What you will be able to do
- Identify and describe the terms company, partnership, and corporation.
- Explain the characteristics, advantages, and disadvantages of various types of companies.
- Explain how companies are formed.
- Describe the benefits of forming a business to manufacture and sell a product.
Background
A company is a business or association usually formed to manufacture or supply products or services for profit. A company can be a partnership, a limited liability partnership (LLP), a corporation, or owned by a single individual.
All companies are set up in accordance with government regulations. In a partnership, the partners share the profits or losses of the business in which they have all invested, and they are personally liable for the company's debt. A limited liability partnership (LLP) transfers much of the firm's personal liability from the partners to the partnership. Accounting and law firms, for example, are generally set up as limited liability partnerships.
A public or listed corporation is a company with publicly traded shares that anyone can buy in a stock market. A public corporation is also legally separated from the stockholders who own it and the managers who run it. A corporation offers these advantages:
- Stockholders are not responsible for the company's debt.
- A corporation continues to exist even if its stockholders or managers change.
- Stockholders can easily sell their ownership shares through the stock market.
A private corporation may be owned by an individual or privately sell stock to fund the business. The partners in the company are called shareholders. They receive shares for their contributions to the business. Shareholders have ownership and minor decision-making power in the company. The company does not sell shares to the public, so you cannot buy shares of a private company on the stock market.
The single most important distinction in this session is public versus private. Public companies sell shares on the open market and answer to outside stockholders. Private companies do not, which means their owners keep more control but have fewer ways to raise large sums of money.
Learn the terms, then test yourself
Tap or click each card to flip it and check the definition.
P&G: Production & Growth
Have you ever ordered from Amazon.com, bought something from The Body Shop, or eaten at a Dunkin' Donuts? Jeff Bezos (Amazon), Anita Roddick (The Body Shop), and William Rosenberg (Dunkin' Donuts) all started as sole proprietorships that grew into internationally recognized brands. There are also partnerships, like the group of former PayPal employees who founded YouTube, and there are companies and corporations, which can be private (no public stock) or public (stock sold on the market).
1. Why do you think a company would change its ownership structure?
2. Why would a private company want to become a public corporation?
The Accident That Made Ivory Soap
What's 99.44/100% pure and floats? Ivory soap. But it did not always float, and it was not always called Ivory. In 1879, Procter & Gamble was producing a new white soap by boiling and stirring ingredients with a steam-powered mixer. One day a worker went to lunch and forgot to turn the mixer off. He returned to find a foamy mixture overflowing the vat. It still looked like soap, so workers poured it into molds, cooled it, cut it into cakes, and shipped it for sale.
Customers soon began asking for "the floating soap." Procter & Gamble figured out what had happened and made sure the soap floated from then on. The name Ivory came from a Sunday church reading of Psalm 45:8, which refers to ivory palaces, and a chemical analysis showing the soap was 99.44% pure. The package still reads "99.44/100% PURE: IT FLOATS" today.
These events trace back to two hardships. James Gamble's family stopped in Cincinnati in 1819 when he fell seriously ill on a flatboat journey from Northern Ireland, and they stayed. Cincinnati's soap industry ran on animal fat from local packinghouses, so James went into soap making. Around the same time, William and Martha Procter also stopped in Cincinnati when Martha fell ill with cholera. She died soon after, and William stayed on to start a candle-making business.
The Proprietor
William's candle business was a proprietorship because he was the sole owner. He had no legal papers to file and no agreements to sign. He simply opened a small store in Cincinnati and started selling candles.
1. What type of business organization did William Procter use when he began producing and selling candles in his small shop in Cincinnati?
2. Name a business in your community that illustrates the same type of organization William Procter used in his original candle-making business.
Okay, Partner
William's new wife's sister was married to James Gamble, making James and William brothers-in-law. In 1837 the soap maker and the candle maker signed a formal partnership agreement, and Procter & Gamble was born. A partnership is just like a proprietorship, except two or more people own and manage the business, sharing any profits or losses. By the company's 50th birthday in 1887, sons from both families had joined, family partners had grown to seven, and the partners wanted to develop and market new products, which would cost far more money than they had.
3. When James Gamble and William Procter started Procter & Gamble in 1837, the business was a partnership. Briefly explain the difference between a partnership and the type of business you identified in question 1.
4. What advantage did a partnership offer James Gamble and William Procter?
5. Did limited liability apply to William Procter's candle-making business, or to the partnership formed by William and James Gamble in 1837?
Let's Incorporate
The youngest partner, Cooper Procter, suggested the partnership become a corporation, believing it could raise enough money to develop and sell new products. A corporation exists independently of the particular stockholders who own it and the managers who run it. It is a legal entity with its own rights and responsibilities. As partners, the family had been personally responsible for all taxes, expenses, and debts, even if it meant paying with their own savings. As a corporation, the business pays its own expenses as a separate legal entity, and an owner's potential loss is limited to the amount invested in shares of stock.
This "limited liability" is an attractive feature of corporations, and a corporation's separate legal status also tells investors the business is built to outlast any single owner. If an owner of a proprietorship or a partnership dies, the business often dies with them. A corporation's stockholders and managers can change while the business continues. Investors also like that they can easily sell shares in the stock market, and that a corporation can hire managers with specialized skills.
The partners agreed, and Procter & Gamble was incorporated in 1890, raising money for growth by selling new shares of stock to investors. Through a diverse range of brands sold in more than 180 countries, Procter & Gamble reported $66.8 billion in net sales in 2018.
6. By 1887, the partnership had grown to include five sons. Why did Cooper Procter recommend ending the partnership and turning the business into a corporation?
7. What is a corporation?
8. Compared with a proprietorship or a partnership, a corporation is usually better at raising funds for growth. Describe at least two features of a corporation that make it attractive to potential investors.
9. Look up a company's stock listing and find two businesses whose products or services you bought during the last week.
10. The businesses you named in question 9 are likely corporations, rather than proprietorships or partnerships. Why do you think this is so?
Procter & Gamble moved through all three structures in one company's history: sole-proprietorship → partnership → corporation. Companies usually change structure because they need more money, more protection from personal liability, or both.
Interest Rates and the Cost of Borrowing
Some years are better than others for companies to go public. It depends on how much money they think they will generate by going public, and how much it would cost them to borrow that money from a bank instead of selling shares. Below are example interest rates from a seven-year span.
| 2012 | 2013 | 2014 | 2015 | 2016 | 2017 | 2018 |
|---|---|---|---|---|---|---|
| 8.5% | 9.5% | 4.75% | 4.25% | 4.00% | 5.25% | 7.25% |
It is better to have a low interest rate. The lower the interest rate, the lower the amount of money a company has to pay back.
It would have cost more in 2012, 2013, and 2018, since those years have the highest rates in the table. It would have cost less in 2014, 2015, and 2016, since those years have the lowest rates.
Let r = rate of interest, l = loan amount, and i = interest amount.
It would cost $688,750.00 more to borrow in 2013 than in 2014.
It would cost $387,500.00 more to borrow in 2015 than in 2016.
Reading a Company's Profit Trend
Below are the profiles of three companies thinking of going public. Each sells high-end fashion accessories.
| Company A | Company B | Company C | |
|---|---|---|---|
| Profits 2014 | $635,000 | — | $1,199,000 |
| Profits 2015 | $654,000 | — | $1,103,000 |
| Profits 2016 | $719,000 | — | $1,048,000 |
| Profits 2017 | $848,000 | — | $1,017,000 |
| Profits 2018 | $992,000 | $2,881,000 | $1,220,000 |
| Company founded in | Dec 2015 | Nov 2017 | May 2000 |
| Average units sold per day | 460 | 320 | 830 |
| Average units on hand | 670 | 2,960 | 870 |
Company A had steady increases in profit. Company B had only one year of profit because it was founded in 2017. Company C had three years of declining profits from 2014 through 2017, but had an increase in 2018.
Company A has had steady increases in profit over the last four years. Growth and expansion could put it ahead of the other two.
Company B posted a huge profit in its first year of business.
Company C had a turnaround year in 2018 and did a great job managing inventory, which could indicate strong management.
A single year of profit tells you very little. What matters is the trend across several years, and how a company's inventory and sales pace compare to one another. High inventory relative to sales can be a warning sign.
Universal Movies Inc.: Should It Go Public?
Universal Movies Inc., based in Texas, was deciding whether to go public in 2018. Pretend you are a junior sales analyst invited to give your opinion. As of December 31, 2016, the company owned, operated, or had interests in 500 theatres with 7,000 screens in the United States, plus 300 theatres and 2,700 screens internationally.
| 2016 Sales (mil.) | $81.3 |
|---|---|
| 1-Year Sales Growth | 21.0% |
| 2016 Net Income (mil.) | $1.1 |
| 1-Year Net Income Growth | 184.9% |
| 2016 Employees | 65 |
| Year | Revenue | Gross Profit | Operating Income | Total Net Income |
|---|---|---|---|---|
| Dec 16 | 81.3 | 10.3 | 2.4 | 1.1 |
| Dec 15 | 67.2 | 8.8 | 1.2 | 0.4 |
| Dec 14 | 58.7 | 9.1 | 1.9 | 0.9 |
| Universal Movies Inc. | Industry | Market | |
|---|---|---|---|
| Price/Sales Ratio | 0.38 | 0.56 | 2.24 |
| Price/Earnings Ratio | 16.11 | 15.83 | 19.23 |
| Price/Book Ratio | 7.19 | 2.15 | 2.18 |
| Price/Cash Flow Ratio | 77.51 | 13.53 | 13.68 |
| Universal Movies | Screen Digital | Excel Pictures | Stanley Brothers | |
|---|---|---|---|---|
| Annual Sales | 81.3 | 11,164.2 | 14,253.6 | 754.9 |
| Employees | 65 | 11,400 | — | 1,251 |
| Market Cap ($ mil.) | 0.0 | 4,243.8 | 4,091.9 | 0.0 |
Universal Movies Inc. would be attractive to investors because it is a small company with a lot of room for growth. Its annual sales are much lower than its top competitors, which is favorable for growth potential rather than a weakness on its own. Revenue, gross profit, and total net income all increased from 2014 to 2016.
Working With Compound Interest
A promising young company wanted to expand. Instead of going public, it borrowed $4,600,000 for a 7-year loan taken out in 2018, at an interest rate of 5%. In each formula below, I is the amount owed at the end of the t-year loan at interest rate r, on a principal of P dollars.
The annual compounding scenario costs the company the least in interest over the seven-year loan.
More frequent compounding always costs the borrower more, and pays the lender more, even at the same stated interest rate. Annual: $6,472,661.94. Quarterly: $6,513,564.60. Continuous: $6,527,710.72. The gap grows with the loan size and the number of years.
Key Takeaways From Session 1
A company can be a sole-proprietorship, a partnership, or a corporation. Each trades off control, personal liability, and access to money differently.
A public corporation sells shares on the open market. A private corporation does not. Going public is usually a trade of ownership control for access to a much larger pool of investment money.
A lower interest rate always means a company pays back less on a loan. Companies compare that cost of borrowing against the money they expect to raise by selling shares instead.
One year of profit does not tell the whole story. Investors look at the trend across several years, alongside inventory levels and how a company compares to its industry and competitors.
The more often interest compounds, the more a borrower ultimately pays, even at an identical stated rate. This same math works in an investor's favor when it is their money compounding instead of their debt.