Rehab A.

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Chapter 4: Types of business organizations

Important definitions:

Limited liability: means that the liability of shareholders in a company is only limited to the
amount invested.

Unlimited liability: means that the owners of a business can be held responsible for the debts
of the business they own. Their liability is not limited to the investment they made in the
business.

Unincorporated business: is one that doesn’t have a separate legal identity. Sole traders and
partnerships are unincorporated business.

Incorporated business: are companies that have separate legal status from their owners

This means that:

a. A company will still exist should one of the owners die

b. A company can make contracts or legal agreements
c. Company accounts are kept separate from the accounts of the owners

Shareholders: are the owners of a limited company. They buy shares which represent part
ownership of a company.

Dividends: payments made to shareholders from the profits (after tax) of a company. they are
the return to shareholders for investing in the company.

A. Business organizations: the private sector

The main types of organizations in the private sector are:

1. Sole trader
Is a business owned and controlled by one person.
Features:
It has few legal formalities
Owned and operated by one person
Unlimited liability

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Advantages of sole trader Disadvantages of sole trader

Few legal regulations
Owner has completed control over his
business – doesn’t consult others before
taking decisions
Free to choose his hours of work and
holidays, prices to charge customers and
whom to employ
Owner is in direct contact with his
customers so provide them with
personalized services and can quickly
respond to their demands
Complete secrecy in business matters
Unlimited liability
No one to consult business matters with
Limited sources of finance (owners savings,
profits from previous years and small bank
loans)
Business is likely to remain small thus
cannot benefit from economies of scale
No continuity of the business after the
death of the owner

2. Partnerships
Is a form of business in which two or more people agree to jointly own and run a
business together.
Features:
Partners contribute to the capital of the business
Partners run the business together
Partners will share profits and losses
Partnership is easy to set up

Advantages of partnerships Disadvantages of partnerships

More capital than in a sole trader business
can be invested
Responsibilities of running the business is
shared – absence of one partner will not
cause problems
Losses are shared by partners
Partners may be motivated to work hard
to make profits
Unlimited liability
Unincorporated business -No separate
legal identity
Partners may disagree on business
decisions
Consulting all partners is time consuming
A dishonest or inefficient partner can
cause losses and all partners will suffer
Business growth is limited to the
investments of 20 partners only

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3. Private limited companies

Are companies that are jointly owned by the people who have invested in the business
(shareholders). Shares are sold to family and friends only and not to the general public.
Features:
The company is owned by shareholders
Directors, who are the most important or majority shareholders, run the company
The company is a separate legal unit from its owners

Shareholders have limited liability

Advantages of private limited companies Disadvantages of private limited companies

Larger sums to invest in the company as
shares can be sold to family and friends
Company is a separate legal identity and
will continue should one of the owners die
Shareholders have limited liability -
shareholders only lose their original
investment in the company
Original owners may be able to keep
control of their business if they didn’t sell
too many shares to other shareholders
Company has higher status than
unincorporated businesses
Significant legal matters in order to form the
company
a. articles of association: contains rules
under which the company will be
managed
b. Memorandum of association: contains
important information about the
company and the directors
Shares cannot be sold or transferred to
anyone else without the agreement of the
other shareholder – some people will be
reluctant to invest in ltd as they may not be
able to sell their shares quickly if they require
their investment back
Accounts of the company aren’t secret as the
have to be sent to registrar of companies and
can be inspected by any person
Finance for expansion is limited as shares
cannot be sold to the general public

4. Public limited companies

Are companies that are jointly owned by the people who have invested in the business
(shareholders). Shares are sold to the general public.
Features
Owned by private individuals from the general public who have invested in the business
Controlled by directors who are elected by shareholders in the AGM
The company is a separate legal unit from its owners
The owners have limited liability

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Advantages of public limited company Disadvantages of public limited company

Shareholders have limited liability
It is incorporated business and is a
separate legal unit
Can raise very large capital sums to invest
in the business
Complicated legal formalities and time
consuming
More regulations and controls by the
government over plc in order to protect
the interests of shareholders (publication
of accounts which can be inspected by any
person)
Selling shares to the public is expensive
due to commission taken by specialize
porkers and cost of printing thousands of
prospectus.

No restrictions on trading of shares
The business has high status which
encourages suppliers to sell on credit to
them. Banks are also willing to lend them.
Customers may also be attracted to buy
from large companies.
Original owners will lose control over their
business as they cannot keep majority of
shares to themselves
Divorce between ownership and control of
the business
There is a risk that the company will be
taken over by a competing business

Control and ownership in a public limited company

Annual General Meeting: is a legal requirement for all companies. Shareholders may
attend and vote on who they want to be on the Board of Directors for the coming year.
At the AGM:
 The directors explain the performance of the company to shareholders.
 The only decision that shareholders can have a real impact on at the AGM
is the election of professional managers as company directors who are
given the responsibilities of running the business and taking decisions.
Directors in turn appoint managers who may not be shareholders at all, to take day-to-
day decisions. This results in divorce between ownership and control of the business.

Divorce between ownership and control of the business: means that shareholders own,
but the directors and managers control the business.

Why divorce is divorce between ownership and control of the business a problem?

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As directors and managers may run the business to meet their own objectives this might
conflict with those of the shareholders.
Directors and managers may seek for increased status, growth of the business to justify
higher salaries and thus may reduce dividends to shareholders to pay for expansion
plans.
The only decision that can be made by shareholders in this situation is to replace the
directors in the AGM which may cause bad reputation and cause instability to the
business as the new directors may lack experience.

Other private sector business organizations

1. Joint ventures
It is when two or more companies agree to start a new project together sharing the
capital, the risks and the profits.

Advantages of joint ventures Disadvantages of joint ventures

Sharing of cost Profits have to be shared with the joint
venture partner
Local knowledge Disagreement over important decisions
may occur
Risks are shared The two join venture partners might have
different ways of running a business due to
difference in culture

2. Franchising
A franchise is a business based upon the use of the brand names, promotional logos and
trading methods of an existing successful business. The franchisee buys the license to
operate this business from the franchisor.

Advantages to the franchisor Disadvantages to the franchisor

Income from selling the license to the Franchisee keeps profits from the outlet
franchisee
Expansion of the franchised business is
faster that if the business used internal
expansion
Less management burden as it is the Poor management of one of the franchised
responsibility of the franchisee outlet could lead to a bad reputation for
Profits from selling products to the the whole business
franchisor

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Advantages to the franchisee
Less chance of business failure because a
well-known product is being sold
Advertising cost is born by the franchisor
Reliability and assured quality of supplies
since all supplies are obtained from the
franchisor
Fewer decisions to make since prices,
store layout and range of products are all
determined by franchisor
Franchisor trains staff and management
Banks find it less risky to lend franchisees
B. Business organizations in the public sector
The public sector includes all businesses owned by the state or central government.
They are usually business that have been nationalized.
Nationalization: selling of businesses that were once owned by private individuals to
the government
Advantages of public corporations
Government ownership of important
businesses is essential. Ex., water supply
Government should own natural
monopolies businesses in order to ensure
that consumers are not taken advantage
of by monopolists. Ex. Railway lines
Government nationalizes failing businesses
to keep it operating and secure jobs
Important public services such as TV are
often in the public sector to provide non-
profitable but important programs to the
public
Disadvantages to the franchisee
Less independent than with operating a
non-franchised business
Unable to take decisions that suits the
local area
License fee must be paid to the franchisor
and possibly a percentage of the annual
turnover
Disadvantages of public corporations
Absence of profit motive may lead to
inefficiency
Government subsidies may lead to
inefficiency. It is also unfair to subsidies a
public corporation and not to subsidize a
similar one in the private sector
There is no close competition to the public
corporations. This results in lack of incentive
to increase consumer choice and increase
efficiency.
Governments can use these businesses for
political reasons. ex., create more jobs just
before elections - inefficient