LOS 28.

a: Compare business structures and describe key features of

corporate issuers.

Business structures refer to how businesses are set up from a legal and organizational point
of view. Key features of business structures include:

● The legal relationship between the business and its owners.

● Whether the owners of the business also operate the business, and if not, the nature of
the relationship between its owners and operators.
● Whether the owners' liability for the actions and debts of the business is limited or
unlimited.
● The tax treatment of profits or losses from the business.

To understand these features, we can compare them among four commonly used types of
business structures: sole proprietorships, general partnerships, limited partnerships, and
corporations.

A sole proprietorship is a business owned and operated by an individual. Legally the business
is an extension of the owner, who is personally responsible for claims against the business (i.e.,
unlimited liability), including taxes, and has the only claim on the net profits from the business.
Sole proprietorships tend to be small in scale because they can only expand within the limits of
the individual owner's ability to secure financing.

To do business on a scale that exceeds that of a sole proprietorship, two or more individuals can
form a general partnership. In this structure, the partnership agreement specifies each
partner's responsibilities for business operations and their shares of the partnership
profits/losses. As with a sole proprietorship, the partners have unlimited liability for claims
against the business, and profits from the business allocated to each partner are taxed as
personal income.

A limited partnership involves two levels of partners. One or more general partners operate
the business and have unlimited liability, as in a general partnership, but this structure also has
limited partners who are liable only for the amount they invest in the partnership (i.e., limited
liability) and have claims to its profits that are proportionate to their investments. Limited
partners typically are not involved in appointing or removing general partners. How the profits
are divided among the general and limited partners is specified in the partnership agreement.
Because they are responsible for managing the business, the general partners typically receive
a larger portion of profits than the limited partners. Profits allocated to the partners are taxed as
personal income to each partner. As we explain in the Alternative Investments topic area, most
private capital firms and hedge funds are structured as limited partnerships. Many large
providers of personal services, such as legal and accounting firms, also use limited partnership
structures.

The feature that distinguishes a corporation, or limited company, from the other business
structures is that a corporation is a legal entity separate from its owners and managers. In this
case, all a corporation's shareholders have limited liability. An owner can lose his entire
investment if the company goes bankrupt and the value of his shares goes to zero, but has no
legal liability for any further claims against the corporation. A corporation may, but is not
required to, distribute its profits to its owners. Most large firms are corporations because that
structure gives them the greatest access to capital, both debt (borrowed capital) and equity
(ownership capital).

Another distinguishing feature of corporations is the separation of its owners and managers. An
investor who buys shares of a corporation does not directly influence the company's day-to-day
operations. Instead, the owners appoint a board of directors that is responsible for hiring the
senior managers to operate the company. The board and the managers it hires are responsible
for acting in the interests of the shareholders.

Professor's Note
 We will examine the voting rights of shareholders in the Equity Investments topic
area.

Corporations can be for-profit or not-for-profit. The purpose of a not-for-profit corporation is to

produce a particular social benefit or pursue a charitable goal on an ongoing basis. Nonprofit
corporations may generate profits, but must reinvest any profits toward its mission rather than
distributing them to owners. Nonprofit corporations are usually not taxed.

For-profit corporations may be public or private. In many countries, including the United States,
a public corporation is one that has shares that are sold to the public and trade in an
organized market. Other countries may consider a corporation public if it has at least a
designated number of owners, even if its shares are not traded on an exchange or in a dealer
market. A for-profit corporation that does not meet these definitions is a private corporation.

Depending on the country, a corporation's profits may be subject to double taxation if the
government taxes companies on their earnings and also taxes dividends (which are distributions
of earnings to owners) as personal income. For example, if corporations pay 30% tax on gross
profits and individuals pay 20% tax on dividends received, the effective tax rate on profits
distributed as dividends is 30% plus 20% of the remaining (1 – 30%), which equals 44%.

Professor's Note

The Level II curriculum discusses how double taxation affects companies' dividend
policies and some of the ways countries address this issue.

LOS 28.b: Compare public and private companies.

Key differences between public and private companies include how they issue shares to
owners, how owners can transfer their shares, and the disclosure requirements to which the
companies are subject.

A company can become public by issuing shares in an initial public offering (IPO), after which
its shares typically trade on an exchange. Once the shares are listed on an exchange, owners
can sell shares, and new owners can buy shares, without dealing directly with the company.

Professor's Note

We describe the mechanics of IPOs in the Equity Investments topic area.

Regulators require public companies to periodically, typically quarterly or semiannually, to report

their financial results in compliance with accepted accounting principles, and disclose other
relevant information such as share purchases and sales by company executives.

Private companies can raise equity capital through a private placement of shares to
accredited investors typically institutions or high net worth individuals. A private placement
memorandum (PPR) includes information about the company and the risks of investing in it.
Disclosure requirements are less strict than those that apply to public companies. For example,
private companies are not required to report financial results publicly or to a regulatory authority.

Investors in private companies tend to have long time horizons. They cannot sell their shares
readily or without the company's approval, as shareholders of public companies can. Rather,
they typically hold these investments until the company goes public or is acquired by another
company. Returns on these investments may be greater on average than investments in public
companies, especially for owners that invest early in a company's life.
Besides an IPO or being acquired by a public company, two other ways a private company can
become public are through a direct listing or a special purpose acquisition company. In a direct
listing, a stock exchange agrees to list a private company's existing shares. This differs from an
IPO in that a direct listing does not raise any new capital for the company, but has advantages in
that it can be done more quickly than an IPO and without involving an underwriter.

A special purpose acquisition company (SPAC) is a corporate structure set up to acquire a

private company in the future. The SPAC raises capital through an IPO and puts the funds into a
trust that it must use to make an acquisition within a specified period of time. The acquired
company does not have to be identified at the time of the IPO. For this reason, SPACs are also
known as blank check companies.

Some transactions result in a public company becoming private. These include a leveraged
buyout (LBO), in which outside investors buy all of the company's outstanding shares and
remove its stock exchange listing, and a management buyout (MBO) in which the company's
managers do so.

LOS 28.c: Compare the financial claims and motivations of lenders and
owners.

A company's lenders (debt holders) have a legal, contractual claim to the interest and principal
payments the company has promised to make. Owners (equity holders) have a residual claim
to the company's net assets (i.e., what remains after all other claims have been paid). That is,
lenders have a higher priority of claims than equity owners.

Both debt holders and equity holders can potentially lose their entire investment if a company
fails, but their losses cannot exceed the amounts they have invested. A key difference between
debt and equity is their upside potentials. Regardless of a company's success, the best result
debt holders can achieve is to receive the interest and principal payments promised by the
company. Equity, on the other hand, has a theoretically unlimited upside if a company succeeds
and grows over time.
Because of this difference in their risk profiles, the interests of debt holders may conflict with the
interests of equity holders. Debt holders are primarily concerned with a company's ability to
repay its obligations, and less concerned with its growth prospects. Equity holders may favor
actions that increase a company's potential growth, but also increase its risk level, such as
adding financial leverage by issuing new debt. A company's existing debt holders may oppose
such actions because increasing the company's risk (and the probability of defaulting on its
debts) does not increase their expected return.

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