its profits or losses

A limited partnership has one or more general partners, or partners who manage the business, receive a salary, share the profits or losses of the business, and have unlimited liability.

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CHAPTER 5 Selecting a Form of Business Ownership

Partnership

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Advantages of a Partnership

Additional Funding: partners can provide more resources

Losses are Shared: single person does not have to absorb the entire loss

More Specialization: partners can focus on their respective

specializations (medical clinics, law firms…)

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CHAPTER 5 Selecting a Form of Business Ownership

Partnership

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Disadvantages of a Partnership

Control is 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.

Unlimited Liability: General partners in a partnership are subject to unlimited liability, just like sole proprietors.

Profits are Shared: 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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CHAPTER 5 Selecting a Form of Business Ownership

Partnership

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S-Corporations

a firm that has 100 or fewer owners and satisfies other criteria. The earnings are distributed to the owners and taxed at the respective personal income tax rate of each owner.

The owners of an S-corporation have limited liability (like owners of corporations), but they are taxed as if the firm were a partnership.

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CHAPTER 5 Selecting a Form of Business Ownership

Partnership

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S-Corporations

S-Corporations have a special taxation structure on the basis of an application made by the IRS (American Revenue Office). Many entrepreneurs are quite inclined to form an S-Company; because this corporate structure structurally brings together the many advantages of both Sole Proprietorship, partnerships..

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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 has all the favorable features of a typical general partnership but also offers limited liability for the partners

CHAPTER 5 Selecting a Form of Business Ownership

Partnership

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CHAPTER 5 Selecting a Form of Business Ownership

Partnership

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Limited Liability Company (LLC)

It typically protects a partner’s personal assets from the negligence of other partners in the firm. This type of protection is highly desirable for partners, given the high frequency of liability lawsuits.

The assets of the company (such as the property or machinery owned by the company) are not protected. Although S-corporations may also provide liability protection, various rules may restrict the limited liability of some owners of S-corporations. LLCs are not subject to such stringent rules.

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Reading (p.164)

Deciding on the Partnership Form of Business

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CHAPTER 5 Selecting a Form of Business Ownership

Corporation

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corporation is a state-chartered entity that pays taxes and is legally distinct from its owners

charter is a document used to incorporate a business. The charter describes important aspects of the Corporation such as the name of the firm, the stock issued, and the firm’s operations.

The people who organize the corporation must also establish bylaws which is a general guidelines for managing a firm

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CHAPTER 5 Selecting a Form of Business Ownership

Corporation

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CHAPTER 5 Selecting a Form of Business Ownership

Corporation

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How Stockholders Earn a Return

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.

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CHAPTER 5 Selecting a Form of Business Ownership

Corporation

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Private versus Public Corporations

Privately held: ownership is restricted to a small group of investors

Publicly held: shares can be easily purchased or sold by investors

Going public: the act of initially issuing stock to the public

Virtually all firms (even Ford Motor Company) were privately held when they were created, some of these firms became publicly held when they needed funds to support large expansion
Publicly held corporations can obtain additional funds by issuing new common stock
By issuing new stock, corporations may obtain whatever funds are needed to support any business expansion

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CHAPTER 5 Selecting a Form of Business Ownership

Corporation

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Advantages of a Corporation

Limited Liability: Owners of a corporation have limited liability

Access to Funds: A corporation can easily obtain funds by issuing new stock

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. (stock market, stock exchange)

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CHAPTER 5 Selecting a Form of Business Ownership

Corporation

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Disadvantages of a Corporation

High Organizational Expense: Because of the necessity to create a corporate charter and file it with the state. Establishing bylaws, issuing stocks
Financial Disclosure: When the stock of a corporation is traded publicly, the investing public has the right to inspect the company’s financial data. firms may be obligated to publicly disclose more about their business operations and employee salaries than they would like.
Agency Problems: when managers do not act as responsible agents for the shareholders who own the business (unnecessary spendings, expensive trips etc.)
High Taxes: Since the corporation is a separate entity, it is taxed separately from its owners (double taxation)

the price received from the sale of stock minus the price paid for the stock (CAPITAL GAIN)

1. 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.

2. 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. Privately held firms are not forced to disclose financial

information to the public.

3. Agency Problems Publicly held corporations are normally run by managers

who are responsible for making decisions for the business that

will serve the interests of the owners. Managers may not always act in

the best interests of stockholders, however. For example, managers

may attempt to take expensive business trips that are not necessary to

manage the business. Such actions may increase the expenses of running

a business, reduce business profits, and therefore reduce the returns

to stockholders. When managers do not act as responsible agents

for the shareholderswhoownthe business, a so-called agency problem

results. There are many examples of high-level managers who made

decisions that were in their best interests, at the expense of shareholders.

One of the most blatant examples occurred at Enron, Inc., which

went bankrupt in 2001. Agency problems are less likely in proprietorships

because the sole owner may also serve as the sole manager and

make most or all business decisions.

4. High Taxes Since the corporation is a separate entity, it is taxed separately

from its owners. The annual taxes paid by a corporation are determined

by applying the corporate tax rate to the firm’s annual earnings.

The corporate tax rate is different from the personal tax rate.

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CHAPTER 5 Selecting a Form of Business Ownership

Corporation

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CHAPTER 5 Selecting a Form of Business Ownership

How Ownership Can Affect Return and Risk

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Impact of Ownership on the Return on Investment

The return on investment in a firm is derived from the firm’s profits. 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 necessarily 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:

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CHAPTER 5 Selecting a Form of Business Ownership

How Ownership Can Affect Return and Risk

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Impact of Ownership on the Return on Investment

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CHAPTER 5 Selecting a Form of Business Ownership

Obtaining Ownership of an Existing Business

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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

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Obtaining Ownership of an Existing Business

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Assuming Ownership of a Family Business

Major decisions regarding the production process and other operations of the firm have been predetermined. If the business has historically been successful, a new owner’s main function may be to ensure that the existing operations continue to run efficiently.

Alternatively, if the business is experiencing poor performance, the new owner may have to revise management, marketing, and financing policies.

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CHAPTER 5 Selecting a Form of Business Ownership

Obtaining Ownership of an Existing Business

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Purchasing an Existing Business

Businesses are sold for various reasons, including financial difficulties and the death or retirement of 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

The seller of the business may provide historical sales volume, which can be used to estimate the future sales volume. However, the prospective buyer must be cautious when using these figures.

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CHAPTER 5 Selecting a Form of Business Ownership

Obtaining Ownership of an Existing Business

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Franchising

Types of franchising

Distributorship
Chain-Style Business

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CHAPTER 5 Selecting a Form of Business Ownership

Obtaining Ownership of an Existing Business

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Types of Franchises

Franchising

Distributorship: a dealer is allowed to sell a product produced by a manufacturer.
A chain-style business: firm is allowed to use the trade name of a company and follows guidelines related to the pricing and sale of the product.
A manufacturing arrangement: a type of franchise in which a firm is allowed to manufacture a product using the formula provided by another company.

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Obtaining Ownership of an Existing Business

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Franchising

Advantages of a Franchise

Proven Management Style: Franchisees look to the franchisors for guidance in production and management.

Name Recognition: Many franchises are nationally known because of advertising by the franchisor.

Financial Support: Some franchisees receive some financial support from the franchisor, which can ensure sufficient start-up funds for the franchisee.

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Obtaining Ownership of an Existing Business

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Franchising

Disadvantages of a Franchise

Sharing Profits: In return for services provided by the franchisor, the franchisee must share profits with the franchisor

Less Control: The franchisee must abide by guidelines regarding product production and pricing, and possibly other guidelines as well

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CHAPTER 5 Selecting a Form of Business Ownership

Obtaining Ownership of an Existing Business

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Reading (p.179)

Deciding Whether to Establish Franchises