Chapter 2. The Structure of Corporations

Chapter 2. The Structure of Corporations

Capitalism is the economic system of business. This is a system based on private enterprise. Individuals and businesses own land, farms, factories, and equipment, and they use those assets in the attempt to earn profits. Capitalism is a good economic system because it can provide rewards for those who work hard and are inventive and creative enough to figure out new and better ways of doing things. The capitalistic system provides most of the jobs and creates most of the wealth in our society. One of the potential rewards for creating value in the economy is wealth for you. The wealth incentive provides the fuel for the constant generation of new ideas and fosters economic value that provides jobs and raises the American standard of living.

Selling products and services for a profit creates economic value. The goal of the firm is to create an environment in which it can earn profits over the long term. The creation of long- term profits is based on two main sources. First, a business must provide products and/or services to its customer base. A large portion of the value of the business comes from the profits, now and in the future, of this business activity. Finding ways to increase the profits from these core operations can increase economic value. Second, potential for increasing profits comes from the growth in sales. Sales growth comes from selling more of the existing product and from providing new products to sell.

However, expansion usually requires more money, or capital. Business activities also entail risk. The ability to access capital and control risk is an important aspect in the success or failure of a firm. Access to capital and ability to control risk are influenced by the manner in which a firm is organized. A business can be a sole proprietorship, a partnership, or a corporation. Each of these organizational forms has different advantages and disadvantages in the business world.

Business Forms

The first form is the sole proprietorship, which is a business owned by a single person. These businesses are relatively easy to start up, and business tax is computed at the personal level. Due to its simplicity, sole proprietorships are ubiquitous, representing more than 70 percent of all U.S. businesses. [1] However, there are several significant drawbacks to this form of business. In particular, such a firm has a limited life (it dies with the owner's death or retirement), it only has a limited ability to obtain capital (it relies on either the firm's own ability to generate funds or personal borrowings), and the owner bears unlimited personal liability for the firm.

A partnership is similar to a sole proprietorship, but it includes more than one owner. As such, a partnership shares similar advantages and disadvantages as the sole proprietorship business form. While one obvious advantage of a partnership over a sole proprietorship is the pooling together of capital, this advantage may not be as important as the pooling together of service-oriented expertise and skill ” especially for larger partnerships. Examples of such partnerships include accounting firms, law firms, investment banks, and advertising firms.

The third business form is the corporation, which is the focus of this book. Less than 20 percent of all U.S. businesses are corporations, but they generate approximately 90 percent of the country's business revenue. [2] The corporation is its own legal entity, as if it were a person. It is an entity that is essentially separate from its owners in the sense that the corporation, in and of itself, can engage in business transactions and other business activities in its own name . The officers of the corporation act like agents for the firm who authorize those activities.

The biggest advantage of the corporate form of business is the access to the capital markets. Public companies can raise money by issuing stocks and bonds to investors. While sole proprietorships and partnerships may access millions of dollars through the business owners' wealth and banks, corporations may eventually access billions of dollars. It is access to this capital that causes entrepreneurs like Bill Gates of Microsoft, Steve Jobs of Apple, and Larry Ellison of Oracle to take their companies public. To raise money for expansion in the capital markets, the business sells stock to investors.

For example, between 1977 and 1980, Apple Computer sold a total of 121,000 computers. In order to meet the potential demand for millions of computers per year, Apple needed to massively expand operations. In 1980, Apple became a public corporation and sold $65 million worth of stock. Steve Jobs, co-founder of Apple, still owned more shares than anyone else. However, he didn't own more than half of the firm. He gave up much ownership in the firm to the new investors for the capital needed to greatly expand the firm. This would later come back to haunt Jobs.

Stockholders, sometimes called shareholders, are the owners of the corporation. These shareholders receive any value that is created by the firm, but they can also lose their investment if the firm goes bankrupt. The process has two benefits. First, ordinary people with some money can invest in business and increase their wealth over the long term . Second, businesses with growth potential can get the capital they need to expand. The expansion creates economic value, jobs, and tax revenue. The corporation has an infinite life unless it is terminated by bankruptcy or merger with another firm. The owners of corporations enjoy limited liability because they can only lose, at most, the value of their ownership shares. Further, corporate ownership is usually quite liquid, which means ownership stakes can be easily bought and sold as stocks in a marketplace , such as the New York Stock Exchange or Nasdaq.

While the advantages of the corporate business form are appealing, there are several major disadvantages. First, corporate profits are subject to business taxes before any income goes to shareholders in the form of dividends . Subsequently, shareholders must also pay personal taxes on their dividend income. Therefore, shareholders are exposed to double- taxation . Second, because corporations typically have many shareholders, running a corporation can be quite expensive. For example, the costs of hiring accountants and legal experts, communicating with all of the shareholders, complying with regulations, and so forth can cost millions of dollars per year. Finally, perhaps the most important disadvantage from our perspective is that corporations suffer from potentially serious governance problems. Because ”unlike a sole proprietorship or partnership business ”corporations are owned by so many investors, and most investors can only own a small stake of a large public corporation, it is likely that shareholders in a corporation do not feel any true sense of ownership, and especially control, over the firms in which they own stock.

While this book focuses on U.S. corporations, we should point out that one major difference between business forms in the United States and those in other countries is the lack of the government-owned and -operated form of business, known as state-owned enterprises (SOEs). For example, in many countries , television, telephone, oil, airline, utility, and other types of companies are state owned and operated. However, we have witnessed a worldwide trend of privatization recently (including countries in Europe, Latin America, and Asia), during which governments have sold these SOEs to private companies and individuals.