Types of Firms: Sole Proprietorships and Partnerships

• The major types of firms include sole proprietorships, partnerships, limited liability companies, private limited companies (Ab), and public limited companies (Abp).

Sole Proprietorships

• A sole proprietorship is a business owned and run by one person.
• This is the most common type of firm worldwide, accounting for 71% of businesses in the US but only 5% of the revenue.
• Setting up a sole proprietorship is straightforward.
• Other investors cannot hold an ownership stake in the firm.
• The owner has unlimited personal liability for the firm's debts and the life of the sole proprietorship is limited to the life of the owner.
• Disadvantages outweigh the advantages for most businesses.
• Owners typically convert the business into a form that limits the owner's liability.

Partnerships

• Partnerships are identical to sole proprietorships, except it has more than one owner.
• All partners are liable for the firm's debt, and a lender can require any partner to repay all the firm's debts.
• The partnership ends with the death or withdrawal of any single partner.
• Partners can avoid liquidation with alternatives like a buyout.
• Limited partnerships have two kinds of owners: general partners and limited partners
• General partners have the same rights and privileges as in sole proprietorships
• Limited partners have limited liability to their investment in the firm
• A death or withdrawal of a limited partner does not dissolve the partnership, and a limited partners liability is transferable
• A limited partner has no management authority and cannot legally be involved in the managerial decision making
• They are dominated by private equity funds and venture capital funds
• Partnerships are used to maintain client confidence.

Limited Liability Companies

• Limited liability companies (LLCs) limit the owners' liability to their investment, where owners cannot be held personally liable for the company's debts.
• LLCs are divided into private and public companies.
• Private companies are not allowed to trade their shares on an organized exchange.
• Public companies may be listed but most choose not to be.

Corporations

• A corporation is a legally defined artificial being, separate from its owners.
• Corporations can enter into contracts, acquire assets, and incur obligations.
• They enjoy protection from seizure of property and are solely responsible for their own obligations.
• The owners are not liable for the corporation's obligations, and the corporation is not liable for the personal obligations of its owners.
• Corporations must be legally formed with a legal document creation upon formation.
• A corporation is a citizen of the state where it is incorporated.
• The corporate charter specifies the initial rules and the entire ownership is divided into shares of stock, where the collection of all outstanding shares is equity.
• An owner is a shareholder, stockholder, or equity holder and is entitled to dividend payments.
• There is no limitation on who can own a corporation's shares.
• Corporations can raise substantial capital by selling ownership shares to outside investors.

Tax Implications for Corporate Entities

• A corporation's profits are subject to taxation separately from its owners' obligations.
• An alternative system for double taxation is known as the imputation system.
• Dividends are considered a flow of profits direct to the shareholders and are not subject to double taxation.

The Financial Manager

• The financial manager makes the financial decisions for the business's investors (shareholders).
• The financial manager's tasks are to make investment decisions, make financing decisions, and manage the firm's cash flows.
• Making investment decisions: the financial manager weighs costs and benefits of investments/projects to determine good uses of shareholders' money in the firm
• These decisions give the shareholders a fundamental picture of the firm's activities and whether it adds value to their investment.
• The picture the investors have of whether a corporation can add value to their capital is essential for gaining investors and raise substantial amount of capital for the corporation's projects
• Making financing decisions requires figuring out how to pay for after deciding which investments to make
• The corporation may have to sell more shares (equity) or borrow money (bonds, debt).
• Treasury Management means ensuring the firm has enough cash to meet obligations day to day, which is managing working capital.
• Working capital refers to cash on hand, inventories, raw materials, loans to suppliers, and payments from customers.
• Companies spend a significant amount of cash before the sales of the product generate any income.

The Goal of the Firm

• Management should make decisions that increase the value of shares, according to shareholders who agree they are better off if this happens
• The board of directors and the management team headed by the chief executive officer (CEO) possesses direct control of the corporation
• Shareholders control board elections, a group of people with ultimate decision-making authority.
• The board sets the rules on how the corporation should be run, how top managers should be compensated, sets policy, and monitors performance.
• The CEO runs the corporation via policies set by the board.
• The most senior financial officer is the chief financial officer (CFO) or financial director.

Ethics and Incentives within Corporations

• Some argue separate management and ownership does not work in the interest of shareholders, the management works against their self-interest.
• An agency problem arises when managers put their self-interest ahead of the shareholders.
• Agency problems are addressed when the managers' interests are tied to the corporation's profits or its share price.
• Compensation contracts can reduce managers' risk by rewarding good performance, but managers may take excessive risk if limited penalty is associated with poor performance.
• A man's benefit may be another's loss, leading to conflicts of interest amongst shareholders.
• Good management increases stock value and vice versa.
• Dissatisfied investors may sell shares.
• A hostile takeover can occur if an individual or organization purchases a large fraction of equity to replace the board and the CEO.

The Stock Market

• Many corporations are public whose shares trade on an organized market (stock market, stock exchange or bourse).
• These markets provide liquidity for a company's shares and determine the market price for the shares
• An investment is liquid if it can be easily turned into cash.
• Examples include the New York Stock Exchange (NYSE), American Stock Exchange (AMEX), National Association of Security Dealers Automated Quotation system (NASDAQ), London Stock Exchange (LSE), Tokyo Stock Exchange (TSE), and NYSE Euronext.
• The primary market refers to a corporation issuing new shares and selling them to investors
• The shares then continue to trade in a secondary market without the involvement of the corporation
• The NYSE is an example of a physical market where market makers match buyers and sellers
• The stocks have two prices: the bid price and the ask price
• Bid price: The price at which a market maker or specialist is willing to buy a security
• Ask price: The price at which a market maker or specialist is willing to sell a security
• Bid-ask spread: The amount by which the ask price exceeds the bid price
• Transaction cost: E.g. the bid-ask spread; an expense such as a broker commission and the bid-ask spread that investors must pay in order to trade securities
• Large investment banks and brokerages buy trading licenses that entitle them to access the floor and trade on the exchange
• Auction market: Is a market where share prices are set through direct interaction of buyers and sellers
• Over-the-counter (OTC) market: Is a market without a physical location, which dealers are connected by computers and telephones (NASDAQ for example)
• An important difference between (physical) auction markets and OTC markets is that OTC markets can have multiple market makers for each share
• Because investors do not directly interact to set the prices, OTC markets are dealer markets
• Dealer market: A market in which dealers buy and sell for their own accounts
• Listing standards: Outlines of the requirements a company must meet to be traded on the exchange
• Many exchanges compete over listings of larger companies.

Financial Institutions

• Financial institutions are entities that provide financial services such as taking deposits, managing investments, brokering financial transactions or making loans
• Financial institutions have a role beyond moving funds from those who have extra funds (savers) to those who need funding (borrowers and firms): they also move funds through time
• Financial institutions also help spread out risk-bearing
• Mutual funds and pension funds take the savings and spread them out among the stocks and bonds of many different companies, limiting the risk exposure to one company (not all eggs in the same basket)