CHOICE OF A SUITABLE FORM OF BUSINESS ORGANISATION

After having discussed the various forms of business organisation with their relative advantages and disadvantages, it would be appropriate now, to examine how a final choice is made of a suitable form of organisation by the entrepreneur concerned. The choice of an appropriate form of ownership organisation is an important entrepreneurial decision; because it has a bearing on income, risk and control as related to the entrepreneur.

The choice of the suitable form is never based on a single factor, it should be based on all relevant considerations concerning the business as known to the entrepreneur at the time of taking a decision. The problem of choice of a suitable form of business organisation arises at two occasions – while starting a new business and secondly, when its expansion becomes essential. It may be noted that there is no single form of business organisation which may be considered the best under all the circumstances; in fact, a form of organisation which is considered the best in one case, may prove to be a complete failure in another case.

At the time of launching a new business enterprise, the choice of the form of ownership is dictated by several factors as given below :

1. Nature of business – Service, trade, manufacturing.

2. Scale of operations – Volume of business (large, medium, small) and size of the market area (local, national, international) served.

3. Degree of direct control desired by owners.

4. Amount of capital required initially and for expansion.

5. D.egree of risk and liability and the willingness of owners to assume personal liability for debts of business.

6. Division of profits among the owners.

7. Length of life desired by the business.

8. Relative freedom from Government regulations (flexibility of operations).

9. Scope and plan of internal organisation.

10. Comparative tax liability.

It must be noted that these factors are interrelated and interdependent. For instance, the amount of capital required and the degree of risk involved depend upon the nature and volume of business operations. The degree of control and the division of profits are both related to risk and liability. Therefore, an entrepreneur should not consider these factors in isolation. The interrelationship between these factors should be duly considered.

Choice of Form of Organisation for Expanding Business

If an entrepreneur carries out of activities of his business successfully over a period of time, there is likely to be a need to expand his business so that much larger dema!1ds are easily met. Since the resources – financial and managerial – of the entrepreneur are limited, he will have to review the existing form of business organisation and find out the possibility of changer-over to another form to carry out the necessary expansion. Thus, while implementing the expansion programme, he has to choose between carrying on with the existing form and changing the existing form of organisation. The main problems that an expanding concern will have to attend to are :

(i) Increased financial requirements.

(ii) Need for internal re-organisation.

(iii) Need for specialised services.

(iv) Increase in the risk and the personal liability of the owners.

(v) Retention of effective control.

(vi) Increased tax liability.

The nature and extent of the problems mentioned above will depend upon the existing form of organisation, the nature and the size of business, and the expansion programme. The various alternatives available to an entrepreneur, if he decides to change the existing form of organisation, are as follows :

(a) A sole trader may employ a manager or change-over to a partnership.

(b) A partnership may have more partners or switch to a private company.

(c) A private company may shift to a public company.

A brief evaluation of these alternatives, on the basis of the characteristics of an ideal form of organisation, discussed earlier, is as follows: First Alternative: Employment of Manager vs. Change-over to Partnership When a. sole proprietor is successful in his business, it becomes essential for him to expand it to meet much larger demand. To achieve this, he needs additional capital and additional help in management. He has two alternatives. He may either employ a paid manager or may take one or more partners. The relative advantages and disadvantages of both the alternatives are examined under the following heads:

(i) Re-organisation: If the sole proprietor decides to employ a manager, there will be no change in the form of an existing organisation. Only a ‘contract of service is to be made with the manager. On the other hand, if one or more patterns are taken, there will be change in the form of organisation from sole-proprietorship to partnership. This change requires entering into a partnership agreement, drafting of a partnership deed and possibly, getting the firm registered; as registration is desirable. Besides this, it is difficult to find out a partner. Thus, as compared to having one or more partners, it is easier to employ a paid manager.

(ii) Capital: When a manager is employed the additional funds are to be arranged by the sole proprietor himself. There is, however, an advantage in this; the sole proprietor does not share profits with the manager and therefore, the repayment of loan is possible out of profits. In case a partner or partners are taken, additional capital will be brought in by him or them. The sole proprietor need not borrow additional funds and bear the burden of their repayment, but the partners will have to be given shares in the future profits of the firm.

(iii) Control: If a manager is employed, full control of the business continues with the sole proprietor. On the other hand, if a partner is taken, control is to be shared with him unless he is a sleeping partner who contributes capital but does not participate in management: Finding such a sleeping partner, however, is difficult.

(iv) Management: In case a manager is employed, the quality of management in the firm is likely to improve; because a manager possesses the necessary knowledge and skill for the purpose. However, the manager may not take full interest in the business; as there is no direct relationship between his efforts and reward; he gets fixed salary. On the other hand, if a partner with necessary managerial skills is taken, he will contribute to additional capital and will also help in successful running of the business. His interest in the business will be full; because he is going to share its profits.

(v) Secrecy: If manager is employed, the sole proprietor can keep all important business secrets to himself. In partnership, all these secrets have to be shared with partners. Therefore, in a partnership; business secrets can be retained by the partners so long as they act in good faith and harmoniously; if they fall out, secrets may become public.

(vi) Business Risks: In case a manager is employed, the sole proprietor has to bear all the business risks; He is personally responsible for the repayment of loans borrowed for the business and has to suffer all the losses. In partnership, risk are shared by all the partners. They are jointly and severally liable for the acts of one another and for the entire debts of the firm.

(vii) Tax Advantage: When a manager is employed, the salary payable to him is a charge against profits of the business. Moreover, interest paid by the sole trader on the loans of the business is allowed as deduction for tax purposes. If a partner is taken, share of profit payable to him is liable to tax in the hands of the firm if the firm is not registered under the Income Tax Act. Thus, in case of partnership, the tax-incidence increases.

(viii) Continuity: With the employment of a manager, the form of organisation does not change. Therefore, even after the appointment of the manager, the sole proprietorship remains unstable; it comes to an end with the death, insolvency or insanity of the proprietor. On the other hand, when a partner is taken, the partnership firm may be carried on by the remaining partners in case of death, insolvency or insanity of one of the partners. Moreover, because of more funds and better capacity to face risks, a partnership is in a better position to survive.

(ix) State Regulation: If a manager is employed, no compliance with any regulation is required. From this point of view, a partnership is also almost at par with sole proprietorship; because state regulation in its case is minimum.

Conclusion: From the above it appears, that in the initial stages of expansion, employment of a manager will be better for the sole trader, provided he has managing capacity and sufficient credit standing for raising additional funds from outside, However, as the business expands further and the sole proprietor wants to diversify his business, it is advisable that he should opt for partnership. The partner(s) will not only contribute to the capital of the firm but will also be helpful in sharing the risks associated with the expanded and diversified business particularly when it is, uncertain and risky. Besides this, a partner or partners, will also contribute towards making the management of the firm effective.

Second Alternative: Partnership vs. Private Company

As the business of the sole proprietor expands further, he is faced afresh with the alternatives of the forms of organisation. He may opt for partnership, or convert his business into private company. Similarly, an expanding partnership firm is also confronted with the alternative forms of organisation. The partners of such a firm may have to decide either in favour of more partners or in favour of private company. While selecting between these two alternatives, the following facts should be taken into consideration:

(i) Re-organisation: As compared to company; the formation of a partnership firm is easier; because there are no legal formalities to be completed is its formation. Registration of the firm is not compulsory. On the other hand, incorporation of a company calls for the compliance of several legal formalities. Thus, on this count, the partnership enjoys a distinct advantage over a private company.

(ii) Capital: For a medium-sized business, both partnership firm and private company can raise sufficient funds. However, a private company can raise more funds; because the limit on the maximum number of members is 50 as against only 20 (10 in the banking business and 20 in non-banking business) in case of a partnership. Nevertheless, the creditworthiness of a partnership is better because of unlimited, joint and several liability of the partners.

(iii) Liability: The liability of each member of a partnership is unlimited, whereas the liability of the members of a private limited company is limited to the face value of the shares held by them. Therefore, partnership firm may be preferable for a medium-sized business with stable character. On the other hand, a private company would be a better choice for a large business of speculative nature. The limited liability is, definitely, a plus point” in favour of private company form of organisation.

(iv) Control: In case a partnership is formed, the original owner has to share control of the firm with other partners unless they are sleeping partners. On the other hand, in a private-company, the original owner may be able to retain effective control of the business by holding the office of the managing director of the company.

(v) Management: In a partnership, since every partner has a right to be consulted with regard to the affairs of the firm, inefficiency may creep in its management because of misunderstanding and conflict among the partners. On the other hand in case of private company, its management rests with the few elected directors who are in a position to take decisions promptly and boldly.

(vi) Secrecy: Secrecy can be maintained in both the forms of organisation almost equally well except that, unlike a partnership firm, a private company has to file its audited accounts with the Registrar of companies.

(vii) Continuity: A partnership firm may come to an end on the death, retirement, insolvency or lunacy of a partner. On the other hand, a private company enjoys continuity and stability and is not affected by change in its members; it may last for generations.

(viii) State Regulation: A partnership firm is subject to nominal Government regulation, even if it is registered. Of the other hand, although a private company enjoys privileges and exemptions under the Companies Act, yet it has to comply with a large number of legal formalities which involve considerable amount of time and money. A partnership has a clear edge over a private company on this count.

(ix) Tax Advantage: A partnership firm is at an advantageous position on the basis of tax liability. A partnership pays tax on its profits at progressive rates whereas a private company pays tax at a flat rate. Therefore, the tax burden is lighter in case of a partnership business than in case of a private limited company, particularly, where the scale of operations is small or medium. However, tax liability would be lower in case of a private company if the business profits are large.

Conclusion: Before going ahead with the re-organisation of the business, the businessmen should consider all the factors mentioned above carefully. A partnership firm is as advantageous as a private company; preference for the latter may be because of the advantage of limited liability. Ultimately the decision will depend on the nature and size of the business and the weight assigned to the various factors discussed above.

 

Third Alternative: Private Company vs. Public Company

In general, for a medium-size business, both a partnership and private limited company are considered suitable. Even for a sole proprietor, whose business is expanding fast, conversion to private limited company may be advisable. He will get the benefits of limited liability and reduced tax liability; presuming his income falls in the higher income bracket. However, when a private company finds it difficult to meet the requirements of its fast growing business, it has to choose between the existing form of organisation and the possibility of converting the private company into a public company. The decision will depend upon the careful consideration of the following factors :

(i) Re-organisation: The formation of a private company is easier that of public company; because the former enjoys many privileges and exemptions. For example, a private company needs only two members for its incorporation as against minimum of seven in a public company. A private company can commence business immediately after its incorporation whereas a public company is required to raise minimum subscription and obtain a certificate for the commencement of business. When business expands, a private company may be converted into a public company by amending the articles of association with respect to number of members, offer of shares to the public and their transferability.

(ii) Capital: The amount of capital that can be raised by private company is limited because of limit on the number of members and restrictions on issue of prospectus to the public. The limited liability of its members puts a limit on its borrowing power. On the other hand, a public company can raise enormous amount of capital from the investors scattered throughout the country. It can also procure additional funds by issue of debentures and by borrowing from special financial institutions.

(iii) Control: Since a private company is a closely controlled company, it is possible for the original entrepreneurs to retain control of the company in their hands by holding key positions on its board of directors. They can restrict the number of members of the private company to retain their control. However, in a public company, control is shared with other investors.

(iv) Management: Both types of company are managed by the elected Board of Directors. In case of a private company, the Board consists of the entrepreneur and his close associates, often family members. Thus, practically, there is no gap between the owners and the manager in a private company. On the other hand, in a public company, the Board consists of non-owners, also many of whom are elected because of their special managerial skills. Thus, professionalism gets boosted in company management.

(v) Secrecy: Unlike a public company, a private company is in much meter position to maintain secrecy in the conduct of its business affairs. Although it is required to file its audited annual accounts with the Registrar of Companies yet they are not open to public. On the other hand, all the papers and documents filed with the Registrar of Companies by a public company are open to public inspection on payment of a nominal fee. Thus, a public company is not in a position to maintain secrecy of its affairs.

(vi) Government Regulation: A private company, being a closely held company, is left relatively free to conduct its affairs without much Government regulation. Rather, it is granted certain privileges and exemptions. On the other hand, a public company, being widely held, involves wider public interests, and therefore, is subject to several legal formalities under various Act. The Government has been given wide powers to regulate and control the management of a public company. The regulatory provisions very often prove cumbersome and costly. Such regulations not only have adverse effect on the freedom of management but also reduce flexibility of operations.

Conclusion: The above analysis suggests that as far as possible an entrepreneur will try to retain his control of the organisation and avoid Government control. He will, therefore, function as a private company. However, when the financial needs of business increase beyond the capacity of a private company, it needs to be converted into a public company.