When enterprises establish a business, they must decide on the form of business ownership. There is no single form that can be said to apply to all individuals, but the person venturing into business need to first consider the following factors.
- Formation requirements
- Ease of creation
- Expenses to start and maintain
- Legal requirements
- Government control and regulation
- Income taxes consequences
The sole proprietorship is far the simplest and easiest way for an entrepreneur to do business. In reality, a sole proprietorship is not even a legal entity at all. The term is used to imply an individual who is self-employed and operates a business alone, but in practice a sole trader rarely work alone in most cases he/she will bring in other staff to help operate the business. The sole trader accepts all the responsibility for the management and finances of the business. By far this is the most common form of business ownership.
Advantages of the sole proprietorship
1. Being own boss the owner has the full control and this eliminates that chance for conflict or misunderstanding during the decision making.
2. Simplicity of creating and dissolving. In most cases you only need an idea, money and a simple license to start. When dissolving you don’t have to consult anyone all you need to do is to simply put a sign on the door saying ‘’out of business’’.
3. Low cost of creating the business. Sole proprietorship is usually one of the least costly forms of business to create. Because legal papers are not necessary, start-up legal expenses are minimal. And since the owner is the boss and probably the only one there will be few labor costs.
4. Total commands over decisions and profits. Since the owner has full control over the business, he/she can make decisions without consulting others and withdrew the money from the business whenever the need arises. And since all the profits goes to the owner there is greater motivation to grow the business.
5. Uncomplicated tax basis. A sole proprietorship is taxed as a person and not the business.
Disadvantages of sole proprietorship
1. Not easy to raise capital to start one’s own business.
2. Risk of financial loss, as the owner risks all the investment put in the business, plus all the debts from doing business given the unlimited nature of business.
3. Lack of continuity. Sole proprietorship is established initial owner, operated the owner and trends to die with the owner.
4. Opportunities for raising further capital are limited this can severely restrict the growth of the business.
5. Unlimited liability. There is no limit on the debts for which the owner is liable. When the business is sued the owner is liable for the debt.
6. Limited skills. The individual may be limited in terms of skills that they may possess, and for this reasons they may be unable to control all parts of the business. (Madura, 2007)
Where two or more people agree to start a business, the maximum limits of the member is twenty. In partnership, the co-owners share the assets, liabilities and profits of the business. (E.g. Procter & Gamble, Johnson & Johnson were one in partnership). In today business most partnership occurs among doctors, lawyers, accountants and other professionals. A partnership is relatively simple to establish and does not require the same amount of record keeping as a corporation.
Unless the partnership agreement provides otherwise, the law that governs who does business as general partners spreads the ownership and management among the partners so that they share equally in the rights and responsibilities. Therefore, the partners share equally in the profits and losses of the business. Each partner is a residual claimant of the business and therefore has an equal claim to money or property left in the business at termination or dissolution, after all debts and liabilities have been paid.
Uniform partnership Act
Rights of the partners
- Share in the management and operations of the business
- Share in any profits the company makes
- Have access to the company’s books and records
- Receive a formal accounting of the business affairs of the partnership
Obligation of the partners
- Share in any losses incurred the business
- Work for the partnership without salary as necessary
- Submit to majority vote or arbitration of differences that may arise among the partners
- Give other partners complete information about all affairs of the partnership.
The co-owners of the business prepare an agreement and where the business life is expected to be more than one year the agreement must be in writing. This document is called partnership agreement. Where none exist a law called Uniform Partnership Act (UPA) will govern the partnership. However the provision of this law may not be favourable as the drafted agreement the partners themselves since it is based on the principles detailed in the above paragraph. The partnership agreement should contain;
- The name of the partnership and those of each partners
- A general description of the type of the business that will be conducted.
- The power and duties of the partners, including any limitations or restrictions.
- The financial contribution each partner will make.
- How profits and losses are to be divided
- How partners can leave the business and the new one is added.
- What steps must be taken to dissolve the partnership.
Advantages of partnership
- There is increased capital due to the partners’ contributions
- Greater access to finance unlike the sole trader
- Wide range of experience and expertise brought different partners
- The business is not taxed; rather it is the individuals who are taxed.
- Losses are shared among the partners according to the agreed ratio.
- Partners are personally liable incase the business incur debts.
- Slow decision making due to consultation
- A decision one partner can lender the other into trouble since they are jointly liable.
- Profit is shared.
- More requirements when starting in comparison with sole trader.
- Lack of continuity due to death of one partner.
What leads to partnership dissolution?
1. An event, which makes it unlawful for the business or the partners to carry on the partnership, occurs
2. The partnership was entered into a fixed period and the fixed period has come to an end.
3. If the partnership was entered in to for a single venture/undertaking, and has come to an end.
4. Death, bankruptcy of any partner or the court order.
Types of partnership
In a general partnership, all partners have unlimited liability. That is the partners are personally liable for all obligations of the firm. Conversely, in a limited partnership, the firm has some partners whose liability is limited to the cash or property they contributed to the partnership. Limited partners are only investor in the partnership and do not participate in its management, but because they have invested in the business, they share its profits or losses. A limited partnership has at least one general partner, or partners who manage the business. These partners receive salary, share the profits or losses of the business and have unlimited liability (Madura 2007) Other forms of partnerships
Limited Liability Partnership (LLP)
An LLP is a form of ownership in which “all” partners receives limited liability protection. The LLP is similar to a general partnership in that all partners can take an active role in managing the day-to-day affairs. However, it has the added benefit of providing the limited liability feature, which is not available to a general partnership. The LLP form of ownership is limited is common to professionals working in the fields of law (attorneys), accountancy, and architects.
The LLP is a flexible form of business. Designed primarily for specific professional services The partners will decide the structure of the organization and the distribution of profits and losses. A formal, written partnership agreement is advisable. The profits and losses “flow down” from the partnership to each partner. Each partner is responsible for paying taxes on their distributive share. The LLP allows each partner to actively participate in management affairs. The LLP provides limited liability protection to each partner. A LLP remains in effect based on partners agreeing to a termination date and as long as all of the general partners remain in the partnership.
Limited Liability Limited Partnership (LLLP)
An LLLP is a new modification of the limited partnership. Similar to a limited partnership, the LLLP consists of one of more general partners and one or more limited partners. The key advantage of this form of ownership is that the general partners receive limited liability on the debts and obligations of the LLLP.
The general partners manage the business operations of the LLLP, while the limited partners typically only maintain a financial interest.
The LLLP is a flexible form of business. Designed to offer limited liability to all partners in the partnership The partners will decide the structure of the organization and the distribution of profits and losses. A formal, written partnership agreement is advisable. The profits and losses “flow down” from the partnership to each partner. Each partner is responsible for paying taxes on their distributive share. An LLLP remains in effect based on partners agreeing to a termination date and as long as all of the general partners remain in the partnership.
Corporation is a distinct, legal entity in itself that is it has a legal life separate from its owners. According to Boone and Kurtz (2003) a corporation is a legal organization with assets and liabilities separate from those of its owner(s). The corporation can enter into contracts, borrow money, sue and be sued and pay taxes just like a person. This is the most common form of business. A company may have a few as two members/ shareholders with no limitation on the membership ceiling. When registering a company there are four documents that should be submitted to the registrar of company:
Memorandum of Association
This should contain the following:
- Name of the company, in the case of a private company the name must have limited as the last word, incase of a public company it will be ‘public limited company’
- Where its registered office is located, physical address and the building
- The liability of the members i.e. the amount of capital they are responsible for providing.
- The capital of the company, this set the limit on the amount of capital the company is allowed to raise (authorized share capital)
Articles of Association
- This is concerned with the internal administration of the company and it is those that are setting up the company that need to decide on the rules they wish to be included in their article. Matters that are normally dealt in the articles;
- The appointment and power that the directors will have
- The rules about shareholders meting and voting
- The types of shares and the shareholders’ right attached to each type.
- The rules and procedures of transferring shares.
- Form 10. Contains details of first directors and secretary, their date of birth, occupation and details of other directorship, they have held within the last five years. They must sign and date the form.
- Form 12. This is a statutory declaration of compliance with all the legal requirements relating to the incorporation of a company. The document must be signed a solicitor, forming the company or one of people named in the form 10 as director in presence of a commissioner for oath.
- After incorporation the article may be altered, but only with 75% majority vote. Companies have two main source of control over its affair i.e. shareholders in a general meeting and the directors who act on behalf of the shareholders (stewardship). The most matter such as the change in constitution, appointment of directors rest with its shareholders in a G.M. most issues require a simple majority vote, although some matters require 75% majority. Given the importance the voting power play in the company management, the type of share that the company issue is of great significance, ordinary share carry full voting right such as preference shares may carry no voting right at all.
- The articles that the directors be responsible for the daily running of the company make decision and act on behalf of the company. Directors can be sanctioned or dismissed in a general meeting.
Advantages of a limited company
- Shareholders have limited liability (can only lose what they have put in the business)
- Additional capital can be raised through issuing of more shares. Right issue
- More access to additional capital from external lenders
- Company name is protected law
- Perpetual existence
- Democratic management
- Easy transfer of ownership
Disadvantages of a limited company
- Employee may feel distant its owners
- Company records are open to the public e.g. annual records-financial disclosure
- Expensive to form a company
- Decision making is complex due to the number of people involved
- Affair are strongly controlled according to companies Acts
- Double taxation, after a company pays its corporate tax its owner will have to pay personal taxes on any distributions of its profits they receive from the corporation in the form of stock dividend.
Agency problem- when managers do not act as responsible agents for the shareholders who own the business. Since managers run the business on behalf of the owners, they may not always act in the best interest of the owners. For examples managers may take an expensive trip which necessarily may not benefit the business, this bring about the problem of agency. Company such as Enron in USA went down due to agency problem Key differences between private limited and public limited companies A private company’s shares are not quoted in the stock exchange and cannot be bought on the open market. For public limited company shares may be listed in the on application stock exchange.
Public limited company has tremendous potential for raising capital inviting the public to subscribe for shares. On the other hand private limited companies are curtailed from the same and hence raising capital become limited. The capital requirement for the two is also different, private require less authorized capital and indeed no set minimum but for plc they require more capital. The directors of plc must be at least two and a private need only one. Private company may dispense with preparing of the accounts but for public it is mandatory.
NB. Businesses today are experiencing changes in the global market. This has seen most firms come together to join forces in order to be able to cope with the dynamics. There are several ways that firms are coming together and these includes; merger-where two or more firms combine to form one company, acquisition-where one firm purchase the property and assumes the obligations of another or where one firm buys a division or subsidiary from another firm. Joint venture- is a partnership between companies formed for a specific undertaking (wild 2008).
Corporation (Legal person)
The corporation was conceived to solve the typical problems of the partnership. Incorporating allows a group of entrepreneurs to act as one, much the way a partnership does, with one important advantage. Since the corporation is a separate legal entity capable of being sued, it can protect its owners absorbing the liability if something goes wrong. In recent years, the corporation has developed as a tax reduction/planning tool.
A corporation is essentially an “artificial person” created and operated with the permission of the state where it is incorporated. It’s a person like you, but only “on paper.” A corporation is brought to life when a person, the incorporator, files a form with a state known as the articles of incorporation. The owner of a corporation is known as a shareholder. Since a corporation is a separate legal entity, the corporation actually owns and operates the business on behalf of the shareholder, under the shareholder’s total control. This separation provides a legal distinction between the owner and the business and provides three important benefits:
It allows you, the owner, to hire yourself as an employee (typically as president) and then participate in company-funded employee benefit plans like medical insurance and retirement plans. Since you and your company are now two separate legal entities, lawsuits can be brought against your company instead of you personally. When debt is incurred in the company name, a separate legal entity, you are not personally liable and your assets cannot be taken to settle company obligations.
A corporation must create bylaws (e.g., how the corporation will operate) that cover items such as stockholder meetings, director meetings, number of officers, and their responsibilities. Based on the corporation’s separate legal entity status, the owners of the corporation are not liable for the losses of the businesses and creditors may only look to the corporation and the business assets for payment.
A separate bank account and separate records are required with this form of entity. The owners have ultimate control of the corporation; but must elect directors who in turn elect officers for the company. The directors make the major decisions, while the officers make the day-to-day decisions. A corporation’s life is perpetual in nature. Ownership is easily transferred through the sale of stock and new owners can be easily added the issuance of additional stock. This form of ownership is more costly to set up and maintain than a sole proprietorship or partnership. Consult an attorney for guidance on setting up your corporate entity
Reasons for incorporation
- Accessing finance
- You need to incorporate if your business involves potential liability that could seriously damage your personal finances.
- You need to incorporate if you’re trying to work for other businesses.
- You need to incorporate to take advantage of the Small Business Deduction.
- You need to incorporate if you’re making enough money that you need to manage your income.
- Generally, the public views incorporated businesses more favourably
Limited Liability Company (LLC)
An LLC is a newer form of business entity. It has advantages over both the corporation and the partnership forms of operating a business. The LLC’s main advantage over a general partnership is that, like the owners (shareholders) of a corporation, the owners (members) of an LLC are generally not responsible financially for the debts and obligations incurred in the course of the LLC’s business. In addition, an LLC has the flexibility to be taxed as a partnership, sole proprietorship, or corporation.
An LLC may have one or more owners, and may have different classes of owners. In addition, an LLC may be owned any combination of individuals or business entities. An LLC is treated as a legal entity separate from its owners, similar to how a corporation is treated, regardless of how the LLC is classified for tax purposes. In general, the owners (members) are shielded from individual liability for debts and obligations of the LLC.
An LLC is formed filing “articles of organization” with the California Secretary of State prior to conducting business. Forming an LLC is simpler and faster than forming and maintaining a corporation. LLCs do not issue stock, and are not required to hold annual meetings or keep written minutes, which a corporation must take in order to preserve the liability shield for its owners. Either before or after filing its articles of organization, the LLC members must enter into a verbal or written operating agreement. A formal, written agreement is advisable. An LLC is typically managed its members, unless the members agree to have a manager manage the LLC’s business affairs.
Generally, members of an LLC that are taxed as a partnership may agree to share the profits and losses in any manner. Members of an LLC classified as a corporation receive profits and losses in the same manner as shareholders of a corporation legally organized as such. An LLC’s life is perpetual in nature. However, the members may agree in the articles of organization or the operating agreement to a date or event that will cause the LLC to terminate. In addition, members of the LLC may vote at any time to end the business operations of the LLC. Co-operatives A co-operative organization can be defined as an organization of members who come together to carry out economic activities and to share proceeds equitably on the basis of co-operative principles.
A cooperative is a legal entity owned and democratically controlled equally its members. A defining point of a cooperative is that the members have a close association with the enterprise as producers or consumers of its products or services, or as its employees. Cooperatives are based on the co-operative values of “self-help, self-responsibility, democracy and equality, equity and solidarity” and the co-operative principles of “voluntary and open membership; democratic member control; member economic participation; autonomy and independence; education and training; co-operation among co-operatives; and concern for community
Economic benefits are distributed proportionally according to each member’s level of participation in the cooperative, for instance a dividend on sales or purchases, rather than divided according to capital invested. The co-operative society is that type of business organizations in which members make efforts to achieve any common objective on voluntary and democratic basis. All cooperatives must adhere to the co-operative principles. These principles are formulated international co-operative alliance which is a world wide confederation of all cooperative organizations.
These principles are;
- Open and voluntary membership
- Democratic administration
- Limited rate of interest
- Disposal of surplus
- Education: the members need to be given adequate education.
- Principle of competition with other co-operatives.
Advantages of co-operatives
- Loyalty- The co-operative societies are voluntary association. Members of cooperative societies are mostly sincere and loyal to one another.
- Democratic administration- all decisions of co-operative societies are made on democratic basis. The members cast their votes and these decisions which have greater support of the members are implemented.
- Common benefit- the main aim of a co-operative society is to provide the best services to all members. Common benefit is taken into consideration.
- It is a means to effect a re-distribution within the population.
- Lack of business experience- members of co-operative societies does not have the experience of business and as a result the societies fail to achieve their objectives.
- Dis-agreement among members- sometimes members of co-operative societies do not agree on specific duties e.g. on the mode of election. This situation may lead to collapse of co-operative society.
- Lack of sufficient capital- co-operatives rely basically on financial contribution from members for the capital but in many developing countries the incomes are relatively low and sometimes members are reluctant to pay high subscriptions or join societies.
- Weakness in management- co-operatives has an inherent weakness in management due to inefficient committees who lack education, experience or who have promoted the length of service than on their ability, efficiency and qualifications.