Introduction to Corporate Finance

1: The Scope of Corporate Finance

Partnerships

A (general) partnership is essentially a proprietorship with two or more owners who have joined their skills

and personal wealth. As in a sole proprietorship, there is no legal distinction between the business and its

owners, each of whom can execute contracts binding on all the other(s), and each of whom is personally

liable for all the partnership’s debts. This sharing of legal responsibility is known as joint and several liability.

Although nothing requires the owners to formalise the terms of their partnership in a written

partnership agreement, most partnerships create such a document. In the absence of a partnership

agreement, the business dissolves whenever one of the partners retires or dies. Furthermore, unless

there is a partnership agreement specifying otherwise, each partner shares equally in business income,

and each has equal management authority. As with a proprietorship, partnership income is taxed only

once: at the personal level.

In addition to the tax benefits and ease of formation that partnerships share with proprietorships,

the partnership allows a large number of people to pool their expertise and capital to form a much

larger enterprise. Partnerships enjoy more flexibility than proprietorships in that the business need not

automatically terminate following the retirement or death of one partner. Industries in which partnerships

are usually the dominant form of organisation include accounting, consulting, engineering, law and

medicine.

The drawbacks of the partnership form resemble those of the sole proprietorship:

■ Limited life – The life of the company can be limited, particularly if only a few partners are

involved. Problems may also result from the instability inherent in long-term, multi-person business

associations.

■ Limited access to capital – For operating capital, the company is still limited to retained profits and

personal borrowings.

■ Unlimited personal liability – This disadvantage is accentuated because the partners are subject to joint

and several liability. As companies grow larger, the competitive disadvantages of the proprietorship

and partnership organisational forms tend to become extremely burdensome. Almost all successful

companies eventually adopt the corporate organisational form.

Limited Partnerships

In many ways, a limited partnership (LP) combines the best features of the (general) partnership and the

corporate organisational forms (which we cover next). This is a recent organisational form in Australia,

dating from legislation put in place in 2000. In any limited partnership, there must be one or more

general partners each of whom has unlimited personal liability. Because only the general partners operate

the business and are legally exposed, they usually receive a greater-than-proportional (in terms of their

capital contribution) share of partnership income. Most of the participants in the partnership are limited

partners. They have the limited liability of corporate shareholders, but their share of the profits from

the business is taxed as partnership income. The limited partners, however, must be totally passive.

They contribute capital to the partnership, but cannot have their names associated with the business;

neither can they take an active role in the operation of the business, even as employees. In return for

this passivity, the limited partners face no personal liability for business debts. This means that, although

limited partners can lose their equity investment in the business, tax authorities (or other plaintiffs)

cannot sue the limited partners personally for payment of their claims. It should be emphasised that

limited partners share in partnership income, which is taxed as ordinary personal income for the partners.

partnership

A proprietorship with two or

more owners who have joined

their skills and personal wealth

joint and several liability

A legal concept that makes

each partner in a partnership

legally liable for all the debts

of the partnership

limited partnership (LP)

A partnership in which most

of the participants (the

limited partners) have the

limited liability of corporate

shareholders, but their share

of the profits from the business

is taxed as partnership income

general partners

One or more participants in

a limited partnership who

operate the business and have

unlimited personal liability

limited partners

One or more totally passive

participants in a limited

partnership, who do not take

any active role in the operation

of the business and do not

face personal liability for the

debts of the business