Understanding Corporate Structures and Ownership | CFA Level I Corporate Issuers

Welcome to our lesson on corporate structures and ownership! We’ll be covering the basics of the most common forms of business organizations. So, buckle up and let’s dive in!

Four Common Business Structures

In this lesson, we’ll explore the following four business structures:

• Sole Proprietorship
• General Partnership
• Limited Partnership
• Corporation

We’ll focus on their legal relationships, owner-operator relationships, liability, and tax treatments.

1. Sole Proprietorship

The sole proprietorship is the simplest structure, where an individual owns and operates the business. Key aspects include:

• Legal relationship: The owner personally funds the business and has full control.
• Liability: The owner has unlimited liability for the business’s actions and debts.
• Tax treatment: Profits are taxed as personal income.

These businesses tend to be small due to limited financing options.

2. General Partnership

A general partnership is like a sole proprietorship but with two or more partners. Key aspects include:

• Legal relationship: The partnership agreement specifies each partner’s roles and responsibilities.
• Liability: Unlimited shared liability for the business’s actions and debts.
• Tax treatment: Profits are shared and taxed as personal income for each partner.

3. Limited Partnership

A limited partnership features at least one general partner and one or more limited partners. Key aspects include:

• Legal relationship: The general partner manages the business, while limited partners invest but don’t manage.
• Liability: General partners have unlimited liability, while limited partners have limited liability.
• Tax treatment: Profits are divided according to the partnership agreement and taxed as personal income.

Examples include private equity firms, hedge funds, and some law firms.

4. Corporation

A corporation is a legal entity separate from its owners and managers. Key aspects include:

• Legal relationship: Shareholders own the corporation, while managers operate it.
• Liability: Shareholders have limited liability.
• Tax treatment: Profits may be subject to double taxation (corporate and personal).

Corporations can be not-for-profit, for-profit, public, or private. Not-for-profit corporations focus on a social or philanthropic mission without the intent of distributing profits to shareholders, while for-profit corporations aim to generate profits for shareholders. Private corporations are typically owned by a limited number of shareholders, and their shares are not publicly traded on organized exchanges. Public corporations, on the other hand, have shares listed on stock exchanges, allowing a broader group of investors to buy and sell shares. The distinction between these types of corporations lies in their purpose, ownership structure, and the accessibility of their shares to the investing public.

Private Companies: Starting Out & Raising Capital

Most corporations begin as private companies, raising equity capital through private placements to accredited investors such as institutions or high-net-worth individuals. The terms and risks of these investments are outlined in a legal document called the private placement memorandum (PPM).

Shares of private companies can’t be traded on organized exchanges, so there’s no visible market price. Instead, shareholders must find another accredited investor and negotiate a price for transferring the shares. Because of these restrictions and a lack of liquidity, investments in private companies generally require higher returns and longer investment horizons than public companies.

Going Public: IPOs, Direct Listings & SPACs

Private companies can go public through:

• Initial Public Offerings (IPOs): Issuing shares to retail investors, with stringent disclosure requirements.
• Direct Listings: Stock exchanges agreeing to list existing shares, without raising new capital.
• Special Purpose Acquisition Companies (SPACs): Corporate structures designed to acquire a private company in the future, raising capital through their own IPOs without identifying a specific target.

Public companies may also be taken private through leveraged buyouts (LBOs) or management buyouts (MBOs).

Capital Sources: Equity vs. Debt

Corporations can raise capital through:

• Ownership capital (equity): Funds provided by shareholders.
• Debt capital: Funds provided by lenders, such as bank loans or bonds.

Debt obligations must be fulfilled, and lenders have priority in claim over shareholders in liquidation scenarios. Shareholders, on the other hand, have residual claim to the net assets of the company.

Risk & Return Profiles for Lenders & Shareholders

Shareholders face higher risk due to share price volatility but have the potential for unlimited upside. Lenders, however, have more predictable cash flows and lower risk, but a capped upside based on the interest they receive. As a result, equity investors generally require higher returns than lenders.

Conflicting Interests: Shareholders vs. Lenders

Shareholders may prefer increased leverage for growth potential, while lenders may oppose it due to the increased risk of default. Issuers may prefer issuing debt due to its lower cost but must also consider the impact of increased leverage risk on the company and its stakeholders.

Issuing new shares lowers leverage risk but may dilute existing shareholders’ ownership, potentially creating conflict.

And that wraps up our introduction to corporate structures and ownership! We’ll be exploring more related topics in future lessons, so stay tuned. See you in the next topic!