3.5: Forms of Business Organizations

Forms of Business Organizations

There are three forms of business organizations that exist in the United States today: sole proprietorships, partnerships, and corporations. Each business type has both advantages and disadvantages, and all three make a free market economy highly competitive and provide a vast array of products and services. Businesses can grow and merge, horizontally or vertically, and evolve into conglomerates or multinationals. As businesses expand they can provide additional jobs, introduce new technology, generate change, and produce tax revenues. Additional organizations such as non-profits, cooperatives, professional associations and the government play a role within the economy as well.

Universal Generalizations

• The types of business ownership reflect the needs of the business owner.
• There are advantages and disadvantages to each type of business ownership that can be created in the free enterprise system.
• Businesses may be organized as individual proprietorships, partnerships, or corporations.

Guiding Questions

1. What are the differences between the different business ownerships?
2. Why are sole proprietorship businesses the most numerous but the least profitable?
3. What are the advantages and disadvantages of each of the different business ownerships?
4. Analyze the amount of liability for each type of business. Which type of business has the least amount of liability for the owner?

Video: Types of Business Organizations

Types of Business Organizations

There are three forms of business organization in the United States:

sole proprietorship,

partnership,

corporation.

Each type of business has advantages and disadvantages.

The most common form of business organization is a sole proprietorship. This is a business owned and operated by one person. This type of business organization is not only the most profitable but also the most numerous. A sole proprietorship is extremely easy to start, and anyone can create a “sole proprietorship”. If you have an idea or an opportunity, you too could begin your own business simply by deciding to go into business. This type of business is easy to manage since you are the boss! The business owner also may keep all of the profits so long as he or she assumes all of the risk. In addition, proprietors do not have to pay any special taxes, simply pay the tax on the income brought in from the business. Wanting to take charge and make the important decisions are the main reasons people choose to start a sole proprietorship. They want to be the boss and do things their own way. Whether the sole proprietorship succeeds or fails, it is up to the proprietor. If, however, the business is not everything that the proprietor hoped it would be, he or she may close the business. There are a few disadvantages to this type of business. The main concern is the unlimited liability, or the personal responsibility, the proprietor assumes. The liability suggests that the owner is 100% responsible for the debts and obligations of the company. The proprietor will be financially responsible for the company. It is up to the owner to acquire capital when necessary through bank loans or other obligations. Unless the business is incorporated to protect the proprietor, he or she can be sued by other individuals or businesses. In addition, the sole proprietor must hire, retain, and give incentives to employees, keep an inventory, manage the business, attract additional employees, and consider if the business should continue if he or she leaves the company.

The next most popular type of business found in a free enterprise economy is a partnership. A partnership is generally a business owned by two or more people. Generally, partnerships are most often found among doctors and lawyers, or in a business where the start-up costs may be prohibitive for just one person. There are two types of partnerships: general and limited. A general partnership exists where all of the partners share the responsibility for all the aspects of the business. A limited partnership is when one or more partners do not participate in the business at all, but are instead financial partners or “silent partners”. They benefit when the business does well, but are only liable for what they contributed to the partnership financially. A limited partnership can protect those partners from being held liable for the business's debts.

Some positive aspects of a partnership: it is easy to start up with a partnership agreement, it is easy to manage, specific aspects of the partnership are agreed to in the partnership paperwork, there are no special taxes, it can easily attract investors, it is somewhat more efficient than a sole proprietorship, and the business may be able to hire additional employees.

The main disadvantages to this type of business is that partners are responsible for each other’s acts. If one partner takes all the money and runs off, then the other partner is still liable for that partner’s actions and the debts incurred by that partner. The partnership is limited in terms of its life. When one partner leaves or dies, the partnership is no longer valid and the company changes. The name may stay the same but because new partners may be added to the partnership the business itself may change.

The third type of company that forms in a free market system is a corporation. This is a very large business that has an entirely different structure compared to a sole proprietorship or a partnership. A corporation is a very formal, legal arrangement. In order to take your partnership or sole proprietorship to this level, the company has to ask permission from the national and state governments to incorporate. It this motion is granted, the company can become public by selling off shares of the company to raise revenues. Otherwise, it may remain a private company with no shareholders.

The main strength of the corporation is that it is considered a “legal entity”. It has all of the rights and responsibilities than an individual has. It can sue and be sued. It can enter into legal contracts, and it can file for bankruptcy. Besides its legal status, the next advantage of a corporation is the ease with which it may raise revenue for the company. It has the ability to borrow from banks or it can sell off shares of its stock (ownership) or corporate bonds (written promises to repay a loan). It can hire professionals to represent it or work for it, there is a limited liability, it has an unlimited life so long as it is still operating, it is easy to transfer ownership in the form of company stocks, and there is name recognition.

The disadvantages of a corporation are: the rules and regulations set forth by the government for corporations, the huge tax burden that they must pay as a corporation, the shareholders have little say in the operation of the business, and it is expensive to set up a corporation, to begin with.

	Sole Proprietorship	Partnerships	Corporations
Advantages	Easy to start up Easy to manage Owner enjoys the profits of successful management Does not have to pay a separate business income tax Psychological satisfaction Easy to get out of business	Easy to start Easy to manage No special taxes Can attract financial capital more easily Slightly larger in size	Can attract financial capital more easily Slightly larger in size Easier to attract top talent to their organization Easy to raise financial capital Professionals are available to run the company Limited liability Unlimited life Easy to transfer ownership
Disadvantages	Unlimited liability Difficulty in raising financial capital Size and efficiency Must carry a minimum inventory Limited managerial experience Difficulty in attracting qualified employees Limited life of the company	Responsible for the acts of the other partners Limited partnership Limited life Conflict may arise	Difficulty and expense of getting a charter Little say in how the business is run Corporate taxes More government regulations

Private Enterprise

Private enterprise, the ownership of businesses by private individuals, is a hallmark of the U.S. economy. When people think of businesses, often giants like Wal-Mart, Microsoft, or General Motors come to mind. But firms come in all sizes, as shown in Table 1. The vast majority of American firms have fewer than 20 employees. As of 2010, the U.S. Census Bureau counted 5.7 million firms with employees in the U.S. economy. Slightly less than half of all workers in private firms are at the 17,000 large firms. This means that they employ more than 500 workers. Another 35% of workers in the U.S. economy are at firms with fewer than 100 workers. These small-scale businesses include everything from dentists and lawyers to businesses that mow lawns or clean houses. Indeed, Table 1 does not include a separate category for the millions of small “non-employer” businesses where a single owner or a few partners are not officially paid wages or a salary, but simply receive whatever they can earn.

Table 1 Range in Size of U.S. Firms (Source: U.S. Census, 2010 www.census.gov)

Number of Employees	Firms (% of total firms)	Number of Paid Employees (% of total employment)
Total	5,734,538	112.0 million
0–9	4,543,315 (79.2%)	12.3 million (11.0%)
10–19	617,089 (10.8%)	8.3 million (7.4%)
20–99	475,125 (8.3%)	18.6 million (16.6%)
100–499	81,773 (1.4%)	15.9 million (14.2%)
500 or more	17,236 (0.30%)	50.9 million (49.8%)

Corporate Stock and Public Firms

A corporation is a business that “incorporates”—that is owned by shareholders that have limited liability for the debt of the company but share in its profits (and losses). Corporations may be private or public, and may or may not have stock that is publicly traded. They may raise funds to finance their operations or new investments by raising capital through the sale of stock or the issuance of bonds.

Those who buy the stock become the owners, or shareholders, of the firm. Stock represents ownership of a firm; that is, a person who owns 100% of a company’s stock, by definition, owns the entire company. The stock of a company is divided into shares. Corporate giants like IBM, AT&T, Ford, General Electric, Microsoft, Merck, and Exxon all have millions of shares of stock. In most large and well-known firms, no individual owns a majority of the shares of the stock. Instead, large numbers of shareholders—even those who hold thousands of shares—each have only a small slice of the overall ownership of the firm.

When a company is owned by a large number of shareholders, there are three questions to ask: How and when does the company get money from the sale of its stock? What rate of return does the company promise to pay when it sells stock? Who makes decisions in a company owned by a large number of shareholders?

First, a firm receives money from the sale of its stock only when the company sells its own stock to the public (the public includes individuals, mutual funds, insurance companies, and pension funds). A firm’s first sale of stock to the public is called an initial public offering (IPO). The IPO is important for two reasons. For one, the IPO, and any stock issued thereafter, such as stock held as treasury stock (shares that a company keeps in their own treasury) or new stock issued later as a secondary offering, provides the funds to repay the early-stage investors, like the angel investors and the venture capital firms. A venture capital firm may have a 40% ownership in the firm. When the firm sells stock, the venture capital firm sells its part ownership of the firm to the public. A second reason for the importance of the IPO is that it provides the established company with financial capital for a substantial expansion of its operations.

Most of the time when a corporate stock is bought and sold, however, the firm receives no financial return at all. If you buy shares of stock in General Motors, you almost certainly buy them from the current owner of those shares, and General Motors does not receive any of your money. This pattern should not seem particularly odd. After all, if you buy a house, the current owner gets your money, not the original builder of the house. Similarly, when you buy shares of stock, you are buying a small slice of ownership of the firm from the existing owner—and the firm that originally issued the stock is not a part of this transaction.

Second, when a firm decides to issue stock, it must recognize that investors will expect to receive a rate of return. That rate of return can come in two forms. A firm can make a direct payment to its shareholders, called a dividend. Alternatively, a financial investor might buy a share of stock in Wal-Mart for $45 and then later sell that share of stock to someone else for $60, for a gain of $15. The increase in the value of the stock (or of any asset) between when it is bought and when it is sold is called a capital gain.

Third: Who makes the decisions about when a firm will issue stock, or pay dividends, or re-invest profits? To understand the answers to these questions, it is useful to separate firms into two groups: private and public.

A private company is owned by the people who run it on a day-to-day basis. A private company can be run by individuals, in which case it is called a sole proprietorship, or it can be run by a group, in which case it is a partnership. A private company can also be a corporation, but with no publicly issued stock. A small law firm run by one person, even if it employs some other lawyers, would be a sole proprietorship. A larger law firm may be owned jointly by its partners. Most private companies are relatively small, but there are some large private corporations, with tens of billions of dollars in annual sales, that do not have publicly issued stock, such as farm products dealer Cargill, the Mars candy company, and the Bechtel engineering and construction firm.

When a firm decides to sell stock, which in turn can be bought and sold by financial investors, it is called a public company. Shareholders own a public company. Since the shareholders are a very broad group, often consisting of thousands or even millions of investors, the shareholders' vote for a board of directors, who in turn hire top executives to run the firm on a day-to-day basis. The more shares of stock a shareholder owns, the more votes that shareholder is entitled to cast for the company’s board of directors.

In theory, the board of directors helps to ensure that the firm is run in the interests of the true owners—the shareholders. However, the top executives who run the firm have a strong voice in choosing the candidates who will be on their board of directors. After all, few shareholders are knowledgeable enough or have enough of a personal incentive to spend energy and money nominating alternative members of the board.

How Firms Choose between Sources of Financial Capital

There are clear patterns in how businesses raise financial capital. These patterns can be explained in terms of imperfect information, is a situation where buyers and sellers in a market do not both have full and equal information. Those who are actually running a firm will almost always have more information about whether the firm is likely to earn profits in the future than outside investors who provide financial capital.

Any young startup firm is a risk; indeed, some startup firms are only a little more than an idea on paper. The firm’s founders inevitably have better information about how hard they are willing to work, and whether the firm is likely to succeed than anyone else. When the founders put their own money into the firm, they demonstrate a belief in its prospects. At this early stage, angel investors and venture capitalists try to overcome the imperfect information, at least in part, by knowing the managers and their business plan personally and by giving them advice.

Government & Business Regulations

When the United States was established, the idea of a competitive market free of government interference was a reality. However, since the late 1800s, the reality of a truly free market system has slowly evolved into a marketplace where the government has played an increasingly larger role. The federal government and the states tried to regulate big business and corporate interests as the nation grew and the population demanded a certain degree of oversight. Government restrictions and legislation limited the growing power and influence of “robber barons”, trusts, and monopolies by the early 1900s. The intervention by the government on behalf of the population began a trend that has grown exponentially over the last one hundred years.

State governments today realize the importance of major industries and corporations and the impact that those businesses can have on the growth of a state’s economy, employment, and resources. Both states and local governments have made attempts to attract corporations by offering tax breaks and relaxing restrictions. Government benefits when businesses expand through payroll taxes, employment opportunities, and better wages for employees. Business benefit when governments offer incentives to relocate or expand.

Compared to one hundred years ago, businesses today are under a great deal more scrutiny and face an overabundance of regulations and restrictions on their business practices and treatment of consumers. States can set insurance rates, regulate banks and insurance companies, determine whether or not a utility company can increase rates on customers, and prohibit certain industries from operating if they harm the environment.

In general, government and business need each other. Governors and even mayors (like here in El Paso) invite companies to visit in order to try to attract new business opportunities to specific locales. Commercials, city chambers of commerce, and newspaper advertisements, all tout the benefits of relocating. Local governments may even go as far as selling municipal bonds or take on enormous debt to help finance the relocation of a company, such as when the El Paso City Council wanted to bring a Triple-A baseball club to the downtown area.

Video: City of El Paso Triple-A Ballpark Time-Lapse

Answer the self check questions below to monitor your understanding of the concepts in this section.

Self Check Questions

1. A sole proprietorship is business owned and run by one person. Do you know any sole proprietors? Do you do business with anyone who owns their own business? Why do you do business with them?
2. What are the advantages and disadvantages of partnership? Do you know any businesses that are partnerships? Do you do business with them? Why or why not?
3. Describe the structure of a corporation. Which corporations do you do business with? Why? What can a corporation do that a sole proprietorship can not?
4. If you were to own a business, what type of organization would you want, a sole proprietorship, a partnership, or a corporation?