Students who attend the corporate finance class often gets very surprised about the course. First off, they don't grasp why understanding different businesses and their purposes and economical processes are important. All they want to do is to start valuating bonds, stocks, etc. and become a "smart and rich" economist. Isn't that all there is to finance? Valuating things all day long and get rich?
That sort of questions always get asked. Not merely in finance. Why know algebra? Why know how it works? Why should a doctor know anatomy if the doctor can study diseases and learn the symptoms? By understanding the very basics of how firms work together with some other important concepts in finance, you'll learn the anatomy of finance, allowing you to start interpreting things in new ways - being a "smart" economist. Sure, you'll learn how to valuate things without this sort of knowledge, but the framework I discussed in my previous article is highly related to this knowledge. Which also, is the purpose of this blog. Letting you understand what is happening out there. Now, let's get started.
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Assume that you one day decide to establish a small lemonade stand in your neighborhood on your own. Meaning that you'll provide the materials and products needed. You'll pay rent and if everything goes well, you'll also pay taxes. When you decide to establish this type of business, we call it a sole proprietorship. That simply means that one person owns and manages the firm.
Now, your lemonade stand is going very well and one day you decide to start selling ice cream as well. But you have a problem - you have no fridge to store the ice cream in. Now, you don't have the money on hand needed to buy a fridge either, so you decide to borrow the money from the bank. What happens if you cannot pay back the loan? Will the lemonade stand be responsible? The answer is no. In a so-called sole proprietorship everything will be on the individual, owning the business, including debts. In other words, you can be personally responsible for not paying back the loan - we say that the sole proprietor has an ulimited liability.
As a conclusion. A sole proprietorship is when one person (the sole proprietor) owns and manage a business. Where all things that happens will be personally handled (including taxes, loans, etc.).
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Anyways, let's go back to the founding of this lemonade stand. Assume that you instead realises that you'll need some help with providing products and materials and/or some other kind of help managing it. You call some friends up and you decide to run it together. In this case, you form a so-called partnership. Theoretically, the partnership and the sole proprietorship are similar to each other. The partners are still personally responsible for any problems/opportunities that occurs. You still have an unlimited liability and there's no distinction between management and owning (other than now you and some friends manage and own it).
However, what you'll have to do, is a partnership agreement. Simply explained, it says how decisions are supposed to be managed and the proportion of the profits to which each partner is entitled.
As you might be thinking, there's many well-known businesses today that started out as a partnership. For instance, Merril Lynch, Morgan Stanley, Salomon, Goldman Sachs, Smith Barney, Apple and Microsoft all started as a partnership.
The message of a partnership is basically: Know thy Partner.
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As capital grows, so does the need of employees and more products and materials - your firm (lemonade stand) starts to expand/grow. When your firm (lemonade stand)reaches a certain point in its expansion, you might decide to incorporate your firm (lemonade stand). Now, there's an obvious, theoretical distinction between this and the two aforementioned types of businesses. A corporation is based on something called articles of incorporation and can be seen as equivalent to a partnership agreement.
In the articles of incorporation, the purpose of the business, the amount of shares that can be issued and the numbers of directors to be appointed is described. From this point of view, you might relate the articles of incorporation with the general view of corporations: "a corporation is a resident of its state." That means, that a business can do pretty much anything within the laws except for voting. For example, it can borrow and lend money. Sue and get sued.
As I wrote earlier the sole proprietor/the partners, both own and manage the business. I certainly claimed that there is no distinction between the two. Now it is. Once incorporated we form a distinction where the shareholders own the business.
So let's say you are a shareholder of the lemonade stand and that the lemonade stand can't repay the loan for the fridge. Will you be personally responsible for that? The answer(s) is: "indirectly you will be affected" and "directly you won't be responsible." Because if the business can't repay its loan, it will probably stop being profitable and start to lose money. When that happens, you lose money that you invested in the company. However, the bank won't call you up and claim that you should pay the bank. This is called limited liability.
Now we know that there is a distinction between ownership and management. Yet, we don't know who manages the corporation. Usually a board of directors is elected and appointed. They represent the shareholders and in turn, they should act in their best interest. This distinction, once again, is one very important feature for a corporation. It gives the corporation more flexibility and permanence than, for example a partnership.
As the shareholders own a part of the business, we can look at shareholders as voters. If an investor owns one share, worth a few dollars, that share can be viewed as one vote for that company. If you own a few shares you're only entitled to a small amount of the profit compared to an investor that owns many shares. So, the number of votes is directly linked to the proportion of profit of which the shareholders are entitled.
Why aren't all business organized like this? Why not form a corporation straight away? Assume that a few partners decide to incorporate immediately. Is that good or bad? Well, with the fact given above, it should be good. However, there's a drawback to this. All corporations have to pay twice as much in taxes. When we looked at sole proprietorship, we said that all things are personally handled, we said that taxation are personally paid. The corporation pays taxes and also the shareholders.
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What if your lemonade stand doesn't seem to fit any of these? When businesses do not fit into these neat categories, we call them hybrids. One you might have seen already is limited partnership. In this case, partners are either classified as general or limited partners. General partners manage the business and an unlimited liability. The limited partners can lose all the money they put in but not more, whereas their management are restricted.
For all of you who live in the United States, you might have seen LLC (limited liability company) and LLP (limited liability partnership). In this case the partners have limited liability and the tax advantage (lower taxes) but still, there's no distinction between management and ownership which is (almost) vital to big companies.
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The following "table" summarises the tree categories mentioned:
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That's all for now. If you have any questions and/or think I should keep this up, please leave a comment. Take care.
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