Forms of Business Organisation

 

 

 

 

 

The forms of business organisation is exceptionally important in both IGCSE and AS Level Business Studies. Many questions – especially longer ones – have at least something to do with a form of business organisation. You need to know these forms of organisation very well so that if it forms the basis of a question, you are immediately aware of what applies to that particular business.

I know that it can seem very confusing (even a bit boring!) to work through at first, so I have put together some notes below to guide you through this topic.

The first form of business organisation that we will cover is the sole trader. Remember, this is the way in which a business can be legally organised and how it is organised in terms of its ownership.

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The sole trader is a business owned and operated by one person and so it is also sometimes known as a sole proprietor. In other words, a sole trader is set up by an entrepreneur who is the only owner of the business.
Since there are few legal requirements the entrepreneur must follow when establishing his or her sole trader firm, we find that the sole trader is the most common form of business organisation. The requirements that do apply are not very time-consuming or costly to the business owner.
The sole trader can employ workers for his or her business. However, these workers cannot have any ownership or part-ownership in the business. The firm remains owned by the original entrepreneur alone.

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Each of the forms of business organisation has its own advantages and disadvantages. These are the reasons either in favour of or against the decision to choose one form of ownership over another. Let’s start with the sole trader’s advantages.
As I mentioned already, there are few legal requirements for the sole trader to abide by when he or she sets up the business. This saves time and money.
The sole trader has both complete control and freedom over the business and the path it takes. The entrepreneur does not have to get the permission of anyone else if he or she wants to purchase new office equipment or open a new branch, for example. The sole trader can also decide his or her own working hours as well.
The sole trader also has the advantage of keeping in contact with his customers and employees. In this way, he or she can establish relationships which could be vital for the long-term success of the business. Sometimes it’s just that personal touch that helps with customer and employee loyalty. This also means that the owner has a better idea of what it is that customers expect from the business, and so the entrepreneur can respond in good time.
The sole trader receives all the profit from the business. This is the amount after tax and expenses have been paid. As a result, the owner is motivated by the profit motive, and will work hard to earn as much profit as possible, especially since the entrepreneur does not have to share it.
The sole trader has a great deal of secrecy over the finances and information about his or her enterprise. Finance information must be provided only to the tax organisation, such as SARS in South Africa.
There are also disadvantages to the sole trader form of organisation. The entrepreneur needs to carefully consider these as well.
Since the business is owned by just one individual, the sole trader has limited input or advice from other business partners. He or she must make all the decisions alone.
A sole trader has unlimited liability. This is the opposite of limited liability and therefore means that the sole trader alone is responsible for any business debt. For example, if the sole trader bought goods on credit from a supplier and does not pay the supplier back in time, the sole trader’s personal assets – like his bank account – can be used to pay the debt. This effectively makes the sole trader his business, and the business is the sole trader.
A sole trader has limited access to finance. Other than his or her own personal finance and savings, the sole trader can only apply for small bank loans. There are no other partners or investors the sole trader can approach for finance, unless he or she changes the form of business organisation. This makes expansion very difficult for a sole trader.
Since the business is small and access to finance is limited, a sole trader lacks expertise. For example, it is unlikely that a sole trader can afford a specialist accountant or marketing assistant for his or her business.
 A sole trader is thus also likely to remain small. The entrepreneur most probably cannot afford to hire many employees or invest very much in the business to expand it.
Because the owner of a sole trading firm is the actually business, he or she can’t pass down the business to anyone else. Thus when the entrepreneur dies, so does the business. This means that there is no continuity.
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The next form of business organisation is the partnership. This is where two or more individuals agree to own and operate a business together.
In setting up and running the business, the partners all contribute to financing the firm.
The partners share decision-making and management. Unlike the sole trader form of organisation, a partnership allows for two or more individuals to run the business.
Since the business is owned by two or more people, the profits that are made by the business must be shared. At the same time, any losses that the firm makes are also shared by the partners.
A partnership is generally established by a written agreement, although a verbal one can sometimes be used alone. However, it is definitely recommended that a proper agreement, called a deed of partnership, is drawn up and signed by the partners. This outlines who is responsible for what as well as any other details about the partnership. This is also important because it helps to prevent any disagreements in the future.
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Now on to the pros and cons of a partnership. Just like all the other forms of business organisation, the entrepreneurs need to consider each of these before adopting a form of organisation.
Taking on partners in a business allows for more capital. Originally, the sole trader had only his or her finance for the business, but with a partnership, there are more investors in the firm. This could lead to expansion.
Also, by taking on additional partners in the business, responsibilities can be shared. This should also be something that is stipulated in the partnership agreement, for example, stating who is responsible for marketing and who manages operations. A partnership thus allows for new expertise and skills to be used in the firm.
Also different from the sole trader, the partnership business means that profits and losses incurred by the business are shared. As a result, partners are still encouraged by the possibility of profit for themselves. They are also still concerned about losses, but not as much as a sole trader would be since the partners must share losses.
On to the disadvantages of the partnership:
First of all, there is still the important issue of unlimited liability. Should the business fail and not be able to pay its debts, the partners are held liable for the business’s debts. Their own finances can be used to pay for the debts of the business. A partnership – like a sole trader – lacks continuity. If one partner passes away, the business ends. There is no separate legal identity for the business.
In a partnership, normally all partners must be consulted before decisions are taken.  This can be time-consuming and possibly bad for business, especially where a decision needs to be taken fairly quickly.
One of the most important things anyone considering a partnership needs to be aware of is the type of partners to go into business with. Inefficient, poor performing or dishonest partners can lead to expensive mistakes or even to the end of a business.
Finally, a partnership can only grow a business to a certain extent. Although a partnership can usually expand further than a sole trader, countries normally limit the number of partners that a business of this organisation can have. At the same time, investment is limited to the number of partners involved.
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Let’s quickly re-cap the sole trader and partnership forms of business organisation. Both of these forms of organisation are what is referred to as unincorporated businesses
This means that they have no separate legal identity  as well as unlimited liability, a lack of continuity, and the owners are in effect the actual business. The business does not stand alone separately; it is defined by its owners.
Now let’s move on to the incorporated forms of business organisation. As we will see, these differ quite a bit from the sole trader and partnership, especially since they offer limited liability and a separate legal identity.
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The first incorporated form of business organisation is the private limited company. The owners of this type of business are those who own shares in the business.
Owners of private limited companies are therefore called shareholders. A share is a piece of ownership, it represents a portion of the ownership of the business. Unlike a partnership or a sole trader, a company’s ownership is divided and each owner, or shareholder, has a portion of ownership equal to the number of shares purchased.
Since ownership is divided, a board of directors is needed to manage the business. In the case of a private limited company, the board of directors are normally the majority shareholders and the original owners of the business.
Finally, a private limited company is a separate legal unit. Although it is owned by shareholders, it has its own identity and can therefore legal actions can be taken in the name of the company. For instance, the company has its own accounts and finance matters that are kept separate from the owners’ financial details.
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Now that we know some details about the private limited company form of business organisation, let’s take a look at its benefits and disadvantages.

A company’s ownership is divided into shares. These shares may not be advertised but only sold to friends and family of the original business owners.  This does however mean that more capital is available from the sale of shares. Parts of the business have been sold, and so the finance earned from the shares could be used to expand and grow the business.

Perhaps the most attractive feature of a private limited company is that it offers limited liability for its owners. Liability is limited only to the shareholders’ original investment in the business. In other words, the only thing a shareholder stands to lose in the company is what he or she paid for the business. If the business fails or does not pay those who loaned it money, like a bank, the shareholders are not liable to pay those outstanding debts. This makes the business a much better prospect for shareholders, and could increase investment in the company.

Let’s say that the business was previously a partnership. If it converts to the private limited company form of organisation, the owners sell shares of the business. If the original owners don’t sell too many shares and remain the majority shareholders, they are able to keep control of the business and guide it on the path they would like to choose for the firm.

Finally, since the company has a separate legal identity and is an incorporated business, it has continuity. If shareholders pass away, the business remains. The new shareholders are those who have inherited shares.

Even though the private limited company is an excellent option for those wanting to keep control of their business but encourage investment in the firm, there are some disadvantages to consider.

A private limited company must comply with a number of legal requirements. Certain documents and forms have to be submitted to government authorities, which can be time consuming and add to the costs of the business, especially if a legal advisor is needed to advise the owners during the process.

Although it might be easy to purchase shares of the company, it can be difficult to sell them. This is because the other shareholders have to agree to the sale of another shareholder’s shares. This could make some potential shareholders uneasy about purchasing shares in the first place.

There is less secrecy over the company’s financial matters. The business’s accounts must be submitted to the relevant authorities, and they are also available for the public to see.

Lastly, although this form of organisation encourages investment and business growth, it is still limited by the fact that the company cannot advertise its shares or be listed on a stock exchange. Growth is therefore possible only to a certain extent.

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The second type of incorporated form of business ownership is the public limited company, also sometimes known as a plc.

These are normally the larger, more well-known businesses. For example, major retailers, mining organisations and insurance companies. They tend to operate on a national or even a global scale.

Public limited companies have the same characteristics as a private limited company except with one major exception  They are able to sell shares to the general public on the stock exchange. When a company converts to this form of business organisation, a document called a prospectus is issued to the public to inform them about the business becoming a plc and that its shares are for sale on a stock market, such as the Johannesburg Stock Exchange (the JSE)

As I mentioned, this form of organisation can be known as a plc or a limited business.

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There is a common mistake that many Business Studies students make about public limited companies.  Some think that because the word ‘public’ appears in the public limited company form of business organisation, the business must be owned by government and operates in the public sector.  This is incorrect, and the opposite is true in fact.  A plc operates in the private sector   and is owned by private individuals and groups

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Let’s take a look at the advantages and disadvantages of the public limited company form of organisation.

Like the private limited company, a plc also offers limited liability. Shareholders stand to lose only what they paid for their shares.

As an incorporated business, the plc offers continuity  meaning that the business has a separate legal identity.

More so than the private limited company, the public limited company can achieve the most amount of capital to be invested in the company.  There is no limit to the number of shareholders. Shares are sold on the stock exchange  to all.

A specific advantage over the private limited company is that a plc offers shareholders flexibility  to buy, sell or transfer their shares with ease. They don’t need the permission of other shareholders to do so.

Because of the large size of a plc and the amount of capital invested in the business, the company has greater status. It can thus attract investors and banks to finance growth and expansion.

A disadvantage of the plc is that it must meet legal requirements, which   are time consuming and can be expensive .

The plc must make all its information available to shareholders.  The plc has to meet the most requirements of all the forms of business organisation.

With the vast amount of shares that could be sold and the great number of shareholders, there is the risk of uncontrolled growth  which leads to management issues. With the business growing so fast, managers might struggle to keep up with the increased ownership and finances involved in the business.

One of the major expenses associated with the conversion to plc status is to be listed on the stock exchange.

Finally, with the great number of shares issued, there is the possibility that the original owners of the business could lose control of the firm if they are no longer majority shareholders. This is an important topic that we will go over in more detail up next.

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There is a very important issue that often arises when a business decides to convert to the public limited company form of organisation, and this is called the ‘divorce’ between ownership and control.

Something that sole traders, partnerships and private limited companies have in common is that the owners of the business remain in control of the firm. They are the majority shareholders in the case of private limited companies, and so they are able to manage the business in a way that meets their goals and aims. In other words, ownership and control remain the same under one individual or one group of individuals. Those who own the business also control the business.

Now when a business converts to plc status, we say that it has ‘gone public’. It has offered its shares for sale on the stock exchange to potentially thousands of individuals. As a result, ownership changes – it is greatly increased. With all the new owners involved, it is practically impossible for every single shareholder to be involved in running the business or even making decisions about its future.

For this reason, shareholders gather together once a year to elect a board of directors. This happens at the AGM, which stands for Annual General Meeting. The elected directors are responsible for running the business and take important managerial decisions. Basically, the elected directors run the business on behalf of its owners, the shareholders.

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This is where the divorce between ownership and control comes in. The shareholders still own the company, but they have granted management of the business over to the elected board of directors. It’s no longer the same people who own and control the business.

This divorce can have some serious consequences. The shareholders might have very different objectives to the directors. For example   Shareholders might seek greater profit in order to increase the dividends they receive, but  the directors could be aiming to expand the business and thus reduce dividends for shareholders at least in the short-term.

Because of the potential disagreements on objectives and how the business is run, shareholders have the power to replace directors at the next AGM the following year.

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Now that we’ve looked at the major forms of business organisation, there are some variations of these forms of organisation. For example joint ventures

This is a situation where two or more business agree to work on a project together.

In doing this, the businesses share capital, in other words, they invest in the project together. They also share the risks involved because if the project fails, not just one business suffers the losses but both do. Should the venture be a success, then the businesses will also share the profit.

Finally, it is very important to remember that a joint venture is not a merger or take over of one firm by another. The businesses agree to work on a project together, but ultimately they remain separate entities.

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Just like the forms of organisation, the business considering a joint venture with another business must think about the advantages and disadvantages of working with a partner in a joint venture.

One advantage is that the firms share the costs. Often a project is too big for one business to undertake alone. For example, if a business in South Africa wants to make use of a business opportunity in Japan, the costs are reduced for the South African firm if it partners with a local Japanese business already operating in the area.

Another important advantage is that the South African business benefits from the Japanese firm’s knowledge of business and economic conditions in Japan. The Japanese business understands the culture and way of doing things in Asia, so the South African business does not have to worry about this.

In a joint venture, risks are shared. This makes a big project, especially a global one, more attractive for businesses. If the project does not succeed, at least two or more businesses are responsible and share the losses.

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Next up is the business practice of franchising. Like joint ventures, franchising deals with businesses working together, however in this case, the relationship is closer between the two firms.

In a franchise, there are two parties involved – the franchisor and the franchisee. The franchisor is the original owner of a business and the franchisee is the one who purchases a franchise business.

A franchisor is a business that offers a product or service just like any other business, but the difference here is that  the franchisor sells via franchisees and  does not have direct contact with those who purchase the goods or services.

In a franchise agreement, the franchisee has permission to use the brand, logos and trading methods of the franchisor  in return for a license purchased from the franchisor.

To sum up a franchise, we could think of it as one central business with many different sub-businesses or outlets owned by different individuals.

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When we consider the pros and cons of franchising, it is important to note they must be viewed from different perspectives. On the one hand, what is an advantage for a franchisor might be a disadvantage for the franchisee, and vice versa for the franchisee.

Let’s take a look at what is good and bad for a franchisor, the person who sells licenses of his business to franchisees.

First of all, a franchisor receives income from selling licenses of his business to franchisees.

As a result of franchising out the business, a franchisor can expand the firm much more quickly than if he had to open all the outlets himself. Instead, the franchisees purchase licenses and can then open new branches of the business, thus doing the work of expansion.

At the same time, the franchisor is not responsible for the management of the outlets. The franchisor does have to fulfill some obligations that would be stipulated in the franchise agreement, but ultimately the day-to-day running of all the franchises is up to the franchisee.

Lastly, the franchisor sells products to the franchisees to then be sold to customers. This means that the franchisor has guaranteed customers, the franchisees.

There are two major disadvantages of franchising for the original franchisor.

Firstly, the franchisor runs the risk of having branches of his business poorly managed. This is because not all franchisees will necessarily run the branches efficiently or even ethically. Any poor performance or unethical activities from a branch could impact the entire business, since customers could now have a negative image and perception of the company as a whole.

Secondly, it is the franchisees who get to keep the profits made by their branch of the franchise. Sometimes franchisors will receive a portion of the profit, but this will depend on the type of signed franchise agreement.

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Now on to the pros and cons for the franchisee. Remember, this is the individual that purchased a license from the franchisor to open a branch of the franchise.

For the franchisee, there is a greater chance of business success than if the franchisee decided to open a new business on his or her own altogether. This is because the franchise might already be widely known and respected, and could already have loyal customers. This saves time in marketing a new business.

Also, the franchisor provides the franchisee with marketing support to run and promote the business. Time is saved again, as well as other costs associated with marketing and advertising.

The franchisee benefits from the fact that he already has a guaranteed supplier of products. Yet again, time is saved because now the franchisee does not have to spend time trying to locate suitable suppliers. The work has been done already.

Franchisees generally have to make fewer decisions than if they were entirely separate, independent businesses. As a franchise, franchisees are able to use the tried and tested, proven methods of the franchise business.

The franchisor further relieves the franchisee of certain responsibilities, such as some human resources functions.

Lastly, banks are generally more willing to help franchisees than other first time businesses. Banks are likely to be aware of the franchise as a whole, and if the franchise has an excellent reputation, the banks could be more helpful in business loans, for example.

Franchisees also face disadvantages

An important consideration is that the franchisee has less independence in decision-making. Normally, all franchises have to comply with certain rules and regulations set up by the franchise agreement. This can give the original franchisor quite a bit of power in controlling the branches of the franchise.

Franchisees are therefore restrained by the franchise agreement. For example, if a franchisee finds another supplier who could offer certain materials at a cheaper rate than the franchisor, the franchisee might not be allowed to use the alternative supplier.

Lastly, the franchisee must of course pay the franchisor for the franchise license. The franchisee might also be required to pay a portion of the branch’s profits to the franchisor.

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The last set of businesses we will consider now is public corporations. Remember, a public corporation not a public limited company. A public corporation operates  in the public sector, which  is owned and controlled by the state.

In other words,  public corporations are nationalised businesses that were purchased by the government. This is the opposite of privatisation, where a government sells a public corporation to private owners.

With public corporations, government chooses who will direct the business and be responsible for its overall management. In a sense, the government is the public corporation’s only shareholder.

As I mentioned, we must never confuse a public corporation for a public limited company.  An example of a public corporation is SAA. South African Airways operates in the public sector because it is owned and controlled by the state. This means that it is tax-payer funded.

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Like other businesses, public corporations also have objectives to guide their activities, but the objectives normally differ quite a bit from the objectives of private sector businesses.

Public corporations often have social objectives. We can think of social objectives as being more charitable than profit-driven. In other words, they aim to uplift an economy instead of just providing owners with as much profit as possible.

The problem with social objectives is that they can sometimes be very costly. Bear in mind that public corporations are owned by the government and therefore funded by tax payers. If it becomes too expensive to keep running a publicly owned business with social objectives, government might decide to operate the firm as private owners would. This makes the business more profit oriented.

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So what are some of the benefits of having government-owned, public corporations?

Firstly, there are certain industries that governments see as strategic for an economy. For example, the electricity supply is seen as vitally important because without a consistent supply of electricity, businesses and the economy as a whole will struggle.

It is also argued that certain industries should be monopolised by the government. In other words, the government alone should operate in an enterprise in a certain industry. This leads to more effective use and management of limited resources. When there is competition between firms, some resources can be wasted, but this is not the case with a government monopoly.

Also, some businesses are nationalised if it appears that a business is about to fail or go bankrupt. The government often does this in order to protect people employed by the business from losing their jobs, and also to protect customers from losing an important business in the market.

Public corporations can ensure the provision of important public services. For example, the water supply in a country is normally a nationalised enterprise, since the government can’t take any risks in leaving this up to the private sector to provide.

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Public corporations are not always the best choice, however, and some have strong arguments against them.

Firstly, nationalised businesses may lack the profit motive since they are funded by the government. This could lead to inefficient business activity.

Related to this, is the suggestion that some public enterprises are become too reliant upon government subsidies. As we’ve already seen, these enterprises are funded by taxpayers. If the business does not perform well, there might be a sense of complacency, especially because managers of the public enterprise believe that the business will continue to be funded by the government in any case.

Often, public enterprises are very large and have access to much finance. This makes competition difficult, leading to reduced customer choice in a particular market.

Lastly, public corporations can become political tools used by government leaders. For example, public corporations might expand and offer new services just before election time. This could be done to promote those in political positions and boost their reputations.

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