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Chapter 4: Options for Organizing Business — Vocabulary Flashcards

Sole Proprietorships

  • Definition: business owned and operated by one individual; most common form in the U.S.
  • Advantages
    • Easy and inexpensive to form; often no legal documents needed; DBA registration optional.
    • Secrecy: owner can keep plans private; no mandatory public financial reporting.
    • Profits belong to owner; owner has full control and quick decision-making.
    • Taxation: profits taxed as personal income; potential tax advantages (retirement accounts).
    • Flexibility and simple dissolution.
  • Disadvantages
    • Unlimited liability: owner’s personal assets at risk for business debts.
    • Limited funds and credit; high reliance on owner’s resources.
    • Limited skills and capacity; hard to attract/retain qualified employees.
    • Life of business tied to owner; continuity/family succession can be an issue.
    • Tax considerations: self-employment tax (
      15.3\%) and personal income tax; may be high depending on profit.
  • Funding and operations
    • Funding often comes from personal funds, banks, friends/family, or microloans; higher perceived risk may raise interest.
    • Home-based and service-oriented businesses common (e.g., restaurants, hair salons, online shops).
    • Example: Etsy enables many sole proprietors; small service-focused firms are prevalent.
  • Practical implications
    • Most common form; roughly frac{3}{4}{(0.75)} of U.S. businesses.
    • Easiest to start; least regulatory burden; but carries the highest personal risk.

Partnerships

  • Definition: an association of two or more persons carrying on as co-owners of a business for profit.
  • Types
    • General partnership (GP): all partners share in management; unlimited liability for debts.
    • Limited partnership (LP): at least one general partner (unlimited liability) and one or more limited partners (liability limited to invested capital; limited partners do not manage).
  • Articles of partnership
    • Legal documents outlining terms (contributions, roles, profit/loss split, withdrawal rules, dispute resolution).
    • Useful to specify issues such as capital contributions, management duties, and buy-sell provisions.
  • Advantages
    • Easy to form; minimal formal requirements beyond registration.
    • Greater availability of capital and diverse skills; larger scale than a sole proprietorship.
    • Potential for better credit and resources due to multiple partners.
  • Disadvantages
    • General partners bear unlimited liability; disputes can derail the business.
    • Life of the partnership ends with a partner’s death/withdrawal; transferring ownership can be difficult.
    • Profit sharing may cause conflict if contributions aren’t equitably matched; risk of unequal effort.
  • Taxation
    • Pass-through taxation: profits pass to partners and are taxed on individual returns; no entity-level tax.
    • Master Limited Partnerships (MLPs) offer tax benefits and liquidity but are more complex.
  • Practical implications
    • Partnerships can be effective with clearly defined roles and strong communication; they require good governance to manage risks and disputes.

Corporations

  • Definition: a legal entity created by the state; assets/liabilities separate from owners; can own property, enter contracts, sue/be sued.
  • Ownership/types
    • Domestic: within the charter state; Foreign: other states the corporation operates in; Alien: outside the country.
    • Private: stock is not publicly traded; Public: stock is freely traded.
  • Formation and governance
    • Formation: file articles of incorporation; obtain corporate charter; issue stock; establish bylaws;
    • Organizational steps: hold initial board of directors meeting, elect officers (CEO, etc.); set up governance framework.
  • Stock and ownership
    • Two main stock types: common (voting rights) and preferred (priority on dividends).
    • Preemptive rights: existing shareholders can buy new shares to maintain ownership percentage.
  • Advantages
    • Limited liability: stockholders are generally not personally liable for debts.
    • Ease of ownership transfer: buying/selling stock does not disrupt operations.
    • Perpetual life: existence continues beyond the life of shareholders; easier to raise capital via stock/bonds.
    • Ability to scale: broad access to capital markets (public/private) to fuel growth.
  • Disadvantages
    • Double taxation: corporate profits taxed at the corporate level (e.g., 21\%) and again as dividends to shareholders.
    • Formation and ongoing compliance can be costly and complex (charter, bylaws, SEC filings for public firms).
    • Disclosure requirements: public companies must file with the SEC; financials become public.
    • ESG/governance scrutiny: board oversight and governance standards (Sarbanes-Oxley implications) have increased.
  • Key elements
    • Board of Directors: elected by stockholders; hires corporate officers; oversees long-term objectives.
    • Corporate officers (e.g., CEO): manage daily operations; accountable to the board.
    • Capital structure: common vs preferred stock; dividends; dilution risk; tax considerations for shareholders.
  • Financial notes
    • Public corporations: extensive disclosure; potential for ESOPs to align employee interests.
    • Private corporations: fewer disclosure requirements; rely on private funding.
  • Public vs private transitions
    • IPO: going public to raise capital; going private (e.g., Dell) to restructure or avoid market pressures.

Other Types of Ownership

  • Joint Ventures (JVs)
    • Definition: a partnership for a specific project or finite time; control shared or led by one partner.
    • Use: large-scale investments, cross-border deals, or strategic collaborations.
  • S Corporations (S Corp)
    • Taxation: taxed as a partnership (pass-through) while retaining limited liability.
    • Eligibility: up to 100 shareholders; domestic (US) shareholders; restrictions on types of shareholders.
    • Benefits: avoids double taxation; limited liability; perpetual life; possible income allocation benefits.
  • Limited Liability Companies (LLCs)
    • Hybrid form: limited liability like a corporation; taxed like a partnership (pass-through) with fewer restrictions.
    • Members can be single or multiple; flexible management; no mandatory formalities like minutes.
    • Examples: Venmo; joint ventures like AT&T & BlackRock for Gigapower.
  • Cooperatives (co-ops)
    • Member-owned, member-controlled organizations focused on service or savings rather than profit.
    • Examples: Ace Hardware (hardware co-op), Berkshire Co-op Market, Ocean Spray, REI (consumer-owned in structure).
    • Purpose: pool resources to reduce costs, increase bargaining power, and share benefits with members.

Mergers, Acquisitions, and Leveraged Buyouts (M&A)

  • Definitions
    • Merger: two companies combine to form a new entity.
    • Acquisition: one company buys another (often by purchasing stock).
    • Leveraged Buyout (LBO): a group borrows heavily to acquire a company, using the target’s assets to secure debt.
  • Why firms pursue M&A
    • Grow through scale, broaden product lines, enter new markets, achieve synergies and cost reductions.
    • Access new technologies and capabilities quickly; respond to competitive pressures.
  • Types of mergers
    • Horizontal: same industry/competitors (e.g., defense contractors merging).
    • Vertical: related levels of the value chain (supplier/customer integration).
    • Conglomerate: unrelated industries.
  • Tender offers and defenses
    • Tender offer: buyer offers to purchase shares at a premium; can be friendly or hostile.
    • Defenses: poison pill (dilute existing shareholders’ value or allow more shares at discount), shark repellant, white knight, or taking the company private to resist takeover.
  • Notable examples and trends
    • Large deals totaling upward of 5\times 10^{12} dollars in recent years.
    • Big Five tech firms aggressively acquire to gain assets and capabilities.
    • Not all acquisitions succeed; culture fit and execution matter.
  • Why acquisitions fail
    • Misaligned culture, overpayments, integration challenges, debt burdens, employee morale impacts.
  • LBO specifics
    • High leverage (often >90\% of the purchase price) funded by debt; repayment relies on target’s cash flows.
    • High-profile example: Elon Musk’s acquisition of Twitter via LBO.
  • Practical notes
    • M&A activity can boost stock prices and market value but can also destabilize organizations if mishandled.

Quick Reference: Key Concepts and Terms

  • Sole proprietorship: one owner; unlimited liability; simplest form.
  • General partnership: shared management; unlimited liability for partners.
  • Limited partnership: general partner(s) plus limited partners with liability limited to investment.
  • Corporation: separate legal entity; limited liability; perpetual life; double taxation unless S corporation.
  • S Corporation: pass-through taxation; limited to 100 shareholders; avoids double taxation.
  • LLC: limited liability with pass-through taxation; flexible management; fewer formalities.
  • Cooperative: member-owned; profit not the primary goal; benefits passed to members.
  • Mergers: combining two firms to form a new entity.
  • Acquisitions: one firm buys another; can create a subsidiary.
  • Leveraged buyout (LBO): acquisition funded largely by debt secured by the target’s assets.
  • Domestic/Foreign/Alien corporation: based where chartered, where it operates, or outside the country.
  • Preemptive right: existing shareholders’ right to buy new shares to maintain ownership.
  • ESOP: Employee Stock Ownership Plan; aligns employee and company interests.
  • Perpetual life: corporation’s existence typically continues indefinitely.
  • Double taxation: corporate profits taxed; dividends taxed to shareholders.
  • Tender offer: offer to buy shares at premium; can be hostile.
  • Poison pill: defense to hostile takeover by making takeover less attractive.