A corporation is a legal entity created by a state, and it is separate and distinct from its owners and managers. This separateness gives the corporation three major advantages: (1) Unlimited life. A corporation can continue after its original owners and managers are deceased. (2) Easy transferability of ownership interest. Ownership interests can be divided into shares of stock, which, in turn, can be transferred far more easily than can proprietorship or partnership interests. (3) Limited liability. Losses are limited to the actual funds invested. To illustrate limited liability, suppose you invested $10,000 in a partnership that then went bankrupt owing $1 million. Because the owners are liable for the debts of a partnership, you could be assessed for a share of the company's debt, and you could be held liable for the entire $1 million if your partners could not pay their shares. Thus, an investor in a partnership is exposed to unlimited liability. On the other hand, if you invested $10,000 in the stock of a corporation that then went bankrupt, your potential loss on the investment would be limited to your $10,000 investment.1 These three factors—unlimited life, easy transferability of ownership interest, and limited liability—make it much easier for corporations than for proprietorships or partnerships to raise money in the capital markets.
The corporate form offers significant advantages over proprietorships and partnerships, but it also has two disadvantages: (1) Corporate earnings may be subject to double taxation—the earnings of the corporation are taxed at the corporate level, and then any earnings paid out as dividends are taxed again as income to the stockholders. (2) Setting up a corporation, and filing the many required state and federal reports, is more complex and time-consuming than for a proprietorship or a partnership.
A proprietorship or a partnership can commence operations without much paperwork, but setting up a corporation requires that the incorporators prepare a charter and a set of bylaws. Although personal computer software that creates charters and bylaws is now available, a lawyer is required if the fledgling corporation has any nonstandard features. The charter includes the following information: (1) name of the proposed corporation, (2) types of activities it will pursue, (3) amount of capital stock, (4) number of directors, and(5) names and addresses of directors. The charter is filed with the secretaryof the state in which the firm will be incorporated, and when it is approved, the corporation is officiallyin existence.2 Then, after the corporation is in operation, quarterlyand annual employment, financial, and tax reports must be filed with state and federal authorities.
The bylaws are a set of rules drawn up by the founders of the corporation. Included are such points as (1) how directors are to be elected (all elected each year, or perhaps one-third each year for three-year terms); (2) whether the existing stockholders will have the first right to buy any new shares the firm issues; and (3) procedures for changing the bylaws themselves, should conditions require it.
The value of any business other than a very small one will probably be maximized if it is organized as a corporation for these three reasons:
1. Limited liability reduces the risks borne by investors, and, other things held constant, the lower the firm's risk, the higher its value.
2. A firm's value depends on its growth opportunities, which, in turn, depend on the firm's ability to attract capital. Because corporations can attract capital more easily than unincorporated businesses, they are better able to take advantage of growth opportunities.
3. The value of an asset also depends on its liquidity, which means the ease of selling the asset and converting it to cash at a "fair market value." Because the stock of a corporation is much more liquid than a similar investment in a proprietorship or partnership, this too enhances the value of a corporation.
As we will see later in the chapter, most firms are managed with value maximization in mind, and this, in turn, has caused most large businesses to be organized as corporations. However, a very serious problem faces the corporation's stockholders, who are its owners. What is to prevent managers from acting in their own best interests, rather
'In the case of small corporations, the limited liability feature is often a fiction, because bankers and other lenders frequently require personal guarantees from the stockholders of small, weak businesses.
2Note that more than 60 percent of major U.S. corporations are chartered in Delaware, which has, over the years, provided a favorable legal environment for corporations. It is not necessary for a firm to be headquartered, or even to conduct operations, in its state of incorporation.
than in the best interests of the owners? This is called an agency problem, because managers are hired as agents to act on behalf of the owners. We will have much more to say about agency problems in Chapters 12 and 13.
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