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Chapter 1: the CorporationThe modern U.S. corporation was born in a courtroom in Washington, D.C., on February 2, 1819. On that day the
U.S. Supreme Court established the legal precedent that the property of a corporation, like that of a person, is
private and entitled to protection under the U.S. Constitution.
1.1 The four types of firms
Sole proprietorship
A sole proprietorship is a business owned and run by one person. Sole proprietorships are usually very small
with few, if any, employees. Although they do not account for much sales revenue in the economy, they are
the most common type of firm in the world.
Sole proprietorships share the following key characteristics:
1. Sole proprietorships are straightforward to set up. Consequently, many new businesses use this
organizational form.
2. The principal limitation of a sole proprietorship is that there is no separation between the firm and the
owner—the firm can have only one owner. If there are other investors, they cannot hold an ownership stake
in the firm.
3. The owner has unlimited personal liability for any of the firm’s debts. That is, if the firm defaults on any
debt payment, the lender can (and will) require the owner to repay the loan from personal assets. An owner
who cannot afford to repay the loan must declare personal bankruptcy.
4. The life of a sole proprietorship is limited to the life of the owner. It is also difficult to transfer ownership of
a sole proprietorship.
For most businesses, the disadvantages of a sole proprietorship outweigh the advantages.
As soon as the firm reaches the point at which it can borrow without the owner agreeing to be personally
liable, the owners typically convert the business into a form that limits the owner’s liability.
Partnership
A partnership is identical to a sole proprietorship except it has more than one owner. The following are key
features of a partnership:
1. All partners are liable for the firm’s debt. That is, a lender can require any partner to repay all the firm’s
outstanding debts.
2. The partnership ends on the death or withdrawal of any single partner, although partners can avoid
liquidation if the partnership agreement provides for alternatives such as a buyout of a deceased or
withdrawn partner.
Some old and established businesses remain partnerships or sole proprietorships. Often these firms are the
types of businesses in which the owners’ personal reputations are the basis for the businesses.
For such enterprises, the partners’ personal liability increases the confidence of the firm’s clients that the
partners will strive to maintain their reputation.
A limited partnership is a partnership with two kinds of owners:
• General partners have the same rights and privileges as partners in a (general) partnership—they are
personally liable for the firm’s debt obligations.
• Limited partners have limited liability—that is, their liability is limited to their investment. Their
private property cannot be seized to pay off the firm’s outstanding debts. Furthermore, the death or
withdrawal of a limited partner does not dissolve the partnership, and a limited partner’s interest is
transferable. However, a limited partner has no management authority and cannot legally be
involved in the managerial decision making for the business.
The general partners control how all the capital is invested. Most often they will actively participate
in running the businesses they choose to invest in. The outside investors play no active role in the
partnership other than monitoring how their investments are performing.
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, Limited Liability Company
A limited liability company (LLC) is a limited partnership without a general partner. That is, all the owners
have limited liability, but unlike limited partners, they can also run the business. LLCs rose to prominence first
in Germany over 100 years ago as a Gesellschaft mit beschränkter Haftung (GmbH) and then in other
European and Latin American countries. An LLC is known in France as a Société à responsabilité limitée (SARL),
and by similar names in Italy (SRL) and Spain (SL).
Corporation
The distinguishing feature of a corporation is that it is a legally defined, artificial being (a judicial person or
legal entity), separate from its owners. Because a corporation is a legal entity separate and distinct from its
owners, it is solely responsible for its own obligations. Consequently, the owners of a corporation (or its
employees, customers, etc.) are not liable for any obligations the corporation enters into. Similarly, the
corporation is not liable for any personal obligations of its owners.
- Formation of a corporation: Corporations must be legally formed, which means that the state in which it
is incorporated must formally give its consent to the incorporation by chartering it. Setting up a
corporation is therefore considerably more costly than setting up a sole proprietorship. For jurisdictional
purposes, a corporation is a citizen of the state in which it is incorporated. Most firms hire lawyers to
create a corporate charter that includes formal articles of incorporation and a set of bylaws. The
corporate charter specifies the initial rules that govern how the corporation is run.
- Ownership of a corporation: There is no limit on the number of owners a corporation can have. Because
most corporations have many owners, each owner owns only a small fraction of the corporation. The
entire ownership stake of a corporation is divided into shares known as stock. The collection of all the
outstanding shares of a corporation is known as the equity of the corporation. An owner of a share of
stock in the corporation is known as a shareholder, stockholder, or equity holder and is entitled to
dividend payments, that is, payments made at the discretion of the corporation to its equity holders.
Shareholders usually receive a share of the dividend payments that is proportional to the amount of stock
they own. A unique feature of a corporation is that there is no limitation on who can own its stock. That
is, an owner of a corporation need not have any special expertise or qualification. This feature allows free
trade in the shares of the corporation. Corporations can raise substantial amounts of capital because they
can sell ownership shares to anonymous outside investors.
Tax Implications for Corporate Entities
An important difference between the types of organizational forms is the way they are taxed. Because a
corporation is a separate legal entity, a corporation’s profits are subject to taxation separate from its owners’ tax
obligations. In effect, shareholders of a corporation pay taxes twice. First, the corporation pays tax on its profits,
and then when the remaining profits are distributed to the shareholders, the shareholders pay their own personal
income tax on this income. This system is sometimes referred to as double taxation.
S Corporations. The corporate organizational structure is the only organizational structure subject to double
taxation. However, the U.S. Internal Revenue Code allows an exemption from double taxation for “S”
corporations, which are corporations that elect subchapter S tax treatment. Under these tax regulations, the
firm’s profits (and losses) are not subject to corporate taxes, but instead are allocated directly to shareholders
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,based on their ownership share. The shareholders must include these profits as income on their individual tax
returns (even if no money is distributed to them). However, after the shareholders have paid income taxes on
these profits, no further tax is due.
The government places strict limitations on the qualifications for subchapter S tax treatment.
In particular, the shareholders of such corporations must be individuals who are U.S. citizens or residents, and
there can be no more than 100 of them. Most large corporations are “C” corporations, which are corporations
subject to corporate taxes. S corporations account for less than one quarter of all corporate revenue.
1.2 Ownership vs Control of Corporations
In a corporation, direct control and ownership are often separate. Rather than the owners, the board of
directors and chief executive officer possess direct control of the corporation.
The Corporate Management Team
The shareholders of a corporation exercise their control by electing a board of directors, a group of people
who have the ultimate decision-making authority in the corporation. In most corporations, each share of
stock gives a shareholder one vote in the election of the board of directors, so investors with the most shares
have the most influence. When one or two shareholders own a very large proportion of the outstanding
stock, these shareholders may either be on the board of directors themselves, or they may have the right to
appoint a number of directors.
The board of directors makes rules on how the corporation should be run, sets policy, and monitors the
performance of the company. The board of directors delegates most
decisions that involve day-to-day running of the corporation to its
management. The chief executive officer (CEO) is charged with running
the corporation by instituting the rules and policies set by the board of
directors. The separation of powers within corporations between the
board of directors and the CEO is not always distinct. It is not uncommon
for the CEO also to be the chairman of the board of directors. The most
senior financial manager is the chief financial officer (CFO).
The Financial Manager
Within the corporation, financial managers are responsible for three main tasks:
• Investment Decisions: The financial manager must weigh the costs and benefits of all investments
and projects and decide which of them qualify as good uses of the money stockholders have invested
in the firm. These investment decisions fundamentally shape what the firm does and whether it will
add value for its owners.
• Financing Decisions. Once the financial manager has decided which investments to make, he or she
also decides how to pay for them. The financial manager must decide whether to raise more money
from new and existing owners by selling more shares of stock (equity) or to borrow the money
(debt).
• Cash Management. The financial manager must ensure that the firm has enough cash on hand to
meet its day-to-day obligations. This job is also commonly known as managing working capital. A
company typically burns through a significant amount of cash developing a new product before its
sales generate income. The financial manager’s job is to make sure that access to cash does not
hinder the firm’s success.
The Goal of the Firm
In theory, the goal of a firm should be determined by the firm’s owners. However, many corporations have
thousands of owners (shareholders). Each owner is likely to have different interests and priorities. The interests of
shareholders are aligned for many, if not most, important decisions. That is because, regardless of their own
personal financial position and stage in life, all the shareholders will agree that they are better off if management
makes decisions that increase the value of their shares.
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, The Firm and Society
In general, if the corporation only makes its shareholders better off, as long as nobody else is made worse off by
its decisions, increasing the value of equity is good for society. The problem occurs when increasing the value of
equity comes at the expense of others.
The 2008 financial crisis highlighted an example of decisions that can increase shareholder wealth but are costly
for society. In the early part of the last decade, banks took on excessive risk. For a while, this strategy benefited
the banks’ shareholders. But when the bets went bad, the resulting financial crisis harmed the broader economy.
When the actions of the corporation impose harm on others in the economy, appropriate public policy and
regulation is required to assure that corporate interests and societal interests remain aligned. Sound public policy
should allow firms to continue to pursue the maximization of shareholder value in a way that benefits society
overall.
Ethics and Incentives Within Corporations
How can the owners of a corporation ensure that the management team will implement their goals?
Agency Problems: many people claim that because of the separation of ownership and control in a corporation,
managers have little incentive to work in the interests of the shareholders when this means working against their
own self-interest. Economists call this an agency problem—when managers, despite being hired as the agents of
shareholders, put their own self-interest ahead of the interests of shareholders.
This agency problem is commonly addressed in practice by minimizing the number of decisions managers must
make for which their own self-interest substantially differs from the interests of the shareholders. Shareholders
often tie the compensation of top managers to the corporation’s profits or perhaps to its stock price. There is,
however, a limitation to this strategy: by tying compensation too closely to performance, the managers might be
asked to take on more risk than they are comfortable taking. As a result, managers may not make decisions that
the shareholders want them to. On the other hand, if compensation contracts reduce managers’ risk by rewarding
good performance but limiting the penalty associated with poor performance, managers may have an incentive to
take excessive risk. Further potential for conflicts of interest and ethical considerations arise when some
stakeholders in the corporation benefit and others lose from a decision. Shareholders and managers are two
stakeholders in the corporation, but others include the regular employees and the community. Managers may
decide to take the interests of other stakeholders into account in their decisions. In some cases, these actions that
benefit other stakeholders also benefit the firm’s shareholders by creating positive indirect effects. In other
instances, when these decisions benefit other stakeholders at shareholders’ expense, they represent a form of
corporate charity. Thus, while some shareholders might support such policies because they feel that they reflect
their own moral and ethical priorities, it is unlikely that all shareholders will feel this way, leading to potential
conflicts of interest amongst shareholders.
The CEO’s Performance: another way shareholders can encourage managers to work in the interests of
shareholders is to discipline them if they don’t. If shareholders are unhappy with a CEO’s performance, they
could, in principle, pressure the board to oust the CEO. However, directors and top executives are rarely replaced
through a grassroots shareholder uprising. Instead, dissatisfied investors often choose to sell their shares. Of
course, somebody must be willing to buy the shares from the dissatisfied shareholders. If enough shareholders
are dissatisfied, the only way to entice investors to buy (or hold on to) the shares is to offer them a low price.
Similarly, investors who see a well-managed corporation will want to purchase shares, which drives the stock
price up. Thus, the stock price of the corporation is a barometer for corporate leaders.
When the stock performs poorly, the board of directors might react by replacing the CEO. In corporations in
which the CEO is entrenched and doing a poor job, the expectation of continued poor performance will decrease
the stock price. Low stock prices create a profit opportunity. In a hostile takeover, an individual or organization—a
corporate raider—can purchase a large fraction of the stock and acquire enough votes to replace the board of
directors and the CEO. With a new superior management team, the stock is a much more attractive investment
àprice rise and a profit for the corporate raider and the other shareholders.
Corporate Bankruptcy: ordinarily, a corporation is run on behalf of its shareholders. But when a corporation
borrows money, the holders of the firm’s debt also become investors in the corporation. While the debt holders
do not normally exercise control over the firm, if the corporation fails to repay its debts, the debt holders are
entitled to seize the assets of the corporation in compensation for the default. If the firm is unable to repay or
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