Forms of Business Ownership and Buying an Existing Business

Forms of Business Ownership and

1. Essentials of Entrepreneurship and Small Business Management Eighth Edition Section 2: The Entrepreneurial Journey Begins Chapter 6 Forms of Business Ownership and Buying an Existing Business Copyright © 2016, 2014, 2011 Pearson Education, Inc. All Rights Reserved.

2. Learning Objectives (1 of 2) 6.1 Explain the advantages and disadvantages of a sole proprietorship and a partnership. 6.2 Describe the similarities and differences of the C corporation and the S corporation. 6.3 Understand the characteristics of the limited liability company.

3. Learning Objectives (2 of 2) 6.4 Explain the process of creating a legal entity for a business. 6.5 Understand the advantages and disadvantages of buying an existing business. 6.6 Define the steps involved in the right way to buy a business. 6.7 Understand how the negotiation process works and identify the factors that affect it.

4. Choosing a Form of Ownership There is no one “best” form of ownership. The best form of ownership depends on an entrepreneur’s particular situation. Key: Understanding the characteristics of each form of ownership and how well they match an entrepreneur’s business and personal circumstances.

5. Factors Affecting the Choice Tax considerations Liability exposure Start-up and future capital requirements Control Managerial ability Business goals Management succession plans Cost of formation

6. Major Forms of Ownership Sole Proprietorship General Partnership Limited Partnership Corporation S Corporation Limited Liability Company

7. Percentage of Business

8. Percentage of Sales

9. Percentage of Net Income

10. Advantages of a Sole Proprietorship Simple to create Least costly form to begin Profit incentive Total decision making authority No special legal restrictions Easy to discontinue

11. Disadvantages of a Sole Proprietorship Unlimited personal liability The company’s debts are the owner’s debts. Limited skills and capabilities Feelings of isolation Limited access to capital Lack of continuity of the business

12. Partnership An association of two or more people who co-own a business for the purpose of making a profit. Always wise to create a partnership agreement : states in writing the terms under which the partners agree to operate the partnership and that protects each partner’s interests in the business.

13. Revised Uniform Partnership Act Three key elements of any partnership: Common ownership in a business. Agreement on how the business’s profits and losses will be shared. The right to participate in managing the operation of a partnership.

14. Advantages of the Partnership (1 of 2) Easy to establish Complementary skills of partners Division of profits Larger pool of capital Ability to attract limited partners

15. Types of Partners General Partners: Take an active role in managing a business. Have unlimited liability for the partnership’s debts. Every partnership must have at least one general partner. Limited Partners: Cannot participate in the day-to-day management of a company. Have limited liability for the partnership’s debts.

16. Types of Limited Partners Two Types of Limited Partners: Silent Partners: Not active in a business but are generally known to be members of the partnership Dormant Partners: Neither active nor generally known to be associated with the business

17. Advantages of the Partnership (2 of 2) Easy to establish Complementary skills of partners Division of profits Larger pool of capital Ability to attract limited partners Minimal government regulation Flexibility Taxation

18. Disadvantages of the Partnership Unlimited liability of at least one partner Capital accumulation Difficulty in disposing of partnership interest without dissolving the partnership Potential for personality and authority conflicts Partners bound by law of agency

19. Corporations The corporation is the most complex of the three major forms of business ownership. It is a separate entity apart from its owners. It has its own legal existence and can do various business activities, such as making contracts, suing and being sued, owning property, and paying taxes. Unlike other forms of business ownership, the life of a corporation does not depend on its owners. This means that shareholders can sell their ownership without affecting the business's operation. Corporations are created by the states, and when a corporation is established, it must follow the regulations and rules of the state it is incorporated in, as well as any other states where it conducts business.

20. Corporations Because a corporation is considered a separate entity from its investors, it allows them to protect themselves from being held responsible for any debts or losses incurred by the company. This means that if the corporation fails or is unable to pay its debts, the investors will only be liable for the amount of money they have invested in the business and their personal assets will be protected. This legal protection is very important to many potential investors,

21. Corporations The corporate form of ownership does not protect its owners from being personally held responsible for fraudulent or illegal acts. Courts now hold small business owners accountable for their corporation's environmental, pension, and legal issues more than ever before. If owners intentionally engage in criminal or negligent behavior while conducting business, courts can disregard the limited liability protection provided by the corporate form and hold the owners liable for the company's debts. “piercing the corporate veil” Courts will pierce the corporate veil and hold entrepreneurs liable for the company’s debts and obligations if the owners deliberately commit criminal or negligent acts when handling corporate business. Courts ignore the limited liability shield the corporate form of ownership provides when an entrepreneur: This can happen if: ● Uses corporate assets for personal reasons or commingles them with his or her personal assets ● Fails to act in a responsible manner and creates an unwarranted level of financial risk for the stockholders ● Makes financial misrepresentations, such as operating with more than one set of books ● Takes actions in the name of the corporation that were not authorized by the board of directors

22. Corporations

23. Corporations Corporation : a separate legal entity from its owners. Types of corporations: Publicly held : a corporation that has a large number of shareholders and whose stock usually is traded on one of the large stock exchanges. Closely held : a corporation in which shares are controlled by a relatively small number of people, often family members, relatives, or friends.

24. C Corporation Traditional form of incorporation. Pays taxes at the corporate tax rate and stockholders also pay taxes on dividends they receive at their individual tax rates. Double taxation : a disadvantage of the corporate form of ownership in which the corporation’s profits are taxed twice, once at the corporate rate and again at the individual rate on the portion of profits distributed to shareholders as dividends.

25. S Corporation No different from any other corporation from a legal perspective. An S corporation is taxed like a partnership, passing all of its profits (or losses) through to individual shareholders. To elect “S” status, all shareholders must consent, and the corporation must file with the IRS within the first 75 days of its tax year. Follow 1/3, 1/3, 1/3 rule of thumb .

26. A corporation seeking S status must meet the following criteria: ● It must be a domestic corporation. ● It can only have only allowable shareholders, including individuals, certain trusts, and estates. ● It cannot include partnerships, corporations, or nonresident aliens as shareholders. ● It cannot have more than 100 shareholders. ● It can only issue one class of stock. However, S corporations can issue shares of stock with different voting rights.

27. Tax Rate Comparison Blank C Corporation S Corporation or LLC Corporate or limited liability company net income $500,000 $500,000 Maximum corporate tax 35% 0% Corporate tax $175,000 After-tax income $325,000 $500,000 Maximum shareholder tax rate 39.6% 39.6% Shareholder tax $65,000* $198,000** Total tax paid $240,000 $198,000 (Corporate tax plus shareholder tax) Blank Blank Total tax savings by choosing an S corporation or limited liability company = $42,000 blank blank *Using the marginal 20% tax rate on dividends: $325,000 × 20% = $65,000. **Using the marginal 39.6% tax rate on ordinary income: $500,000 × 39.6% = $198,000.

28. Limited Liability Company (LLC) Resembles an S Corporation but is not subject to the same restrictions. Two documents required: Articles of organization : similar to the corporation’s articles of incorporation, actually create the LLC by establishing its name and address, its method of management (board managed or member managed), its duration, and the names and addresses of each organizer. In most states, the company’s name must contain the words “limited liability company,” “limited company,” or the letters “L.L.C.” or “L.C. Operating agreement : , similar to a corporation’s bylaws, outlines the provisions that govern the way the LLC will conduct business, such as members’ capital contributions to the LLC; members’ rights, roles, and responsibilities; the admission or withdrawal of members; distributions from the business; and the way the LLC will be managed.

29. Limited Liability Company (LLC) The limited liability company (LLC) , like an S corporation, offers its owners limited personal liability for the debts of the business, providing a significant advantage over sole proprietorships and partnerships. LLCs, however, are not subject to many of the restrictions currently imposed on S corporations and offer more flexibility than S corporations. Although an LLC can have just one owner, most have multiple owners (called “members”). LLCs offer their owners limited liability LLC members can include non-U.S. citizens, partnerships, and corporations. Unlike a limited partnership, which prohibits limited partners from participating in the day-to-day management of the business, an LLC does not restrict its members’ ability to become involved in managing the company. Today most entrepreneurs form LLCs for their new businesses

30. Limited Liability Company (LLC) In addition to offering its members the advantage of limited liability, LLCs also avoid the double taxation imposed on C corporations. Like an S corporation, an LLC does not pay income taxes; its income passes through to the members, who are responsible for paying income taxes on their shares of the LLC’s net income. Because they are not subject to the many restrictions imposed on other forms of ownership, LLCs offer entrepreneurs another significant advantage: flexibility. An LLC permits its members to divide income (and thus tax liability) as they see fit, including allocations that differ from their percentages of ownership. These advantages make the LLC an ideal form of ownership for many small companies across many industries—retail, wholesale, manufacturing, real estate, or service. Because it offers the tax advantage of a partnership, the legal protection of a corporation, and maximum operating flexibility, the LLC is the fastest-growing form of business ownership.

31. Limited Liability Company (LLC) Despite their universal appeal to entrepreneurs, LLCs suffer some disadvantages. They can be expensive to create, often costing between $1,500 and $5,000. Some states also impose annual fees on LLCs. Unlike corporations, which can operate “for perpetuity,” LLCs have limited life spans. Entrepreneurs who want to provide attractive benefits to themselves and their employees will not find this form of ownership appealing because the cost of those benefits is not tax deductible in an LLC. Because there is no stock involved, this form of ownership also is not suitable for companies whose owners plan to raise money through an IPO or who want to use stock options or an ESOP as incentives for employees.

32. Creating a Legal Business Entity The average cost to create a legal business entity is about $1,000, but it can range from $500 to $5,000. Can use Web sites like MyCorporation and BizFilings and incorporate for just $100. But, be careful! The cost of filing incorrectly can be high. States have different regulations on forming business entities.

33. Buying an Existing Business

34. Key Questions to Consider Before Buying a Business (1 of 2) Is the right type of business for sale in the market in which you want to operate? What experience do you have in this particular business and the industry in which it operates? How critical is experience in the business to your ultimate success? What is the company’s potential for success? What changes will you have to make – and how extensive will they have to be – to realize the business’s full potential?

35. Key Questions to Consider Before Buying a Business (2 of 2) What price and payment method are reasonable for you and acceptable to the seller? Is the seller willing to finance part of the purchase price? Will the company generate sufficient cash to pay for itself and leave you with a suitable rate of return on your investment? Should you be starting a business and building it from the ground up rather than buying an existing one?

36. Advantages of Buying an Existing Business Successful existing businesses often continue to be successful It may already have the best location Employees and suppliers are established Equipment is already installed Inventory is in place and trade credit is established It’s turnkey New owners can use the previous owner’s experience Financing is easier to obtain It’s a bargain!

37. Disadvantages of Buying an Existing Business The financial costs are high It’s a “loser” Previous owner may have created ill will “Inherited” employees may be unsuitable The location may have become unsatisfactory Equipment and facilities may be obsolete or inefficient Change and innovation can be difficult to implement Inventory may be outdated or obsolete Accounts receivable may be worth less than face value The business may be overpriced

38. Acquiring a Business

39. The Acquisition Process

40. Negotiating the Deal Go into negotiations with a list of objectives ranked in order of priority. Try to understand what the seller’s priorities are. Work to establish a cooperative relationship based on honesty and trust. Avoid an “if you win, then I lose” mentality Look for areas of mutual benefit

41. Copyright