Corporate Structures and Ownership

Question 1

Define a sole proprietorship in terms of liability, tax on profits and residual claim

Answer 1

Liability: Owner has unlimited liability

Tax on profits: As personal income

Residual claim: owner has 100% of claim on net assets

Question 2

Define a general partnership in terms of liability, tax on profits and residual claim

Answer 2

Liability: Partners have unlimited liability

Tax on profits: As personal income

Residual claim: partnership agreement states operating responsibilities and claims on net assets for each partner

Question 3

Define a limited partnership in terms of liability, tax on profits and residual claim

Answer 3

Liability: One or more general partners who manage the business and have unlimited liability, and multiple limited partners who each have limited liability.

Tax on profits: As personal income

Residual claim: partnership agreement specifies how profits are to be divided among the general and limited partners

Question 4

Define a Corporation in terms of liability, tax on profits and residual claim

Answer 4

Liability: A corporation is a legal entity separate from its owners and managers. All owners have limited liability.

Tax on profits: A corporation may, but is not required to, distribute its profits to its owners as dividends. Dividends are subject to double taxation (corporate tax and personal income tax) in some countries.

Residual claim: owners

Question 5

Explain how public and private companies raise capital

Answer 5

Public companies (depending on the country) has shares listed on a stock exchange or has at least a minimum number of owners. Public companies are subject to greater disclosure requirements than private companies.

Private companies can raise capital through private placements of securities, but only to accredited investors (not to the public).

Question 6

How can a private company become public?

Answer 6

A private company can become public by:

1. Issuing shares in an initial public offering
2. Carrying out a direct listing on a stock exchange, or
3. Being acquired by a public company, which may be a special purpose acquisition company. In a leveraged buyout or a management buyout, a public company is changed to a private company.

Question 7

Compare the financial claims and motivations of lenders and owners.

Answer 7

Claims:

Debt holders have a legal claim to the interest and principal the company promises.

Equity holders have a residual claim to the company’s net assets after debt repayment; that is, debt holders have a higher priority of claims than equity holders.

Motivations:

Debt has limited upside potential; the best result for debt holders is to receive the promised principal and interest payments.

Equity has (theoretically) unlimited upside potential. This difference may increase conflicts of interest between debt holders and equity holders.