Why Businesses Choose to Exist in Different Forms
The way the business is formed means how it is owned. Each form of ownership has advantages and disadvantages.
Some business will change their form over time, others will stay the same for many years.
When you consider which form is best for each business, you need to understand the objectives of the business and how much risk the owners want to take.
Businesses which are owned by shareholders have responsibilities to meet their shareholders’ needs. These needs can impact on the business objectives and decision-making processes.
The Role of Shareholders and Why They Invest
Unlimited liability is dangerous for any business which must buy goods or services on credit before turning them into products to sell. This doesn’t matter so much for the type of one-person business, such as a window cleaner or supply teacher who sell their own time.
Therefore, if there’s a risk of losing the money a shareholder has invested, a major advantage of being incorporated is limited liability.
Also, because the investor knows the limit of their risk, it’s easier to raise money.
Money raised in this way is called share capital. It comes from selling shares in the business, which means selling a ticket to claim a proportion of future profits. These tickets are known as ordinary share capital. A shareholder or a group of shareholders need 50.1% of the share capital to control the business.
Shareholders provide capital at the foundation of a business when they buy the first issue of shares. After that, any time that a share is sold, the money goes to the owner of the share, not the business.
The incentive to own shares is twofold:
- Every year, a shareholder may receive a dividend. This is a small proportion of the profit.
- The value of shares may grow. If the business is successful, its dividends will increase and thus the shares become more valuable.
Dividends are a proportion of the profit paid out to shareholders as a reward for their investment and for bearing the risk. The total dividend is distributed in accordance with the relative proportion of each shareholder’s share ownership.
A business would almost never pay a dividend if it makes a loss, although it is not obliged to pay a dividend if it makes a profit. It may say it wants to use the profits to reinvest in the firm.
Market capitalisation is total value of all the shares. It is calculated by the total number of shares multiplied by the value of each share. It is a good measure of the general size of the business and whether it’s becoming more valuable in relation to other businesses.
The share price could rise or fall for the following reasons:
- If the dividend changes or is predicted to change. A higher dividend makes the share more valuable. A profitable business or potentially profitable business will see its share price increase.
- If the business might be sold to another company.
- If the business launches a new product.
- If the business fails to meet objectives, especially financial targets, its share price could fall
- If the external environment changes, which might affect the market in which the business operates.
Shareholders want the share price to increase. If it doesn’t, they will put pressure on the board of directors to make changes. If the directors fail, then the shareholders can sack the directors and replace them with people who they think will do the job more effectively.
Types of Business
A business is either corporate or non-corporate.
A corporate business is a separate legal entity. That means it can make contracts, sue and be sued. The owners of that business are not liable for any costs incurred should the business go bankrupt.
A non-corporate business is a person (or persons). They are personally liable for any costs incurred by the business and they can be sued personally.
Sole traders and some partnerships are non-corporate. Private limited companies, public limited companies, mutual and charities are corporate.
A corporate business has limited liability. Shareholders (owners) are only liable for the money they have put into the business. Limited liability protects these owners should the business go bankrupt. Any outstanding debts that the business cannot pay will not be paid by the shareholders.
As a non-corporate business a sole trader, and some partnerships that are not incorporated, bear all responsibility for the liabilities generated by the business. A sole trader is not necessarily a one person business as it may have employees.
Advantages: Cheap to set up, all the profits go to the owner, the owner makes the decisions and doesn’t have to publish results for shareholders or file accounts with Companies House.
Disadvantages: Unlimited liability, may have difficulty raising finance.
Private limited companies
One or more shareholders (owners), who share the profits. The owners may or may not be the business managers. The business enjoys limited liability but has more administrative costs as a result. A private limited company can raise money by issuing and selling more shares.
Advantages: Limited liability, easier to borrow money than sole traders, doesn’t have to disclose as much detail as public limited companies.
Disadvantages: More difficult to sell shares – majority of shareholders need an agreement with other shareholders first, cannot raise the same sort of finance as PLCs, and it has some administration fees, although not as much as PLCs.
Public limited companies (PLCs)
Many owners, who share the profits. Shares are bought and sold in the open market. It’s unlikely that major shareholders will be directors, though directors may well have shares.
Advantages: Limited liability, greater access to finance, easier to gain credit from suppliers.
Disadvantages: Needs to meet needs of shareholders, disclose more information, and subject to regulatory regime of stock exchanges and markets. Expensive to administer.
Private and public sector businesses
Private sector companies are owned by the members of the public, or other businesses. Public sector companies are owned by the government. Therefore, there are no shareholders in a public sector company. They don’t make profits, they make surpluses.
NPOs, mutuals and charities
Non-profit organisations plough any surpluses back into their operations. They will be keen to generate surpluses, because these surpluses can be used to invest in the organisation and allow it to grow.
Mutuals are businesses which are “owned” by their members, for example, building societies. They aim to generate returns for the members.
Charities don’t have owners but are run by a board of directors who are trustees required to follow the objects set out in the trust deed. They are subject to regulation by the Charities Commission.
The Effects of Ownership on Mission, Objectives, Decisions and Performance
Sole traders make all their own decisions without pressure from shareholders.
By contrast, shareholders are interested in the growth in value of their shareholdings and returns on their investment. That might make the business look to generate short-term profits at the expense of long-term profits.
In private limited companies, the shareholders may have a longer term view because they are likely to be more closely related to the business and its management.
In PLCs, there’s normally a greater separation as between the owners and the directors.
|Limited liabilities||Shareholders are only liable for the money they have invested ‐ not for the overall debts and liabilities of their business|
|Sole trader/unlimited partnership||A one‐person business, or a group of people working together but not incorporated, with unlimited liability for the debts of that business|
|Private limited company||A business owned by shareholders who have limited liability; the shares cannot be sold on the Stock Exchange|
|Public limited company||A business owned by shareholders who have limited liability; the shares can be traded on the Stock Exchange|
|Private sector||Businesses owned by private individuals or other businesses|
|Public sector||Businesses owned by the government|
|Non-profit organisation||A business which reinvests any profits (surpluses) back into the business|
|Mutuals||Businesses which are owned by the workers and/or customers|
|Shareholders||Owners of shares in a business|
|Ordinary share capital||The finance raised from the sale of shares in a limited company|
|Market capitalisation||The total value of all the shares: share price x number of shares|
|Dividends||Payments to shareholders taken from retained profit|
- What is the difference between a corporate and non-corporate business?
- Your answer should include: person / separate / legal / entity
- Identify two incentives for shareholders to provide capital to a business.
- Your answer should include: capital / growth / dividends
- What can protect owners from bankruptcy?
- Your answer should include: limited / liability
- What’s the equation for market capitalisation?
- Your answer should include: shares / number / value
- Exam Style QuestionAS Specicen paperDo you think that buying shares in Royal Mail plc when they were first sold was a good decision? Justify your answer. [16 marks]
- Your answer should include: balance / however / conclusion / because / Royal Mail / investors / government / profit / short-term / long-term / dividends / growth / shareholders
Explanation: This is a 16 mark question, so you should be spending at 16 minutes on it. You should define shares, and then think about the pros and cons of buying shares. For these questions, make a point, explain why it's relevant to this question, then explain the business studies behind it. Finally, you need to say why it's a good decision. That means putting weight to your answer.