07/05/2022

Chapter 5
How to Form a Business

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Learning Objectives
LO 5-1 Compare the advantages and disadvantages of sole
proprietorships.
LO 5-2 Describe the differences between general and limited partners,
and compare the advantages and disadvantages of partnerships.
LO 5-3 Compare the advantages and disadvantages of corporations and
summarize the differences between C corporations, S
corporations, and limited liability companies.
LO 5-4 Define and give examples of three types of corporate mergers,
and explain the role of leveraged buyouts and taking a firm
private.
LO 5-5 Outline the advantages and disadvantages of franchises, and
discuss the opportunities for diversity in franchising and the
challenges of global franchising.
LO 5-6 Explain the role of cooperatives.

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Basic Forms of Business Ownership

Sole proprietorship — A business owned, and usually
managed, by one person.
Partnership — A legal form of business with two or more
owners.
Corporation — A legal entity with authority to act and have
liability separate from its owners.

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Figure 5.1 Forms of Business

Ownership

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appendix

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Sole Proprietorships 1 of 2
Advantages of Sole Proprietorships
1. Ease of starting and ending the business
2. Being your own boss
3. Pride of ownership
4. Leaving a legacy
5. Retention of company profits
6. No special taxes

LO 5-1
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Sole Proprietorships 2 of 2
Disadvantages of Sole Proprietorships
1. Unlimited liability — The responsibility of business owners for
all of the debts of the business.
2. Limited financial resources
3. Management difficulties
4. Overwhelming time commitment
5. Few fringe benefits
6. Limited growth
7. Limited life span

LO 5-1
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Partnerships 1 of 4
Major Types of Partnerships
• General partnership — A partnership in which all owners share
in operating the business and in assuming liability for the
business’s debts.
• Limited partnership — A partnership with one or more general
partners and one or more limited partners.

LO 5-2
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Partnerships 2 of 4
Types of Partners
• General partner — An owner (partner) who has unlimited
liability and is active in managing the firm.
• Limited partner — An owner who invests money in the business
but does not have any management responsibility or liability for
losses beyond the investment.
• Limited liability — The responsibility of a business’s owners for
losses only up to the amount they invest; limited partners and
shareholders have limited liability.

LO 5-2
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Partnerships 3 of 4
Other Forms of Partnerships
• Master limited partnership (MLP) — A partnership that looks
much like a corporation (in that it acts like a corporation and is
traded on a stock exchange) but is taxed like a partnership and
thus avoids the corporate income tax.
• Limited liability partnership (LLP) — A partnership that limits
partners’ risk of losing their personal assets to only their own
acts and omissions and to the acts and omissions of people
under their supervision.

LO 5-2
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Partnerships 4 of 4
Advantages of Partnerships
• More financial resources
• Shared management and pooled/complementary skills and
knowledge
• Longer survival
• No special taxes

Disadvantages of Partnerships
• Unlimited liability
• Division of profits
• Disagreements among partners
• Difficulty of termination

LO 5-2
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Figure 5.2 Questions to Ask When

Choosing a Business Partner
Do you share the same goals?
Do you share the same vision for the company?
What skills does the person have? Do they complement yours?
What can the person bring to the business?
What type of decision maker is the person?
Do you trust each other?
How does the person respond to adversity?
Does he or she try to solve the problem or try to defend his or her ego?
Can the person accept constructive criticism?
To what extent can you build excitement into the partnership?

LO 5-2
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Corporations 1 of 8
Conventional (C) Corporation — A state-chartered legal
entity with authority to act and have liability separate from
its owners (its stockholders).

LO 5-3
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Figure 5.4 Corporate Types

Alien corporations do business in the United States but are chartered
(incorporated) in another country.
Domestic corporations do business in the state in which they are chartered
(incorporated).
Foreign corporations do business in one state but are chartered in another.
Closed (private) corporations have stock that is held by a few people and isn’t
available to the general public.
Open (public) corporations sell stock to the general public.
Quasi-public corporations are chartered by the government as an approved
monopoly to perform services to the general public.
Professional corporations are owned by those who offer professional services.
Nonprofit (or not-for-profit) corporations don't seek personal profit for their
owners.
Multinational corporations operate in several countries.
LO 5-3
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Corporations 2 of 8
Advantages of Corporations
• Limited liability
• Ability to raise more money for investment
• Size
• Perpetual life
• Ease of ownership change
• Ease of attracting talented employees
• Separation of ownership from management

LO 5-3
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Corporations 3 of 8
Disadvantages of Corporations
• Initial cost
• Extensive paperwork
• Double taxation
• Two tax returns
• Size
• Difficulty of termination
• Possible conflict with stockholders and board of directors

LO 5-3
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Figure 5.5 How Owners Affect

Management

Jump to long description in

appendix
LO 5-3
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Corporations 4 of 8
Individuals Can Incorporate
• Anyone—truckers, doctors, plumbers, athletes, and small
business owners—can incorporate.
• Normally stock is not issued to outsiders when individuals
incorporate, so the advantages and disadvantages are not
exactly the same as for large corporations.
• Major advantages are limited liability and possible tax benefits.

LO 5-3
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Corporations 5 of 8
S Corporations
• S corporation — A unique government creation that looks like a
corporation but is taxed like sole proprietorships and
partnerships.
• S corporations have shareholders, directors, and employees,
plus the benefit of limited liability.
• Profits are taxed only as the personal income of the
shareholders.

LO 5-3
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Corporations 6 of 8
S Corporations continued
• Qualifications for S Corporations
• Have no more than 100 shareholders
• Have shareholders that are individuals or estates, and who (as
individuals) are citizens or permanent residents of the U.S.
• Have only one class of stock
• Derive no more than 25% of income from passive sources

• If an S corporation loses its S status, it may not operate under it

again for at least 5 years.

LO 5-3
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Corporations 7 of 8
Limited Liability Companies
• Limited liability company (LLC) — A company similar to an S
corporation but without the special eligibility requirements.
• Advantages of LLCs:
1. Limited liability
2. Choice of taxation
3. Flexible ownership rules
4. Flexible distribution of profits and losses
5. Operating flexibility

LO 5-3
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Corporations 8 of 8
Limited Liability Companies continued
• Disadvantages of LLCs:
1. No stock, therefore ownership is nontransferable
2. Limited life span
3. Fewer incentives
4. Taxes
5. Paperwork

LO 5-3
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Corporate Expansion: Mergers

and Acquisitions 1 of 2
Merger — The result of two firms forming one company.
Acquisition — One company’s purchase of the property
and obligations of another company.
Types of Mergers
• Vertical merger — The joining of two companies in different
stages of related businesses.
• Horizontal merger — The joining of two firms in the same
industry.
• Conglomerate merger — The joining of firms in completely
unrelated industries.

LO 5-4
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Figure 5.8
Types of
Mergers

Jump to long description in

appendix
LO 5-4
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Corporate Expansion: Mergers

and Acquisitions 2 of 2
Leveraged buyout (LBO) — An attempt by employees,
management, or a group of private investors to buy out the
stockholders in a company.
LBOs have ranged in size from $50 million to $34 billion
and have involved everything from small family businesses
to giant corporations.
Business acquisitions are not limited to U.S. buyers.

LO 5-4
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Franchises 1 of 7
Franchise agreement — An arrangement whereby
someone with a good idea for a business (franchisor) sells
the rights to use the business name and sell a product or
service (franchise) to others (franchisees) in a given
territory.
More than 733,000 franchised businesses operate in the
U.S., employing approximately 13.3 million people.

LO 5-5
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Franchises 2 of 7
Advantages of Franchises Disadvantages of Franchises
1. Management and 1. Large start-up costs
marketing assistance
2. Shared profit
2. Personal ownership
3. Management regulation
3. Nationally recognized
4. Coattail effects
name
5. Restrictions on selling
4. Financial advice and
assistance 6. Fraudulent franchisors
5. Lower failure rate

LO 5-5
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https://www.efda.org.eg/
https://www.egypttoday.com/Article/15/64060/Your-Guide-
to-Franchise
https://www.msme.eg/ar/Pages/default.aspx
https://www.franchisedirect.com/internationalfranchises/egy
pt/62/

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Franchises 3 of 7
Diversity in Franchising
• Women own about half of U.S. companies, yet ownership of
franchises is about 21 percent.
• More women are becoming franchisors. Auntie Anne’s,
Decorating Den, and Build-a-Bear were started by women.
• DiversityFran is an initiative to build awareness of franchising
opportunities within minority communities.
• Dunkin Brands’ Diversity in Franchising Initiative offers financing
and development support to minorities and military veterans.
• Over 20 percent of franchises are minority-owned.

LO 5-5
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Franchises 4 of 7
Home-Based Franchises
• Advantages:
• Relief from commuting stress
• Extra family time
• Low overhead expenses

• Main Disadvantages:
• Isolation
• Long hours

LO 5-5
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Franchises 5 of 7
E-Commerce in Franchising
• Most brick-and-mortar franchises have expanded online.
• Many franchisors prohibit franchisee-sponsored sites because
conflicts can erupt.
• Sometimes “reverse royalties” are sent to franchisees who
believe their sales were hurt by the franchisor’s site.
• Other franchises are solely based online.

LO 5-5
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Franchises 6 of 7
Using Technology in Franchising
• Franchisors use technology, including social media, to:
• Extend their brands
• Meet the needs of both customers and franchisees
• Expand their businesses

LO 5-5
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Cooperatives

• A business owned and controlled by the

people who use it—producers, consumers, or
workers with similar needs who pool their
resources for mutual gain.
• A different kind of organization to meet their
needs for electricity, child care, housing,
health care, food, and financial services.
• E.g. Central Agriculture Cooperative Union
“Buy and sell fertilizers and farm equipment”

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Types of Cooperatives
• You can generally categorize cooperatives by who owns and
manages them.
1. A consumer cooperative is a type of cooperative that is
owned and controlled by the customers who buy goods or
services from it.
2. A producer cooperative is a cooperative owned by
workers - the people who actually provide the goods and
services. A common example of a producer's cooperative
is a farmer's cooperative that owns and manages a grain
storage.
3. A hybrid cooperative of a producer and consumer
cooperative where both employees and customers own
and control the business.

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Appendix of Long Image

Descriptions

©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.

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Appendix 1 Figure 5.1 Forms of Business

Ownership
Percentage of businesses:
• Sole proprietorships, 72 percent
• Corporations, 20 percent
• Partnerships, 8 percent

Percentage of total receipts:

• Corporations, 81 percent
• Partnerships, 13 percent
• Sole proprietorships, 6 percent

Return to original slide

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Appendix 2 Figure 5.5 How Owners Affect

Management
Owners and stockholders elect a board of directors. The
board, in turn, hires officers. The officers set corporate
objectives and select managers. The managers supervise
employees, who are at the bottom of the chart. The daily
operations are structured as a pyramid with officers at the
top.

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Appendix 3 Figure 5.8 Types of Mergers

A soft drink company buys a mineral water company, which
is a horizontal merger (companies in the same industry).
A soft drink company buys an artificial sweetener company,
which is a vertical merger (companies in different stages in
related industries).
A soft drink company buys a snack food company, which is
a conglomerate merger (companies in unrelated
industries).

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