INTRODUCTION TO FINANCE

I T YPES OF B USINESS O RGANIZATION

It is important that the business owner seriously considers the different forms of business organization
types such as sole proprietorship, partnership, and corporation. Which organizational form is most
appropriate can be influenced by tax issues, legal issues, financial concerns, and personal concerns. For
the purpose of this overview, basic information is presented to establish a general impression of business
organization.
There are eight primary factors that decide how a business is structured and operated. These factors are:
creation - how a business is started
management - how a business is managed and operated on a daily basis
ownership - who owns the business's property and assets
profit - how the business's profit and assets are distributed
liability - who is accountable for the business's legal responsibilities
taxation - how the business is taxed
continuity - the duration of a business
termination - winding up of a business
Sole Proprietorship
A Sole Proprietorship consists of one individual doing business. Sole Proprietorships are the most
common form of business organization in the United States, however they account for little in the way
of aggregate business receipts.
Advantages
Ease of formation and dissolution. Establishing a sole proprietorship can be as simple as printing up
business cards or hanging a sign announcing the business. Taking work as a contract carpenter or
freelance photographer, for example, can establish a sole proprietorship. Likewise, a sole
proprietorship is equally easy to dissolve.

Typically, there are low start-up costs and low operational overhead.

Ownership of all profits.

Sole Proprietorships are typically subject to fewer regulations.

No corporate income taxes. Any income realized by a sole proprietorship is declared on the owner's
individual income tax return.

Disadvantages
Unlimited liability. Owners who organize their business as a sole proprietorship are personally
responsible for the obligations of the business, including actions of any employee representing the
business.

Limited life. In most cases, if a business owner dies, the business dies as well.

It may be difficult for an individual to raise capital. It's common for funding to be in the form of
personal savings or personal loans.

The most daunting disadvantage of organizing as a sole proprietorship is the aspect of unlimited
liability. An advantage of a sole proprietorship is filing taxes as an individual rather than paying
corporate tax rates. Some hybrid forms of business organization may be employed to take advantage of
limited liability and lower tax rates for those businesses that meet the requirements. These include S
Corporations, and Limited Liability Companies (LLC's). Where S-Corps are a Federal Entity, LLC's are
regulated by the various states. LLC's give the option for profits from the business to pass through to the
owner's individual income tax return.
Partnership
A Partnership consists of two or more individuals in business together. Partnerships may be as small as
mom and pop type operations, or as large as some of the big legal or accounting firms that may have
dozens of partners. There are different types of partnershipsgeneral partnership, limited partnership,
and limited liability partnershipthe basic differences stemming around the degree of personal liability
and management control.
Advantages
Synergy. There is clear potential for the enhancement of value resulting from two or more
individuals combining strengths.

Partnerships are relatively easy to form, however, considerable thought should be put into
developing a partnership agreement at the point of formation.

Partnerships may be subject to fewer regulations than corporations.

There is stronger potential of access to greater amounts of capital.

No corporate income taxes. Partnerships declare income by filing a partnership income tax return.
Yet the partnership pays no taxes when this partnership tax return is filed. Rather, the individual
partners declare their pro-rata share of the net income of the partnership on their individual income
tax returns and pay taxes at the individual income tax rate.

Disadvantages

Unlimited liability. General partners are individually responsible for the obligations of the
business, creating personal risk.

Limited life. A partnership may end upon the withdrawal or death of a partner.

There is a real possibility of disputes or conflicts between partners which could lead to dissolving
the partnership. This scenario enforces the need of a partnership agreement.

A partnership firm in India is governed by The Partnership Act, 1932. Two or more people can form a
Partnership subject to maximum of 20 partners. A partnership deed is prepared that details the amount of
capital each partner will contribute to the partnership. It also details how much profit/loss each partner
will share. Working partners of the partnership are also allowed to draw a salary in accordance with The
Indian Partnership Act. A partnership is also allowed to purchase assets in its name. However the owner
of such assets are the partners of the firm. A partnership may/may not be dissolved in case of death of a
partner. The partnership doesnt really have its own legal standing although a separate Permanent
Account Number (PAN) is allotted to the partnership. Partners of the firm have unlimited business
liabilities which means their personal assets can be attached to meet business liability claims of the
partnership firm. Also losses incurred due to act of one partner is liable for payment from every partner
of the partnership firm.
A partnership firm may or may not be registered with Registrar of Firms (ROF). Registration provides
some legal protection to partners in case they have differences between them. Until a partnership deed is
registered with the ROF, it may not be treated as legal document. However, this does not prevent either
the Partnership firm from suing someone or someone suing the partnership firm in a court of law.
As pointed out, unlimited liability exists for partnerships just as for sole proprietorships. One way to
alleviate this risk is through Limited Liability Partnerships (LLP's). As with LLC's, LLP's may offer
some tax advantages while providing some risk protection for owners.
Limited Liability Partnership
Limited Liability Partnership (LLP) firm is a new form of business entity established by an Act of the
Parliament. LLP allows members to retain flexibility of ownership (similar to Partnership Firm) but
provides a liability protection. The maximum liability of each partner in an LLP is limited to the extent
of his/her investment in the firm. An LLP has its owner Permanent Account Number (PAN) and legal
status. LLP also provides protection to partners for illegal or unauthorized actions taken by other
partners of the LLP. A Private or Public Limited Company as well as Partnership Firms are allowed to
be converted into an Limited Liability Partnership.
Corporation
Corporations are probably the dominant form of business organization in the United States. Although
fewer in number, corporations account for the lion's share of aggregate business receipts in the U.S.
economy. A corporation is a legal entity doing business, and is distinct from the individuals within the
entity. Public corporations are owned by shareholders who elect a board of directors to oversee primary
responsibilities. Along with standard, for-profit corporations, there are charitable, not-for-profit
corporations.
The public sector is the part of the economy concerned with providing various government services. The
composition of the public sector varies by country, but in most countries the public sector includes such

services as the military, police, public transit and care of public roads, public education, along with
health care and those working for the government itself, such as elected officials. The public sector
might provide services that a non-payer cannot be excluded from (such as street lighting), services
which benefit all of society rather than just the individual who uses the service. Businesses and
organizations that are not part of the public sector are part of the private sector. The private sector is
composed of the business sector, which is intended to earn a profit for the owners of the enterprise, and
the voluntary sector, which includes charitable organizations. Examples of public sector companies in
India: Air India, Engineers India Ltd., Hindustan Aeronautics, Goa Shipyard, Indian Oil Corporation,
India Tourism Dev Corp., ONGC, Steel Authority of India. Examples of private sector companies:
Reliance Industries, Infosys, Tata group, Aditya Birla group.
The corporate private sector can be further subdivided into private limited companies and public limited
companies.
Characteristics
Incorporated association. In India companies are incorporated when they are registered under the
Companies Act, 1956. Private companies require certificate of incorporation and public limited
companies require certificate of commencement of business.
Ownership separate from management. A company receives its share capital from its shareholders.
Every shareholder is an owner of his company to the extent of his shareholding. But the day to day
management is not taken care of by the shareholders. The shareholders elect a board of directors who are
made responsible for managing the company affairs.
Limited Liability. The liability of a shareholder is limited to the extent of his shareholding in the
company. He is not liable for anything beyond that.
Separate legal entity. This means that every company has a separate legal identity and existence
different from its shareholders and board of directors. It is an artificial person that can enter into
contracts in its own name under its common seal. It can buy and sell property while entering into legal
contracts with third parties in its own name. It can sue and be sued for breach of contract. It acts
through its directors who have been elected by the shareholders.
Perpetual succession. A company is independent of the life of its members. Its existence is not affected
in any way by the death, insolvency or exit of any shareholder. This lends stability and long life to a
company as compared to other forms of business organizations.
Transferable shares. Every shareholder of a public limited company can freely transfer his shares to any
other person at any time for any price. But private limited companies may place restrictions on
transferability of shares.
Advantages

Unlimited commercial life. The corporation is an entity of its own and does not dissolve when
ownership changes.

Greater flexibility in raising capital through the sale of stock.

Ease of transferring ownership by selling stock.

Limited liability. This limited liability is probably the biggest advantage to organizing as a
corporation. Individual owners in corporations have limits on their personal liability. Even if a
corporation is sued for billions of dollars, individual shareholder's liability is generally limited to
the value of their own stock in the corporation.

Disadvantages
Regulatory restrictions. Corporations are typically more closely monitored by governmental
agencies, including federal, state, and local. Complying with regulations can be time consuming and
costly.

Higher organizational and operational costs. Corporations have to file articles of incorporation with
the appropriate state authorities. These legal and clerical expenses, along with other recurring
operational expenses, can contribute to budgetary challenges.

Double taxation. The possibility of double taxation arises when companies declare and pay taxes on
the net income of the corporation, which they pay through their corporate income tax returns. If the
corporation also pays out dividends to individual shareholders, those shareholders must declare that
dividend income as personal income and pay taxes at the individual income tax rates. Thus, the
possibility of double taxation.

Private Limited Company

A Private Limited Company in India is similar to a C-Corporation in the US. Private Limited Company
allows owners to subscribe to its shares by paying a share capital fees. On subscribing to shares, the
owners/members become shareholders on the company. A Private Limited Company is a separate legal
entity both in terms of taxation as well as liability. The personal liability of the shareholders is limited to
their share capital. A private limited company can be formed by registering the company name with
appropriate Registrar of Companies (ROC). Draft of Memorandum of Association and Article of
Association are prepared and signed by the promoters (initial shareholders) of the company. A Private
Limited Company can have between 2 to 50 members with minimum share capital of Rs 1,00,000 (one
lac). To look after the day to day activities of the company, Directors are appointed by the Shareholders.
Minimum two Directors must be appointed to look after the daily affairs of the company. A Private
Limited Company has more compliance burden when compared to a Partnership and LLP. For example,
the Board of Directors must meet every quarter and at least one annual general meeting of Shareholders
and Directors must be called. Accounts of the company must be prepared in accordance with Income
Tax Act as well as Companies Act. Also Companies are taxed twice if profits are to be distributed to
Shareholders. Closing a Private Limited Company is a tedious process and requires many months.
One the positive side, Shareholders of a Private Limited Company can change without affecting the
operational or legal standing of the company. Generally Venture Capital investors prefer to invest in
businesses that are Private Limited Company since it allows great degree of separation between

ownership and operations. It also allows investors to exit the company by selling shares without being
liable for company affairs.
Public Limited Company
Public Limited Company is similar to Private Limited Company with the difference being that number
of shareholders of a Public Limited Company can be unlimited with a minimum seven members. It is
generally very difficult to establish a public limited company. A Public Limited Company can be listed
in a stock exchange. A Listed Public Limited Company allows shareholders of the company to trade its
shares freely on the stock exchange. A Public Limited Company requires more public disclosures and
compliance from the government as well as market regular SEBI (Securities and Exchange Board of
India) including appointment of independent directors on the board, public disclosure of books of
accounts, cap of salaries of Directors and CEO. Like a Private Limited Company, a Public Limited
Company is also an independent legal person, its existence is not affected by the death, retirement or
insolvency of any of its shareholders.
II S OURCES OF FINANCE
To finance growth, any ongoing business must have a source of funds. Apart from bank and trade debt,
the principal sources are retained earnings, debt securities, equity securities, and private equity.
Retained Earnings
A significant source of new funds that corporations spend on capital projects is earnings. Rather than
paying out earnings to shareholders, the corporation plows those earnings back into the business.
Plowback is simply reinvesting earnings in the corporation. It is an attractive source of capital because it
is subject to managerial control. No approval by governmental agencies is necessary for its expenditure,
as it is when a company seeks to sell securities, or stocks and bonds. Furthermore, stocks and bonds have
costs associated with them, such as the interest payments on bonds, while retaining profits avoids these
costs. An organization may consider opportunity cost of retained earnings for its shareholders.
Debt Securities
A second source of funds is borrowing through debt securities. A corporation may take out a debt
security such as a loan, commonly evidenced by a note and providing security to the lender. A common
type of corporate debt security is a bond, which is a promise to repay the face value of the bond at
maturity and make periodic interest payments called the coupon rate. For example, a bond may have a
face value of $1,000 (the amount to be repaid at maturity) and a coupon rate of 7 percent paid annually;
the corporation pays $70 interest on such a bond each year. Bondholders have priority over stockholders
because a bond is a debt, and in the event of bankruptcy, creditors have priority over equity holders.

Equity Securities
The third source of new capital funds is equity securitiesnamely, stock. Equity is an ownership interest
in property or a business. Stock is the smallest source of new capital but is of critical importance to the
corporation in launching the business and its initial operations. Stock gives the investor a bundle of legal
rightsownership, a share in earnings, transferability and, to some extent, the power to exercise control
through voting. The usual way to acquire stock is by paying cash or its equivalent as consideration.
Other Forms of Finance
While stock, debt securities, and reinvested profits are the most common types of finance for major
corporations (particularly publicly traded corporations), smaller corporations or start-ups cannot or do not
want to avail themselves of these financing options. Instead, they seek to raise funds through private
equity, which involves private investors providing funds to a company in exchange for an interest in the
company. A private equity firm is a group of investors who pool their money together for investment
purposes, usually to invest in other companies. Looking to private equity firms is an option for startupscompanies newly formed or in the process of being formedthat cannot raise funds through the
bond market or that wish to avoid debt or a public stock sale. Start-ups need money to begin operations,
expand, or conduct further research and development. A private equity firm might provide venture
capital financing for these start-ups. Generally, private equity firms that provide a lot of venture capital
must be extremely savvy about the start-up plans of new businesses and must ask the start-up
entrepreneurs numerous challenging and pertinent questions. Such private equity firms expect a higher
rate of return on their investment than would be available from established companies. Today, venture
capital is often used to finance entrepreneurial start-ups in biotechnology and clean technology.
Sometimes, a private equity firm will buy all the publicly traded shares of a companya process
commonly termed going private. Private equity may also be involved in providing financing to
established firms.
Another source of private equity is angel investors, affluent individuals who operate like venture
capitalists, providing capital for a business to get started in exchange for repayment with interest or an
ownership interest. The main difference between an angel investor and a venture capitalist is the source
of funds: an angel investor invests his or her own money, while venture capitalists use pooled funds.
Private equity firms may also use a leveraged buyout (LBO) to finance the acquisition of another firm. In
the realm of private equity, an LBO is a financing option using debt to acquire another firm. In an LBO,
private equity investors use the assets of the target corporation as collateral for a loan to purchase that
target corporation. Such investors may pursue an LBO as a debt acquisition option since they do not need
to use muchor even anyof their own money in order to finance the acquisition.

A major drawback to private equity, whether through a firm or through venture capital, is the risk versus
return trade-off. Private equity investors may demand a significant interest in the firm, or a high return, to
compensate them for the riskiness of their investment. They may demand a say in how the firm is
operated or a seat on the board of directors.
Stocks and Bonds
Stocks, or shares of stock, represent an ownership interest in a corporation. Bonds are a form of longterm debt in which the issuing corporation promises to repay the principal amount at a specific date.
Stocks pay dividends to the owners, but only if the corporation declares a dividend. Dividends are a
distribution of a corporation's profits. Bonds pay interest to the bondholders. Generally, the bond
contract requires that a fixed interest payment be made every six months.
Every corporation has common stock. Some corporations issue preferred stock in addition to its common
stock.
Investors are always told to diversify their portfolios between stocks and bonds, whats the difference
between the two types of investments? Let us take a look at the difference between stocks and bonds on
the most fundamental level.
Stocks is an Ownership Stake, Bonds are Debt
Stocks and bonds represent two different ways for an entity to raise money to fund or expand their
operations. When a company issues stock, it is selling a piece of itself in exchange for cash. When an
entity issues a bond, it is issuing debt with the agreement to pay interest for the use of the money.
Stocks are simply shares of individual companies. Heres how it works: say a company has made it
through its start-up phase and has become successful. The owners wish to expand, but they are unable to
do so solely through the income they earn through their operations. As a result, they can turn to the
financial markets for additional financing. One way to do this is to split the company up into shares,
and then sell a portion of these shares on the open market in a process known as an initial public
offering, or IPO. A person who buys stock is therefore buying an actual share of the company, which
makes him or her a part owner however small. This is why stock is also referred to as equity.
Bonds, on the other hand, represent debt. A government, corporation, or other entity that needs to raise
cash borrows money in the public market and subsequently pays interest on that loan to investors. Each
bond has a certain par value (say, $1000) and pays a coupon to investors. For instance, a $1000 bond
with a 4% coupon would pay $20 to the investor twice a year ($40 annually) until it matures. Upon
maturity, the investor is returned the full amount of his or her original principal except for the rare
occasion when a bond defaults (i.e., the issuer is unable to make the payment).

The difference in stocks and bonds for Investors

Since each share of stock represents an ownership stake in a company meaning the owner shares in the
profits and losses of the company - someone who invests in the stock can benefit if the company
performs very well and its value increases over time. At the same time, he or she runs the risk that the
company could perform poorly and the stock could go down or, in the worst-case scenario (bankruptcy)
disappear altogether.
Individual stocks, and the overall stock market, tend to be on the riskier end of the investment spectrum
in terms of their volatility and the risk that the investor could lose money in the short term. However,
they also tend to provide superior long-term returns. Stocks are therefore favored by those with a longterm investment horizon and a tolerance for short-term risk.
Bonds lack the powerful long-term return potential of stocks, but they are preferred by investors for
whom income is a priority. Also, bonds are less risky than stocks. While their prices fluctuate in the
market sometimes quite substantially in the case of higher-risk market segments - the vast majority of
bonds tend to pay back the full amount of principal at maturity, and there is much less risk of loss than
there is with stocks.
IPO - Initial Public Offer: Public issues can be classified into Initial Public offerings and further public
offerings. In a public offering, the issuer makes an offer for new investors to enter its shareholding
family. The issuer company makes detailed disclosures as per the DIP guidelines in its offer document
and offers it for subscription. Initial Public Offering (IPO) is when an unlisted company makes either a
fresh issue of securities or an offer for sale of its existing securities or both for the first time to the public.
This paves the way for listing and trading of issuer's securities. IPO is New shares Offered to the public
in the Primary Market .The first time the company is traded on the stock exchange. A prospectus is
issued to read about its risk before investing. IPO is A company's first sale of stock to the public.
Securities offered in an IPO are often, but not always, those of young, small companies seeking outside
equity capital and a public market for their stock. Investors purchasing stock in IPOs generally must be
prepared to accept very large risks for the possibility of large gains. Sometimes, Just before the IPO is
launched, Existing shareholders get a very liberal bonus issues as a reward for their faith in risking
money when the project was new.
How to apply for a public issue? When a company floats a public issue or IPO, it prints forms for
application to be filled by the investors. Public issues are open for a few days only. As per law, any
public issue should be kept open for a minimum of 3days and a maximum of 21 days. For issues, which
are underwritten by financial institutions, the offer should be kept open for a minimum of 3 days and a
maximum of 21 days. For issues, which are underwritten by all India financial institutions, the offer
should be kept open for a maximum of 10 days. Generally, issues are kept open for only 3 to 4 days. The
duly complete application from, accompanied by cash, cheque, DD or stock invest should be deposited

before the closing date as per the instruction on the from. IPO's by investment companies (closed end
funds) usually contain underwriting fees which represent a load to buyers.
Types of stock
Common stock versus Preferred stock: Common stock and preferred stock both represent some degree
of ownership of a company. Holding shares of common stock gives you the opportunity to vote in the
election of the board of directors. This is usually equivalent to one vote per share that you own. Owning
preferred stock usually guarantees the payment of dividends but does not come with voting rights.
Typically, common stock shareholders receive one vote per share to elect the companys board of
directors (although the number of votes is not always directly proportional to the number of shares
owned). The board of directors is the group of individuals that represents the owners of the corporation
and oversees major decisions for the company. Common stock shareholders also receive voting rights
regarding other company matters such as stock splits and company objectives.
In addition to voting rights, common shareholders sometimes enjoy what are called preemptive
rights. Preemptive rights allow common shareholders to maintain their proportional ownership in the
company in the event that the company issues another offering of stock. This means that common
shareholders with preemptive rights have the right but not the obligation to purchase as many new shares
of the stock as it would take to maintain their proportional ownership in the company.
The right of current shareholders to maintain their fractional ownership of a company by buying a
proportional number of shares of any future issue of common stock. Most states consider preemptive
rights valid only if made explicit in a corporation's charter. also called subscription privilege or
subscription right.
Preemptive right is a good option for those investing in startup companies to ensure that no matter how
successful the organization becomes, the amount of ownership and voting power of the investors remains
the same.
Ownership in either type of stock entitles you to a piece of the company's profit. One way profit is
distributed to the shareholders is through dividends, which are often paid in cash from the company's
earnings. Dividends are usually paid on a quarterly basis.
Common stockholders never know the value of their dividends in advance, while preferred stockholders
receive dividends at a fixed rate. While the dividends on preferred stocks tend to be higher than those on
common stock, they will not appreciate with company growth.
Investors can think of preferred [stocks] as somewhere between a stock and a corporate bond, as they
trade on an exchange the way stocks do, but the dividends are generally quite high, like those from longmaturity bonds.

Like bonds, preferred stocks are rated by credit rating agencies. Ratings range from "higher-quality
investment-grade offerings to lower-rated, high-yield or 'junk' issues."
Risks
Common stock tends to respond to general market volatility. Its level of risk also varies greatly by
company. Purchasing common shares of a well-established company is less risky than trying your hand
with penny stocks. However, when viewed over long investment holding periods, common stocks have
historically offered higher returns than preferred stocks or bonds. Preferred stocks are more volatile than
their bond cousins, and sometimes as volatile as common stocks because trading liquidity in the preferred
sector can dry up in times of extreme market stress.
During times of financial trouble, a company will not default if it suspends preferred dividends, as is the
case with missed bond payments. If the shares are not cumulative, the company does not have the
obligation to pay missed dividends. Preferred stock may be callable, which means the company has the
right to purchase the shares from the shareholder at a certain price at any time. However, as mentioned
above, dividends on preferred stock tend to be higher than dividends on common stock.
In the case of bankruptcy, preferred stock owners rank above common stock owners but below ordinary
bondholders. This means that if the company goes bankrupt, common stockholders only get paid if there
is something leftover after the creditors, bondholders and preferred stockholders get their shares. The
bottom line is that common shareholders rarely get anything in bankruptcy cases, while preferred
stockholders have a better chance of getting at least some money back.
In general, there are four different types of preferred stock:
Cumulative: These shares give their owners the right to accumulate dividend payments that were
skipped due to financial problems; if the company later resumes paying dividends, cumulative
shareholders receive their missed payments first.
Non-Cumulative: These shares do not give their owners back payments for skipped dividends.
Participating: These shares may receive higher than normal dividend payments if the company turns a
larger than expected profit.
Convertible: These shares may be converted into a specified number of shares of common stock.
Since preferred shares carry fixed dividend payments, they tend to fluctuate in price far less than
common shares. This means that the opportunity for both large capital gains and large capital losses is
limited. Because preferred stock, like bonds, has fixed payments and small price fluctuations, it is
sometimes referred to as a hybrid security