Because learning changes everything.

Chapter 5
How to Form a Business

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 Chapter Contents

Basic Forms of Business Ownership

Sole Proprietorships
Partnerships
Corporations
Corporate Expansion: Mergers and Acquisitions
Franchises
Cooperatives

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 Learning Objectives

LO 5-1 Compare the advantages and disadvantages of sole proprietorships.

LO 5-2 Describe the differences between general and limited partners, and compare the
advantages and disadvantages of partnerships.
LO 5-3 Compare the advantages and disadvantages of corporations and summarize the
differences between C corporations, S corporations, and limited liability companies.
LO 5-4 Define and give examples of three types of corporate mergers, and explain the role of
leveraged buyouts and taking a firm private.
LO 5-5 Outline the advantages and disadvantages of franchises, and discuss the
opportunities for diversity in franchising and the challenges of global franchising.

LO 5-6 Explain the role of cooperatives.

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 Basic Forms of Business Ownership

Three Major Forms

• Sole proprietorship — A business owned, and usually managed, by one
person.
• Partnership — A legal form of business with two or more owners.
• Corporation — A legal entity with authority to act and have liability separate
from its owners.

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 Figure 5.1 Forms of Business Ownership

Although corporations make

up only 20 percent of the total
number of businesses, they
earn 81 percent of the total
receipts. Sole proprietorships
are the most common form
(72 percent), but they earn
only 6 percent of the receipts.

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 Sole Proprietorships

Advantages: Disadvantages:
1. Ease of starting and ending the 1. Unlimited liability — The
business. responsibility of business owners
for all debts of the business.
2. Being your own boss.
2. Limited financial resources.
3. Pride of ownership.
3. Management difficulties.
4. Leaving a legacy.
4. Overwhelming time commitment.
5. Retention of company profits.
5. Few fringe benefits.
6. No special taxes.
6. Limited growth.
7. Limited life span.
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 TESTPREP 1

• Most people who start businesses in the United States are sole
proprietors. What are the advantages and disadvantages of sole
proprietorships?
• Why would unlimited liability be considered a major drawback to
sole proprietorships?

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 Partnerships 1

Major Types of Partnerships

• General partnership — A partnership in which all owners share in operating
the business and in assuming liability for the business’s debts.
• Limited partnership — A partnership with one or more general partners and
one or more limited partners.

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 Partnerships 2

Types of Partners
• General partner — An owner (partner) who has unlimited liability and is active
in managing the firm.
• Limited partner — An owner who invests money in the business but does not
have any management responsibility or liability for losses beyond the
investment.
• Limited liability — The responsibility of a business’s owners for losses only up to the amount
they invest; limited partners and shareholders have limited liability.

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 Partnerships 3

Other Forms of Partnerships

• Master limited partnership (MLP) — A partnership that looks much like a
corporation (in that it acts like a corporation and is traded on a stock exchange)
but is taxed like a partnership and thus avoids the corporate income tax.
• Limited liability partnership (LLP) — A partnership that limits partners’ risk of
losing their personal assets to only their own acts and omissions and to the
acts and omissions of people under their supervision.

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 Partnerships 4

Advantages of Partnerships Disadvantages of Partnerships

• More financial resources. • Unlimited liability.
• Shared management and • Division of profits.
pooled/complementary skills and
• Disagreements among partners.
knowledge.
• Difficulty of termination.
• Longer survival.
• No special taxes.

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 Figure 5.2 Questions to Ask When Choosing a Business
Partner

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 TESTPREP 2

• What is the difference between a limited partner and a general

partner?
• What are some of the advantages and disadvantages of
partnerships?

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 Corporations 1

Conventional (C) Corporation

• A state-chartered legal entity with authority to act and have liability separate
from its owners (its stockholders).
• Enables many people to share in ownership.

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 Figure 5.4 Corporate Types
You may find some confusing types of corporations when reading about them. Here are a few of the
more widely used terms:
Alien corporations do business in the United States but are chartered (incorporated) in another country.
Domestic corporations do business in the state in which they are chartered (incorporated).
Foreign corporations do business in one state but are chartered in another. About one-third of all
corporations are chartered in Delaware because of its relatively attractive rules for incorporation. A foreign
corporation must register in states where it operates.
Closed (private) corporations have stock that is held by a few people and isn’t available to the general
public.
Open (public) corporations sell stock to the general public.
Quasi-public corporations are chartered by the government as an approved monopoly to perform services
to the general public.
Professional corporations are owned by those who offer professional services.
Nonprofit (or not-for-profit) corporations don't seek personal profit for their owners.

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 Corporations 2

Advantages of Corporations Disadvantages of Corporations

• Limited liability. • Initial cost.
• Ability to raise more money for • Extensive paperwork.
investment.
• Double taxation.
• Size.
• Two tax returns.
• Perpetual life.
• Size.
• Ease of ownership change.
• Difficulty of termination.
• Ease of attracting talented employees.
• Possible conflict with stockholders and
• Separation of ownership from board of directors.
management.

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 Figure 5.5 How Owners
Affect Management

Owners have an influence on how a

business is managed by electing a board of
directors. The board hires the top officers
(and fires them if necessary). It also sets
the pay for those officers. The officers then
select managers and employees with the
help of the human resource department.

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 Corporations 3

Individuals Can Incorporate

• Anyone—truckers, doctors, plumbers, athletes, and small business owners—
can incorporate.
• Stock is normally not issued to outsiders when individuals incorporate, so they
do not share the advantages and disadvantages of large corporations.
• Major advantages are limited liability and possible tax benefits.

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 Corporations 4

S Corporations
• A unique government creation that looks like a corporation but is taxed like sole
proprietorships and partnerships.
• Have shareholders, directors, and employees, plus the benefit of limited liability.
• Profits are taxed only as the personal income of the shareholders.
• If an S corporation loses its S status, it may not operate under it again for at
least 5 years.

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 Corporations 5

Limited Liability Companies

• LLCs are similar to an S corporation but without the special eligibility
requirements.
• Advantages of LLCs: • Disadvantages of LLCs:
1. Limited liability. 1. No stock; ownership is nontransferable.
2. Choice of taxation. 2. Fewer incentives.
3. Flexible ownership rules. 3. Taxes.
4. Flexible distribution of profits and losses. 4. Paperwork.
5. Operating flexibility.

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 TESTPREP 3

• What are the major advantages and disadvantages of

incorporating a business?
• What’s the role of owners (stockholders) in the corporate
hierarchy?
• If you buy stock in a corporation and someone gets injured by one
of the corporation’s products, can you be sued? Why or why not?
• Why are so many new businesses choosing a limited liability
company (LLC) form of ownership?

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 Corporate Expansion: Mergers and Acquisitions 1

Types of Expansion
• Merger — The result of two firms forming one company.
• Acquisition — One company’s purchase of the property and obligations of
another company.

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 Corporate Expansion: Mergers and Acquisitions 2

Types of Mergers
• Vertical merger — The joining of two companies in different stages of related
businesses.
• Horizontal merger — The joining of two firms in the same industry.
• Mergers between competitors must prove to the Federal Trade Commission (FTC) that the
new combined company does not limit competition unfairly.

• Conglomerate merger — The joining of firms in completely unrelated

industries.

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 Figure 5.8
Types of Mergers

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 Corporate Expansion: Mergers and Acquisitions 3

Other Types of Expansion

• Take a firm private — Management or a group of stockholders take control by
obtaining all the firm’s stock.
• Leveraged buyout (LBO) — An attempt by employees, management, or a
group of private investors to buy out the stockholders in a company.
• Range in size from $50 million to $34 billion and involve everything from small family
businesses to giant corporations.

• Business acquisitions are not limited to U.S. buyers.

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 Franchises 1

Franchising
• Franchise agreement — An arrangement whereby someone with a good idea
for a business (franchisor) sells the rights to use the business name and sell a
product or service (franchise) to others (franchisees) in a given territory.
• Can be formed as a sole proprietorship, a partnership, or a corporation.
• More than 733,000 franchised businesses operate in the U.S., creating 7.6
million jobs.

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 Franchises 2

Advantages of Franchises Disadvantages of Franchises

1. Management and marketing 1. Large start-up costs.
assistance.
2. Shared profit.
2. Personal ownership.
3. Management regulation.
3. Nationally recognized name.
4. Coattail effects.
4. Financial advice and assistance.
5. Restrictions on selling.
5. Lower failure rate.
6. Fraudulent franchisors.

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 Franchises 3

Diversity in Franchising
• Women own about half of U.S. companies, yet ownership of franchises is about
35 percent.
• More women are becoming franchisors, such as those who started Auntie Anne’s, Decorating
Den, and Build-a-Bear Workshops.

• Minorities own less than 19 percent of businesses, yet over 30 percent of

franchises are minority-owned.
• DiversityFran and Federal Minority Business Development Agency build awareness of
franchising opportunities within minority communities and provide training and support.

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 Franchises 4

Home-Based Franchises
• Advantages: • Disadvantages:
• Relief from commuting stress. • Isolation.

• Extra family time. • Long hours.

• Low overhead expenses.

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 Franchises 5

E-commerce in Franchising
• Most brick-and-mortar franchises have expanded online.
• Many franchisors prohibit franchisee-sponsored sites because conflicts can
erupt.
• Sometimes “reverse royalties” are sent to franchisees who believe their sales
were hurt by the franchisor’s site.

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 Franchises 6

Using Technology in Franchising

• Franchisors use technology, including social media, to:
• Extend their brands.
• Meet the needs of both customers and their franchisees.

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 Franchises 7

Franchising in Global Markets

• Even smaller franchises are going global.
• Canada is the most popular target for U.S.-based franchises, but so is China, South Africa, the
Philippines, and the Middle East.

• They offer the same advantages as in the U.S.: convenience and a predictable
level of service and quality.

• Adapting products and brand names to different countries creates challenges.

• Foreign franchises also come to the U.S.

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 Cooperatives

Cooperative (Co-Op)
• A business owned and controlled by the people who use it—producers,
consumers, or workers with similar needs who pool their resources for mutual
gain.
• Serve one billion members worldwide.
• Members democratically control the business by electing a board of directors
that hires professional management.
• Other cooperatives are formed to give members more economic power as a
group than they have as individuals, such as a farm cooperative.

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 TESTPREP 4

• What are some of the factors to consider before buying a

franchise?
• What opportunities are available for starting a global franchise?
• What is a cooperative?

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Because learning changes everything. ®

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