Forms of Business Ownership

WEEK TWO 1 Prepared by Dr. Jane N. Were  Introduction One of the important decisions that an entrepreneur needs to take before launching a business enterprise is that of selecting the form of business organization for his/ her venture. Choosing a legal entity for the vent...

WEEK TWO 1 Prepared by Dr. Jane N. Were  Introduction One of the important decisions that an entrepreneur needs to take before launching a business enterprise is that of selecting the form of business organization for his/ her venture. Choosing a legal entity for the venture is not a onetime event. The form of organization can be changed from time to time. As a business grows and matures, it becomes necessary to periodically review whether the current form of business remains appropriate. No single form of business organization works best in all situations and is appropriate. The entrepreneur thus needs to select the best form that meets his needs and that of the enterprise. Choice of business organization can be based on the following;  The type and size of business  The cost of starting and maintaining the form  Form of business liability applicable  Desired level of autonomy by the entrepreneur  Tax considerations  If and the number and type of investors one wishes to attract  The level of financing required 2 Prepared by Jane N. Were  Sole Proprietorship  A sole proprietorship is a business owned by one person. The owner may operate on his or her own or may employ others. The owner of the business has personal liability of the debts incurred by the business. A sole proprietorship is the least expensive and easiest way to start your business.  What is simpler than finding a location for your business and opening the doors? All right, I might have oversimplified it there, but it really is pretty easy. You will have to register a business name and obtain other local licenses which will depend on your local government. There will also be fees associated with obtaining them.  Hiring an attorney would be a smart move and the attorney fees will be less than other forms of business as there is a smaller amount of documents to be filed because the owner of the business has the final word in all business decisions. 3 Prepared by Dr. Jane N. Were  Advantages of Sole proprietorship  It is easy to start a one-person business because there are few legal intricacies. Compares to other forms of business organizations, sole proprietorships are easier and simpler to start and to wind up.  The sole trader takes all decisions alone. This means that decisions are made timely and quickly. Implementing of the decisions is also fast because very few people are involved.  The sole trader enjoys all the profit from his business and this may encourage him to work harder. He will also be more careful to avoid any losses because he knows that he will suffer the losses alone even from his private source.  Sole traders are in better position to establish direct contacts both with their customers and employees. Such contacts are more likely to lead to better understanding of employees and customer needs and result in provision of better services. Better services will mean greater success for the business. 4 Prepared by Dr. Jane N. Were  Disadvantages  The sole trader is personally liable for al the debts of the business. If the assets of the business are not enough to pay the liabilities, personal property can be attached by the creditors.  Sole traders are often unable to raise sufficient capital funds. They have to rely on their own ability to raise money to finance their own businesses. This is not always easy.  A sole trader may be unable to attract and/or keep highly qualified persons who seek opportunities to manage, operate, and share in the profit of the business. He may also not be able to retain good employees because of inability to provide them with attractive terms and conditions of service. 5 Prepared by Dr. Jane N. Were Sole proprietorships suffer from lack of continuity because the life of the business is usually limited to the life- span of the owner. This means that the business is likely to close down if the owner becomes bankrupt, dies, is unable to run the business or is imprisoned. Sole traders suffer from lack of training and/or specialization. They also have to work for long hours and also these may adversely affect performance, including net incomes. 6 Prepared by Dr. Jane N. Were  Formation & Dissolution  It is by registration by the Registrar of Business names at the Attorney General Office. Any name wished by the sole trader, (e.g., Mwangi & Sons, Patel & Sons or Joy Salon). It is maintained by licenses from the local authorities.  Dissolution  No formality is required. 7 Prepared by Dr. Jane N. Were  Partnership  A partnership is a form of business in which two to twenty people operate for the common goal which is often making profit. In most forms of partnerships, each partner has personal liability of the debts incurred by the business. There are three typical classifications of partnerships: general partnerships, limited partnerships, and limited liability partnership.  The two most common types of partnerships are limited partnerships and general partnerships. Two to twenty people can form a general partnership through a simple oral agreement. 8 Prepared by Dr. Jane N. Were   Starting a partnership with an oral agreement is not recommended, you should get legal documents drawn up by an attorney.  You can expect the fees for this to be higher than a sole proprietorship, but they should be less than what you would expect for incorporating.  A large benefit for having a legal partnership drawn up is that it will aid you in resolving any future business disputes. A down side to a partnership is that a partner can be held responsible for the actions of other partners in the business in addition to their own actions. 9 Prepared by Dr. Jane N. Were  Types of Partners  General partner: As discussed earlier, the general partner has unlimited liability for the firm’s debt  Limited Partner. As stated above, a limited partner has limited liability in the partnership.  Active partner. One in normal partnership practice, as partner sharing in every way the capital contribution, management and shares in profit and liabilities of the business. He may be given a fixed area of responsibility e.g. sales. He is disclosed to the public as being a partner.  Silent partner: refers to a limited partner who does not participate actively in the management of the organization. He is disclosed to the public as being a partner. 10 Prepared by Dr. Jane N. Were  Secret partner. Is a limited partner who actively participates in management of the firm and is not disclosed to the public as being a partner.  Nominal Partner. Is not one of the owners or actual partners of the firm but allows his name to be identified with the business. He does not contribute any capital nor take any part in management of the firm. He, however, becomes liable for the firm’s obligations in an unlimited basis. The nominal partner lends his name to be used by the business for a fee. The business benefits because it uses the partner’s name for promotional purposes. Such partner must, therefore, be well known person who can enhance the firm’s prestige and reputation  Quasi partner. One who is presented to the public as a partner although he contributes no capital and does not participate in the management of the firm. He may share the profit and liabilities of the firm.  Minor partner. This is a person serving as a partner while he is under the statutory majority age of eighteen years. Since he is a minor, his liability is limited to his capital. However, on attaining the statutory majority age, he will rank as an active partner with unlimited liability 11 Prepared by Dr. Jane N. Were  Deed of Partnership The partnership terms are governed by the Kenya’s Partnership Act, 1963 or a Deed of Agreement. Where the Deed exists, it operates instead of the terms of the Act. The agreement defines the following terms and conditions under which the partnership will operate.  Name and purpose of business  Location of business and commencing date  Name, address and occupation of each partner.  Status or type of each partner, e.g. limited, general, active, dominant, minor or quasi  Capital to be contributed and in what ratios  Interest rates to be paid on capital (if any)  Remuneration of partners  How profits and losses will be shared  Drawing allowable each year  Duties and rights of each partner  Admission, withdrawal and expulsion of partners. 12 Prepared by Dr. Jane N. Were  Advantages of Partnerships  Ease of formation – Formation of partnership is easy because all that is essentially needed in a partnership is an agreement between the partners. The partnership agreement is usually prepared in writing although an oral control is also acceptable. In other words formation of a partnership is free from complicated legal requirement.  Additional sources of capital- Partners can sometimes raise more capital than a sole trader since ownership vests in a group of two or more (maximum twenty), each of whom can contribute capital. A partnership is also likely to be more creditworthy than a sole trader  Broader management base- each partner may have expertise in different functions of the firm such as finance and sales. The partners can, therefore, be called upon to be responsible for those functions in which they are specialized. 13 Prepared by Dr. Jane N. Were   Ease of expansion- Expansion can be done very easily by increasing the size of the partnership, including addition of specialists’ skills.  Sharing of losses and liabilities – liabilities are better spread to a number of persons thus reducing the burden on any one person. This spreading of risk to many encourages more people to join partnership because the risks are less than in sole proprietorship.  Duration – partnership have longer durations than sole proprietorships because death or retirement of one partner cannot interrupt the partnership where the partnership has more than two partners and also where provisions have been made to perpetuate the partnership. 14 Prepared by Dr. Jane N. Were  Disadvantages of Partnerships  Unlimited liability – The liability of general partners is unlimited. This means that if the assets of the partnerships are not sufficient enough to pay its debts, the partners are obligated to pay the debts from their personal resources.  Difficulty in making decisions- Since partnership consist of two or more owners, authority is divided and decisions may be difficult to reach. Delay may also occur when reaching decisions because all the partners have to be consulted.  Lack of continuity – A partnership has a limited and uncertain life. A partnership can be terminated very easily especially if the partners disagree or if one partner dies or in incapacitated. 15 Prepared by Dr. Jane N. Were   Sharing of profits – Since partners have to share in the profits of the firm, this lead to minimization in direct benefits accruing from personal efforts of individual partners. This is more so where some partners may be contributing more than others to the well-being of the firm  Frozen investment – It is often difficult for a partner to withdraw his investment. The buying out of a partner may be difficult unless specifically arranged for in a written agreement. Partners who may wish to withdraw find it impossible to do so and leads to dissatisfaction and lack of commitment to the firm.  Limited accesses to capital – Partnerships have difficulties in obtaining large sum of capital especially long term financing. This is a serious problem especially if the firm intends to finance major development projects. 16 Prepared by Dr. Jane N. Were  Dissolution of Partnership  A partnership may be dissolved in the event of the following circumstances. a) If it is a temporary partnership, such as a joint venture, at the expiry of the specified period or on the completion of the purpose of the enterprise. b) If a partner notifies the other partners, in writing, of his intention to dissolve the partnership. c) If a partner suffers mental ailment, is declared bankrupt or dies. d) If the partnership business becomes unlawful (usually due to changes in the law). This can happen if a law is introduced banning the activities of the type carried out by the firm. e) A court may dissolve a partnership on application from a partner or any other interested party under the following:  If a partner acts contrary to the provisions of partnership deed and damage the interest of the firm;  Where the partnership cannot run at s profit;  Where prevailing circumstances make it only fair and just to dissolve the partnership 17 Prepared by Dr. Jane N. Were  Corporation  A corporation is either a limited or unlimited liability entity that has a separate legal personality from its members. A corporation can be organized for-profit or not-for-profit. A corporation is owned by multiple shareholders and is overseen by a board of directors, which hires the business's managerial staff. In addition to privately owned corporate models, there are state-owned corporate models.  Incorporating your business does not require that you have an attorney, however it is highly recommended. The structure of a corporation is complex. It is more expensive to organize it than the other two business entities. Corporate control lies with the person who has ownership of the most shares of stock. If a single stockholder or a group of stockholders own at least 51% of the stock they can make decisions of policy. 18 Prepared by Dr. Jane N. Were   Corporations will have annual meetings of stockholders and regularly scheduled meetings for the board of directors with records kept to document their decisions. The size of the corporation will affect how formally or informally it can operate. Smaller corporations might operate less formally, but still need to keep proper documentation.  Stockholders can hold officers of corporations liable for any actions which might have been improper. In those kinds of cases stock ownership is generally where the liability is limited to unless there was a fraud committed. An attorney can help you decide to incorporate as either a C or S type corporation. 19 Prepared by Dr. Jane N. Were  Types of Companies  Companies can be grouped into two categories: registered and statutory companies. Registered companies are those that are formed, registered and operate under the Companies Act, 1962, Cap 486, Laws of Kenya. These constitute the most common type of companies and are the main subject of our discussion  Statutory companies are created by an Act of Parliament. The powers and functions of these companies are defined by the Acts that created them. Most companies owned by Kenya Government (commonly referred to as parastatal organizations) fall in this category. Examples are Agricultural Finance Corporation (AFC), the Industrial and Commercial Development Corporation (ICDC) and the Kenya National Trading Corporation Ltd (KNTC)  Registered companies may further be classified into public, private, limited or unlimited companies. 20 Prepared by Dr. Jane N. Were  FORMATION OF A COMPANY  Person intending to form a joint stock company are required to furnish the Registrar of Companies with the following documents:  Memorandum of Association  Article of Association (or adoption of model Articles, termed Table A in the Act)  Lists of directors, with details of names, addresses, occupations, shares subscripted and statement of agreement to serve as directors  A statement signed by directors stating that they agree to act as such  A declaration that the necessary requirements of registration have been duly complied with. This declaration can be signed by the Company Secretary or by one of the directors or promoters of the company.  If these documents are found to be in order by the Registrar of Companies, he may ask the promoters of the company to pay the necessary registration fees. After payment of the fees, a Certificate of Incorporation, giving legal entity to the company issued. 21 Prepared by Dr. Jane N. Were  The Memorandum of Association  This is the most important document to be prepared when forming a company. It lays down and defines the powers and limitations of the company. The document governs the relationship of the company with outsiders and any person dealing with the company needs to know its contents.  It contains the following six clauses:  Name clause – This clause states the name of the company ending in “Limited”.  Situation clause- This clause states the domicile of the company, that is, where the registered office is situated.  Object clause- This is the most important clause. It sets out specifically all the aims, objectives and the purposes of the proposed company.  Capital clause- This clause sets out the share capital the company wishes to have. The total value of all the shares is called the nominal share capital.  Liability clause- this clause states that the liability of the shareholders shall be limited  Declaration clause- This clause states the willingness of the promoters to form themselves into a limited company. 22 Prepared by Dr. Jane N. Were  ARTICLES OF ASSOCIATION  This document lays down the rules and regulations for the internal organization of the company as follows:  The different types of shares and the rights and powers of each separate class or type.  Transfer of shares procedures  Classes of loan capital issued and their rights and powers as well as the transfer procedures.  Kinds of meetings and the methods of calling and conducting meetings.  Details concerning directors as to numbers, election or appointment, qualifications and disqualifications, power, duties and liabilities in the management of the company.  Appointment of the secretary to the company under the Act, remuneration, powers, duties and responsibilities.  Details of the procedures for keeping records of share and loan registers, meetings of all the types, accounting and audit.  Arrangements for the declaration and distribution of dividends on share capital and interest on loan capital  Rules governing the appointment of auditors 23 Prepared by Dr. Jane N. Were  Advantages of Companies Limited liability: This means that even if the company is unable to pay it debts, the shareholders cannot in accordance with the law lose more than the value of their investment in the company. Transferability of Ownership: Ownership in a company can be transferred very easily. Shareholders in public limited companies can sell their shares to other people whenever they wish. Continuous existence: The legal existence of any company is not affected by the death of any shareholder unlike the sole proprietorship and partnership. 24 Prepared by Dr. Jane N. Were  Greater ease of Raising Capital: Companies can raise capital with greater ease than sole proprietorships and partnerships. This is possible because companies can invite the public to buy shares.  Specialized management: Because of it size and scope of operations, a company can afford to hire well qualified employees who can manage the company efficiently.  Board of Directors Management: The companies are managed by board of directors. A board of directors may be formed in such a way that experts in various fields included.  Economies of scale: Large sums of capital enable large- scale operations which result in reduced costs per unit produced and consequently higher profit. 25 Prepared by Dr. Jane N. Were  Disadvantages of Companies  Legal restrictions: A company can only operate in accordance with its memorandum and articles of associations. This may sometimes be too limiting especially if a company wishes to engage in more profitable activities which are not covered by the above documents and there is not enough time to alter the document.  Complications in formation: Forming a company is more costly, complicated and time-consuming.  Impersonality and lack of secrecy: Unlike the sole proprietorship and partnership, the dispersed ownership of the company leads to impersonality and consequent avoidance of personal interest and responsibility. 26 Prepared by Dr. Jane N. Were  Slow and expensive decision making: This is because of the nature of the decision making process in companies. In companies, all important decisions are normally taken by the directors and more important decisions by the shareholders. Direct control by owners is not possible: The owners (shareholders) do not control the company directly. There control is of a very indirect character because direct control is vested in the board of directors. Taxation: The Company is a taxable entity for income tax purposes. It pays taxes separately from the owners. A corporation tax is levied on the net profit of the company. 27 Prepared by Dr. Jane N. Were  Winding up a Company  Winding up is the process by which a companies legal existence is brought to an end. It’s done by liquidation. He technically kills the company and makes arrangement for its burial.  Burial process  Setting of the list of contributories (claimants)  Collecting the companies assets  Paying companies debts and other liabilities (salaries to workers)  Distributing the surplus assets (if any) among shareholders.  Types of Wind-ups  Compulsory by court (liquidation) - through a petition.  Voluntary by members or creditors  Under High Court Supervision 28 Prepared by Dr. Jane N. Were  Cooperatives  Cooperative is a limited liability entity that can organize for-profit or not-for-profit. A cooperative differs from a corporation in that it has members, as opposed to shareholders, who share decision- making authority.  Cooperatives are typically classified as either farmers co-operatives, consumer cooperative or worker cooperative. Cooperatives are fundamental to the ideology of economic democracy. 29 Prepared by Dr. Jane N. Were  Formation and Operation  Co-operatives are registered by the Commissioner for Co-operative Development (hereafter referred to as CCD) who is empowered to do so by an Act. The CCD can also refuse to register a co-operative or cancel the registration of a co-operative society. Co-operatives societies are normally registered with limited liability. 30 Prepared by Dr. Jane N. Were