CHAPTER 5

McGraw-Hill/Irwin Copyright © 2015 by the McGraw-Hill Companies, Inc. All rights reserved.

How to Form a Business

LEARNING OBJECTIVES

5-2

1. Compare the advantages and disadvantages of sole proprietorships.

2. Describe the differences between general and limited partners, and compare the advantages and disadvantages of partnerships.

3. Compare the advantages and disadvantages of corporations and summarize the differences between C corporations, S corporations and limited liability companies.

LEARNING OBJECTIVES

5-3

4. Define and give examples of three types of corporate mergers, and explain the role of leveraged buyouts and taking a firm private.

5. Outline the advantages and disadvantages of franchises, and discuss the opportunities for diversity in franchising and the challenges of global franchising.

6. Explain the role of cooperatives.

ANNE BEILERAuntie Anne’s

5-4

• Started selling pretzels when her family was living paycheck to paycheck.

• Now Auntie Anne’s has over 1,200 locations and brings in over $410 million!

• Beiler sold the company in 2005 to start focusing on charity work.

NAME that COMPANY

5-5

In 2013, this company became the largest firm in terms of revenue to be taken private through a leveraged buyout. After closing the $25 million deal, the founder now controls a 75% stake of the company he started in his dorm room.

Name that company!

MAJOR FORMS of OWNERSHIP

5-6

• Sole Proprietorship -- A business owned, and usually managed, by one person.

• Partnership -- Two or more people legally agree to become co-owners of a business.

• Corporation -- A legal entity with authority to act and have liability apart from its owners.

FORMS of BUSINESS OWNERSHIP

5-7

Source: Forbes, www.forbes.com, accessed November 2014.

ETHNIC BUSINESS CENTERSCities with the Most Minority-Run Firms

5-8

Photo Credit: James Rintamaki

1. Atlanta, GA

2. Baltimore, MD

3. Nashville, TN

4. Houston, TX

5. Miami - Ft. Lauderdale, FL

MAJOR BENEFITS of SOLE PROPRIETORSHIP

5-9

LO 4-1

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 profit

6) No special taxes

DISADVANTAGES of SOLE PROPRIETORSHIPS

5-10

LO 4-1

1) Unlimited Liability -- Any debts or damages incurred by the business are your debts, even if it means selling your home, car or anything else.

2) Limited financial resources

3) Management difficulties

4) Overwhelming time commitment

5) Few fringe benefits

6) Limited growth

7) Limited life span

Source: Inc., www.inc.com, accessed November 2014.

WORK-LIFE BALANCING ACT

5-11

% of small business owners

Work over 80 hours per week Work over 40 hours per week

TEST PREP

5-12

• Most people who start businesses in the U.S. are sole proprietors. What are the advantages and disadvantages of sole proprietorships?

• Why would unlimited liability be considered a major drawback to sole proprietorships?

• General Partnership -- All owners share in operating the business and in assuming liability for the business’s debts.

MAJOR TYPES of PARTNERSHIPS

5-13

LO 4-2

• Limited Partnership -- A partnership with one or more general partners and one or more limited partners.

TYPES OF PARTNERS

5-14

LO 4-2

• 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 enjoys limited liability. Limited Liability means that liability for the debts of the business is limited to the amount the limited partner puts into the company; personal assets are not at risk.

OTHER FORMS of PARTNERSHIPS

5-15

LO 4-2

• Master Limited Partnership -- A partnership that looks much like a corporation, but is taxed like a partnership and thus avoids the corporate income tax.

• Limited Liability Partnership -- Limits partners’ risk of losing their personal assets to the outcomes of only their own acts and omissions and those of people under their supervision.

ADVANTAGES of PARTNERSHIPS

5-16

LO 4-2

• More financial resources

• Shared management and pooled/complementary skills and knowledge

• Longer survival

• No special taxes

DISADVANTAGES of PARTNERSHIPS

5-17

LO 4-2

• Unlimited liability

• Division of profits

• Disagreements among partners

• Difficult to terminate

There is no such thing as a perfect partner but ask these questions when you try to find your best match:

PICKING YOUR PARTNER

5-18

LO 4-2

• Do you share the same goals?

• Do you share the same vision for the company?

• What skills does he/she have? Are yours the same?

• What can he/she bring to the business?

• What type of decision maker is he/she?

• Do you trust each other?

• How does he/she problem solve?

• What do you think you should do?

• What will be the consequences of your decision?

GOOD BUSINESS, BAD KARMA?

5-19

Imagine you and your partner own a construction company. You receive a subcontractor’s bid you know is 20% too low. This could potentially put the subcontractor out of business. Accepting the bid will improve your chances of getting a big job. Your partner wants to take the bid:

TEST PREP

5-20

• What’s the difference between a limited partner and a general partner?

• What are some of the advantages and disadvantages of partnerships?

CONVENTIONAL CORPORATIONS

5-21

LO 4-3

• Conventional (C) Corporation -- A state-chartered legal entity with authority to act and have liability separate from its owners (its stockholders).

ADVANTAGES of CORPORATIONS

5-22

LO 4-3

• 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

HOW OWNERS AFFECT MANAGEMENT

5-23

LO 4-3

Source: Fortune, www.fortune.com, accessed November 2014.

The BIG BOYS of BUSINESSAmerica’s Largest Corporations

5-24

Photo Credit: Walmart Stores

LO 4-3

1. Walmart

2. Exxon Mobil

3. Chevron

4. Berkshire Hathaway

5. Apple

Source: Forbes, www.forbes.com, accessed November 2014.

PRIVACY PLEASEThe Ten Largest Private Corporations in the U.S.

5-25

LO 4-3

DISADVANTAGES of CORPORATIONS

5-26

LO 4-3

• Initial cost

• Extensive paperwork

• Double taxation

• Two tax returns

• Size

• Difficulty of termination

• Possible conflict with stockholders and board of directors

Source: Bloomberg Businessweek, www.businessweek.com, accessed November 2014.

EVEN the BIG GUYS MAKE MISTAKES

5-27

LO 4-3

B CORPORATIONS LET SUSTAINABILITY SET SAIL

5-28

• Michael Dimin saw tons of fish were left to rot after fishermen caught too much.

• Registered his company, Sea2Table as a benefit corporation.

• B-corporations are judged on how they meet their own set of socially or environmentally beneficial goals.

WHO CAN INCORPORATE?

5-29

LO 4-3

• 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.

OLDIES BUT GOODIESAmerica’s Oldest Corporations

5-30

LO 4-3

S CORPORATIONS

5-31

LO 4-3

• 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 shareholder.

WHO CAN FORM S CORPORATIONS?

5-32

LO 4-3

• Qualifications for S Corporations:

- Have no more than 100 shareholders.

- Have shareholders that are individuals or estates and 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.

LIMITED LIABILITY COMPANIES

5-33

LO 4-3

• Limited Liability Company (LLC) -- Similar to an S corporation, but without the 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

DISADVANTAGES

of

LLCs

5-34

LO 4-3

1. No stock, therefore ownership is nontransferable

2. Limited life span

3. Fewer incentives

4. Taxes

5. Paperwork

TEST PREP

5-35

• What are the major advantages and disadvantages of incorporating a business?

• What’s the role of owners (stockholders) in the corporate hierarchy?

• If you buy stock in a corporation and someone gets injured by one of the corporation’s products, can you be sued? Why or why not?

• Why are so many new businesses choosing a limited liability company (LLC) form of ownership?

• Merger -- The result of two firms joining to form one company.

MERGERS and ACQUISITIONS

5-36

LO 4-4

• Acquisition -- One company’s purchase of the property and obligations of another company.

TYPES of MERGERS

5-37

LO 4-4

• Vertical Merger -- The joining of two firms in different stages of related businesses.

• Horizontal Merger -- The joining of two firms in the same.

• Conglomerate Merger -- The joining of firms in completely unrelated industries.

LEVERAGED BUYOUTS

5-38

LO 4-4

• Leveraged Buyout (LBO) -- An attempt by employees, management or a group of 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 businesses to giant corporations.

• In 2012, foreign investors poured $166 billion into U.S. companies.

FRANCHISING

5-39

LO 4-5

• 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 770,000 franchised businesses operate in the U.S., employing approximately 8.5 million people.

Source: Entrepreneur, www.entrepreneur.com, accessed November 2014.

MAKE WAY for the NEWBIESTop New Franchises

5-40

LO 4-5

ADVANTAGES of FRANCHISING

5-41

LO 4-5

1. Management and marketing assistance

2. Personal ownership

3. Nationally recognized name

4. Financial advice and assistance

5. Lower failure rate

DISADVANTAGES of FRANCHISING

5-42

LO 4-5

1. Large start-up costs

2. Shared profit

3. Management regulation

4. Coattail effects

5. Restrictions on selling

6. Fraudulent franchisors

THE BUILDING BLOCKS of FRANCHISING

5-43

• Bricks 4 Kidz was created as a way to help kids understand engineering and construction.

• Since the business was low cost and easily reproduced, this led to over 200 franchises in the U.S. and 11 other countries.

• Women own about half of U.S. companies, yet ownership of franchises is about 21%.

WOMEN in FRANCHISING

5-44

LO 4-5

• More women are becoming franchisors. Auntie Anne’s and Jazzercise and are owned by women.

MINORITY-OWNED FRANCHISES

5-45

Photo Credit: Tom Magliery

LO 4-5

• DiversityFran is an initiative to build awareness of franchising opportunities within minority communities.

• Domino’s Pizza launched a minority franchise recruitment program called Delivering the Dream.

• Over 20% of franchises are minority-owned.

HOME-BASED FRANCHISES

5-46

LO 4-5

Advantages:

• Relief from commuting stress

• Extra family time

• Low overhead expenses

Main Disadvantages:

• Isolation

• Long hours

Source: Entrepreneur, www.entrepreneur.com, accessed November 2014.

HOME SWEET HOMETop Home-Based Franchises

5-47

LO 4-5

E-COMMERCE in FRANCHISHING

5-48

LO 4-5

• 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.

GIVING ENTREPRENEURS OPTIONS with DIGITAL FRANCHISING

5-49

• Chris Jeffrey created OrderUp shortly after graduating college.

• OrderUp links up restaurants with hungry patrons and allows people to order online while OrderUp takes a small commission.

• For a startup fee of $42,000 franchisees receive software and training to launch OrderUp in their area.

GLOBAL FRANCHISING

5-50

LO 4-5

• Canada is the most popular target for U.S.-based franchises.

• China, South Africa, the Philippines and the Middle East are becoming popular despite high cost.

• International franchising goes both ways – some foreign franchises have come to the U.S.

Source: Richard Gibson, Wall Street Journal, www.wsj.com, accessed November 2014.

WHAT to CHOOSE?Picking Franchises that May Survive a Recession

5-51

LO 4-5

• Focus on tried-and-true name brands.

• Stick to core goods and services.

• Be choosy about the site.

• Don’t pinch pennies.

• Have a fallback choice.

• Don’t assume the franchise will pay off.

Source: Entrepreneur, www.entrepreneur,com, accessed November 2014.

HIGH FLYERSTen High-Performing Franchises

5-52

Photo Credit: Innisfree Hotels

LO 4-5

1. Anytime Fitness

2. Hampton Hotels

3. Subway

4. Supercuts

5. Jimmy John’s

6. 7-Eleven

7. Servpro

8. Denny’s

9. Pizza Hut

10. Dunkin Donuts

COOPERATIVES

5-53

LO 4-6

• Cooperatives -- Businesses owned and controlled by the people who use them– producers, consumers, or workers with similar needs who pool their resources for mutual gain.

• Worldwide, co-ops serve one billion members!

• Members democratically control the business by electing a board of directors that hires professional management.

TEST PREP

5-54

• What are some of the factors to consider before buying a franchise?

• What opportunities are available for starting a global franchise?

• What is a cooperative?