4.1 Organizational Forms, Corporate Issuer Features, and Ownership

Question 1

The three main types of organizations in a market economy

Answer 1

government entities, non-for-profit non-governmental organizations (non-profits), and for-profit businesses, also known as companies

Question 2

The three basic categories of business forms that are commonly used in most jurisdictions

Answer 2

sole proprietorships, partnerships, and limited companies.

Question 3

The key areas of focus when comparing different organizational forms of businesses are:

Answer 3

Legal identity: The legal relationship between the business and its owner(s)

Operational control: The relationship between the owner(s) and the managers who operate the business

Business liability: The liability exposure of individual owners with respect to activities undertaken by the business

Taxation: The treatment of business profits/losses for tax purposes

External financing: The ability to raise debt and new equity to fund operations

Question 4

The most basic business structure

Answer 4

sole proprietorship

Question 5

sole proprietorship

Answer 5

owned by an individual (also known as a sole trader) who has supplied the business with capital by investing personal funds and is a full participant in its day-to-day operations

This is the most commonly-used organizational form, with many family-owned businesses structured this way. In many jurisdictions, no formal legal registration is required to start a sole proprietorship and the business automatically dissolves when the owner ceases operations or dies.

effectively an extension of its owner who enjoys the full benefit of the profits that the business generates but is also fully liable for its actions, liabilities, and obligations

While this structure provides the advantages of simplicity and flexibility, opportunities to grow the business are limited by the owner’s personal financial resources and appetite for risk.

Question 6

General Partnerships

Answer 6

two or more owners accept roles and responsibilities that are formalized in a legal partnership agreement

This structure is very similar to a sole proprietorship, except that having more than one owner allows for additional resources (e.g., expertise, capital). Smaller professional services firms (e.g., accounting, medicine) commonly adopt this ownership model because it allows individuals with complementary skills to collaborate and accomplish more than they could individually.

Each partner contributes an equal share of capital and receives a proportionate share of the profits. Partners are personally responsible for covering any of the firm’s liabilities, including any portion that other partners are unable to pay. Despite the ability to draw upon more resources and capital than would be available to sole trader, opportunities for growth remain limited by the partners’ financial resources and their collective appetite for risk.

Question 7

Limited Partnerships

Answer 7

like a general partnership in the sense that a group of individuals pool their resources into a joint enterprise.

Limited partnership agreements can be very complex, specifying the roles, responsibilities, and access to profits for different types of partners.

Question 8

general partner (GP)

Answer 8

A general partner (GP) is granted authority over business operations and is personally responsible for any of the firm’s liabilities.

In exchange for accepting these responsibilities and risks, the GP typically receives a disproportionately large share of the profits.

Question 9

Limited partners (LPs)

Answer 9

primarily play the role of capital providers.

They are separated from the business’ operations, although the GP may consult LPs and draw upon their expertise. The limited partnership structure shields LPs from business liability in the sense that they cannot lose more than the value of their investment.

However, they do expose themselves to risk by granting sole discretion over managerial decisions to the GP.

Additionally, LPs often have little (or even no) ability to sell or transfer their ownership positions.

Question 10

Limited Liability Partnerships

Answer 10

only limited partners and no general partner

All partners are have limited liability and managerial responsibilities.

In practice, partners agree to appoint one or more managing partners to perform the operational role that would be filled by a GP in a limited partnership structure

Question 11

pass-through businesses

Answer 11

the entity itself is not taxed but profits (or losses) are treated as the partners’ personal income for tax purposes

All net income generated by the firm is deemed to be passed through and taxed, regardless of whether it is has been distributed or retained and reinvested by the partnership.

Question 12

Limited Companies

Answer 12

like a limited partnership in the sense that the ownership and management role are separated. However, under this type of structure, the business is owned by shareholders (not partners), who all enjoy the protection of limited liability.

Shareholders elect representatives to serve on the company’s board of directors, which is responsible for appointing professional managers to senior executive roles such as CEO and CFO.

Shares in a limited company are more easily transferrable than partnership interests.

can be classified as public or private

Question 13

Public limited companies

Answer 13

also known as corporations, although these businesses may be privately owned.

The corporation is the organizational form that is of greatest interest to investors because it is the structure that almost universally used by large businesses that issue tradable securities.

Question 14

A private limited company, or limited liability company (LLC)

Answer 14

a pass-through business that does not pay tax on the income that it generates. Instead, the firm’s profits are taxed as the personal incomes of its individual owners (i.e., shareholders).

LLCs are subject to legal restrictions on the number of owners and votes are required to approve transfer ownership interests, which limits the company’s ability to grow.

Question 15

public limited companies (better known as corporations)

Answer 15

face no limitations on the number of owners they can have and their shareholders are free to transfer their ownership interest as they wish.

The vast majority of large, for-profit enterprises are structured as corporations because the legal framework for public limited companies allows the greatest access to a capital.

Question 16

The major disadvantage of corporations

Answer 16

a public limited company’s income is taxed twice — once at the corporate level, and again at the individual owner level for any profits that are distributed to shareholders. This second level of taxation can be avoided to the extent that profits are retained by the corporation and reinvested to expand its operations.

Question 17

why are public limited companies or corporations described as corporate issuers?

Answer 17

because the external financing that they require to grow their operations is obtained by issuing debt and equity securities in capital markets

Question 18

double taxation

Answer 18

tax shareholders on the dividend income they have received from a company’s after-tax profits

Question 19

a company’s free float

Answer 19

includes only those shares that are actively traded on a public exchange

Question 20

a private placement memorandum (PPM)

Answer 20

a legal document that specifies the terms of the offering

Private companies looking for additional capital to finance their expansion must seek potential investors in the primary market. Typically, these companies issue a private placement memorandum (PPM)

Question 21

there are three ways that firms can join the ranks of public companies.

Answer 21

initial public offering (IPO)

Direct listing (DL)

Acquisition

Question 22

Direct listing (DL)

Answer 22

executed without the services of an underwriter because no new capital is raised.

Rather, the company’s shares become listed on an exchange, where they can be sold by existing shareholders.

This is a faster, less costly alternative to an IPO.

Question 23

special purpose acquisition company (SPAC)

Answer 23

can be created for the specific purpose of acquiring a private company to take it public.

SPACs are created by raising funds in an IPO with the intention of finding an acquisition target. The proceeds of the IPO must be placed in a trust account and the SPAC has a finite time period (e.g., 18 months) to complete the acquisition of a private company or return the funds to investors.

SPACs are known as “blank check” companies because investors do not know which company will ultimately be acquired. However, the backgrounds of the SPAC’s executives will at least provide an indication of which industry will be targeted.

Prior to the development of SPACs, it was common to use dormant listed firms with previous operating histories, known as shell companies, to acquire private companies in a process known as a reverse merger.

Question 24

leveraged buyout (LBO)

Answer 24

the company’s shares are delisted and it is no longer subject to the same disclosure and regulatory requirements

established public company to be taken private through “go-private” transactions

Question 25

The owner exposed to the least business liability is a:

A) sole trader.

B) partner in a general partnership.

C) general partner in a limited partnership.

Answer 25

B) partner in a general partnership.

because general partnerships are like sole proprietorships with the important distinction that they allow for additional resources to be brought into the business along with the sharing of business risk among a larger group of individuals.