Session 2: Forms of Business Organisation Learning Objective - Outlining different forms of business, their features, advantages and disadvantages.
Important Terms - Sole proprietorship
- Partnership.
- Limited liability partnership.
- Limited company.
- Ordinary shares
- Preference shares
Forms of Business Organisation - Sole Proprietorship
An unincorporated business owned by an individual and is not treated as a separate legal entity to its owner. The individual receives all profits or losses and is liable to the obligations of the business. Sole proprietorships represent the largest number of businesses in most countries, but typically they are the smallest in size.
Advantages of sole proprietorship:
- Cheap set up cost
There are no legal complications in setting up a sole proprietorship. There are no minimum or maximum limits for capital. The business is flexible in its operations as it can engage in any other operations without any restriction as it may be the case with the limited companies. - Reduced operating costs
As much of the running of the business is done by the owner, the business saves on labour costs as will not be required to hire expert help. Being run by the owner ensures prompt decision making and is able to capture business opportunities as they arise. - The business avoids corporation tax
Sole proprietorship is not required to pay corporation tax because it is not a separate legal entity from its owner so the profit made by the business will be taxed in the hands of its owner. Personal tax is slightly lower than corporation tax. Example here in Malawi the first K36,000 is tax free for a sole trader, next K18,000 is at 10% , next K18,000 at 20% and the K1,128,000 at 30% and the excess over 40%. While for the incorporated companies the rate is 30% regardless of the level of profit made. - It is subjected to few government regulations
As stated above there is no regulation on minimum or maximum capital, the sole proprietorship is not required to file its accounts with the registrar of companies no need to produce memorandum and articles of association. There is no compulsory audit as is the case with limited companies.
Disadvantages of Sole proprietorship:
- Failure to raise funds
Many financial institutions consider sole proprietorship as risky ventures and are not willing to extend finance to these entities. Sole proprietor may not able to raise capital on his own unlike in partnership where they are able to share the financial burden of raising funds. - The proprietor has unlimited liability
As the business is not treated as a separate legal entity from its owners any unpaid debt by the enterprise can be recovered from the personal wealth of the owner even if it was generated from other sources not related to the business. - Short life of business
Most sole proprietorship faces the problem of succession, if the original owner dies then the business goes with him or her. Usually there are no laid plans for continuity in most sole proprietorships. - Lack of business skills
There is no division of responsibilities in most sole proprietorships as management and running of the business is done by a single individual. This affects the daily operations of the business because if the owner is sick or engaged in other personal activities then usually the business is incapacitated.
- Parnership
A Partnership is a relationship that subsists between or more persons carrying on business in common view of sharing the profits or losses of the business. It operates as a collection of sole proprietorship. The partners share the profits and losses of the partnership according to an agreed –upon formula. Generally, any partner can bind the partnership to another party, and if necessary, the personal resources of each partner can be called on to pay obligations of the partnership. A partnership, just like as sole proprietorship, is not a separate legal entity legal entity from its owners hence the need to call on private assets when partnership fails to settle any obligation.
A partnership must be dissolved if the ownership changes, as when a partner leaves or dies. If the business is to continue as a partnership after this occurs, anew partnership must be created and new partnership agreement be signed.
Contents of Partnership Agreements
The written agreement can contain as much, or as little, as the partners want. The law does not say what it must contain. The usual accounting contents are: - The capital to be contributed by each partner.
- The ratio in which profits are to be shared.
- The rate of interest, if any, to be paid on capital before the profits are shared.
- The rate of interest, if any charged on partnership drawings.
- Salaries to be paid to partners.
- Arrangements for admission on new partner.
- Procedures to be carried out when a partner retires or dies.
Limited Partnership
Limited partnerships are partnerships containing one or more limited partners. Limited partners are those partners which are not liable for the partnership debts.i.e they can not use personal properties to cover the partnership unpaid liabilities.
Limited partnership has the following characteristics and restrictions on their role in the partnership; - Their liability for the debts of partnership is limited to the capital they have put in. They can loose the capital but can not be required for more money to pay partnership debts.
- They are not allowed to take out or receive back any part of their contribution to their partnership during its lifetime.
- They are not allowed to take part in the management of the partnership or to have the power to make the partnership take decision. If they do, then they will be liable to partnership debts.
- All partners cannot be limited partners, so they must be at least one general a partner with unlimited liabilities.
Advantages of partnership
- Cheap set up cost
There are no legal complications in setting up just as in a sole proprietorship. There are no minimum or maximum limits for capital. The business is flexible in its operations as it can engage in any other operations without any restriction as it may be the case with the limited companies. - More capital raised
Partnership is able to raise more capital than the Sole proprietorship though not as much as can be raised by the limited company. - Reduced tax liability
Just as in sole proprietorship the partnership is not required to pay corporation tax. Each partner will be assessed tax on individual basis basing on the profits allocated from partnership. As stated above individual tax is lower than the corporation tax.
Disadvantages of partnership
- The proprietor has unlimited liability
As the business is not treated as a separate legal entity from its owners any unpaid debt by the enterprise can be recovered from the personal wealth of the Partners even if it was generated from other sources not related to the business. The liability is high in partnership as the action by one partner will render all partners liable even if the action was effected without their consent. The exception is for a limited partner as is not required to share the debts of the partnership. - Short life of business
When one partner dies or retires legally means the partnership is dissolved and there will be a need to negotiate for a new partnership. Transfer of ownership is very difficult unlike in limited companies where the stake can be acquired or disposed off easily. - Failure to raise capital
It is very difficult to obtain large loans from financial institutions as they consider partnerships as more risky. Partnerships may not able to raise capital as in limited companies because they have no access to share markets. - Limit on number of partners
Partnership has a requirement that its members should not be less than two and can not exceed twenty, so even if more people are willing to join and bring in new capital they are legally barred.
- Limited Liability Corporation
A limited liability corporation is a legal entity created through state approval, which is treated as a separate person from its owners. A limited company is said to possess a ‘separate legal identity’ from its shareholders. This means a company can sue or be sued, can own assets and its liabilities will not affect the personal property of its owners.
The capital of limited company is divided into shares. Shares can be of any nominal value 50t, K1, K2 or any other amount per share. To become a member of a limited company or a shareholder, a person must buy one or more of the shares.
If the shareholders have paid in full for the shares, their liability is limited to what they have already paid on those shares. If a company loses all its assets all the shareholders can lose are the amount they paid on the shares.
Private and Public Companies
There are two classes of companies, the public and the private company. Their main differences are that the public company is the one which must satisfy the following: - Its memorandum of association must state that it is a public company and it has registered as such.
- Minimum membership is two and has no maximum number.
- It is allowed to offer its shares to offer its shares to the public.
- Its name must end with the word ‘public limited company’ or ‘PLC’.
A private company is usually, but not always smaller business, and may be formed by one or more persons. It is defined as a company which is not public. The main difference with public company is that: - The number of members is restricted to 50.
- It is not allowed to offer its shares for subscription to the public at large.
Dividend
Shareholders of a limited company obtain their reward in the form of a share of the profits, known as dividends. The directors consider the amount of profits and decide on the level of profit to be distributed as dividend and amount of profit to be retained in business as reserves. It is important to note that the shareholders cannot propose a higher dividend for themselves than already proposed by the directors
Share Capital - Ordinary shares
These are shares which are subordinate to all other classes of shares in terms of dividend and liquidation distribution. Ordinary shareholders are the owner of the business and they have voting rights in all affairs of the enterprise. They have powers to appoint and dismiss the directors. Their entitlement to dividend depends on amount which has been declared by the directors. - Preference shares
These are share which contain the fixed amount of dividend. If the shares are quoted as 100,000 K1 12% Dividend means that every year the shareholder should expect K12,000 (12%*K100,000).They carry no voting rights unless they are participatory preference shares. Preference shares are of two types. - Cumulative preference shares
These are entitled to fixed amount of divided and if dividend for the year has not been settled may be due to inadequate profit, any outstanding dividend is carried forward to be paid in the year of abundant profit. - Non cumulative preference shares
The share holders in this case lose any outstanding dividend for the year because there is no right to carry forward unpaid dividend for the year.
Advantages of a Limited Company - Limited liability of members
Member’s liability is restricted only any amount of unpaid shares for the company; otherwise there is no requirement to make further contribution out of personal property for the debts of the business. - Ability to raise more capital
Inviting venture capitalists or other potential shareholders is relatively easy for limited companies than in other forms of businesses. Companies have better chances of obtaining long term finance from financial institutions. - Business continuity
As it is easy to transfer ownership through share transfers, it is also easy to pass ownership of a company from generation to generation. The limited companies also are able to maintain but also attract quality employees which result in efficient operation of the business.
Disadvantages of Limited Company - Tax burden
A limited company is subjected to high tax rates and the shareholders are subjected to double taxation. The company’s profit is subjected to tax and when shareholders receive dividends they are also taxed. - High setting and operating costs
A limited company has to go through rigorous stages in order to be registered. The company is required to file its accounts with registrar of companies and tax authorities annually.
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