J

Chapter 4: Options for Organizing Business – Practice Flashcards

Chapter 4: Options for Organizing Business — Comprehensive Study Notes

Note: These notes synthesize the transcript content into a detailed, organized study aid. They include major and minor points, definitions, examples, implications, and key figures or numbers mentioned in the transcript. All mathematical expressions and monetary figures are shown in LaTeX format where appropriate.

LO goals

  • LO 4-1 Describe advantages and disadvantages of the sole proprietorship form.
  • LO 4-2 Describe the two types of business partnership and their advantages and disadvantages.
  • LO 4-3 Describe the corporate form of organization and its advantages and disadvantages.
  • LO 4-4 Describe other types of ownership (joint ventures, S corporations, LLCs, cooperatives).
  • LO 4-5 Assess the advantages and disadvantages of mergers, acquisitions, and leveraged buyouts.

Overview of ownership forms

  • Three primary forms of business ownership: sole proprietorship, partnership, and corporation.
  • Other forms discussed: S corporations, limited liability companies (LLCs), cooperatives.
  • Additional topics: trends in business ownership and nonprofits (501(c)(3)).
  • Table reference: Table 4.1 compares various forms of ownership.
  • Relevance: Form chosen affects operation, taxes, and control.

Sole Proprietorships

  • Definition: A business owned and operated by one individual; the most common form in the United States.
  • Common examples: small retailers, restaurants, hair salons, flower shops, dog kennels, etc.
  • Notable examples in transcript: Propel Electric Bikes (Chris Nolte); Coca-Cola, eBay, Walmart (started as sole proprietorships).
  • Roles: Owner manages day-to-day decisions; easy to form; often home-based or online-enabled (e.g., Etsy marketplace).
  • Illustration: Entrepreneurs can use third-party tools (Zoom, Asana, Trello) and platforms (Amazon, Microsoft, Google, Disney, Under Armour) started from home.
  • Key data: Sole proprietorships outnumber corporations; they generate fewer sales/income on average.
  • Industry distribution: Many sole proprietors focus on services rather than manufacturing due to capital needs.
  • Figure reference: Figure 4.1 shows relative numbers of forms (sole proprietorships vs corporations, etc.).
  • Taxation: Profits taxed as personal income; self-employment tax (15.3%) plus other taxes; can include retirement accounts with tax advantages.
  • Advantages
    • Quick decisions due to single ownership (owner-manager).
    • Ease and low cost of formation: often no formal legal documents; DBA registrations if needed.
    • Secrecy: greatest potential for secrecy; less public disclosure of plans and finances.
    • Profit retention: owner keeps all profits.
    • Flexibility and control: owner has full control and can respond quickly to market changes.
    • Practical use of home base sites or small storefronts (e.g., Etsy helps small proprietors reach customers).
    • Low regulatory burden (fewer federal/state requirements, especially if few employees).
  • Disadvantages
    • Unlimited liability: owner’s personal assets at risk for business debts.
    • Limited funds: access to capital is constrained to personal funds, banks, friends/family, SBA, or personal assets; higher reliance on personal credit.
    • Lack of continuity: business typically ends if owner dies or becomes incapacitated; sale or succession planning is challenging.
    • Limited skills and labor capacity: owner must handle many roles (management, marketing, finance, accounting, etc.); hiring professionals helps but doesn’t replace the owner’s control.
    • Taxation complexity: profits taxed as personal income; self-employment tax; possible high tax burden depending on income level.
    • Government regulation: greater freedom; but still subject to laws (employee and consumer protection, licensing where required).
    • Difficulty in obtaining large-scale financing: potential lenders may view higher risk; may rely on nonbank entities or crowdfunding (e.g., GoFundMe, Kickstarter, Indiegogo, OurCrowd).
  • Formation and site considerations
    • Site selection is still required; many operate from home or online platforms.
    • Role of platforms: Go-to-market through marketplaces (e.g., Etsy) for expanded reach; Etsy hosts 7.4 million sellers selling >120 million products.
  • Examples and implications
    • Sole proprietorships are easy to start but carry significant personal risk; they are ideal for start-ups with limited capital and high flexibility needs.
    • The trend of entrepreneurship boomed post-COVID-19; pandemic and Great Resignation contributed to entrepreneurial activity.
  • Practical considerations
    • If expanding, consider partnerships or incorporation to mitigate unlimited liability and raise capital.
    • If secrecy and control are paramount, sole proprietorships have advantages; but be mindful of succession planning.
    • Tax planning opportunities (retirement accounts) exist for sole proprietors.

Partnerships

  • Definition: A form of business organization defined by the Uniform Partnership Act as an “association of two or more persons who carry on as co-owners of a business for profit.”
  • General vs. Limited partnerships
    • General partnership: complete sharing in management; unlimited liability for debts; all partners participate in management.
    • Limited partnership: at least one general partner (unlimited liability) and at least one limited partner (liability limited to initial investment; limited partners do not participate in management).
    • Master Limited Partnership (MLP): a limited partnership with liquidity of a corporation and tax benefits of a partnership; commonly used in oil and gas, pipelines, etc.
  • Articles of partnership
    • Legal documents outlining the basic agreement; many states require it; even if not required, advisable to prevent disputes.
    • Typical contents (from Table 4.3):
    • Name, purpose, location
    • Duration of the agreement
    • Authority and responsibility of each partner
    • Character of partners (general or limited, active or silent)
    • Amount of contribution from each partner
    • Division of profits or losses
    • Salaries of each partner
    • Withdrawals allowed for each partner
    • Death of partner
    • Sale of partnership interest
    • Arbitration of disputes
    • Required and prohibited actions
    • Absence and disability
    • Restrictive covenants
    • Buying and selling agreements
  • Types of partnerships
    • General partnership: equal sharing in management; unlimited liability for debts; higher risk to all partners if one makes a bad decision.
    • Limited partnership: includes limited partners who do not participate in daily management; profits shared per agreement; risk limited to initial investment for limited partners.
  • Key advantages of partnerships (Table 4.2 references)
    • Ease of organization: simple structure; no formal chartering required beyond state registration.
    • Availability of capital and credit: combination of partners’ talents and resources; larger potential for financing than sole proprietorships.
    • Combined knowledge and skills: diverse skill sets across partners; can lead to higher-quality service/products.
    • Decision-making: faster responsiveness in small partnerships; in larger partnerships, may slow due to coordination needs.
    • Regulatory controls: fewer regulatory burdens than corporations (e.g., no requirement to file public financial statements).
  • Common disadvantages of partnerships
    • Unlimited liability for general partners; potential disproportionate risk if one partner has greater resources.
    • Responsibilities and conflicts: all partners may be liable for actions of others; disputes can threaten the business; life of the partnership ends with death/withdrawal of a partner; dissolution may be required.
    • Valuation and transfer of ownership: no public market for partnership interests; difficult to value shares; selling interest can be challenging unless a valuation method is specified in the articles.
    • Disparities in profits and effort: profit-sharing may feel unfair if one partner contributes more, leading to tension.
    • Taxation: partnerships are pass-through entities for taxes; partners report share of profits on individual tax returns; no corporate tax at the entity level, though certain entities like master limited partnerships have specific reporting requirements.
  • Real-world examples and insights in the transcript
    • Okusa JRINK and Apothékary case: illustrates advantages (combining money/knowledge/skills) and potential drawbacks (partner exit can disrupt the venture).
    • The text uses entrepreneurship case studies (e.g., Shizu Okusa) to highlight how partnerships can enable growth but also present risk when partners exit or pivot.
  • Practical takeaway
    • Articles of partnership are crucial to prevent disputes and define roles, profit-sharing, and governance.
    • Partnerships blend skills and capital but require careful management of liability, decision rights, and exit strategies.

Corporations

  • Definition: A corporation is a legal entity created by the state; assets and liabilities are separate from owners; it can enter contracts, sue, and be sued as a person.
  • Ownership structure
    • Can be privately held or publicly traded; stockholders share profits after obligations are paid; dividends are cash payments to stockholders.
    • Stock types: common stock and preferred stock. Common stockholders vote and may receive dividends; preferred stockholders have priority on dividends but typically lack voting rights.
    • Preemptive rights: existing shareholders often have the first right to purchase newly issued shares to maintain ownership percentage.
  • Domestic, foreign, alien
    • Domestic: operates in the state of incorporation.
    • Foreign: operates in states other than where incorporated.
    • Alien: operates outside the country of incorporation.
  • Private vs public corporations
    • Private: stock owned by a few individuals; not publicly traded; often family-owned (e.g., Publix Super Markets).
    • Public: stock is tradable by the public; disclosure requirements (SEC filings) apply; examples include IBM, McDonald’s, Apple, etc.
  • Creating a corporation
    • Incorporators file articles of incorporation with the state; a corporate charter is issued.
    • The Model Business Corporation Act (common in states) requires 10 items in the articles of incorporation, e.g.:
    • Name and address of the corporation
    • Objectives
    • Classes of stock and number of shares
    • Expected life
    • Financial capital required
    • Provisions for transferring shares
    • Provisions for internal corporate regulation
    • Registered business address
    • Names/addresses of initial board of directors
    • Names/addresses of incorporators
    • After charter, an organizational meeting is held to establish bylaws and elect directors.
  • Bylaws and governance
    • Bylaws establish the rules and procedures; may create committees of the board.
    • The board of directors oversees management; hires corporate officers (CEO, president).
    • Sarbanes-Oxley Act influenced governance practices (e.g., director compensation, independence requirements).
  • Stock ownership and rights
    • Common stock: typically voting rights; one vote per share; boards elected by common stockholders; proxy voting is common.
    • Preferred stock: priority over dividends; usually no voting rights; cumulative dividends are common (unpaid dividends accrue and must be paid before other stockholders are paid).
    • Preemptive rights protect existing ownership percentages when new shares are issued.
  • Advantages of corporations
    • Limited liability: stockholders’ liability is limited to their investment; personal assets are generally protected from business debts.
    • Ease of ownership transfer: shares can be bought/sold without terminating the business; sale or transfer generally does not disrupt operations.
    • Perpetual life: not affected by death or withdrawal of owners; company can continue indefinitely unless otherwise specified.
    • Access to capital: easier to raise money through stock issuance and bonds; public markets allow broad fundraising.
    • Tax planning and retention: profits can be retained for growth; some earnings may be reinvested instead of paid as dividends (retained earnings).
  • Disadvantages of corporations
    • Double taxation: corporate profits taxed at the corporate level and again as personal taxes when dividends are distributed to stockholders (21% corporate tax rate in the U.S.; global average around 24%).
    • Formation and ongoing costs: chartering is costly; legal and filing fees; annual maintenance fees; SEC disclosure for public companies.
    • Regulatory burden: high due diligence, reporting, and compliance obligations; ongoing public disclosures.
    • Employee-owner separation: many employees are not stockholders; ESOPs exist to align interests but add complexity.
  • Going public and going private
    • IPO (initial public offering): becoming a public corporation by selling stock in public markets.
    • Going private: management or a new owner buys all public stock to remove the company from public markets; used to gain more control or restructure without public scrutiny.
    • Dell example: private once, then public again; demonstrates that a firm can switch between private/public states.
  • Nonprofit and quasi-public corporations
    • Nonprofits are organized as 501(c)(3) organizations; focus on service rather than profit; donor funding and grants support operations; examples include Feeding America, Sesame Workshop, American Red Cross, Habitat for Humanity.
    • Quasi-public corporations are government-owned/operated entities (e.g., NASA, U.S. Postal Service) focused on providing services rather than profits.
  • Workplace and governance considerations
    • Board of Directors: elected by stockholders to oversee long-term objectives; responsible for care and loyalty; hires corporate officers; governance quality matters (property of Sarbanes-Oxley era).
    • Director compensation and independence: trend toward higher director pay; debates about governance effectiveness; increasing independence to avoid conflicts of interest.
    • Employee stock ownership plans (ESOPs): align employee and company interests; potential to boost productivity and retention.
  • Financial structure and reporting
    • Public corporations disclose financial information to investors and regulators (SEC filings); annual reports summarize finances and plans; SEC data is publicly accessible.
    • Private corporations have fewer public disclosures but still must meet tax and regulatory obligations.
    • Perpetual life vs. dissolution risk: private/business failures or bankruptcy can end a corporation; generally designed for longevity.
  • Examples and notable cases
    • The transcript notes the prevalence of large public corporations and private firms; it also highlights that many well-known firms began as small private entities before going public.
    • Private giants: Publix (private, large retailer); Apple, IBM, Caterpillar, Procter & Gamble, etc. (public and multinational).
  • Transfer of ownership and capital structure
    • Public corporations can issue bonds and stock to raise funds; external funding is a hallmark of large corporations.
    • Private corporations may rely more on private equity, family capital, or bank loans.

Other Types of Ownership

  • Joint Ventures
    • Definition: A partnership established for a specific project or for a limited time; control may be shared or dominated by one partner.
    • Use cases: large-scale investments (natural resources, new product development); can involve government partners as well.
    • Example: JPMorgan Chase & Co. formed a JV with Haven Realty Capital to buy/develop $1B in suburban single-family rental homes.
    • Key considerations: alignment of goals, governance structure, and exit strategies; joint ventures can be temporary or project-specific.
  • S Corporations (Subchapter S)
    • Tax treatment: taxed as a partnership; profits/losses pass through to owners, avoiding double taxation; retains limited liability.
    • Popularity: represent about half of corporate filings; benefits include simple taxation, limited liability, perpetual life, and income shifting.
    • Disadvantages: restrictions on number and type of shareholders (e.g., not more than 100 shareholders; certain types of entities or non-residents cannot be shareholders).
  • Limited Liability Companies (LLCs)
    • Definition: A form of ownership that provides limited liability like a corporation, but is taxed like a partnership; fewer restrictions on members.
    • Features: can be single-member or multi-member; flexible management; simpler compliance (no mandatory minutes or resolutions like corporations).
    • Examples: Venmo is an LLC; Gigapower LLC is a joint venture by AT&T and BlackRock to expand fiber-optics; demonstrates cross-industry joint ventures and flexible structures.
    • Rationale: blends best characteristics of corporations and partnerships; strong asset protection for members.
  • Cooperatives (Co-ops)
    • Definition: An organization owned and operated by its members (individuals or small businesses) with the aim of benefiting members rather than generating profit for external shareholders.
    • Examples: Berkshire Co-op Market; Ocean Spray; REI (consumer-owned)
    • Purpose: to enable members to achieve higher profits or lower costs through purchasing power, shared marketing, and collective buying.
    • Operating philosophy: typically aims to operate without profit or with minimal profit to sustain the cooperative; members share in savings or profits.
  • Nonprofit organizations (501(c)(3))
    • Focus: provide services rather than earn profits; owned by a government entity is not the case; instead, nonprofits operate for public benefit.
    • Funding: donations, grants, and service fees; tax-exempt status provides tax advantages for donors and the organization; required to file federal tax forms for accountability and compliance.
    • Examples: public charities (Leukemia & Lymphoma Society), private foundations, private operating foundations (e.g., Habitat for Humanity ReStore stores support the home-building program).

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

  • Definitions and purposes
    • Merger: two (usually corporate) entities combine to form a new company.
    • Acquisition: one company purchases another (often via stock purchase) and may become a subsidiary or merge operations.
    • LBO (Leveraged Buyout): investors borrow to acquire a company using the target’s assets to guarantee the loan; often highly financed, sometimes up to ~95% borrowed in certain deals.
  • Why M&A?
    • Growth: expand operations, enter new markets, acquire new products or capabilities.
    • Synergy: cost reductions, revenue enhancements, and strategic advantages.
    • Speed: faster entry into capabilities than building internally; the Big Five tech firms frequently acquire startups to access new tech and talent.
    • Stock value and market position: M&A can boost stock prices and market value.
  • Major trends and examples (transcript highlights)
    • High M&A volumes in recent years (deal activity exceeding several trillion dollars historically).
    • The Big Five tech companies (Amazon, Alphabet/Google, Apple, Microsoft, Meta) actively acquiring others to bolster capabilities like AI, blockchain, robotics, VR/AR, and 5G.
    • Examples of notable mergers and acquisitions:
    • Discovery and WarnerMedia forming Warner Bros. Discovery.
    • AOL and Time Warner merger (historic example).
    • Amazon acquiring Diapers.com (example of an acquisition that did not meet profitability expectations).
    • Google acquiring Nest; Amazon acquiring Whole Foods; these illustrate cultural and strategic fit challenges.
  • Types of mergers
    • Horizontal merger: two firms in the same industry/level merge (e.g., defense contractors Martin Marietta and Lockheed to form Lockheed Martin).
    • Vertical merger: firms at related levels merge (e.g., a company acquiring a supplier or customer).
    • Conglomerate merger: unrelated industries combine (e.g., Berkshire Hathaway with GEICO, Dairy Queen, BNSF, etc.).
  • Tender offers and defense mechanisms
    • Tender offer: an offer to buy some or all of another company’s stock at a premium.
    • Hostile takeovers: management may resist; mechanisms include poison pills, shark repellents, white knights, or leveraged buyouts to discourage the bid; the attacked firm may take actions like going private to avoid takeover.
  • Leveraged buyouts (LBOs)
    • Structure: investors borrow money to finance most of the purchase; assets of the target serve as collateral.
    • Risk: the debt burden can be substantial; the strategy can fail if economic conditions worsen or debt service is unmanageable.
    • Example: Elon Musk’s acquisition of Twitter via an LBO.
  • Potential downsides and criticisms
    • Cultural and strategic misalignment can lead to failed integrations.
    • Debt burden can strain the acquired company and employees; layoffs or culture clashes may reduce morale and productivity.
    • Short-term stock-price focus may undermine long-term health and innovation.
  • Learnings and considerations for evaluating M&A
    • The importance of strategic fit and cultural alignment.
    • The role of due diligence in identifying integration challenges and synergy opportunities.
    • The need to balance debt levels with expected cash flows and growth opportunities.

Trends in Business Ownership: Mergers, Acquisitions, & Corporate Structures

  • Proliferation of M&A activity across industries; technology and communications sectors are particularly active.
  • The rise of the Big Five tech firms driving consolidation through acquisitions of smaller firms with strategic assets.
  • The balancing act between growth through acquisitions and maintaining corporate culture and employee morale.
  • Public vs private market dynamics influence M&A strategy (e.g., private equity-driven buyouts, IPOs, and delistings).
  • Governance implications: board independence, executive compensation, and regulatory scrutiny (antitrust considerations).

Practical Takeaways for Exam Preparation

  • Understand each ownership form’s defining characteristics, advantages, and disadvantages.
  • Be able to contrast liability, taxation, governance, and capital-raising capabilities across sole proprietorships, partnerships, and corporations.
  • Recognize how S corporations, LLCs, and cooperatives fit into the landscape and the reasons a business might choose one over another.
  • Explain why firms pursue mergers, acquisitions, and leveraged buyouts, including potential benefits and risks.
  • Apply the concepts to real-world scenarios (e.g., a founder choosing to transition from a sole proprietorship to an LLC, or a tech firm pursuing an acquisition for AI capabilities).
  • Include examples and case studies from the transcript (e.g., Shizu Okusa’s partnership experience, AT&T and BlackRock joint venture Gigapower, Dell’s private/public transitions).
  • Be prepared to discuss regulatory and governance aspects (e.g., the Sarbanes-Oxley Act, SEC disclosures, preemptive rights).

Notable Figures, Concepts, and Examples to Remember

  • Table 4.1: Forms of ownership (Sole Proprietorship, Partnership, S Corporation, C Corporation, LLC) and their structural/ tax implications.
  • Figure 4.1: Visual comparison of forms (sole proprietorships, partnerships, S corporations, C corporations).
  • Table 4.2: Keys to success in business partnerships (e.g., equitable profit sharing, diverse skill sets, ethics/compliance, communication, transparency).
  • Table 4.4: World’s biggest dividend payers (illustrative data on dividends for large public companies).
  • Table 4.5: America’s largest private companies by revenue (e.g., Cargill, Koch Industries, Publix, etc.).
  • Table 4.6: American companies with >50% revenues from outside the U.S. (context for global operations).
  • Table 4.7: The largest mergers of all time (illustrative scale of M&A activity).
  • Notable case: AT&T and BlackRock joint venture Gigapower LLC (LLC example for a joint venture in fiber-optics).
  • Notable case: Dell’s private-to-public-to-private lifecycle to illustrate going private and re-listing dynamics.
  • Critical thinking prompts embedded in the content (e.g., evaluating advantages/disadvantages of partnership in Okusa’s case, the role of investor funds in Apothékary).