L-5 Business Organigations

OPTIONS FOR ORGANIZING SMALL AND LARGE BUSINESSES

Most people sometime consider starting their own business. In the US, most businesses are small businesses, many employing fewer than five people. However, before entering the world of business, an entrepreneur needs to understand its framework. Every business owner must choose the form of legal ownership that best meets the company’s needs.

Several variables affect the choice of the best way to organize your business:

·        How easily can you set up this type of organization?

·        How much financial liability can you afford to accept?

·        What financial resources do you have?

·        What strengths and weaknesses do you see in other businesses in the industry?

·        What are your own strengths and weaknesses?

Most Businesses are Small Businesses

A small business is a firm that is independently owned and operated and is not dominant in its field. The small business administration (SBA) also considers sales and number of employees to identify small businesses for specific industries;

·        Most manufacturing businesses are considered small if they employ fewer than 500 people

·        A wholesaler must not employ more than 100 people

·        Most retailers and other services are small if their annual sales are less than $5 million

·        An agricultural business is small if its sales are less than $500,000 per year

Typical Small-Business Ventures

Businesses least likely to be acquired by larger firms are those that sell services, rely on consumer trust and proximity, and keep overhead costs low. Small businesses provide the majority of jobs in the construction, agricultural services, wholesale trade, services, and retail trade industries.

Retailing is another important industry for today’s small businessperson. Small-business retailing includes stores that sell shoes, jewelry, office supplies and stationery, clothing, flowers, drugs, convenience foods and many other products.

Powell’s Books, based in Portland, Oregon, is one of the most successful retail bookstores in the US. In contrast to so-called “Big Box” book superstores like Barnes & Noble and Books-A-Million that use their huge buying power to secure lower prices for large orders and Amazon.com’s well known high-tech, stock-everything strategy, Powell’s competes by specializing in used, sometimes hard-to-find books. Through its seven bookstores and its Web site (Powells.com), Powell’s serves customers who like buying from an independent store. Sometimes, two competitors cooperate with each other. Powell’s buys returned books from Amazon.com at a discount and sells them as used. Amazon fills orders for out-of-print books through Powell’s.

Most likely to be a Small Firm	Fewer than 20 workers	Least likely to be a Small Firm	Fewer than 20 workers
Dentists	98%	Hospitals	4%
Home builders	97	Paper mills	22
Florists	97	Nursing homes	23
Hair Salons	96	Oil pipelines	25
Auto repair	96	Electric utilities	39

Almost half of small businesses in the US are home-based businesses – firms operating from the residence of the business owner. Since 1980, the number of people working at home has more than doubled. A major factor in this growth is the increased availability of personal computers and other communications devices such as fax machines and cell phones. Working from home helps keep costs down.

Some home businesses are using the internet to attract customers and keep marketing costs down, such as ShadeSaver.com, who sell 50% of their products through eBay, the online auction site. Other benefits of a home-based business include greater flexibility and freedom from the time and expense of commuting.

Drawbacks include isolation and less visibility to customers.

Many small businesses are more competitive because of the Internet. However, the internet does not automatically guarantee success, as illustrated by the thousands of dot.com failures in the early years of e-commerce.

Contributions of small business to the economy

Small businesses form the core of the economy. Businesses with fewer than 500 employees generate 47% of total US Sales and over half the nation’s gross domestic product. They also employ 53% of the private non-farm workforce.

Small businesses contribute to the economy in three main ways; creating jobs, creating new industries and attracting new industries. Seventy-five percent (75%) of new jobs created in the US over the last 10 years were at companies with fewer than 500 workers.  Small firms are dominant factors in many of the industries that that have added the most jobs: engineering and management services, construction trade contractors, wholesale trade, amusement and recreation, social services, and restaurants.

Many of today’s leading companies such as Microsoft and Dell started as small businesses. The growth of new businesses not only creates new goods and services but also drives local economies. Another contribution is the services provided to the larger corporate community such as outsourcing of security and logistics.

Community leaders realize the importance of small businesses to their cities, and successful revitalization programs have improved conditions in depressed areas by attracting new industries. Government has supported poorer areas by providing tax breaks and loan guarantees.

Advantages of a small business

Small businesses differ in many ways from larger firms including organization, market positions, staff capabilities, managerial styles, organizational structures and financial resources. However, these differences are not disadvantages. There are four main advantages of small businesses; innovation, superior customer service, lower costs and opportunities to fill isolated niches.

Small businesses are often fertile grounds in which to plant innovative ideas for new goods and services. Albany Molecular Research, for example, focuses on research and development for new drugs on a contract basis. The company employs 200 chemists and tackles research projects for such industry giants as DuPont Pharmaceuticals and Eli Lilly.

In a typical year, small firms will develop twice as many product innovations per employee than larger firms. They also obtain more patents per sales dollar than larger firms. Key innovations that were developed by small firms include the airplane, the personal computer, optical scanner and soft contact lens. One area where small firms will be involved in the near future is security – whether it’s the protection of information or the protection of people.

Small firms are also able to offer superior customer service because of their greater flexibility and by tailoring its product line and services to the needs of customers.

Small firms are also able to keep costs down by keeping overhead costs down. Overhead costs are those not directly related to the services provided. Many small firms reduce rent and electricity by operating out of homes. In addition, these small firms often carry little or no inventory, further reducing total operating costs. A typical small business sets up a lean organization with a small staff and few support personnel. The lower costs of maintaining a small permanent staff can provide a distinct advantage for a small business.

Another advantage of small firms is their ability to fill isolated market niches. A niche market may be thought of as a narrowly defined group of potential customers. A distinct niche market usually evolves out of a market niche, where potential demand is not met by any supply.

A niche market is usually avoided by larger firms because their high overhead costs force them to set minimum size for their target markets. An example of a firm filling an isolated niche would be a retail store that specializes in selling products designed for left-handed people – such as golf sticks. In some industries, most firms are small businesses, such as restaurants.

Disadvantages of a small business

The main disadvantages facing small firms are management shortcomings, inadequate financing, and government regulations. Because of these difficulties, 24% fail within 2 years, 52% fail within 4 years, 62% of all small firms fail within 6 years and the figure is 82% within 10 years.

One of the main factors behind failure is the lack of management skills. Entrepreneurs often have great marketing and interpersonal skills but lack other crucial skills such as financial management skills.

Another leading cause of problems is inadequate financing. Owners assume that enough cash will be generated from operations during early months to cover expenses. However, starting a business is expensive and many businesses fail within 2 years.

Sources of Small-Business Financing:
Trade Credit	61%
Personal Credit Card	39%
Business Credit Card	28%
Line of Credit	26%
Motor Vehicle Loan	24%
Equipment Loan	14%
Financial Lease	9%
Mortgage Loan	6%

The main sources of finance for new firms are trade credit, personal credit card and business credit card. Trade credit is purchasing goods or equipment from a supplier who finances the purchase by delaying the date of payment for those goods. A line of credit is an agreement between a bank and a borrower, indicating the maximum amount of credit the bank will extend to the borrower.

The biggest users of credit cards are tiny firms with less than 10 employees. Inadequate financing also makes it more difficult to attract talented people, who are tempted by the better benefits and salaries on offer at larger firms. One option is to offer stock options to workers, whereby the success or failure of the firm is tied to the performance of the worker.

Another disadvantage of small firms is the complexity of business regulations and paperwork. Congress sometimes exempts the smallest companies from certain regulations.

Benefits of a good business plan

Despite all the pitfalls, many small businesses succeed. They can increase the chances of survival by two methods:

·        Developing a good business plan

·        Use resources available such as the SBA.

A business plan is a written document that provides an orderly statement of a company’s goals, the methods by which it intends to achieve these goals, and the standards by which it will measure achievements. A good business plan will include a detailed time frame for achieving specific goals, projections of money flows (both income received and expenses paid), and units for measuring achievements (sales, profits, or changes in market share). The plan should also include the methods by which a firm will achieve specific goals, procedures it will follow, and values that define important standards for conduct.

It is important to do research before starting a business.  A business plan typically includes the following components:

·        An executive summary that briefly describes the venture

·        An introduction

·        A financial section that includes financial forecasts of need for funds and when breakeven will occur – the level of sales at which revenues equal costs

·        A marketing section that describes the target market and marketing plan

·        Resumes of Principals

The business plan should also include information on how the business will be organized (sole proprietorship, partnership, or corporation) and when it will need to hire employees.

Business plans are discussed in more detail in appendix C

The Small Business Administration (SBA)

The SBA is the principal government agency concerned with helping small US firms and it is the advocate for small businesses within the federal government. The primary operating functions are to provide financial assistance, aid in government procurement matters, and providing management training and consulting.

Financial assistance is in the form of guarantees it provides for small business loans made by private lenders such as banks. Direct loans from the SBA are only available in a few special situations, such as natural disaster recovery and energy conservation or development programs. Even in these special situations, a business must contribute a portion of the proposed project’s total cost in cash, home equity, or stocks to qualify.

The SBA also guarantees microloans, loans of less than $25,000 to very small firms. These microloans may be used to buy equipment or operate a business but not to buy real estate or pay off other loans. Microloans are available from nonprofit organizations, federal economic development administration, some state governments, some private sources such as credit unions and community development groups. Loans are also available through small business investment companies (SBICs). SBICs invest in small firms together with government loans. SBICs are profit-making organizations but are more flexible than banks.

Another financial resource underwritten by the SBA is the Angel Capital Electronic Network (ACE – Net), which matches entrepreneurs looking for start-up capital with potential investors willing to invest in partial ownership of company. The goal is to help businesses seeking smaller amounts of capital than those handled by bigger investment firms. The SBA also provides set-aside programs, where certain government contracts are restricted to small businesses. Set-aside programs are also common in the private sector, particularly among large corporations.

Small-Business Opportunities for Women and Minorities

The numbers of women-owned and minority-owned businesses are growing much faster than the overall growth in US businesses. Women own almost 40% of US businesses, and one of eight of these is owned by minority women. The fastest growth of women-owned business is occurring in construction, wholesale trade, transportation and communications, agribusiness, and manufacturing industries. There is a powerful business support network of women entrepreneurs including the National Foundation for Women Business Owners (NFWBO). The SBA also has programs assisting women business owners.

The growth in businesses owned by minorities (African-Americans, Hispanics and Asian Americans) has far outpaced the overall growth in businesses in the US.

The Franchising Alternative

A major factor in the growth of small business is an approach called Franchising. Franchising is a contractual business arrangement between a manufacturer or another supplier and a dealer. The contract specifies the methods by which the dealer markets the good or service of the supplier. Franchises can involve both goods and services; some well-known franchises are Burger King, Subway and McDonalds.

A franchising agreement takes place between a franchisor and a franchisee. The individual or firm purchasing the franchise is called the franchisee – a small-business owner who contracts to sell the good or service of the supplier – the franchisor – in exchange for some payment which is either a flat fee or royalties (expressed as a percentage of sales by franchisee). The franchisor usually helps with building plans, site selection, managerial and accounting systems, and other services to assist the franchisee. Although franchising is more likely to succeed than independent businesses, many franchises do go out of business every year.

Advantages of franchising are the following; a prior performance record, a recognizable company name, a business model that has been successful in other locations, a tested management program and business training for the franchisee.

In addition, a widely known brand name gives the franchisee tremendous advantages such as confidence in attracting certain segments of the market. McDonalds, for example, teaches prospective franchisees at Hamburger University the dos and don’ts of the burger business.

On the negative side, franchise fees and royalty payments can be very expensive for new businesses. These payments may be very high for the first few months of the business when the franchisee business is unprofitable. Another potential disadvantage of franchising may be customer unhappy at one franchise and may avoid all franchises.

It is important for future franchise owners to research the investment properly by looking at the financial performance of the franchise, talking to current owners of franchises and also talk to consumer protection agencies like the Better Business Bureau and the Federal Trade Commission (FTC).

Small business goes global:

For a small business, it is daunting to confront the global challenges, including cultural, legal, and economic barriers. However now over 95% of US exporters are businesses with fewer than 500 employees, and they sell more than one of every four dollars worth of all US exports. Small businesses can maintain a global presence via using the internet.

The US is far from the top in the amount of entrepreneurial activity league table. Based on the percentage of adults who either launched a new business last year or who currently operate a company less than 43 months old, the top prize goes to Mexico, where almost on adult in five meets the definition. Australia and New Zealand are tied for second place, followed by Korea, Brazil and Ireland. The US, with one adult in eight qualifying as an entrepreneur, is currently in seventh place.

The internet is contributing greatly to the ability of small firms to become more international. But globalization does not necessarily mean becoming bigger. In some cases, companies are finding that staying small in overseas markets is more profitable.

Alternatives for Organizing a Business:

All companies can take the form of one of three types of legal ownership; sole proprietorship, partnership and corporation. In the USA, 73% of businesses are sole proprietorships, 21% are corporations and 6% are partnerships (see figure 5.9).

Sole proprietorships are the simplest and oldest form of ownership. Most sole proprietorships are small businesses such as small retail outlets. The advantage of sole proprietorships is that they are easy to form and dissolve. The owner has the right to retain all profits after payment of personal income taxes. Another advantage of sole ownership is flexibility: the owner can make management decisions without consulting others, take prompt action when needed, and keep trade secrets where appropriate. One of the disadvantages of sole proprietorships is the unlimited financial liability. Also the owner must operate with financial resources limited to the owner’s personal funds and money they can borrow. Such limitations can keep the business from expanding. Another disadvantage is that the owner must handle a wide range of management and operational tasks, and as the business grows, he may not be able to deal with all types of complex situations. Finally, Sole proprietorships lack long-term continuity, since death, bankruptcy, retirement, or a change in personal interests can terminate the business. These limitations can make potential customers nervous about buying major goods or services from a sole proprietorship.

The Uniform Partnership Act, which regulates the formation of partnerships in most U.S. states defines a partnership is an association of two or more persons who operate a business as co-owners by voluntary legal agreement. The partnership was the preferred form of ownership for professionals offering services, such as physicians, lawyers and dentists. However, recently most of these service providers have switched to other organizational forms to limit personal liability.  

 Like sole proprietorships, partnerships are easy to form, but unlike sole proprietorships, partnerships are not easy to dissolve. Some of the advantages of partnerships are increased access to borrowing funds and the combination of complementary skills and knowledge.

The main disadvantage of partnerships is unlimited financial liability, although in some states partners can reduce this risk by forming limited liability partnerships. Breaking up partnership is also a much more complicated undertaking than dissolving a sole proprietorship. Rather than simply withdrawing funds from the bank, the partner who wants out must find someone to buy his or her interest in the firm.

Risk can be reduced by forming a limited liability partnership where laws limit the liability of partners to the value of their investment in the company. The death of a partner also threatens the survival of a partnership. Taking out life insurance coverage may ease the financial strains of such events. The insurance proceeds can permit the surviving partner to retain control of the business.

Another disadvantage of partnerships is that there may be personal conflicts between the partners which would threaten the survival of the partnership.

The final form is a corporation, with assets and liabilities separate from it owners. Most corporations are large businesses, such as General Motors or IBM.

Advantages of corporations are the limited financial liability, specialized skills of workers, access to expanded finances such as loans and stock sales.

One disadvantage is the double taxation of earnings; company pays taxes and then owners pay taxes on dividends. Corporations also face some legal issues that other types do not face. The number of laws and regulations that affect corporations has increased dramatically in recent years because of Sarbanes-Oxley Act.

This double taxation can be avoided by forming S corporations (called subchapter S corporations, whose owners elect to pay federal income taxes as partnerships while retaining the liability limitations typical of corporations). However, in recent years the IRS (Inland Revenue Service) has begun to focus on auditing S corporations, looking for those whose owners might be using artificially low pay as a method for reducing their taxes.

Business owners may also form limited liability companies (LLC) to secure the corporate advantage of limited liability while avoiding a double taxation characteristic of corporations. An LLC is governed by an operating agreement that resembles a partnership, except that it reduces each partner’s liability for actions of other owners. Professional corporations such as law offices and accounting firms often use a similar approach.

Changing Legal Structures to Meet Changing needs:

Before deciding an appropriate legal form, many factors need to be considered, including:

·   Personal financial situation and fund needs after operations begin

·   Management skills and limitations

·   Management styles and capabilities for working with partners

·   Concerns about exposure to personal liability

The legal form of organization is an important, but not permanent decision. For example, business growth may allow a sole owner to change to a partnership or LLC.

Organizing and Operating a Corporation:

There are three main types of corporations; domestic, foreign or alien. A company is domestic in the state where it is incorporated. It is a foreign corporation in other states, and is an alien corporation when operating in foreign countries.

Each state in USA mandates a specific procedure for incorporating a business. There are a minimum number of incorporators – the individuals who create the corporation. Also the name must end with Company, Corporation, Incorporated, or Limited to show that the owners have limited liability. (See figure 5.10) The information provided in the articles of incorporation forms the basis on which a state grants a ‘corporate charter’, a legal document that formally establishes a corporation. After securing the charter, the owners prepare the company’s bylaws, which describe the rules and procedures for its operation.

Depending on size, a corporation will have most of the levels shown in figure 5.11. There are Stockholders at the top, which elect the Board of Directors. The Board sets overall policy and hires the CEO. Top Management include the CEO (chief executive officer), the COO (chief Operating officer) and also CFO (chief financial officer).  Then there are middle managers, whose responsibilities include operations management and acting as liaison between top management and supervisory management. Supervisory managers coordinate daily operations and evaluate junior staff performance.

Some companies are family-owned, or closely held, where the shareholders manage the company. In open corporations, or publicly held corporation, shares are sold to the public, establishing diversified ownership. Publicly held corporations usually hold annual stockholders’ meetings, where managers report on performance, and stockholders vote on matters such as election of officers. There are two main types of stock, preferred and common. Preferred stock usually does not allow voting but has priority in receiving dividends. Stockholders elect a board of directors – the governing body of a corporation. The board sets overall policy, authorizes major transactions involving the corporation. Most boards include both inside and outside directors – people not employed by the company.

Another alternative is employee ownership, where workers buy shares of the company they work in. This is a growing trend as companies want workers to have a stakeholder mentality and care about the profit or loss situation. Sometimes, share prices are boosted by this type of organization.

Form of ownership	Number of Owners	Liability	Advantages	Disadvantages
Sole proprietorship	One owner	Unlimited	Owners retains all profits, easy to form and dissolve, flexibility	Unlimited financial liability, financing limitations, management deficiencies
Partnership	Two or more	Personal assets of operating partner	Easy to form, Can benefit from complementary skills	Unlimited financial liability, interpersonal conflicts, difficult to dissolve
Corporation	Unlimited	Limited	Limited financial liability, specialized management skills, expanded financial capacity, economies of scale	Difficult and costly to form and dissolve, tax disadvantages, legal restrictions

Mergers and Acquisitions (M&A):

In recent years merger mania has hit U.S. corporations. Petroleum giants have become even larger due mega mergers as BP Amoco and Exxon Mobil. Growth was also the primary motivation behind pharmaceutical giant Pfizer’s purchase of rival Pharmacia Corp. for $60 billion dollars in stock. This merger allowed Pfizer to add a leading arthritis medication to its list of blockbuster drugs.

The terms ‘merger’ and ‘acquisition’ are often used interchangeably, but their meanings differ. In a ‘merger’, two or more firms combine to form one company; in an ‘acquisition’, one firm purchases the property and assumes the obligations of another.     

Many mergers and acquisitions (M&A) take place on international basis as managers attempt to enter new markets and improve the global competitiveness for their companies.

 Mergers can be classified as vertical, horizontal, or conglomerate. A vertical merger combines firms operating at different levels in the production and marketing process – the combination of a manufacturer and large retailer for example. Here, two primary goals are pursued; to assure adequate flows of raw materials and supplies needed or to increase distribution. Microsoft, for example, buys small software firms that have strong products.

A horizontal merger joins firms in the same industry for reasons like diversification, increase in customer base to cut costs, or offer expanded product lines. Cendant, which already owned the car rental firm Avis, purchased the Budget rental car company $107 million.   

A conglomerate merger combines unrelated firms. The main reasons here are diversification, spur sales growth or to spend a cash surplus that might otherwise make a firm a takeover target. Conglomerate mergers may join firms in totally unrelated industries. A firm well known for conglomerate mergers is GE which owns television broadcasters NBC and cable programmers CNBC and MSNBC (in a venture with Microsoft), along with its businesses such as appliances, aircraft engines and industrial products.

Experts argue the wisdom of such mergers. The usual argument in favor of such mergers is that a company has management expertise it can use to succeed in a variety of industries. However, the stock of an acquiring company often falls in price when it makes an acquisition, suggesting that investors doubt the value of the strategy.   

A Joint Venture is a partnership between companies formed for a specific undertaking. Sometimes a company enters into a joint venture with a local firm or government, sharing the operation’s costs, risks, management, and profits with its local partner. A joint venture may also enable companies to solve a mutual problem. Four U.S. pipeline companies entered into a joint venture to provide better service to the oil refineries that used their services.

Public and Collective Ownership:

Here, a unit or agency of government owns and operates an organization. In the US, some local governments own some firms, like water systems. Sometimes, public ownership results when private investors are unwilling to invest in what they consider high-risk projects. At times, public ownership has replaced private ownership of failed organizations.

Certain functions, such as water systems, are considered too important to not be in the hands of government.

A cooperative is an example of collective ownership. Owners join forces to collectively operate all or part of the functions in their industry. Cooperatives allow small businesses to obtain quantity purchase discounts, reducing costs and enabling the cooperative to pass on the savings to its members. Marketing and advertising expenses are shared among members, and the co-op’s facilities can also serve as a distribution center.