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/complement

ary 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.

Company State Industry

Cargill MN Farming

Koch Industries KS Chemicals

Dell TX Computers

Bechtel CA Construction

PricewaterhouseCoopers NY Business Services

Mars VA Food

Pilot Flying J TN Convenience Stores

Publix Supermarkets FL Grocery

Ernst & Young NY Business Services

C&S Wholesale Grocers NH Food Wholesale

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

Company Bad Move

Atari

The amount of surplus from a bad game was so big,

the copies had to be buried in a New Mexican

landfill.

BlockbusterPassed on a partnership with Netflix and ended up

going bankrupt in 2011.

Coca-ColaNew Coke lasted only 77 days because Coca-Cola

received more than 1,500 complaint calls a day.

Pan American World

Airways

After the bombing of Flight 103, the airline blamed

the government after the victims’ families filed a

$300 million lawsuit.

Pets.com

Debuted with a $3 million Super Bowl ad and a

Macy’s Thanksgiving Day Parade float. Nine months

later, they went bankrupt.

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

Company Year Started Type of Company

J.E. Rhoads & Sons 1702 Conveyer Belts

Covenant Life

Insurance1717 Insurance

Philadelphia

Insurance1752

Insurance

Contributorship

Dexter 1767 Adhesives & Coatings

D. Landreth Seed 1784 Seeds

Bank of New York 1784 Banking

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

Rank Company Industry

1 Mac Tools Automotive tools

2 Bricks 4 Kidz Toys

3 Orange Leaf Frozen Yogurt Frozen yogurt

4 Sears Hometown Appliances

5 Fitness Revolution Personal and group fitness

6 The Grounds Guys LLC Landscape management

7 Paul Davis Emergency Services Restoration

8 Doc Popcorn Food

9 Title Boxing Club Personal and group fitness

10 Fuzzy’s Taco Shop Food

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

Rank Company Industry

1 Jan-Pro Disaster Restoration

2 Cruise Planners Travel

3 Vanguard Cleaning Systems Commercial Cleaning

4 Snap-on Tools Professional Tools

5 Matco Tools Professional Tools

6 Jazzercise Fitness

7 CleanNet USA Commercial Cleaning

8 Budget Blinds Home Décor

9 Coverall Health-Based Cleaning Commercial Cleaning

10Chem-Dry Carpet & Upholstery

Cleaning

Commercial and

Residential Cleaning

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?