Sole proprietorships are typically owned and operated by one person or family. The owner is personally responsible for all debts incurred by the business, but the owner gets to keep any profits the firm earns, after paying taxes. The owner’s liability or responsibility for paying debts incurred by the business is considered unlimited. That is, any individual or organization that is owed money by the business can claim all of the business owner’s assets (such as personal savings and belongings), except those protected under bankruptcy laws.
Normally when the person who owns or operates a proprietorship retires or dies, the business is either sold to someone else, or simply closes down after any creditors are paid. Many small retail businesses are operated as sole proprietorships, often by people who also work part-time or even full-time in other jobs. Some farms are operated as sole proprietorships, though today corporations own many of the nation’s farms.
Partnerships are like sole proprietorships except that there are two or
more owners who have agreed to divide, in some proportion, the risks
taken and the profits earned by the firm. Legally, the partners still
face unlimited liability and may have their personal property and savings
claimed to pay off the business’s debts. There are fewer partnerships
than corporations or sole proprietorships in the United States, but
historically partnerships were widely used by certain professionals, such
as lawyers, architects, doctors, and dentists. During the 1980s and
1990s, however, the number of partnerships in the U.S. economy has grown
far more slowly than the number of sole proprietorships and corporations.
Even many of the professions that once operated predominantly as
partnerships have found it important to take advantage of the special
features of corporations.
Corporations
In the United States a corporation is chartered by one of the 50 states as a legal body. That means it is, in law, a separate entity from its owners, who own shares of stock in the corporation. In the United States, corporate names often end with the abbreviation Inc., which stands for incorporated and refers to the idea that the business is a separate legal body.
Limited Liability
The key feature of corporations is limited liability. Unlike proprietorships and partnerships, the owners of a corporation are not personally responsible for any debts of the business. The only thing stockholders risk by investing in a corporation is what they have paid for their ownership shares, or stocks. Those who are owed money by the corporation cannot claim stockholders’ savings and other personal assets, even if the corporation goes into bankruptcy. Instead, the corporation is a separate legal entity, with the right to enter into contracts, to sue or be sued, and to continue to operate as long as it is profitable, which could be hundreds of years.
When the stockholders who own the corporation die, their stock is part of their estate and will be inherited by new owners. The corporation can go on doing business and usually will, unless the corporation is a small, closely held firm that is operated by one or two major stockholders. The largest U.S. corporations often have millions of stockholders, with no one person owning as much as 1 percent of the business. Limited liability and the possibility of operating for hundreds of years make corporations an attractive business structure, especially for large-scale operations where millions or even billions of dollars may be at risk.
When a new corporation is formed, a legal document called a prospectus is prepared to describe what the business will do, as well as who the directors of the corporation and its major investors will be. Those who buy this initial stock offering become the first owners of the corporation, and their investments provide the funds that allow the corporation to begin doing business.
Separation of Ownership and Control
The advantages of limited liability and of an unlimited number of years to operate have made corporations the dominant form of business for large- scale enterprises in the United States. However, there is one major drawback to this form of business. With sole proprietorships, the owners of the business are usually the same people who manage and operate the business. But in large corporations, corporate officers manage the business on behalf of the stockholders. This separation of management and ownership creates a potential conflict of interest. In particular, managers may care about their salaries, fringe benefits, or the size of their offices and support staffs, or perhaps even the overall size of the business they are running, more than they care about the stockholders’ profits.
The top managers of a corporation are appointed or dismissed by a corporation’s board of directors, which represents stockholders’ interests. However, in practice, the board of directors is often made up of people who were nominated by the top managers of the company. Members of the board of directors are elected by a majority of voting stockholders, but most stockholders vote for the nominees recommended by the current board members. Stockholders can also vote by proxy—a process in which they authorize someone else, usually the current board, to decide how to vote for them.
There are, however, two strong forces that encourage the managers of a corporation to act in stockholders’ interests. One is competition. Direct competition from other firms that sell in the same markets forces a corporation’s managers to make sound business decisions if they want the business to remain competitive and profitable. The second is the threat that if the corporation does not use its resources efficiently, it will be taken over by a more efficient company that wants control of those resources. If a corporation becomes financially unsound or is taken over by a competing company, the top managers of the firm face the prospect of being replaced. As a result, corporate managers will often act in the best interests of a corporation’s stockholders in order to preserve their own jobs and incomes.
In practice, the most common way for a takeover to occur is for one
company to purchase the stock of another company, or for the two
companies to merge by legal agreement under some new management
structure. Stock purchases are more common in what are called hostile
takeovers, where the company that is being taken over is fighting to
remain independent. Mergers are more common in friendly takeovers, where
two companies mutually agree that it makes sense for the companies to
combine. In 1996 there were over $556.3 billion worth of mergers and
acquisitions in the U.S. economy. Examples of mergers include the
purchase of Lotus Development Corporation, a computer software company,
by computer manufacturer International Business Machines Corporation
(IBM) and the acquisition of Miramax Films by entertainment and media
giant Walt Disney Company.
Takeovers by other firms became commonplace in the closing decades of the
20th century, and some research indicates that these takeovers made firms
operate more efficiently and profitably. Those outcomes have been good
news for shareholders and for consumers. In the long run, takeovers can
help protect a firm’s workers, too, because their jobs will be more
secure if the firm is operating efficiently. But initially takeovers
often result in job losses, which force many workers to relocate,
retrain, or in some cases retire sooner than they had planned. Such
workforce reductions happen because if a firm was not operating
efficiently, it was probably either operating in markets where it could
not compete effectively, or it was using too many workers and other
inputs to produce the goods and services it was selling. Sometimes
corporate mergers can result in job losses because management combines
and streamlines departments within the newly merged companies. Although
this streamlining leads to greater efficiency, it often results in fewer
jobs. In many cases, some workers are likely to be laid off and face a
period of unemployment until they can find work with another firm.
How Corporations Raise Funds for Investment
By investing in new issues of a company’s stock, shareholders provide the funds for a company to begin new or expanded operations. However, most stock sales do not involve new issues of stock. Instead, when someone who owns stock decides to sell some or all of their shares, that stock is typically traded on one of the national stock exchanges, which are specialized markets for buying and selling stocks. In those transactions, the person who sells the stock—not the corporation whose stock is traded—receives the funds from that sale.
An existing corporation that wants to secure funds to expand its operations has three options. It can issue new shares of stock, using the process described earlier. That option will reduce the share of the business that current stockholders own, so a majority of the current stockholders have to approve the issue of new shares of stock. New issues are often approved because if the expansion proves to be profitable, the current stockholders are likely to benefit from higher stock prices and increased dividends. Dividends are corporate profits that some companies periodically pay out to shareholders.
The second way for a corporation to secure funds is by borrowing money
from banks, from other financial institutions, or from individuals. To do
this the corporation often issues bonds, which are legal obligations to
repay the amount of money borrowed, plus interest, at a designated time.
If a corporation goes out of business, it is legally required to pay off
any bonds it has issued before any money is returned to stockholders.
That means that stocks are riskier investments than bonds. On the other
hand, all a bondholder will ever receive is the amount of money specified
in the bond. Stockholders can enjoy much larger returns, if the
corporation is profitable.
The final way for a corporation to pay for new investments is by reinvesting some of the profits it has earned. After paying taxes, profits are either paid out to stockholders as dividends or held as retained earnings to use in running and expanding the business. Those retained earnings come from the profits that belong to the stockholders, so reinvesting some of those profits increases the value of what the stockholders own and have risked in the business, which is known as stockholders’ equity. On the other hand, if the corporation incurs losses, the value of what the stockholders own in the business goes down, so stockholders’ equity decreases.
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