What are common forms of business organization? A private enterprise economy the firm is the agency that executes the orders of the consumers. It is a voluntary association of resource owners organized for the purpose of making profits by producing for sale economic goods and services. The firm sells to individuals, to other firms, and to the State and its subdivisions.
In addition to business firms, there are many voluntary, non-profit making associations catering to human needs. These are churches, lodges, private schools, and philanthropic corporations. The State is an association that uses resources and provides goods and services. Membership is compulsory, and the managers do not have to keep the organization “out of the red,” as do the managers of private business firms. Hence there is no easy method of determining the scope of its activities. One of the tasks of economics and political science is to determine the appropriate roles of the State and of private profit-making firms in societies that desire to maintain the institutions of private property and private enterprise.
Our concern in this article is with private, profit-seeking firms. Such firms vary from the one-man shop and the small family farm to the huge enterprise with dozens of separate plants and tens to hundreds of thousands of paid workers. The term plant refers to the basic production unit. With a few exceptions, such as railroads, a plant is located in a single community. A firm, on the other hand, may consist of one plant or many. Altogether there are over three million non-agricultural firms in the United States and close to six million agricultural firms, i.e., farms, most of which are very small.
Smallness is also characteristic of the firms outside of agriculture. 91.3 percent of the 3,316,700 nonagricultural firms doing business in the United States in 1939 had less than 8 employees, while less than one percent hired more than 99. Only three-tenths of one percent had more than 249 employees on their payrolls. But these large firms, while few in number, are responsible for the bulk of nonfarm employment. In round numbers, 16 million, or 57 percent, of the gainfully employed not engaged in agriculture were working for firms employing 100 or more workers. The 4,900 largest firms, those with 500 or more workers, represented one-fifth of one percent of all non-agricultural firms and gave employment to 40 percent of the nonagricultural labor force. The 90 odd percent of small firms employed less than one-quarter of the working population (23.7%). More than a million and one-half had no hired workers. These were the self-employed and the members of their families.
The proportions will not be very different today. It is customary to group firms into a few major classifications according to some common characteristic, such as materials handled or products made. United States Government statistics recognize seven large groupings: the extractive industries; contract construction; manufacturing; transportation, communication, and public utilities; wholesale trade; service industries; finance, insurance, and real estate—with many subgroups under each. The term “industry” is used interchangeably to cover one of the major classifications or one of the narrower subgroups. The term lacks precision and hence lends itself to misuse. It is easy, for example, to prove that an industry is monopolistic by simply narrowing the definition of the industry to cover a single, highly specialized product. let’s discuss in detail various forms of business organization.
FORMS OF BUSINESS ORGANIZATION
Any form of voluntary association requires either tacit or formal public approval. In the United States, there are four forms of business organization:
- Individual proprietorship
In the individual proprietorship, a single individual is legally responsible for the conduct of the business, is entitled to all the profits, and is obliged to meet all the losses to the full extent of his ability. The business may be large or small and it may be conducted in a single plant or in many plants; the proprietor may supply all the labor and capital himself as well as the management, as in the case of a one-man repair shop; or he may hire a large number of workers, including a salaried manager, and borrow a substantial part of his operating capital. The typical and important feature of this form of organization is that all those who cooperate with the proprietor do so on terms agreed upon in advance.
The workers receive explicit wages; the suppliers of capital receive explicit interest. If the proprietor does not own the land used in his operations, he pays explicit rent. In brief, the proprietor pays all the expenses of production and gains legal title to all the money derived from the sale of the goods and services produced by the firm. If receipts exceed explicit expenses, the excess in the eyes of the law belongs to him. Often this excess may be less than he could earn by working for someone else. A proprietor gets no wages; he earns no interest on his own capital invested in the firm. If expenses exceed receipts, he must nonetheless meet all his explicit expenses on pain of bankruptcy. His home, the savings which he had not intended to commit to the business, everything is involved.
The advantages of the individual proprietorship are fairly obvious: the unity of command, the ability to make quick decisions, the complete dedication of the owner to the success of the venture. The great disadvantage of this form of business organization is that it does not lend itself to the bringing together of the capital needed to finance really large enterprises. The resources and the credit of even a very wealthy man would not be adequate for the requirements of even a medium-sized enterprise in the United States today.
Also, the unlimited liability that the individual proprietor must assume tends to deter wealthy men from engaging in an enterprise involving unlimited liability. To do so would jeopardize all of their resources and not merely those directly committed to the business. Numerically, individual proprietorships outnumber the other three categories, but in terms of work done they play a less important role in the American economy. The family farm, the tiny grocery store, the garage, the filling station, and the one-man lawyer’s or doctor’s office are examples of the single proprietorship.
The partnership is nothing more than an enlargement of the single proprietorship. Each partner may commit the firm and in turn is legally liable for the acts of the other partners, as well as for those of subordinates. This unlimited liability gives the partnership excellent credit standing but imposes a degree of risk that has made this form of organization, like the individual proprietorship, unsuitable to most enterprises requiring large amounts of capital. Another disadvantage of the partnership grows out of the necessity of dissolving the firm and reorganizing it every time a change occurs in the membership or in the relative investments of the several partners. This right of withdrawal places a minority partner in a strong bargaining position in the case of any proposal to which he strongly objects. It thus complicates prompt decision making. The partnership form of organization is most practical when the number of partners involved is small and the relationship between the partners intimate.
The corporate form of organization developed slowly. In the 16th and 17th centuries a group of individuals would buy “shares” in a single adventure—a trading expedition to India or the Hudson Bay Region, for example. They participated in the profits or losses of the expedition according to the relative value of their shares. The Company of Adventurers disbanded after the completion of each project. The problems of continuity and authority had not been solved. The “regulated” companies which came next partially met these needs. British “regulated” companies were given royal charters and monopoly privileges in parts of the world under British control. Such were the British East India Company, and Virginia, the London and the Plymouth Companies that established and administered the first settlements in what is now the United States. Each member of a “regulated” company was permitted to provide his own capital, look out for it and withdraw it at his pleasure.
Effective centralization of control had not been achieved, and the problem of continuity had been only partially solved. An important forward step occurred in 1662 when the British East India Company was converted into a “joint stock” company. Under the new arrangement, the assets of the company were represented by transferable shares which could be bought and sold without affecting the amount of capital at the disposal of the management. Those who provided the equity capital in this fashion exercised their control through their right to choose the management. Each shareholder cast as many votes as he owned shares. The problems of continuity and authority had been solved. This continued to be the situation for the next 200 years. Then, around 1850, the last step was taken with the introduction of the principle of limited liability. Shareholders were relieved of legal responsibility for all losses over and above what they had put in when they bought the shares. In the United States owners of the bank, a stock is usually liable up to twice the par value of their shares.
Main features of the corporation. The corporation is thus a partnership with features added which (a) enable individuals to enter or withdraw from the firm without interrupting its legal existence —Continuity; (b) tighten lines of command so as to secure unity of decision and of action in what would otherwise be an unwieldy organization— Authority; and (c) limit the losses of owners to their equity investments in the organization—Limited Liability. Equity investment or equity capital refers to resources that are supplied by the owners of the enterprise. It is, par excellence, risk capital put into the business with the expectation of getting a substantial return but with the realization that part or all may be lost, and that in any event, the affairs of the business may make it impossible or expedient for the management to make any return in a particular year. The reward to equity capital does not form part of the explicit expenses of the firm. No equity capital refers to resources loaned to the firm for a consideration stated in advance. This consideration, interest, is an explicit expense which must be met punctually regardless of whether the firm is or is not making a profit.
A corporation comes into existence by an act of government. It receives a charter from the state. Originally these charters were granted by special acts, but the danger of corruption and the popular favor which corporations enjoyed during most of the 19th century led to the passage of general laws governing the granting of charters. Although our Federal Government has the power to grant charters and occasionally does so, as, in the case of our national banks, most private American corporations hold theirs from the individual states. With some exceptions, a charter granted by one state entitles a corporation to do business in all the other states.
Corporation and partnership compared. In law, the partnership and the corporation are very different things. The real entities in a partnership are the partners. It is they, and not the firm, who carry on the business, who sue or are sued for breach of contract, and who pay income taxes on the partnership earnings. Under federal and state income tax laws the profits and the losses of partnerships are treated as additions to or deductions from the personal incomes of the partners. The partners pay personal income taxes at the rates determined by their total taxable incomes whether or not the profits are actually withdrawn from the business.
The corporation, on the other hand, is a “legal” person and as such is entitled to many of the rights and immunities of “natural” persons. It may not be deprived of its property except by due process of law. It is a person in the sense that one state may not discriminate against a corporation created by a sister state. The corporation conducts business through its officers; it may sue and be sued; it makes profits and experiences losses. A minority stockholder, unlike a minority partner, cannot block an action, provided the action has the approval of those holding a majority of the stock, by threatening to withdraw from the corporation. Nor can he force the corporation to return his money. All he can do is offer his shares for sale in the open market. The proceeds may or may not reimburse him for his original investment.
Under federal and state laws the profits of the corporation are taxable as such. They form no part of the income of the stockholders until they are actually distributed, and then they are taxed again. Since individuals and only individuals actually pay taxes, the result is double taxation of that part of a person’s income derived from making risk-capital available to firms organized as corporations. In the partnership, on the other hand, the income is taxed to the partners in proportion to their interest, whether it is distributed or not.
Cooperatives are private firms organized for the primary purpose of serving their own members and not the general public. They may either buy or sell for their members. The Rochdale Pioneers. The operating rules that cooperatives generally follow are very much the same as those worked out by the small group of textile workers in Rochdale, England, in 1844, when they arranged to buy a few staples for themselves. The Rochdale Society of Equitable Pioneers, as they called themselves, agreed:(1) that goods should be sold at prevailing prices; (2) that savings (earnings) should be distributed according to purchases; (3) that interest on capital should be restricted to a fixed rate; (4) that membership should be open to all; (5) that each member should have one vote and no more; (6) that full information—based on proper audits and accounts—should be presented to the members; (7) and that all business should be conducted on a cash basis. The vast cooperative movement is generally regarded as the outgrowth of the efforts of this little group of British workers to eliminate the middleman and his profits and bring the consumer into direct contact with the producer.
Comparison with other forms of business organization. The cooperative resembles the corporation in a number of respects: (a) the suppliers of the equity capital enjoy limited liability; (b) they appoint the directors and the officers of the firm, who in general (c) have the same powers as do the officers and directors of corporations; and finally (d) individuals may withdraw their equity capital without endangering the continuity of the firm.
The differences, nonetheless, are striking:
(a) The suppliers of equity capital get only a limited dividend.
(b) Each stockholder has only one vote regardless of his investment. This is in marked contrast to the practice in the corporation. (It conforms rather with the practice in modern mass democracies in which each citizen has only one vote regardless of his wealth and of how much he must contribute to the expenses of the State. In this sense the cooperative is a more democratic form of business organization than the corporation.)
(c) The real profits of the cooperative are paid out to the cooperators not in proportion to their equity interests in the firm but in proportion to the business they do with it, either as buyers or sellers. They are patronage dividends rather than risk-capital dividends. They may be paid to anyone doing business with the cooperative or reserved exclusively for those customers who are also stockholders. In general, the bulk of the business of cooperatives is done with their members, a fact which automatically limits the scope of this form of business organization.
(d) The most striking difference, at least in the early days of cooperatives, was in the spirit and purpose. The first cooperatives were started by working class people (England) or by workers or peasants (Continental Europe). They were a form of self-help. The appeal was to group solidarity and to the spirit of service. In part, they were an expression of protest against profits and the profit motive. As they have grown larger, the sentiment of solidarity has undoubtedly weakened, but the tradition of service is still strong and reflects itself in the relatively moderate salaries paid to top executives.
The future of the cooperative movement should depend on how well cooperatives serve as agents for carrying out the orders of consumers. If cooperatives receive no special favors, there can be no valid objection by owners of profit-seeking businesses to the field they manage to carve out for themselves. Many believe, however, that the recent and rather rapid increase in the number of cooperatives and in the volume of business done by cooperatives in the United States is due not so much to their efficiency as to the tax advantages they receive from the Federal Government. Cooperatives pay no tax on money accumulated for expansion, whereas the other forms of business organization pay a relatively heavy tax on comparable accumulations. The alleged justification for this differential treatment of the cooperative is that the money really belongs to the patrons. If an attempt were made to tax these surpluses, so runs the argument, the cooperatives would avoid the tax by lowering their selling prices, if their patrons are buyers, or by raising their buying prices if their patrons are sellers. In brief, cooperators deny that the earnings of cooperatives are profits. There could be no objection in principle to the tax treatment accorded cooperatives if the other forms of business organization received similar treatment. But the corporation, it will be recalled, has to pay a heavy tax on any profits held back for expansion purposes, and, in addition, the stockholders have to pay a personal tax on the distributed earnings (dividends) without any allowance for the fact that the income from which the dividends are paid has already been heavily taxed. Partnerships and individual proprietorships are not subject to this type of double taxation, but the earnings are subject to the personal income tax, regardless of whether or not they are used for expansion.
The immunity of cooperatives from taxation on their net earnings thus gives them a competitive advantage over corporations, partnerships, and individual proprietorships when it comes to raising new capital for expansion purposes. It is true that the cooperatives can avoid the tax by altering their buying or selling prices, but if they do they then have to induce the cooperators to put up more money to finance their expansion programs. It is always much easier to get people to leave unpaid money claims in a firm than it is to get them to put them back in once they have been paid out.
SOCIAL SIGNIFICANCE OF THE CORPORATION
The rapid growth of the corporate form of business organization clearly proves that it is peculiarly appropriate to the requirements of the complex division of labor. Presumably, consumers are better off because of the perfecting of this method of organizing an enterprise. Two further favorable consequences deserve consideration. The field for private enterprise widened. The privileges of incorporation have greatly extended the field within which private enterprise can operate effectively. Stated negatively, it has reduced man’s dependence upon the state as a provider of goods and services.
Many goods and services can be supplied efficiently only by large firms, operating without a break over long periods of time. An example is rail transportation. If private firms cannot accumulate the funds or provide the continuity needed for such operations, then the operations must be undertaken by the government. The corporate form of organization has provided the continuity lacking in both the partnership and individual proprietorship. At the same time, it has provided a convenient way for literally thousands of people to pool their resources to finance the operations of a single firm. Even more important to the raising of capital, the device of limited liability has reduced the risk to each person who shares in the venture. The person of some means does not wish to place his entire fortune in jeopardy each time he participates in a venture. Yet this is what he must do if the venture is organized under the individual proprietorship or partnership form. Through its limited liability feature, the corporate form of organization has made it possible for private firms to obtain the financing needed for large-scale operations and thus has widened the sphere for private enterprise.
Capital formation promoted. In a private enterprise society, rising levels of living depend upon voluntary saving, investing, and capital formation and upon improvements in technology. All these actions involve risks. The privilege of incorporation has reduced the repressive effects of risk by providing a wide variety of investment opportunities capable of appealing to individuals of very different temperaments, ranging from extreme caution to recklessness. The individual can so blend his investments as to secure the degree of risk on his total wealth that fits his particular temperament. There can be no doubt about the fact that the corporation has greatly stimulated the volume of saving and hence increased the annual rate of capital formation. An understanding of the relationship of the corporation to the rate of capital formation requires some discussion of the two principal ways in which corporations obtain outside funds for expansion purposes: borrowing through the sale of bonds and notes and obtaining equity investment through the issue of preferred and common stock.
Bonds and notes. Those supplying funds through the purchase of bonds and notes have a claim to stipulated payments (interest) at stipulated times (annually, semi-annually, or shorter intervals) regardless of whether the company is or is not making money. Failure to pay the interest or the principal when due automatically throws the company into technical bankruptcy. The bond and note holders may or may not insist upon the liquidation of the company. If they do, their claims on the physical and other assets of the enterprise stand ahead of those who supplied the equity or ownership capital.
Preferred and common stock. A common characteristic of preferred and common stock is that the payment of dividends is discretionary. They may be “passed,” i.e., omitted, without throwing the company into technical bankruptcy. Preferred stock differs from common stock, however, in a number of important respects. First of all, the dividend on preferred stock is fixed in advance, whereas there is no stipulated dividend to which the owner of common stock is entitled. If the preferred stock is cumulative, all “passed” dividends must be paid before any dividends may be paid on common stock. It follows that noncumulative preferred stock is frequently much more risky than common stock. Another difference is that preferred shares are usually nonvoting. The real ownership of the corporation is in the hands of the holders of the common stock. They are entitled to whatever remains after all other claims have been settled in full. The income from a common stock is thus residual. If nothing remains, the holders get nothing. If a company is liquidated and its assets sold, again the holders of the common stock receive only what is left after all other claims have been satisfied in full.
Our purpose in making this brief excursion into the field of corporate finance is to show that the device of limited liability has greatly widened the range of outlets for the savings of those who are not prepared to go into business for themselves and has thus contributed to the exceptionally rapid growth of the American economy. It would be an exaggeration to say that the corporation produces savers where otherwise there would be no savers, but it is probably true that the corporation greatly stimulates private saving and investment where the willingness to save already exists.
The device of limited liability is thus a social invention of great significance, comparable in its importance, probably, to any single invention in the field of natural science. And like discoveries in the field of the natural sciences, this one is entirely amoral. It can be put to good or too bad purposes. Critics of the corporation allege that this form of business organization facilitates certain types of unethical business behavior, makes it possible for businesses to grow too big, and promotes a concentration of power in private hands that threatens the vitality of our democratic institutions.
Unethical business practices. The following practices are illustrative of the “unethical business practices” charge: excessive directors’ fees; excessive salaries and bonuses; stock market dealings by directors.
Excessive directors’ fees. Some companies pay their directors as much as $100 for each meeting attended. Directors could thus make around $5,000 in fees if meetings were held weekly. For many of them, this would represent substantially more than the dividends from their holdings in the company. If the meetings were held in a convenient place and were brief, the majority of the directors might be favorably disposed to unnecessarily frequent meetings. In a small company, this drain on its revenues could reduce considerably the rate of return on the common stock. What the “inside” group of stockholders lost in dividends would be profitably offset by their directors’ fees. The common stockholders who were not directors would be the victims of this sharp, yet entirely legal, practice. It would be very difficult for them to prove before a court of law that the Board of Directors was meeting too frequently.
Excessive salaries and bonuses. The payment of unnecessarily high salaries and bonuses to the top management is said to be another way in which the legitimate interests of the rank and file of the common stockholders can be hurt. Again the effect is likely to be more serious in small- and intermediate-sized companies than in very large ones, and it is in the latter that the very large awards usually occur. The effect of overly generous salaries and bonuses on the other claimants to the company’s earnings is insignificant in the case of giant corporations. In 1948 General Electric, for example, had over 180,000 wage and salaried employees, more than 250,000 common stockholders, and realized net sales of close to $1,000,000,000. Suppose that it could be proved that in a corporation of that size ten men on the Board of Directors and five officers, who were also members of the Board of Directors, were getting $1,000,000 more than was necessary to secure their services.
This is a lot of money when divided among 15 men. Yet the effect on the customers, stockholders, and the other employees is very slight. Prices could be cut by only one-tenth of one percent if the money were used exclusively for that purpose. Had it gone to the wage and lower-salaried personnel, (say, five-sixths of the total number employed) the average wage rate could not have been increased by as much as one-half cent per hour. (At 2000 hours per employee—50 weeks at 40 hours per week—General Electric provided some 360 million man-hours of employment. An additional $1,000,000 spread evenly over five-sixths of this payroll amounts to one-third of a cent per hour or less than 14 cents per week.) Nor could $1,000,000 added to net profits mean much to the average stockholder in a company with more than 250,000 stockholders. Needless to say, these practices are just as objectionable ethically whether indulged in by large companies or by small ones. Popular faith in private capitalism is inevitably weakened by acts of this sort. They also complicate the task of maintaining good labor relations.
A firm that pays extravagant top salaries finds it very difficult to explain satisfactorily to the rank and file its inability to pay an additional five cents an hour. It is probably true that a cut-back of these salaries to the level of top clerks would not provide the means to advance wages generally by as much as one cent an hour. This answer does not satisfy the men, and the reason that it does not is probably due more to resentment at what they consider the overpayment at the top than it is to dissatisfaction with the going rate. This attitude complicates good labor-management relations and confronts large corporations with a problem which cannot be solved in a wholly satisfactory manner. Since really able leadership is extremely scarce, they must bid high for it, regardless of the reactions of the rank and file of their employees.
Stock market speculation. The market value of a company’s common stock depends much more on future earnings than upon the value of the company’s physical assets. The proceeds from the sale of $100,000 worth of common stock may have been used to build a factory, but the stock will not be worth much if the factory operates at a loss. Stock values are exceedingly sensitive to coming events. This fact gives members of management an excellent opportunity to speculate in the stocks of their companies. They know a great deal more than outsiders possibly can know about coming developments that will affect the company’s earnings, favorably or unfavorably.
Indeed through a generous or a parsimonious dividend policy, or through the handling of obsolescence and depreciation expenses, or through the issuing of optimistic or pessimistic forecasts, and in many other ways, management can create misleading impressions regarding the affairs of the company and then buy or sell with the certainty of making a profit. For obvious reasons, this abuse is more likely to be found in large companies than in small ones. State laws and more recently federal laws have attempted to stop these practices. The situation is greatly improved.
The list of alleged sharp practices could be greatly lengthened. Many are already historical curiosities. This shows what can be done when public opinion is really aroused and stays aroused. Unethical practices there will always be because of defects in human character. There is no reason to believe that the abolition of the corporation or the nationalization of all large businesses would reduce the opportunities for men to act dishonorably. It is probable that unethical practices occur at least as frequently in partnerships and individual proprietorships as in big corporations, in nationalized enterprises as in privately owned enterprises. The corporation and the problem of bigness. Much more serious than the allegation that the privilege of incorporation has encouraged unethical business practices is the charge that it has made possible the growth of firms that are too big, from the point of view of efficiency; and dangerous because of the resulting concentration of power in private hands.
The “power” charge touches upon issues in the realm of political theory and political philosophy. The implication is that a workable democracy can be preserved only by limiting the maximum size of the firm, even if this means some sacrifice of material well-being. The charge that the privilege of incorporation permits firms to grow beyond their most economical size implies that competition is not effective.