Fundamentals of Corporate Finance

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The Firm and the Financial Manager 5
after the Internal Revenue Service has taken its cut. The advantages of a proprietorship
are the ease with which it can be established and the lack of regulations governing it.
This makes it well-suited for a small company with an informal business structure.
As a sole proprietor, you are responsible for all the business’s debts and other liabilities. If the business borrows from the bank and subsequently cannot repay the loan, the
bank has a claim against your personal belongings. It could force you into personal
bankruptcy if the business debts are big enough. Thus as sole proprietor you have unlimited liability.
PARTNERSHIPS
Instead of starting on your own, you may wish to pool money and expertise with friends
or business associates. If so, a sole proprietorship is obviously inappropriate. Instead,
you can form a partnership. Your partnership agreement will set out how management
decisions are to be made and the proportion of the profits to which each partner is entitled. The partners then pay personal income tax on their share of these profits.
Partners, like sole proprietors, have the disadvantage of unlimited liability. If the business runs into financial difficulties, each partner has unlimited liability for all the business’s debts, not just his or her share. The moral is clear and simple: “Know thy partner.”
Many professional businesses are organized as partnerships. They include the large
accounting, legal, and management consulting firms. Most large investment banks such
as Morgan Stanley, Salomon, Smith Barney, Merrill Lynch, and Goldman Sachs started
life as partnerships. So did many well-known companies, such as Microsoft and Apple
Computer. But eventually these companies and their financing requirements grew too
large for them to continue as partnerships.
CORPORATIONS
As your firm grows, you may decide to incorporate. Unlike a proprietorship or partnership, a corporation is legally distinct from its owners. It is based on articles of incorporation that set out the purpose of the business, how many shares can be issued, the
number of directors to be appointed, and so on. These articles must conform to the laws
of the state in which the business is incorporated. For many legal purposes, the corporation is considered a resident of its state. For example, it can borrow or lend money,
and it can sue or be sued. It pays its own taxes (but it cannot vote!).
The corporation is owned by its stockholders and they get to vote on important matters. Unlike proprietorships or partnerships, corporations have limited liability, which
means that the stockholders cannot be held personally responsible for the obligations of
the firm. If, say, IBM were to fail, no one could demand that its shareholders put up
more money to pay off the debts. The most a stockholder can lose is the amount invested
in the stock.
While the stockholders of a corporation own the firm, they do not usually manage
it. Instead, they elect a board of directors, which in turn appoints the top managers. The
board is the representative of shareholders and is supposed to ensure that management
is acting in their best interests.
This separation of ownership and management is one distinctive feature of corporations. In other forms of business organization, such as proprietorships and partnerships,
the owners are the managers.
The separation between management and ownership gives a corporation more flexibility and permanence than a partnership. Even if managers of a corporation quit or are
SOLE PROPRIETOR
Sole owner of a business
which has no partners and
no shareholders. The
proprietor is personally liable
for all the firm’s obligations.
PARTNERSHIP
Business owned by two or
more persons who are
personally responsible for all
its liabilities.
CORPORATION
Business owned by
stockholders who are not
personally liable for the
business’s liabilities.
LIMITED LIABILITY
The owners of the
corporation are not
personally responsible for its
obligations.

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