Forms of Ownership PDF

## Chapter 7: Forms of Ownership ### Section A: Forms of Ownership ### 1. Choosing a Form of Ownership In Grade 10 you studied the detail and content pertaining to Forms of Ownership. This year we are looking at the extent to which a business's chosen form of ownership may contribute to the success...

## Chapter 7: Forms of Ownership ### Section A: Forms of Ownership ### 1. Choosing a Form of Ownership In Grade 10 you studied the detail and content pertaining to Forms of Ownership. This year we are looking at the extent to which a business's chosen form of ownership may contribute to the success or failure of the business. #### Factors which may impact on the success or failure of the business will include: 1. **Formation procedures** The more legal formalities involved in starting the business, the more expensive, difficult and time-consuming it will be to establish it. 2. **Legal persona and liability** As you learnt in Grade 10, the business obtains legal persona when it is registered. When the business has legal personality, it offers the owners limited liability because the business can sue and be sued in its own right and therefore owners do not risk losing their personal possessions. 3. **Continuity of existence** A business will only have continuity of existence if it has legal persona (is a legal entity) apart from the owners. If there is continuity it means that a change in ownership (e.g. the death or retirement of one of the owners or the addition of a new owner) does not affect the existence of the business and therefore increases the possibility of success for the business. 4. **Tax implications** NOTE: Please make sure you familiarise yourself with the latest tax legislation as announced in the annual National budget in February. The progressive tax system applies to individuals in South Africa. This means the higher the income, the higher the tax percentage (for example, to a maximum of 45%) that applies. The owner of a sole trader and the partners in a partnership are taxed on their personal income / profits from the business and could be taxed up to a maximum of 45%. Therefore, if a sole trader and the partners receive a substantial amount of profit, they will be taxed more than a CC and company. In a CC and a company the business is responsible to pay tax on profits generated. A fixed percentage of, for example, 28% company tax applies to the company whilst shareholders will pay a dividends tax. 5. **Management / control aspects** The owner of the business must decide if they would prefer to keep control over the management of the business. * In a sole trader, partnership and close corporation the owners are usually involved in the day-to-day management of the business. * In a company, shareholders (owners) usually delegate the management of the business to a Board of Directors: which means there is a separation between ownership and management. 6. **Capital requirements based on the size of the business and nature of products/services** The size of the business will largely determine the amount of capital required. In addition, the type of product to be manufactured and / or sold, or the service that will be rendered may also impact on the capital requirements. For example, a manufacturer producing on a large scale will probably need more capital than a service undertaking as the manufacturer will have to buy expensive machinery and equipment. Mass producers will therefore require a form of ownership where more owners can contribute to raise capital (more owners = more capital). ### 2. Factors that may contribute to the success or failure of a business #### 2.1 Sole Trader **Number of owners** There is only one owner in a sole trader. This could potentially contribute to both the success and / or failure of the business. **The positive aspect in having only one owner is:** * The ability to make quick decisions which gives them flexibility to adapt to changing conditions. * Lowering the risk of lost opportunities if they have to first consult with other owners. * That the owner knows that they will get all the profits, so they will be more motivated to be successful (i.e. the owner will be more conscientious). **Being a sole trader, however, could also pose certain problems that could increase the chances of failure. Think about the following:** * The sole trader is the only person who can contribute capital (either own or borrowed) and this limits both the expansion and growth of the business. * In terms of management, the owner relies on their own initiative and does not always have somebody with whom to discuss important decisions or alternatives. * The owner may also not have someone to take over if their are ill or go on holiday - this could lead to management problems and may increase the possibility of failure. **Formation Procedure** A Sole Trading business is easy to start. There are no requirements or procedures to follow in order to establish a sole trader. This limits costs (expenditure) and may increase the chances of success. **Legal personality and liability** A sole trader cannot be registered as a business with a separate legal persona from the owner. The owner therefore has unlimited liability for the debts of the business, i.e. their personal belongings can be lost if the business fails and this may limit the owner's risk taking behaviour. **Tax** The sole trader has to pay tax in their personal capacity on all profit taken from the business. Progressive personal income tax scales are applied, i.e. the higher his income, the higher the percentage tax to be paid. This means that the owner has to make provision for tax by reducing the profits they can reinvest in the business as capital, and this limits the potential for future growth. **Continuity of Existence** As the sole trader has no legal personality there is no continuity of existence and a change in ownership leads to the demise of the business, unless it is sold to someone else. #### 2.2 Partnership **Number of owners** There is a minimum of two and no maximum to the number of partners in a partnership. * This makes it possible for more people (owners) to contribute capital and thus the business can grow and expand more than a sole trader is able to. * All partners are usually actively involved in the management of the business and therefore productivity can improve due to division of labour. Each partner is performing the activity in which they are an expert. * More than one person can decide on important issues and because two heads are better than one, it may improve the chances of success of the business. **However, all partners have to agree before a decision can be taken, i.e. slow decision-making may mean lost opportunities and a lower chance of success.** **Formation procedure** The only formation procedure required for a partnership is a Partnership agreement / Partnership articles and this can be entered into verbally although it is preferable to do it in writing. In fact, it could even be a tacit (implied) agreement but this could cause legal problems at a later stage and is best avoided. The Partnership Agreement is a contract defining the terms and conditions as agreed upon by the partners. This lack of a formal establishment procedure makes it easy and cheap (no major expenses) to start a partnership and there may therefore be more capital available to buy stock or equipment needed which improves the chances of success. **Competitive position** Forming a partnership can eliminate competition between smaller sole traders. This means the new partnership is in a better competitive position and improves the chances of success of the business. This is especially true if it combines different skills from the two sole traders e.g. two small catering businesses combine where the one sole trader is an excellent chef and the other a brilliant event organiser. **Legal personality and liability** A partnership cannot be registered as a business with a separate legal persona from the partners / owners. * This results in partners having unlimited liability and this may motivate partners to work harder to make the business successful. * On the other hand, it could mean that partners are scared that if one makes a mistake, all have to pay because partners are jointly and severally responsible (i.e. unlimited liability) for the debts of the business. This could make partners over-cautious and opportunities could be lost. **Continuity of existence** The chances of success in a partnership are further limited by the fact that the business does not have continuity of existence, i.e. the partnership must be dissolved when one partner dies or retires or if a new partner joins. **Taxation** Each partner pays tax on their personal income, i.e. the more profit they receive, the higher percentage tax each individual partner must pay (for example, progressive tax at a maximum of 45%). Can you remember what was said about this when we discussed a sole trader? The same tax law applies in a partnership as in the sole trader and therefore the same will be true here about possibilities of success or failure. #### 2.3 Close Corporation (CC) (Take note of the Companies Act information at the end of this chapter which states that new CC's can no longer be registered but for an undetermined period of time will continue to exist in their current format.) **Number of owners** Members are restricted to $\bf{10}$ owners. * Expansion may thus become difficult if a large amount of capital needs to be raised. What are the implications for success or failure for the business? * According to legislation, only a natural person may be a member of a CC. This means that another CC or a company may not have an interest in a CC. This also limits capital and thus expansion and the possible long term success of the business. * All members have to agree if one of the members wants to sell his interest in the CC. If members cannot reach an agreement about one member selling his or her interest, what are the implications for the success or failure of the business? The members usually take an active role in the management of the business and this makes it a very suitable form of ownership for a small business where owners want to be involved in the daily management. **The advantages are:** * Members can specialise in the activity / management function that they have a flair for and this helps to increase productivity. * More than one person can decide on important issues and this may improve the chances of success of the business. **The disadvantage are:** * All members (or at least the majority of the interest holders) have to agree before a decision can be taken, i.e. slow decision-making may mean lost opportunities and a lower chance of success. * The chance of conflict also increases as more people are involved in the decision-making process. **The financial statements of a CC need not be audited by a CA (Chartered Accountant). No auditing fees means lower costs and thus potentially more capital to expand. However, the statements have to be signed off by a member of SAIPA (South African Institute of Professional Accountants). Think about the implications of this for the success and / or failure of the business...** **Legal personality and liability** The CC is registered as a separate legal entity from the owners (members) of the business. * Members have limited liability. * A member only stands to lose the investment made in the CC if the business lands in financial difficulty. Personal belongings are not at risk and this may motivate members to take more risks. Is this to the advantage or disadvantage of the business? **Continuity of Existence** As the CC is a separate legal entity, it possesses unlimited continuity (i.e. its existence does not depend on the owners). A change in the members does not affect the CC as a form of ownership. Continuity can end when members decide to discontinue the business' existence, in the event of liquidation or as a result of a court decision. **Tax** Because the CC is a legal entity, the CC as a business pays tax. The rate at which a CC pays tax is at a fixed percentage of $\bf{28\%}$ (in 2020) company tax on all profits. **Exercise 7.1 CC Legal Personality and Liability** How would legal personality and the limited liability of members affect the potential success or failure of a CC? #### 2.4 Companies: Public and Private **Number of owners and capital** There is a minimum of one and no maximum number of shareholders in a company. The maximum number of shareholders is limited to the number of shares available to be sold. In theory, more shareholders gives you access to more capital, but it all depends on the wealth of the shareholders and how much each one is prepared to invest. **Management** The shareholders of a company do not have a direct share in the management of the business. * Management is the responsibility of the Board of Directors, as appointed by the shareholders at the Annual General Meeting (AGM). * A shareholder's voting rights for the Board of Directors is determined by the type and number of shares that they have. For every one ordinary share the shareholder has, they get one vote. * Remember there are other types of shares as well (e.g. preference shares), but they don't have voting rights because they have other benefits such as higher dividends. * The implications of shareholders voting for the Directors (and thus being able to appoint someone else as a director if satisfactory work is not delivered), are: * Directors are kept accountable. * Shareholders have a say through the voting process. Because a Private company is potentially smaller than a public company, the directors are usually the shareholders as well. Advantages and disadvantages for the success or failure of the business: **Possible advantages** * Easier and faster decision making and implementation * More shareholder involvement * Better relationships **Possible disadvantages** * More interaction and discussion could delay decisions in the pursuit of total consensus. * Limited input or a lack of variety in skills on the Board. **Buying and selling shares** The shares of a public company are freely negotiable on the JSE Ltd (the South African Stock Exchange). This means it is (relatively) easy for shareholders to sell their shares if they wish to do so. What do you think are the implication for success or failure as a result of this relatively liquid investment option? Shares in a private company can only be bought by invitation from existing shareholders (i.e. transferability is limited). In addition, a shareholder can only sell his or her shares with the permission of all other shareholders. Does this have any implication for the possible success or failure of the business being run as a private company? **Exercise 7.2 Companies** Have a brief class discussion on the implications for success or failure of being able to buy and sell shares on a Stock Exchange. ### 3. Details of the Companies Act #### 3.1. The Act makes reference to two types of companies * **Non-Profit Companies (NPC):** A Non-Profit company must be registered with an objective that is related to cultural or social activities, communal or group interests. Under this Act no NPC may distribute income or property to any member or director. No NPC may convert to, amalgamate with or merge with any profit company. * **Profit Companies:** There are four types of Profit companies under the Act: * **State-Owned Companies (SOC):** These are companies that have been registered in terms of the Companies Act and are Government or Municipality owned. * **Private Companies [(Pty) Ltd]:** This type of company is no longer limited to 50 shareholders. Ownership is unlimited. Private Companies will, however, continue to restrict transferability of the shares. * **Public Companies [Ltd]:** A Public Company under this new Act requires only one shareholder, as opposed to the previous Act, where a minimum amount of seven shareholders were needed. * **Personal Liability Companies [Inc or Incorporated]:** These are companies where the directors are jointly and severally liable with the company for all the debts, for the specific period that they are in office (acting as directors). Some companies may be established under specific conditions. These are called **Ring Fenced Companies (RF)** and are companies that are established to provide a specific function only (special condition). For these companies, RF should appear directly after the name of the company [XYZ RF Ltd] #### 3.2. The formation of a Company (Profit and Non-Profit) under the Companies Act * One or more "persons" may incorporate as a profit company and in the case of a non-profit company three or more "persons" are required for incorporation. * **Incorporation of a new company is done when Notice to Incorporate and the Memorandum of Incorporation (MOI) have been filed at the CIPC - Companies and Intellectual Property Commission.** * **Notice to Incorporate** - This is done by means of a notice given to the Commission from the Incorporators, where they inform the Commission of the intent to have the company registered. CIPC - Companies and Intellectual Property Commission. * **Memorandum of Incorporation (MOI):** The MOI is a detailed document providing all the information that the Memorandum and Articles of Association did in the previous Act. In addition, it also sets out the rights, duties and responsibilities of all shareholders, directors and any other relevant officers in relation to the company. * The MOI also addresses any important matter that is not dealt with in the Companies Act 2008. It may also make amendments to alterable provisions of the Act. Alterable provisions are rules within the Act which may the altered (changed) in a company's MOI. The Act has 53 of these rules which could be altered to suit the specific company. The MOI may also contain special conditions relating to the company and will state the requirements for the amendment of such a condition. The MOI may also prohibit the amendment of particular provision within the MOI. * **A registration certificate will be issued to the company once the Commission is happy that the company has fulfilled all the requirements for incorporation.** **Example of an alterable provision** According to the Act, an ordinary resolution must be approved by more than 50% of the shareholders voting on the resolution and a special resolution must be approved by at least 75% of the shareholders voting on the resolution. A company's MOI may however require a higher percentage of voting rights to approve an ordinary resolution or a lower percentage of voting rights to approve any special resolution, provided that there must be a margin of at least $\bf{10\%}$ points between the requirements for approval of an ordinary resolution and a special resolution. #### 3.3 Transparency, Accountability and Integrity of Companies The Companies Act places special emphasis on the Transparency and Accountability of companies. The Acts states that Prescribed Officers have two types of duties: * **Fiduciary duty and** * **Duty to act with care and skill.** **Fiduciary duty:** is within the terms of the common law (e.g. act in the best interest of the company, act with proper purpose; as well as the Company's Officers' duty regarding information, etc). **Duty of care and skill:** is the reasonable and expected care and skill somebody should demonstrate in order to fulfill a particular function (knowledge, skill and experience). Prescribed Officers are required to maintain a minimum level of skill depending on the required function. **Corporate Governance:** is a framework of practices and rules by which a board of directors ensures consistent accountability, fairness and transparency regarding the company's relationship with all its stakeholders. The Act sets out the requirements and guidelines for transparency and good governance.** In addition to complying with the requirements of transparency and accountability, Public- and State-owned companies are in future required to comply with extended requirements. These requirements include the appointment of a company secretary, an auditor and an audit committee. Other companies (i.e. if the company is not Public- and State-owned) are not required to comply with these extended requirements, except to the extent where the companies' MOI provide otherwise, they are required to be audited in terms of the draft regulations or if they voluntarily choose to be audited. * **The King Code:** applies to all companies regardless of size or operational structure. It places the emphasis on an "APPLY or EXPLAIN" approach (see Note 1). The Code puts structures and procedures in place which allow Prescribed Officers to discharge their legal duties and to oversee companies trading legally. However it needs to be remembered that the King Code is not part of the legislation, but simply a guideline to good Corporate Governance. * **Note 1: “APPLY or EXPLAIN”:** means that Companies should APPLY the King Code (good corporate governance): in doing so the Prescribed Officers will meet both duties as stated in the Act. If companies do not apply this King Code they will have to EXPLAIN their actions to shareholders and the greater public (public scrutiny). * **Public- and State-Owned Companies:** are required to appoint Social- and Ethical Committees unless they are a subsidiary of another company which already has established such committees (which can perform the relevant duties) or they have special exemption not to do so. These committees must constitute at least three directors and, in addition, an Advisory Panel must be appointed. The panel must be made up of members of a registered profession related to social and ethical matters (e.g. Law, Health and Education) and persons who represent the community and public interest. * **The Minister of Trade and Industry:** may also prescribe that other companies (or a category of companies) should extend their transparency and accountability by implementing Social- and Ethical Committees. This would be done if it is seen as desirable in the public interest in terms of its annual turnover, the size of its workforce or the nature and extent of the Activities. * **The function of these committees:** is to monitor the company's activities in light of relevant legislation, other legal requirements and Codes of Best Practice relating to social and economic developments (including human rights, corruption and BBBEE), good corporate citizenship, the environment, health and public safety, consumer relationships as well as labour and employment. They are also tasked to draw matters within their spheres of responsibility to the Board's attention and to report to shareholders at each AGM. * **This Advisory Panel:** is not given any statutory rights or obligations, meaning that this panel does not have the right to vote at a Board meeting, nor is the advisory panel held to the status or obligations of a Director - they are there merely to assist the Committee. ### References: * Hitchcock, R. 2010. Sink or Swim (Cutting Edge DVD Seminar) * KPMG Brochure. 2010. The Companies Act No. 71 of 2008. Advisory. KPMG. Johannesburg. * Republic of South Africa (RSA). 2008. Companies Act No. 71 Of 2008. Pretoria: Government Printer. * Webber Wentzel Brochure. 2010. A Guide To The New Companies Act. Webber Wentzel Attorneys. Johannesburg. ### Exercise 7.4: Choose your Business Structure Your friend Hussein is planning to start a catering business. He is unsure whether to go it alone or have a partner. * Read the case study below and give him advice on how he could go about choosing the best form of ownership. * Explain the benefits, as well as the challenges of establishing a company as opposed to any other form of ownership (remember that he will not be able to start a CC). * You may tabulate your points. Every entrepreneur will need to choose the form of ownership for their business. Read the article below on the factors they must consider when choosing the correct form of ownership to suit their specific equirements. ### Choose Your business structure Of all the choices you need to make when starting a business, one of the most important is the type of legal structure you select for your company. Not only will this decision have an impact on how much you pay in taxes, it will also affect the amount of paperwork your business is required to produce, the personal liability you face, and your ability to raise money. Mark Kalish is co-owner and vice president of EnviroTech Coating Systems Inc., a company that applies powdered paint through an electrostatic process to items ranging from motorcycles to musical instruments. Kalish has also been involved with a number of other start-up businesses, both as an owner and in various management positions. The answer to the question of "What structure makes the most sense?" depends, he says, on the individual circumstances of each business owner. "Each situation I've been involved with has been different," he says. "You can't just make an assumption that one form is better than another." #### Selecting a business entity When making a decision about the type of business to form, there are several criteria you need to evaluate. Kalish and EnviroTech co-owner John Berthold focused on the following areas when they chose the business format for their company: 1. **Legal liability** To what extent does the owner need to be insulated from legal liability? This was a consideration for EnviroTech, confirms Kalish. He and Berthold had a hefty investment in equipment, and the contracts they work on are substantial. They didn't want to take on personal liability for potential losses associated with the business. "You need to consider whether your business lends itself to potential liability and, if so, whether you can personally afford the risk of that liability," Kalish says. "If you can't, a sole proprietorship or partnership may not be the best way to go." 2. **Tax implications** Based on the individual situation and goals of the business owner, what are the opportunities to minimise taxation? There are many more tax options available to companies than to sole proprietorships or partnerships. 3. **Cost of formation and ongoing administration** Tax advantages however, may not offer enough benefits to offset the other costs of conducting business as a company. Kalish refers to the high cost of record-keeping and paperwork, as well as the costs associated with incorporation, as reasons that business owners may decide to choose another option--such as a sole proprietorship or partnership. Taking care of administrative requirements often eats up the owner's time and therefore creates costs for the business. 4. **Flexibility** Your goal is to maximise the flexibility of the ownership structure by considering the unique needs of the business as well as the personal needs of the owner or owners. Individual needs are a critical consideration. No two business situations will be the same, particularly when multiple owners are involved. No two people will have the same goals, concerns or personal financial situations. 5. **Future needs** When you're first starting out in business, it's not uncommon to be "caught up in the moment." You're consumed with getting the business off the ground and usually aren't thinking of what the business might look like five or ten years down the road. What will happen to the business after you die? What if you are in a partnership and, after a few years, you decide to sell your share? Keep in mind that the business structure you start out with may not meet your needs in years to come. Many sole proprietorships evolve into some other form of business - like a partnership or company - as the business grows and the needs of the owners change. The bottom line? Don't take this very important decision lightly, and don't make a choice based on what somebody else has done. Carefully consider the unique needs of your business and its owners, and seek expert advice before settling on a particular business format.