Chapter 7 - Choosing the right legal structure

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Chapter 7 Choosing the right legal structure for the business

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Chapter 7 In this chapter we will look at the key decision of choosing the right legal structure for a new business. We will learn about The benefits and drawbacks of sole traders, partnerships and private and public limited companies The importance of limited and unlimited liability status

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Learning Objectives At the end of this chapter you will be able to Understand the main features of different types of business structure, and their benefits and drawbacks. Understand the difference between unincorporated and incorporated structures Understand the significance of liability Explain the process of starting different types of business structure Evaluate the benefits and drawbacks of each type of business structure for specific situations and be able to make reasoned conclusions about the most appropriate.

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Setting the Scene Read Compass Point case study Write quick notes Class discussion

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What is the best legal structure? There are 4 different types of legal structure Sole trader Partnership Private Limited Public limited Think about your allocated type What kind of company would chose this structure? What do they have to do gain this structure? What are the advantages of this structure? What are the disadvantages of this structure? Make a poster to present to the class

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Which is the right legal structure? This is one of the first decisions to be made It affects The amount of tax and national insurance paid The records and accounts that have to be kept The liability faced by the owner if the business fails The sources of finance available The way decisions are made Options Unincorporated Sole trader Partnership Incorporated Private limited company Public limited company

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Which is the right legal structure? Incorporation basically means that you create a legal entity (something that exists as far as the law is concerned). If you J. Smith were a sole trader or partnership and you were going out of business it would be you J.Smith that would personally liable to pay any debts and it would be you that would appear in court. If you were J.Smith Ltd the debts would belong to the business and it would be the business (not you personally) that would be taken to court When a business is unincorporated the owner is the business

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Sole Trader (Unincorporated) The most common and simplest form of business organisation One person operating a business alone Very little procedure to get going Need to keep records for tax, national insurance and VAT purposes of tax and national insurance paid In the UK there are numerous sole traders but they contribute less to total output than limited companies Benefits Simple and quick to set up Inexpensive to set up Any profit made is the owners to keep or reinvest Owner has complete control and all decisions are his/hers. Simplicity often means a close business/customer relationship Hours of work can be tailored to suit the entrepreneur

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Sole Trader (Unincorporated) Drawbacks Unlimited liability – the owner is personally liable for all debts incurred by the business Difficult to raise additional finance – owners have little security against which to raise more. Banks may be willing to help if there is a good business plan All decisions rest with the owner but they may not have the expertise. The owner may know everything about the product but nothing about finance and marketing etc. The drive comes from the owner – business is vulnerable if the owner becomes ill or other things happen in their life

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Partnerships (Unincorporated) The simplest way two or more (up to 20) people can be in business together. Although it is not a requirement partners often draw up a Deed of partnership that puts in writing How much of the finance each will contribute How much control over decisions each partner has How the profits will be shared How the partnership can be ended Benefits Few procedures to set up (as with sole trader) The expertise of more than one person can be brought into the business for decision making and sharing work load (unlike the sole trader) Different partners may specialise in different aspects of the business Each partner can contribute finance

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Partnerships (Unincorporated) Drawbacks Unlimited liability just like the sole trader – the owners are all personally liable for all debts incurred by the business. A bad decision by one of the partners will have consequences for all the partners The partners are legally bound to honour the decisions of the others The partnership will end on the death or resignation of a partner A maximum of 20 people can join a partnership thus limiting the size of the business and sources of funds In the exam you may have to justify a decision about which is the best form of legal structure. Don’t just restate the benefits and drawbacks. Apply your points by considering why the particular business would benefit most from one form rather than another

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Private Limited companies (incorporated) The owners are shareholders Amount of ownership depends on how many shares are owned. E.g. if a business has 100 shares in total and 20 of these are held by one person, that person owns 20% of the company 20% of the shares = 20% equity Must have Ltd in the name Limited liability – the owners liability is limited to the amount they have invested in the company This means that if the business goes bust the owners will not have personal assets seized. Because there is limited liability limited companies go through a much more complicated process when they are created Must keep much more detailed records so that potential investors and lenders can make sure the company is being run properly Limited Liability – owners are not liable for the debts of the business; they can lose no more than the sum they invested

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Private Limited companies (incorporated) This is a popular form of business for family businesses and small well established businesses. Shares can only be sold privately and with only with the consent of the shareholders Benefits Access to funds through the issue of shares Stable form of business structure Limited liability is a benefit to shareholders Incorporation means the business exists even if the shareholders die or resign Drawbacks Banks may see the business as a risk More complicated set up process Lenders may see limited liability as a risk Registrar of companies – the government department that can allow firms to become incorporated; located at companies house where the annual accounts of limited companies are available for public scrutiny

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Becoming a PLC Why? (the advantage!) If we want to grow our company we need a lot of finance . We can’t really ask the bank for that money. If we become a public limited company and sell shares on the stock market we will raise the money that we need Companies sell shares to the public to raise the large amounts of finance that they need to invest into their company and grow

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Becoming a PLC Downside It will be very expensive to do this. We will need to pay legal fees to the lawyers. We will need to advertise the business to the public. Plus we will need to underwrite the shares. That means that we have to pay a fee to the underwriters who will guarantee to buy any shares that we don’t sell. I heard that it can cost up to £1 million It takes a long time to float a business and it can be very expensive but that does depend on how much your company is worth

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The managers run the company and they believe that they know what is best for that company Becoming a PLC Downside If we sell our shares on the market we will have greedy shareholders watching our every move. They will want to see their share price go up and expect to be paid a dividend each year. Instead of making decisions that are best for the company in the long term we might be pushed to think about only making short term profit to push the share price up There is no proof that stock exchange listing leads to short-termism, only the suspicion that in many cases it does Sometimes shareholders and managers have different ideas of how to run their companies. This is called divorce (or separation) of ownership and control The shareholders own the company so they think they have the right to say how it is managed

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Becoming a PLC We don’t have to sell all of our shares. Look at Sports Direct. Mike sold 43% of their shares. He got 300p per share and made £900 million. Companies can sell all or part of their business as long as they sell more than £50,000

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Becoming a PLC If the market price of our shares goes up we will not make any money. We will only raise money on the initial sale Companies only make money the first time they sell/issue the shares. They don’t make money when the shares change price. It does affect the value of their company because the value of the company is share value x number of shares That is true, however if we only sell 49% of our shares and they reach a good price we can sell some more at a later date when we need more finance

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Why be a shareholder I want to make money so that when I am old and not working I will be able to live to a good standard I could save money in the bank but the interest rates I receive are so low. I want to make more money from my money If I buy shares I should get a regular income from the company (dividend). This is my payback for investing in them If the share price goes up I will make money. For example if I buy 100 shares at £3 I will spend £300. If they go up to £4 I can sell them for £400. The share value has increased To buy shares I can go to a financial investor and he will invest my money into different shares. He is the expert so he knows which companies I should be investing in. He knows when to buy and when to sell so that I make the most money Shareholders are argued to be profit maximisers – they only care about the dividends and share value Sometimes shareholders will agree to forgo their dividends so that the business can invest more, grow and bring larger long term benefits

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How does share value or dividend change? The shares are traded on the stock market. The market dictates the price of the shares It is all about demand for the shares If the demand for shares increases the shares will increase in value If investors don’t think that the company is performing very well the demand for the shares will go down. If the demand goes down the price goes down The dividend is dependent on the amount of profit the business makes – if they make a lot of profit they may pay out large dividends (maybe once or twice a year) The dividend is also dependent on how much the business wants to invest back into the business. If they want to invest more they will pay less in dividends

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Public Limited companies (incorporated) The owners of a plc are shareholders as with a private ltd company The difference is that the shares are bought and sold publicly on the stock exchange – anyone can buy them Shares have a market value – on any given day shares can be traded which affects the share price Remember – A company raises funds only when it first issues shares. When shares are bought and sold on the stock exchange this does not generate funds for the business (this is a second hand market). It is only an indicator of how popular the company is and how much would be gained from issuing further shares. Benefits The main benefit is the scale of funds raised from a flotation Future funds an be raised because banks see plc’s as stable and will lend large sums of money

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Public Limited companies (incorporated) Drawbacks The process of flotation is very expensive and complicated someone has to underwrite the shares that may not be sold (they have to guarantee to buy the shares that are not bought) The company must have a minimum of £50,000 in share capital of which 25% must be sold before the plc can trade It is not possible to control who owns the shares Competitors, customers and suppliers can buy A takeover cannot be prevented There is a large amount of financial information that must be provided so that investors can see how the business is doing Separation of ownership and control – shareholders own and managers manage

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Not-for-profit businesses – social enterprises Some businesses are not motivated to make profit Estimates of 55,000 social enterprises in the UK and growing Examples – Jamie Oliver’s Restaurant 15, The Eden Project and Café Direct Social enterprises aim to provide social benefit Charities are an example of a social enterprise The still want to make a profit but that profit is reinvested into the business so that social aims can be met rather than paid out to owners The Eden Project As well as creating stunning gardens and laying on fantastic arts and music events, much of our energy goes into: running transformational social and environmental projects on our doorstep and around the world creating unforgettable learning experiences for students doing valuable research into plants and conservation making sure we run our operations in the greenest possible way.

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Not-for-profit businesses – social enterprises Benefits Entrepreneurs can make a living and feel they are doing something valuable which is motivating Society benefits from the business success Customers may be more willing to buy from a social enterprise May be easier to recruit, motivate and retain employees Grants or other sources of finance may be available from sources that share the same aim Drawbacks Profit and social aims may conflict The entrepreneur will always have to accept a lower return Jamie Oliver's Fifteen is a restaurant that uses the magic of food to give unemployed young people a chance to have a better future. Profits go to the Jamie Oliver Foundation

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Summarising Read Case Study P49 Answer Questions

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Learning Objectives – did we achieve them? At the end of this chapter you will be able to Understand the main features of different types of business structure, and their benefits and drawbacks. Understand the difference between unincorporated and incorporated structures Understand the significance of liability Explain the process of starting different types of business structure Evaluate the benefits and drawbacks of each type of business structure for specific situations and be able to make reasoned conclusions about the most appropriate.