Introduction to Corporate Finance

PART 1: INTROdUCTION

1-3 LEGAL FORMS OF BUSINESS

ORGANISATION

Companies exist so that people can organise to pursue profit-making ventures. This section examines

how companies organise themselves legally, and discusses the costs and benefits of each major form. We

begin with the most popular forms of business organisation in Australia, and then look at some forms that

are used in countries other than Australia.

1-3a BUSINESS ORGANISATIONAL FORMS IN AUSTRALIA

The three key legal forms of business organisation in Australia have historically been the sole

proprietorship, the partnership and the company. These have recently been joined by a fourth type,

the limited partnership. The sole proprietorship is the most common form of organisation. The largest

businesses tend to be organised as companies, and they account for a large fraction of total Australian

business sales and profits. The principles and tools that financial analysts use to do their jobs apply to all

of these organisational forms.

Sole Proprietorships

A sole proprietorship is a business with a single owner. In fact, in sole proprietorships, there is no legal

distinction between the business and the owner. The business is the owner’s personal property; it exists

only as long as the owner lives and chooses to operate it, and all business assets belong to the owner.

Furthermore, the owner bears personal liability for all the company’s debts and pays income taxes on its

earnings. In recent years, sole traders and partnerships made up about 45% of actively traded businesses

in Australia, but generated less than 10% of total sales.^3

Simplicity and ease of operation constitute the principal benefits of the proprietorship. However, this

organisational form suffers from weaknesses that in most cases limit the company’s long-term growth

potential. These include the following:

■ Limited life – By definition, a proprietorship ceases to exist when the founder retires or dies. Although

the founder-entrepreneur can pass the assets of the business on to a third party, most of what makes

the business valuable is tied to the proprietor personally. Furthermore, changes in ownership of

successful companies can trigger large tax liabilities.

■ Limited access to capital – A proprietorship can obtain operating capital from only two sources:

reinvested profits and personal borrowing by the entrepreneur. In practice, both of these sources are

easily exhausted.

■ Unlimited personal liability – A sole proprietor is personally liable for all the debts of the business,

including judgements awarded to a plaintiff in any successful lawsuit. This is a high risk, which often

is not insurable; and the risk is not spread widely, because the sole proprietor has a small investment

by definition.

3 Berk, J, DeMarzo, P, Harford, J, Ford, G, Mollica, V, and Finch, N. Fundamentals of Corporate Finance, 2nd edition. Pearson Australia,

2012: 421.

LO1.3

sole proprietorship
A business with a single owner