Form of OwnershipForm of

Ownership

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Choosing a Form of Ownership

There is no one “bestbest” form of ownership.

The best form of ownership depends on an entrepreneur’s particularparticular situationsituation.

KeyKey: Understanding the characteristics of each form of ownership and how well they match an entrepreneur’s business and personal circumstances.

Factors Affecting the ChoiceTax considerations

Liability exposureStart-up and future capital

requirementsControlManagerial abilityBusiness goalsManagement succession

plansCost of formation

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Structuring the New Venture

There exists a number of different business structures that differ in several important aspects.

The most common Forms of Business Organization are:

Sole proprietorship Partnership Corporation

Other Forms of Ownership

S CorporationLimited Liability CompanyJoint Venture

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Sole Proprietorship The sole proprietorship is a form of

business organization in which an

individualindividual introduces his capitalcapital, use of his

own skillskill and intelligence in the

managementmanagement of its affairs and is solely responsible for the results of its operation.

In the eye of the law, there is no no

distinction distinction between the business and the individual’s private affair

Advantages of the Sole Proprietorship

Simple to createLeast costly form to beginProfit incentiveTotal decision-making authorityNo special legal restrictionsEasy to discontinue

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Disadvantages of the Sole Proprietorship

Unlimited personal liabilityLimited skills and capabilitiesFeelings of isolationLimited access to capitalLack of continuity

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Liability Features of the Basic Forms of Ownership

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Sole Proprietorship

Claims of Sole Proprietor’s CreditorsClaims of Sole Proprietor’s Creditors

Sole Proprietor’s Personal AssetsSole Proprietor’s Personal Assets

Sole ProprietorshipExample: Photo studio, bookshop,

bakeries, small town restaurants, retail stores, radio and watch repair shops, and other elementary forms of business where personal service is important.

It is frequently the most appropriate form of a new business.

It’s also called sole ownership and sole ownership and individual proprietorship.individual proprietorship.

PartnershipAn association of two or more two or more

people people who co-own co-own a business for the purpose of making a profit.

Always wise to create a partnership agreementpartnership agreement.

Best partnerships are built on trust and respecttrust and respect.

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Types of PartnersGeneral partnersGeneral partners

Take an active role in managing a business.Have unlimited liability for the

partnership’s debts.Every partnership must have at least one

general partner.Limited partnersLimited partners

Cannot participate in the day-to-day management of a company.

Have limited liability for the partnership’s debts.

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Limited Partnership

A partnership composed of at least one general partner and one or more limited partners.

General partner in this partnership is treated exactly as in a general partnership.

Limited partner has limited liability and is treated as an investor in the business.

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Other Types of Partners Secret partnerSecret partner

Takes an active role in managing a partnership but whose identities are unknown to the public. i.e. general public does not know of this person’s partnership.

Silent partnerSilent partnerAs opposed to a secret partner, his/her identity and involvement, is known to the general public, but is inactive in managing the business.

Dormant or sleeping partnerDormant or sleeping partnerIs nether known to the general public nor active in management.

Others???

Advantages of Partnership

Easy to establishComplementary skills of partnersDivision of profit between partners Larger pool of capitalAbility to attract limited partners

Definite legal status

Motivation of important employees

Tax advantage over a corporation

Flexibility

Disadvantages of the Partnership

Unlimited liability of at least one partner

Capital accumulationDifficulty in disposing of partnership

interestLack of continuityLack of harmony between partners Potential for personality and

authority conflictsPartners bound by law 18

Liability Features of the Basic Forms of Ownership

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Partnership

Claims of Partnership’s CreditorsClaims of Partnership’s Creditors

Partnership’s AssetsPartnership’s AssetsGeneralPartner’sPersonalAssets

GeneralPartner’sPersonalAssets

GeneralPartner’sPersonalAssets

GeneralPartner’sPersonalAssets

CorporationA separate legal entity from its

owners.Types of corporations:

DomesticDomestic – a corporation doing business in the region in which it is incorporated.

ForeignForeign – a corporation doing business in a region other than the region in which it is incorporated.

AlienAlien – a corporation formed in country but doing business in another country. 20

Corporation

Types of corporations:Publicly heldPublicly held – a corporation that has

a large number of shareholders and whose stock usually is traded on one of the large stock exchanges.

Closely held Closely held – a corporation in which shares are controlled by a relatively small number of people, often family members, relatives, or friends.

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Corporation

Is also known as Joint Stock Joint Stock Company

A corporation is an artificial person artificial person authorized and recognized by lawauthorized and recognized by law, with distinctive name and a common seal.

It comprises of transferable shares transferable shares of fixed values, carrying limited liability and having a perpetual or continued or uninterrupted succession of life.

Characteristics of CorporationSeparate legal entity

It can sue or be sued.

It has the right to manage its own affairs.

Shareholders cannot be liable for the acts of the corporation.

Limited liability

Since the corporation has separate legal entity its debts are its own. The assets and liabilities, rights and obligations incidental to the company’s activities are of the company and not of its members.

Characteristics of Corporation

Transferability of shares Transferability of shares It is easy to transfer ownership in a corporation.

A stockholder may sell stock to another person and transfer the membership and membership interest freely without consulting other stockholders.

Perpetual existence Perpetual existence Death, insanity, retirement and withdrawal of

shareholders will not affect the company. Common sealCommon seal

A corporation has a common seal with the name of the company engraved on it, which is used as a substitute for its signature through its agents.

Characteristics of Corporation

Separation of ownership from Separation of ownership from managementmanagement All shareholders, large in numbers, do

not have the opportunity of managing the day-to-day activity of the corporation.

SupervisionSupervision A company is created by the legal

process of incorporation. While it exists, it is subject to detailed regulation

It has a written constitutionIt has a written constitution

Advantages of the Corporation

Limited liability of stockholdersAbility to attract capitalAbility to continue indefinitelyTransferable ownership

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Advantages of a Corporation

Legal entity status

Managerial efficiency

Financial strength

Scope of expansion is high

Disadvantages of a Corporation

Lack of owner’s personal interestowner’s personal interest

Difficulty of formation/Cost and timeCost and time

Delay in decisiondecision making

Lack of secrecysecrecy

Oligarchy and fraudulent managementmanagement

Potential for diminished managerial incentivesincentives

Potential lossloss ofof controlcontrol by founder(s)

Double taxationDouble taxation

Liability Features of the Basic Forms of Ownership

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Corporation

Claims of Corporation’s CreditorsClaims of Corporation’s Creditors

Corporation’s AssetsCorporation’s Assets

Shareholder’sPersonal AssetsShareholder’sPersonal Assets

Shareholder’sPersonal AssetsShareholder’sPersonal Assets

BarrierBarrierBarrier

Barrier

S CorporationNo different from any other

corporation from a legal perspective.For tax purposes, however, an S

corporation is taxed like a partnership, passing all of its profits (or losses) through individual shareholders.

To elect “S” status, all shareholders must consent, and the corporation must file with some requirements

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Liability Features of the Basic Forms of Ownership

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S-Corporation

Claims of S-Corporation’s CreditorsClaims of S-Corporation’s Creditors

S-Corporation’s AssetsS-Corporation’s Assets

Shareholder’sPersonal AssetsShareholder’sPersonal Assets

Shareholder’sPersonal AssetsShareholder’sPersonal Assets

BarrierBarrierBarrier

Barrier

Limited Liability Company (LLC)

Resembles an S corporation but is not subject to the same restrictions.

Two documents required: Articles of organizationOperating agreement

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Limited Liability Company (LLC)

An LLC cannot have more than two of these four corporate characteristics:Limited liabilityLimited liabilityContinuity of lifeContinuity of lifeFree transferability of interestFree transferability of interestCentralized managementCentralized management

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Liability Features of the Basic Forms of Ownership

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Limited Liability Company (LLC)

Claims of LLC’s Creditors Claims of LLC’s Creditors

LLC’s Assets LLC’s Assets

Member’sPersonal AssetsMember’sPersonal Assets

Member’sPersonal AssetsMember’sPersonal Assets

BarrierBarrierBarrier

Barrier

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Reading Assignment?

What other forms of business structures exist?

FranchisingFranchising

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Franchising

A system in which semi-semi-independent business owners independent business owners (franchisees) pay fees and royalties (franchisees) pay fees and royalties to a parent company (franchiser) in to a parent company (franchiser) in return for the right to become return for the right to become identified with its trademark, to sell identified with its trademark, to sell its products or services, and often its products or services, and often to use its business format and to use its business format and system. system.

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Cont…Franchising: A legal arrangement legal arrangement by which

one company allows its products, services, or business format to be used by others for a fee

Franchisee: A company or individual who individual who pays for the legal right pays for the legal right to use the product, service, or format of another

Franchisor: A company that grants company that grants to another company or individual the legal right to use its product, service, or format

Franchising Basics

Franchisee gets the right to useuse all of the elements of a fully integrated fully integrated business operation.

Essence of what franchisees purchase from the franchisers: ExperienceExperience.

Key Question: What can a franchise do for me that I cannot do for myself?

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• Businesses for which franchising works best have the following characteristics:• Businesses with a good track record good track record

of profitability. • Businesses which are easily easily

duplicatedduplicated.

• Franchising offers franchisees the advantage of starting up quickly based on a proven trademarkbased on a proven trademark, and the tooling and infrastructure as opposed to developing them.

Franchising Basics

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• Two important payments are made to a franchisor: • (a) A royaltyroyalty for the trade-

mark and • (b) ReimbursementReimbursement for the

training and advisory services given to the franchisee

• These two fees may be combined in a single 'management' fee

Franchising Basics

The Franchising Boom !!!

Annual sales of more than $1 trillion of almost every product or service imaginable.

Franchise sales account for 44 percent of total retail sales.

A new franchise opens somewhere in the world every six-and-a-half minutes.

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Boom!

The Franchising Relationship

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The Franchiser The Franchisee

Oversees and approves; may choose site

Provides prototype design

Makes general recommendations and training suggestions

Determines product or service line

Can only recommend prices

Establishes quality standards; provides list of approved suppliers; may requirefranchisees to purchase from the franchisor

Develops and coordinates national adcampaign; may require minimum level ofspending on local advertising

Sets quality standards and enforces themwith inspections; trains franchisees

Provides support through an establishedbusiness system

Chooses site with franchiser’s approval

Pays for and implements design

Hires, manages, and fires employees

Modifies only with franchiser’s approval

Sets final prices

Must meet quality standards; must purchaseonly from approved suppliers; must purchasefrom franchisor if required.

Pays for national ad campaign; complies withlocal advertising requirements; gets franchisorapproval on local ads

Maintains quality standards; trains employeesto implement quality systems

Operates business on a day-to-day basis withfranchiser’s support

Site selection

Design

Employees

Products and services

Prices

Purchasing

Advertising

Quality control

Support

Element

Source: Adapted from Economic Impact of Franchised Businesses: A Study for the International Franchise Association, National Economic Consulting Practice ofPriceWaterhouseCoopers, (IFA Educational Foundation, New York: 2004), pp. 3,5.

Types of Franchising

Trade name

Product distribution

Pure (Business format)

Others

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Benefits of Franchising

Management trainingtraining and supportsupportStart-upOngoing

BrandBrand name appeal

StandardizedStandardized qualityquality of goods and services

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Benefits of Franchising

NationalNational advertisingadvertising programFranchisees contribute 1

percent to 5 percent of sales

Financial assistanceFinancial assistanceSome franchisers offer

financial assistance to franchisees.

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Benefits of Franchising

Proven products and business formats

Centralized buying powerSite selection and territorial

protectionGreater chance for success

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Drawbacks of Franchising

Franchise fees and ongoing royaltiesAverage initial franchise investmentRoyalties range from 1 percent to 11

percent of franchisees’ salesStrict adherence to standardized

operationsRestrictions on purchasing

Approved suppliers only

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Drawbacks of FranchisingLimited product lineContract terms and renewal

Average term = 10.3 yearsUnsatisfactory training

programsMarket saturationLess freedom

“Happy prisoners”

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Ten Myths of Franchising1. Franchising is the safest way to go into

business because franchises never failfranchises never fail.

2. I’ll be able to open my franchise for less money less money than the franchiser estimates.

3. The biggerbigger the franchise organization, the more successful I’ll be.

4. I’ll use 80 percent of the franchiser’s business system, but I’ll improveimprove upon it by substituting my experience and know-how. 55

Ten Myths of Franchising

5. All franchises are the samesame.6. I don’t have to be a hands-on

manager. I can be an absenteeabsentee ownerowner and still be very successful.

7. Anyone can be a satisfiedsatisfied, successfulsuccessful franchise owner.

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Ten Myths of Franchising

8. Franchising is the cheapestcheapest way to get into business for yourself.

9. The franchiser will solve my business solve my business problemsproblems for me; after all, that’s why I pay an ongoing royalty fee.

10. Once I open my franchise, I’ll be able to run things the way I want to.way I want to.

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In Ethiopia …

Sources of Funds:Equity and Debt

Sources of Funds:Equity and Debt

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Financing Ventures How will you finance your

business?

Where do you find the money? (Source of Capital)

What is capital?Capital is the amount of cash and other assets owned by a business.

Capital can also represent the accumulated wealth of a business, represented by its assets less liabilities.

Capital can also mean stock or ownership in a company.

Three Types of Capital

FixedFixed - used to purchase the permanent or fixed assets of the business (e.g., buildings, land, equipment, and others).

WorkingWorking - used to support the small company's normal short-term operations (e.g., buy inventory, pay bills, wages, or salaries, and others).

GrowthGrowth - used to help the small business expand or change its primary direction.

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Capital is any form of wealth Capital is any form of wealth employed to produce more employed to produce more wealth for a firm.wealth for a firm.

Debt Capital and Equity Capital

Equity CapitalRepresents the personal investment personal investment

of the owner(s) in the business. Is called risk capital risk capital because

investors assume the risk of losing their money if the business fails.

Does notnot have to be repaid have to be repaid with interest like a loan does.

If other people are involved, means that an entrepreneur must give up some ownership in the company to outside investors.

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Debt Capital

Must be repaid with interestrepaid with interest. Is carried as a liabilityliability on the

company’s balance sheet.Can be just as difficult to secure as

equity financing, even though sources of debt financing are more numerous.

Can be expensiveexpensive, especially for small companies, because of the risk/return tradeoff.

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Raising Capital

Raising capital to launch or expand a business is a challenge.

Many entrepreneurs are caught in the “credit crunch.”

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How will you finance your business?What Is Financing ?

Means of obtaining the resources to purchase an item, then paying back the loan in a set time period.

Financing is typically categorized into two fundamental types: debt debt financing financing and equity financingequity financing.

How will you finance your business? Debt financing:

Means borrowing money that is to be repaid

over a period of time, usually with interest.

Can be either short-term or long-term

The lender does not gain an ownership lender does not gain an ownership

interest in your business. In smaller

businesses, personal guarantees are likely

to be required on most debt instruments

How will you finance your business?Equity financing

Describes an exchange of money for a share exchange of money for a share

of business ownership of business ownership (without having to

repay a specific amount of money at any

particular time)

The major disadvantage to equity financing is

the dilution of your ownership dilution of your ownership interests and

the possible loss of control loss of control that may

accompany a sharing of ownership with

additional investors.

Sources of finance

Sources of Finance

Internal Sources

(Owner capital or owners equity)

External Sources

(Borrowed or debt capital)

Sources

Internal Sources

Personal saving

Friends and relatives

Partners

Public stock sale (going

public)

External SourcesCommercial banksTrade creditEquipment suppliersCredit unionsInsurance companies

Sources

The “Secrets” to Successful Financing

1. Choosing the right sources of capital is a decision

that will influence a company for a lifetime.

2. The money is out there; the key is knowing where

to look.

3. Raising money takes time and effort.

4. Creativity counts. Entrepreneurs have to be as

creative in their searches for capital as they are in

developing their business ideas.

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The “Secrets” to Successful Financing

5. The World Wide Web puts at entrepreneur’s fingertips vast resources of information that can lead to financing.

6. Be thoroughly prepared before approaching lenders and investors.

7. Entrepreneurs should not underestimate the importance of making sure that the “chemistry” among themselves, their companies, and their funding sources is a good one.

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Layered Financing

Entrepreneurs must cast a wide net to capture the financing they need to launch their businesses.

LayeringLayering – piecing together capital from multiple sources.

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Sources of Equity FinancingPersonal savingsFriends and family membersPartnersCorporationsVenture capital companiesPublic stock sale

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Personal Savings

The first place an entrepreneur should look for money.

The most common source of equity capital for starting a business.

Outside investors and lenders expect entrepreneurs to put some of their own capital into the business before investing theirs.

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Friends and Family Members

After emptying their own pockets, entrepreneurs should turn to those most most likely to invest likely to invest in the business: friends and family members.

Careful!!! Inherent dangers lurk in family/friendly business deals, especially those that flop.

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Friends and Family Members

Guidelines for family and friendship financing: Consider the impact of the investment on

everyone involved. Keep the arrangement “strictly business.” Settle the details up front. Never accept more than investors can afford to

lose. Create a written contract. Treat the money as “bridge financing.” Develop a payment schedule that suits both

parties. Have an exit plan.

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Commercial Banks

Short-term loansCommercial loansLines of creditFloor planning

Intermediate and long-term loans Installment loans and

contracts 80

...the heart of the financial market ...the heart of the financial market

for small businesses!for small businesses!

Commercial Bank

Banks provide unsecured and secured loans. But to secure a bank loanto secure a bank loan, an entrepreneur typically will have to answer a number of question

What do you plan to do with the money (credit facility)?

How much do you need? When do you pay back? After how long will you need it? How will you repay the loan?

Due to different reasons banks are more cautious more cautious in lending money since they cannot afford to incur more bad loans.

Most bankers refer to the five Cs ( Criteria) of credit in making lending decision.

Commercial Bank

Character

CollatralCondition

Five Cs

Capital

Capacity

Where Do You Find the Money?( Source of Finance) CapacityCapacity: The prospective lender will want to know exactly

how you intend to repay the loan. The lender will consider

the cash flow from the business, the timing of the

repayment, and the probability of successful repayment of

the loan.

CapitalCapital: is the money you personally have invested in the

business and is an indication of how much you have at risk

should the business fail. In some cases, it may need to be

at least 25% of the total amount needed to start your

business.

ConditionsConditions: Will the money be used for working

capital, additional equipment, or inventory?

CharacterCharacter is the general impression you make on the

potential lender or investor. The lender will form a

subjective opinion as to whether or not you are

sufficiently trustworthy to repay the loan or generate

a return on funds invested in your company. Your

educational background and experience in business

and in your industry will be reviewed.

Where Do You Find the Money?( Source of Finance)

CollateralCollateral: or "guarantees" are additional

forms of security you can provide the

lender. If for some reason, the business

cannot repay its bank loan, the bank wants

to know there is a second source of

repayment. Assets such as equipment,

buildings, accounts receivable and in some

cases inventory

Where Do You Find the Money?( Source of Finance)

Asset-Based Borrowing

Businesses can borrow money by pledging as collateral pledging as collateral otherwise idle assetsotherwise idle assets – accounts receivable, inventory, and others

Advance rateAdvance rate – the percentage of an asset’s value that a lender will lend.

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Asset-Based Borrowing

Discounting accounts receivable

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AccountsReceivable

Inventory financingInventory financing

Sources of Debt Capital

Commercial banks

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Vendor financing (trade Vendor financing (trade credit)credit)

Equipment suppliersEquipment suppliers Commercial finance Commercial finance

companiescompanies Saving and loan Saving and loan

associationsassociations

Asset-based lendersAsset-based lenders

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Sources of Debt Capital

Stock brokerage houses Insurance companiesCredit unionsBondsSmall Business Investment

Companies (SBICs)Small Business Lending

Companies (SBLCs)90

Internal Methods of Financing

Factoring - selling accounts receivable outright

Leasing - assets rather than buying them

Credit cards

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Going Public

Initial public offering (IPO) - when a company raises capital by selling shares of its stock to the public for the first time.

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Successful IPO Candidates

Consistently high growth ratesStrong record of earnings3 to 5 years of audited financial

statements that meet or exceed standards

Solid position in a rapidly growing industrySound management team with experience

and a strong board of directors

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Advantages of “Going Public”

Ability to raise large amounts of capital

Improved corporate image Improved access to future

financing Attracting and retaining key

employees Using stock for acquisitions Listing on a stock exchange

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Disadvantages of “Going Public”

Dilution of founder’s ownershipLoss of controlLoss of privacyFiling expensesAccountability to shareholdersPressure for short-term

performanceTiming

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