Question

 

a) Discuss the three major legal forms of business organisation available to businesses together with their respective advantages and disadvantages.

b) Define an agency problem. Illustrate an example of agency problems.

Answer 1

1. Three major legal forms of business organisation available to businesses together with their respective advantages and disadvantages:

1. Partnership: Partnerships are based upon an agreement and consists of two or more individuals in business together who make all the business decisions, share the profits of the business, and who bear the financial responsibility for any losses. Agreement has all the information about the share of ownership, share of profit of each partner in the business and the division of responsibility for running the business. The partners may contribute different amounts of financial capital to the organisation

Advantages:

• Low setup cost: Business is relatively easy to setup as there is low setup cost and formalities.
• High management skills: There will be pool of knowledge of different people because single person can’t manage the partnership. Therefore there is availability of high management skills.
• Low regulatory involvement: There may be less regulatory involvement as compare to companies.

Disadvantages:

• Unlimited Liability: The liability lies fully on partners as they are individually responsible for the liabilities and risk. Therefore in partnership, there is unlimited liability.
• Easily dissolve: The duration of partnership business depends upon life of partners. Partnership ends when partners die.
• Goal congruence: There may be conflicts among partners as they have their own opinions.

1. Company: A company is a legal entity doing business, and is distinct from the individuals within the entity. A company is generally organized to earn a profit from business activities. Companies may be either public company issuing equity to shareholders or private company. A company needs to be formally registered under registrar of companies and proper Memorandum and Article of association are also formed. Companies can be both profit and non-profit based. Generally main objective of company is to make profits. The company is owned by individual’s shareholders who have pur­chased equity shares in the company. A shareholder’s share of ownership of the company will equal the number of shares owned by that individual divided by the total number of shares outstanding.

Advantages:

• Perpetual existence: The company is an entity of its own and does not dissolve when ownership changes.
• Large capital base: Large sums of capital can be raised by issuing shares, bonds and by borrowing from Public financial institutions.
• Limited liability. Owners are not personally liable if business suffers a loss. They are liable only for their share in business.

Disadvantages:

• Regulatory restrictions and interventions: Companies specifically public companies are closely monitored by government as they involve the amount of taxpayers. Also companies have to follow legal rules, guidelines and acts of Government.
• High operational cost: Huge legal and operational cost is involved.
• Conflict in goals: There is possibility of agency problems as there may be conflict in goals of shareholders and directors.

1. Sole Proprietorship Concern: The sole proprietorship is the simplest form of business organisation. It is owned by one individual who makes all the business decisions. Owner is responsible for all the profits and losses. No legal work is required to set up a sole proprietorship.

Advantages:

• Easy to set up: There are no formalities to set up sole proprietorship business. There is low setup and operational cost involved.
• No Income tax: Incomes are taxed only once. Income tax is charged on personal income of sole proprietor.
• Negligible government intervention: There are no regulations to be followed.

Disadvantages:

• Difficult to raise capital: It may be difficult for an individual to raise capital as he has to use his own funds or take loans.
• Limited Life: If business owner dies, sole proprietorship will also dissolve.
• Unlimited liability: Sole proprietor is personally liable for the obligations of business.

b. An agent is a party that acts of behalf of a principal.

In business the shareholders (the principals) appoint directors (the agents) to work on their behalf.

THE AGENCY PROBLEM

The agency problem involves ensuring that agents are acting in the best interests of the principals, rather than in their own best interests. It arises as a result of two main factors:

1. Self-interest: The agenda and objectives of the directors are unlikely to perfectly align with those of the owners.

2. Information asymmetry: The directors know more about the company than the owners. Directors may work for the best of their interest ignoring the interest of shareholders.

There are two key approaches:

1. Governance: Appointing non-executive directors to monitor the activities of the executive directors

2. Remuneration: This need to be carefully considered to ensure the directors (agents) are working in the best interests of the shareholders (agents)

Example for agency problem:

Difficulties with remuneration: Remunerating directors to ensure they work in the best interests of shareholders is difficult in practice.

1. Linking bonuses to current year profits: This can create short-termism as directors prioritise short-term profits at the expense of everything else. E.g. Directors may save money to boost short term profits by cutting training or not replacing staff but this will destroy long term value.

2. Linking bonuses to share price: This may encourage risk taking as directors will achieve huge bonuses if the risk pays off but will not lose anything if it does not.