Private Business Ownership Structures
Private Business Ownership Structures
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Before we explore the different types of Private Business Ownership Structures (and more importantly, the reasons why specific businesses might choose them) it is important to understand the concepts of INCORPORATION, LIABILITY and TAXATION.
Taxation
Taxation
Sharing the Responsibility: How Taxes Work
Imagine living in a giant apartment building with lots of neighbors. To keep the building running smoothly, you all need to pitch in for shared things like cleaning the hallways, maintaining the elevator, and fixing the roof.
Taxes and Responsibility. Taxes work in a similar way for a country. The government uses tax money to pay for essential services that benefit everyone, like roads, schools, parks, and firefighters. Taxation is the system by which the government collects this money from its citizens. It's a way of sharing the responsibility for running the country.
Enforcing Tax Responsibility. Just like everyone in the apartment building needs to contribute their share, most countries have laws that require citizens to pay taxes. These laws are enforced through the court system. If someone doesn't pay their taxes, the government can take legal action, which could involve fines or even penalties.
How Much Do We Pay? The amount of taxes people pay is usually based on their income. Income is the money you earn from working, running a business, or other sources. The idea is that people who earn more have a greater ability to contribute to the shared expenses of the country.
Different Types of Taxes. Income tax is just one type of tax. Governments also collect taxes on things like sales (goods you buy), property (land and buildings you own), and even special taxes on things like gasoline or cigarettes.
Liability
Liability
Imagine you're hanging out with friends and accidentally bump into someone, spilling their coffee all over them. In most cases, you'd apologize and offer to pay for their replacement coffee or cleaning. That's taking responsibility for your actions!
Liability in Business: Businesses operate similarly. Liability is the legal responsibility a business has for the consequences of its actions. Just like you might be responsible for replacing someone's coffee, a business can be held responsible for things like:
Faulty products: If a product malfunctions and injures someone, the business could be liable for the damages.
Breach of contract: If a business breaks a promise in a contract, they could be held liable for any financial losses caused.
Employee actions: Businesses are generally liable for the actions of their employees while they're on the job.
Courts and Enforcement
The court system plays a big role in enforcing liability. If someone believes a business has wronged them, they can file a lawsuit. The court will then decide if the business is liable and, if so, what compensation (money or other actions) the business owes the other party.
Limited vs. Unlimited Liability: There are two main types of liability for businesses:
Limited Liability: This protects the owners' personal assets from business debts. Think of it like having a separate "business wallet" to pay for business-related problems. This is common for corporations (C Corps and S Corps).
Unlimited Liability: This means the owners are personally responsible for all the business's debts. There's no separate business wallet; the owner's personal finances are on the hook. This applies to sole proprietorships and general partnerships.
Incorporation
Incorporation
In order to determine taxation and liability, (as well as a number of other things), it is important to know who bears responsibility for the actions of an individual 'body'.
It is easy to determine this for individuals in society because (amongst other things) they have a registered name and identity number. However, this is not as easy to determine for a business.
To help with this challenge, the goverment places a number of requirements on business owners - including a requirement to register the business and select an appropriate ownership structure. This structure will determine who is liable for the actions of the business (and how much they are liable for) and how taxation will be levied on any business profits.
There are two main categories of ownership structure: Unincorporated and Incorporated businesses.
Unincorporated Businesses (Like Sole Traders and Partnerships) have not gone through the process of 'Incorporation' which makes the business into its own legal entity (or person) that is separate in the eyes of the law from the individual business owner or owners. Consequently, the business owner and the business are viewed as the 'same person' in terms of both liability and taxation. The owners are 'fully liable' for any debts or damages caused by the activites of the business, and all of their assets (including the family home) are required to be used to meet any debts or remediate any damages. This is called Unlimited Liability.
Because the business owner(s) are viewed as the same entity as the business in the eyes of the law, any profits earned by the business are viewed as the individual income of the owner(s) and they are required to pay individual income tax on these profits.
Incorporated businesses (such as privately held or publically held companies) undertake a complicated legal process called 'Incorporation'. This process 'separates' the business from its owner and create a new 'legal entity' (or person). This new 'entity' (person) is liable for the debts and actions of the business, and the liability that each individual owner faces is limited to the funds that they invested in the business. This is known as Limited Liabilty because the liability that each owner holds is 'Limited to their investment.
The process of incorporation also impacts how the business is taxed. Instead of each individual owner being charged income tax, the business pays business tax. These rates are usually lower than income tax rates in the higher income brackets.
Private businesses range in size from just one person to multiple partners across many different types of ownership which include:
Un-Incorporated Ownership Structures
Un-Incorporated Ownership Structures
Sole Trader (Sole Proprietor)
Sole Trader (Sole Proprietor)
A sole trader (also known as a sole proprietor) is a commercial for-profit business owned by a single person.
A sole trader is the most popular type of ownership and is often referred to as self employed or sole proprietor
The term 'sole trader' describes any business that is owned and controlled by one person
Although this person can employ as many people as needed, the sole trader is the only owner of the business.
A business owner can still register as a sole trader even if they have employees and are often individuals who provide a specialist service like plumbers, hairdressers or photographers.
Advantages of a Sole Trader Structure
Advantages of a Sole Trader Structure
Disadvantages of a Sole Trader Structure
Disadvantages of a Sole Trader Structure
The advantages of setting up a business as a sole trader (or sole proprietor) as a type of for-profit (commercial) organization include:
It is the quickest and easiest type of business to set up. Sole traders can avoid complicated and costly set-up procedures.
The owner receives all of the profits if the business succeeds.
Sole traders are likely to be highly motivated as the owners have a sense of achievement from running their own business and can keep all of the profits made.
The sole trader (owner) has complete control without having to consult with or be accountable to others.
Decision-making is also swift as the owner does not have to consult anyone else and seek their permission to execute a decision.
The sole trader enjoys privacy as it only needs to publish its financial accounts to the tax authorities (rather than to the general public like a publicly held company).
The owner can benefit from tax advantages. As a small business, many sole traders work from home, so can claim tax concessions by using part of their home for business purposes.
However, there are some potentially significant disadvantages of being a sole trader too. These include:
The finance to set up and run the business is generally provided by the owner (from personal savings) as s/he cannot easily access external sources of finance.
The sole trader accepts all the risks of owning and running their own business, including any losses made or even the collapse of the organisation.
The workload for a sole trader can be extremely high. There is no one else to share ideas or to ask questions, so all pressures, burdens and responsibilities fall on the owner. This means the sole trader often has to work very long hours.
Legally, a sole trader is treated as the same legal entity as the business, i.e. it is an unincorporated business. This means the sole trader has unlimited liability so is responsible for any debt owed to other individuals or organisations, even if this requires the owner to pay the debts from their personal belongings and assets.
There is a lack of continuity in the operations of the business if the owner is unwell, wishes to take a holiday or wants to retire. The latter is a main reason why many sole trader businesses struggle to continue.
Since access to external finance is difficult for most sold traders (because they represent a high degree of risk), expansion of the business is difficult.
Partnership
Partnership
A partnership is a commercial business that is owned by two or more people and strives to earn a profit for its owners.
For an ordinary partnership, the maximum number of partners is usually capped at twenty owners, although this does vary from one country to another. However, some organizations can have more than 20 partners, such as law firms and health clinics.
Partnerships are similar in nature to a sole trader but are legally owned by two or more people.
Typical examples of partnerships are skilled people and professionals who decide to set up a business together such as trades people, dentists, and solicitors.
Many family-run businesses are also established as partnerships. The owners of a partnership are called partners.
A partnership agreement is a key legal document which is agreed and signed by all partners of the business and covers all the key legalities of the business such as how management decisions are made and how profits are shared.
Advantages of the Partnership Structure
Advantages of the Partnership Structure
The advantages of partnerships as a type of for-profit (commercial) business organisation include:
Partnerships can raise far more finance than sole traders, especially as there can be up to 20 partners (subject to the laws in different countries) in the business. Silent partners (also known as sleeping partners) can provide additional capital without having any role in the actual running of the business.
Having partners enables the firm to benefit from having more ideas and different skills and expertise.
Unlike a sole trader, partners can share the burden of their workload and responsibilities.
Hence, unlike a sole trader, partnerships benefit from continuity as the partnership can remain in operation if a partner is unwell or wants to go on a family vacation.
Partnerships can benefit from specialisation and the division of labour. For example, a law firm might have partners who specialize in different specialisms, such as criminal law, civil law, business law and tax law.6
As with sole traders, business affairs of a partnership are kept confidential, so only the tax authorities need to know about the financial position of the partnership.
Disadvantages of the Partnership Structure
Disadvantages of the Partnership Structure
However, there are limitations or disadvantages to setting up a business as a partnership. These potential drawbacks include:
As the business has more than one owner, this can easily lead to disagreements and conflict between the owners, which can seriously damage the running of the partnership.
Decision making is slower than with sole traders because there are more owners involved. This can also lead to disagreements and conflicts between the owners
Unlike with a sole trader, the profits made by a partnership must be shared between all the owners.
In general, partners have unlimited liability so are liable for any debts, fines, penalties or law suits against the business, even if this these were caused by another partner in the firm. However, sleeping partners are exempt from unlimited liability.
Compared to limited liability companies, access to finance is restricted to the finances available from the different partners in the firm. There is no maximum number of owners in limited liability companies, so they can raise finance through their shareholders.
There is no continuity if a partner decides to leave the firm or if one of the partners die. This is because such cases would void the Deed of Partnership. There would be a time delay in setting up a new partnership agreement.
Incorporated Ownership Structures
Incorporated Ownership Structures
Companies (also known as corporation) are commercial for-profit businesses owned by shareholders. Hence, the profits of a company belong to and are shared among the various owners. As incorporated businesses, the owners have limited liability.
Limited liability protects shareholders who cannot lose more than the amount they invested in the business. This is because shareholders are not personally liable for the debts of the company should it go into debt or bankruptcy. In legal terms, there is a divorce of ownership and control as the owners (shareholders) are treated as separate legal entities from those who control and run the business (the board of directors and CEO). It is the board of directors and the CEO (or managing director) who are responsible for the strategic direction of the company.
Whilst the specific language used to identify the two main types of companies varies depending on the country that the business is operating in, it is commonly accepted that there are two categories of limited liability companies (LLC), these are:
Private Limited (or Privately Held) Businesses, and
Public Limited (or Publicly Held) Businesses.
Private Limited (or Privately Held) Business
Private Limited (or Privately Held) Business
A Private Limited Company is owned by its shareholders who are typically the directors of the business and shares cannot be offered to the general public.
The company and its owners are separate legal entities, i.e., there is a legal divorce (separation) of ownership and control, with the owners (shareholders) appointing a board of directors to run the company on their behalf.
Owners have limited liability, so if the business experiences a financial collapse, then the owners will only be liable for the capital they invested in the company.
Most privately held companies (often referred to as private limited companies) are small businesses, with shares typically owned by family, relatives, and friends.
The ownership of a limited company is divided up into equal parts called shares and the owners are now classed shareholders.
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These shares cannot be advertised for sale nor sold via a stock exchange such as the New York Stock Exchange.
There is usually no legal requirement for the company to publish detailed financial accounts for the general public (this is only needed for corporate tax purposes).
Common examples of a Private Limited Company are local retailers, such as a high street shop or a restaurant.
Advantages of the Private Limited Company Structure
Advantages of the Private Limited Company Structure
The advantages of establishing a business as a private limited (or privately held) company as a type of for-profit (commercial) organization include the following points:
There is better control of a privately rather than publicly held company, as shares in a privately held company cannot be bought or sold without the agreement of existing shareholders.
Significantly more finance can be raised compared with a sole trader (one owner) or a partnership (up to 20 owners).
Privately held companies have greater privacy compared to publicly held companies; the latter must make their final accounts available to the general public.
Shareholders have limited liability, so cannot lose more than what they invest in the company. Owners are protected against any misconduct or misjudgements of those who run the company.
Unlike a sole trader or partnership, a privately held company can enjoy continuity in the event of the death of a major shareholder.
Disadvantages of the Private Limited Company Structure
Disadvantages of the Private Limited Company Structure
However, the potential limitations (or disadvantages) of being a private limited (or privately held) company include:
Privately held companies can only sell their shares to family, friends, and employees, with the approval of the majority of existing shareholders. This can make it difficult to buy and sell shares in the company.
They are more expensive to operate than a sole trader or partnership. For example, there are higher legal fees and auditing fees (for checking and approving of the financial accounts).
A privately held company can become a target for a takeover by a larger company which purchases a majority stake, although other owners have to agree to the sale of the company.
Public Limited (or Publicly Held) Company
Public Limited (or Publicly Held) Company
Also known as a joint-stock company or publicly held company, a public limited company is owned by shareholders with the shares being bought and sold by the general public, without the need for the prior approval of existing owners.
Shares in a publicly held company can be bought and sold via a stock exchange (or stock market), such as the New York Stock Exchange (NYSE), London Stock Exchange, Hong Kong Stock Exchange, Tokyo Stock Exchange, Shanghai Stock Exchange, and the National Association of Securities Dealers Automated Quotations (NASDAQ).
When a company first sells its shares to become a publicly held company, it does so through an initial public offering (IPO) via a stock exchange.
In order to protect shareholders, publicly held companies are strictly regulated and are required to publish their final accounts each year.
As there is no legal limit placed on the maximum number of shareholders in a publicly held company, the company can raise a significant amount of finance so long as it can attract investors.
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Advantages of the Public Limited Company Structure
Advantages of the Public Limited Company Structure
The advantages of establish a business as a public limited company as a type of for-profit (commercial) organization include the following points:
Additional finance can be raised through a share issue (the process of subsequently selling more shares in a company). Hence, it is easier for publicly held companies to obtain finance from a stock exchange to fund its growth and evolution by selling additional share capital. In 2010, Brazil’s state oil company Petrobras raised $70 billion, in the world’s largest share issue.
It is also easier for large publicly held companies to borrow money from bank loans and mortgages, due to their lower level of risk for financial lenders.
As with privately held companies, the shareholders of publicly held companies enjoy limited liability.
Large publicly held companies get to enjoy the benefits of operating on a large scale, such as opportunities to exploit economies of scale, market share, and market power.
As with privately held companies, publicly held companies enjoy continuity even if a principal or major shareholder leaves the organization or passes away.
Disadvantages of the Public Limited Company Structure
Disadvantages of the Public Limited Company Structure
The limitations or drawbacks of being a public limited company include the following points:
There is a lack of privacy because the general public have access to the financial accounts of publicly held companies.
Limited liability companies must produce an Annual Report and Final Accounts, which includes details such as the reporting of profits (or losses) in the Profit & loss account, as well as the assets of the business and where cash has been spent during the last twelve months in the Balance sheet. These final accounts are scrutinised by an external auditor (usually chartered accountants) before the information is distributed to shareholders. As a legal requirement, this can be quite an expensive and time-consuming task, especially for larger multinational companies.
Publicly held companies are the most administratively difficult and expensive form of commercial for-profit business to set up and run. For example, there are high costs of complying with the rules and regulations of the stock market.
As the general public can buy and sell share freely, there is always a potential threat that a rival company will make a takeover bid.
Large companies can suffer from diseconomies of scale. Being too large can cause inefficiencies in the company, and hence higher average costs of production.
Franchises
Franchises
Franchising is often confused as a business ownership structure, when in fact it is an agreement between two different businesses. Just like a deed of partnership governs the responsibilities of each partner in a business, the franchising agreement is a legal document that sets out the rights and responsibilities of each party involved in the franchise. The franchising agreement will clearly identify one business as the franchisor, and another business as the franchisee.
Under the franchising agreement, the franchisor will give the legal rights to a franchisee to buy, own and sell goods and services using the franchisor’s brand. For this privilege, the franchisee has to buy the right to use the brand name and business model of the established franchisor. In addition, the buyer must also pay royalties to the franchisor, based as a re-determined percentage of the franchisee’s sales revenues. They are also contractually obliged to respect and follow the cultural norms and corporate practices of the franchise business organization.
Franchisees (the businesses buying the rights to another businesses brand and intellectual property) are often sole traders who own and run a single unit, but they can also be partnerships or large business organizations. Franchising is hugely popular in the fast food, hotels and restaurants industries.
As with all forms of businesses, establishing a franchisee can be very expensive. Franchisee need to make a significant up-front financial investment in the franchise. For example, to purchase a franchised McDonald's restaurant means having at least £100,000 ($135,000) in unencumbered funds (sources of finance that are free of debt or other financial liability). In addition, franchisees need to prove they can lead and work within the McDonald's framework to give both the franchisee and franchisor (McDonald's) the greatest chance of success. This screening process can take over 12 months, before a franchise agreement is approved.
Advantages and Disadvantages of Franchising for the Franchisor
Advantages and Disadvantages of Franchising for the Franchisor
Advantages of Franchising for the Franchisor
Advantages of Franchising for the Franchisor
Franchising is a faster method of growth. It is advantageous for the franchisor to use partner firms to purchase, own and run additional franchised outlets. This means franchising can actually be cheaper than other methods of growth for the franchisor.
Franchisees fund the growth of the franchise as they pay an upfront fee to purchase the franchise license. In addition, the franchisor received royalties, usually calculated as a percentage of the franchisee’s sales revenues.
The franchisor benefits from selling the franchise agreement to someone who has been vetted and is more motivated to succeed than salaried managers employed to run a particular store, unit or outlet.
The franchisor, in its pursuit of growth in other geographical locations, can also again from the franchisee’s local knowledge.
Disadvantages of Franchising for the Franchisor
Disadvantages of Franchising for the Franchisor
The franchisor’s corporate image and brand reputation is at risk if a franchisee is negligent and/or incompetent. Breaking the franchise agreement with such franchisees can be a both time consuming and costly.
Therefore, although not the owner of a franchised outlet, the franchisor still needs to ensure quality standards are met. This means the franchisor may need to closely monitor the operations of their franchisees; after all, their reputation and overall business model is at stake.
The franchisee, as the owner of the franchised unit, gets to keep the profits they generate. This would not be the case if the franchise chose to grow organically.
The franchise method of growth is not applicable to all businesses as they lack the expertise, resource and brand awareness to attract buyers (franchisees).
Advantages and Disadvantages of Franchising for the Franchisee
Advantages and Disadvantages of Franchising for the Franchisee
Advantages of Franchising for the Franchisee
Advantages of Franchising for the Franchisee
The success rate of franchising is very high in most industries. Franchisees gain access to a tried and test business model.
In many cases, the franchisee benefits from the brand recognition and brand loyalty established by the franchisor. Hence, there are opportunities for the franchisee to earn large profits.
Franchisees receive ongoing support and expert advice from the franchisor, such as upskilling training, market research findings, and legal advice. This improves the chances of success for the franchisees. For example, before a person is approved to operate as a McDonald's franchisee, they have to complete a comprehensive restaurant training programme for a minimum of 26 weeks.
They gain from the purchasing economies of scale of the franchisor, rather than facing much higher costs (of inventory, for example) if operating as a sole trader of a much smaller, independent organization.
Disadvantages of Franchising for the Franchisee
Disadvantages of Franchising for the Franchisee
Buying a franchise is usually very expensive. Even so, the process of applying for a franchise license is typically complex and time consuming. Even after paying for the start-up costs and running costs of the business, the franchisee must also pay a percentage of its sales revenues to the franchisor as royalty payments. This can cut a franchisee’s profit margins quite substantially.
The franchisee is constrained by the standards and practices set by the franchisor. The franchisee must follow the franchisor’s established business model, without scope for truly independent decision making or innovation.
Like the franchisor, each individual franchisee is at risk of a damaged reputation if another franchisee of the business makes a serious blunder.
Learning Activity - Compare and contrast two businesses
Learning Activity - Compare and contrast two businesses
franchises---buying-a-mcdonald-s-franchise-(br-sept-2013)(1).pdffranchises---running-a-mcdonald-s-franchise-(br-nov-2013).pdfCo-operative (Not-for-profit)
Co-operative (Not-for-profit)
Cooperatives are for-profit social enterprises that are owned and managed by their members.
Examples are employee cooperatives, producer cooperatives, managerial cooperatives and customer cooperatives. Cooperatives exist throughout the world, but are predominant in the agricultural and retail sectors of the economy in many parts of Europe.
According to the United States Federation of Worker Cooperatives (USFWC), there were 612 worker cooperative in the US in 2021, generating a gross revenue of $283 million. Globally, there are around 3 million organizations set up as a cooperative and around 12% of the world population are members of at least one of these cooperatives.
Common ‘members’ of a co-operative include customers, employees, and local residents, with each member having a chance to express their views and share the business’ profits.
Features of Co-Operatives
Features of Co-Operatives
As a category of for-profit social enterprises, cooperatives strive to provide a service for the members, providing and creating value, instead of seeking to earn a desired level of profit margin for their member-owners. However, any profits of the cooperative are shared with its members.
Most cooperatives are registered as limited liability organizations. Like limited liability companies, cooperatives have a separate legal entity from their shareholder owners. Hence, shareholders, directors, managers, and employees are not held personally liable for any debts incurred by the cooperative.
All member shareholders are expected to help run the cooperative, although it is overseen by an elected board of directors that makes long-term strategic decisions.
All members of a cooperative have equal voting rights, irrespective of their role in the business or their level of investment in the cooperative.
Members of a cooperative have limited liability, restricted to the amount they invested in the business.
Cooperatives tend to have a democratic culture, with empowerment of its members to make decisions. The organizational structure is rather flat as there is decentralised decision making
Advantages of the Co-Operative Company Structure
Advantages of the Co-Operative Company Structure
The advantages of establishing cooperatives as a form of for-profit social enterprise include:
Cooperatives are not difficult or expensive to set up.
Cooperatives are tax exempt because the focus of the business is on serving the collective interests of its member-owners and the community (such as home care associations for the elderly).
As all member shareholders are expected to help run the cooperative, it is more likely to succeed.
Similarly, as the owners have equal voting rights, the cooperative is more democratic so the members feel equally important to the success of the business. This is likely to lead to a harmonious working environment.
There is an absence of pressure from external investors and shareholders, so the member-owners of the cooperative can run the business that best suits their own interests.
As cooperatives strive to benefit their members and society, they often qualify for government financial support.
Unlike partnerships or sole traders, there is continuity in a cooperative should a key owner leave the organization, for whatever reason.
Disadvantages of the Co-Operative Company Structure
Disadvantages of the Co-Operative Company Structure
However, there are potential drawbacks of establishing a business as a cooperative. These include the following points:
As cooperatives are not profit-driven, it can be difficult to attract investors, financiers and member-shareholders.
Similarly, employees and managers of cooperatives may lack the financial motivation to excel, due to the absence of a profit motive.
Most cooperatives have very limited sources of finance as their capital depends on the amount contributed by their members.
Most cooperatives are unable to hire a range of specialist managers to run the business, due to the lack of financial rewards and sources of finance to remunerate their senior staff. This can limit the success of the cooperative.
A democratic culture is not always effective. Despite some members having more to contribute to the organization and greater responsibilities, they only get one vote as do all other members. This can be somewhat inefficient and perceived as unfair for some members.
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