In 1901 pharmacist Charles Walgreen bought the drugstore in which he worked on the South Side of Chicago. Today Walgreen’s is the largest drugstore chain in the United States. If, like Charles Walgreen, you start on your own, with no partners or stockholders, you are said to be a sole proprietor. You bear all the costs and keep all the profits after the Internal Revenue Service has taken its cut. The advantages of a proprietorship are the ease with which it can be established and the lack of regulations governing it. This makes it well-suited for a small company with an informal business structure. As a sole proprietor, you are responsible for all the business’s debts and other liabilities. If the business borrows from the bank and subsequently cannot repay the loan, the bank has a claim against your personal belongings. It could force you into personal bankruptcy if the business debts are big enough. Thus as sole proprietor you have unlimited liability.

Instead of starting on your own, you may wish to pool money and expertise with friends or business associates. If so, a sole proprietorship is obviously inappropriate. Instead, you can form a partnership. Your partnership agreement will set out how management decisions are to be made and the proportion of the profits to which each partner is entitled. The partners then pay personal income tax on their share of these profits. Partners, like sole proprietors, have the disadvantage of unlimited liability. If the business runs into financial difficulties, each partner has unlimited liability for all the business’s debts, not just his or her share.

The moral is clear and simple: “Know thy partner.” Many professional businesses are organized as partnerships. They include the large accounting, legal, and management consulting firms. Most large investment banks such as Morgan Stanley, Salomon, Smith Barney, Merrill Lynch, and Goldman Sachs started life as partnerships. So did many well-known companies, such as Microsoft and Apple Computer. But eventually these companies and their financing requirements grew too large for them to continue as partnerships.

As your firm grows, you may decide to incorporate. Unlike a proprietorship or partnership, a corporation is legally distinct from its owners. It is based on articles of incorporation that set out the purpose of the business, how many shares can be issued, the number of directors to be appointed, and so on. These articles must conform to the laws of the state in which the business is incorporated. For many legal purposes, the corporation is considered a resident of its state. For example, it can borrow or lend money, and it can sue or be sued. It pays its own taxes (but it cannot vote!). The corporation is owned by its stockholders and they get to vote on important matters.

Unlike proprietorships or partnerships, corporations have limited liability, which means that the stockholders cannot be held personally responsible for the obligations of the firm. If, say, IBM were to fail, no one could demand that its shareholders put up more money to pay off the debts. The most a stockholder can lose is the amount invested in the stock. While the stockholders of a corporation own the firm, they do not usually manage it. Instead, they elect a board of directors, which in turn appoints the top managers. The board is the representative of shareholders and is supposed to ensure that management is acting in their best interests. This separation of ownership and management is one distinctive feature of corporations. In other forms of business organization, such as proprietorships and partnerships, the owners are the managers. The separation between management and ownership gives a corporation more flexibility and permanence than a partnership. Even if managers of a corporation quit or are dismissed and replaced by others, the corporation can survive. Similarly, today’s shareholders may sell all their shares to new investors without affecting the business. In contrast, ownership of a proprietorship cannot be transferred without selling out to another owner-manager.

By organizing as a corporation, a business may be able to attract a wide variety of investors. The shareholders may include individuals who hold only a single share worth a few dollars, receive only a single vote, and are entitled to only a tiny proportion of the profits. Shareholders may also include giant pension funds and insurance companies whose investment in the firm may run into the millions of shares and who are entitled to a correspondingly large number of votes and proportion of the profits. Given these advantages, you might be wondering why all businesses are not organized as corporations. One reason is the time and cost required to manage a corporation’s legal machinery. There is also an important tax drawback to corporations in the United States. Because the corporation is a separate legal entity, it is taxed separately. So corporations
pay tax on their profits, and, in addition, shareholders pay tax on any dividends
that they receive from the company.1 By contrast, income received by partners
and sole proprietors is taxed only once as personal income.

When you first establish a corporation, the shares may all be held by a small group, perhaps the company’s managers and a small number of backers who believe the business will grow into a profitable investment. Your shares are not publicly traded and your company is closely held. Eventually, when the firm grows and new shares are issued to raise additional capital, the shares will be widely traded. Such corporations are known as public companies. Most well-known corporations are public companies. The financial managers of a corporation are responsible, by way of top management and the board of directors, to the corporation’s shareholders. Financial managers are supposed to make financial decisions that serve shareholders’ interests.