Chapter 8 The Organizational Plan: Teams, Structures, Alliances, and Directors

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1 CHAPTER OUTLINE Spotlight: Company X 1 Building a Management Team Describe the characteristics and value of a strong management team. Management Team Managers and other key persons who give a company its general direction Teams may change, but must be accomplished respectfully Add team members as needed Provides diversity of talent making venture stronger Competence required depends on type of business and nature of operations Using family allows the owner to know and trust as well as pay less (sometimes) How does the team concept fit the individualistic nature of most entrepreneurs? For example, how does an entrepreneur learn to delegate? Achieving Balance Competence in all areas (finance, marketing, etc.) Competent insiders and outside specialists Expanding Social Networks Social network an interconnected system comprising relationships with other people Used to access information or get advice Communicates legitimacy and jump-starting sales Popular choices LinkedIn.com Twitter.com Yelp.com Facebook.com Social capital The advantages created by an individual s connections in a social network.reciprocation a powerful social rule based on an obligation to repay in kind what another has done for or provided to us 2 Choosing a Legal Form of Organization Explain the common legal forms of organization used by small businesses. Exhibit 8-1 Forms of Legal Organization for Small Businesses As each of these legal forms is discussed, have students suggest local businesses that fit each option. The Sole Proprietorship Option Business owned by one person, who bears unlimited liability for the enterprise Most basic business form Unlimited liability liability on the part of an owner that extends beyond the owner s investment in the business Exhibit 8-2 Percentage of Small Businesses by Legal Form of Organization indicates Sole Proprietorship makes up largest percentage The Partnership Option Legal entity formed by two or more co-owners to carry on a business for profit 78

2 Qualifications of Partners Involves consideration of legal issues as well as personal and managerial factors Should be honest, healthy, capable, and compatible Exhibit 8-3 The Advantages and Disadvantages of Partnerships Suggestions Choose your partner carefully Be open, but cautious, about partnerships with friends Test-drive the relationship, if possible Create a combined vision for he business Prepare for the worst Rights and Duties of Partners Partnerships agreement document that states explicitly the rights and duties of partners (especially important with family members) Joint and several liability liability of each partner resulting from any one partner s ability to legally bind the other partners Termination of a Partnership Death, incapacity, or withdrawal of a partner ends partnership Requires liquidation or reorganization of the business May result in substantial losses to all partners, but may be necessary The C Corporation Option Definitions Corporation business organization that exists as a legal entity and provides limited liability to its owners Legal entity business organization that is recognized by the law as having a separate legal existence C corporation ordinary corporation, taxed by the federal government as a separate legal entity The Corporate Charter Document that establishes a corporation s existence Sometimes called articles of incorporation or certificate of incorporation Brief, in accord with state law, and broad in its statement of the firm s powers Corporate bylaws outline the basic rules for ongoing formalities and decisions of corporation such as size of board of directors, duties and responsibilities of directors and officers, scheduling meetings of directors and shareholders, etc. Rights and Status of Stockholders Ownership evidenced by stock certificates (a document specifying the number of shares owned by a stockholder) Pre-emptive right right of stockholders to buy new shares of stock before they are offered to the public Limited Liability of Stockholders- stockholder liability restricted to the amount of money they invest in the business Death or Withdrawal of Stockholders ownership easily transferable 79

3 Maintaining Corporate Status Must hold annual meetings of both the shareholders and the board of directors Keep minutes to document the major decisions of shareholders and directors Maintain bank accounts separate from owners bank accounts File separate income tax return for the business 3 Criteria for Choosing an Organizational Form (see Exhibit 8-4 Comparison of Basic Legal Forms of Organization) Identify factors to consider in choosing among the primary legal forms of organization Initial Organizational Requirements and Costs Liability of Owners Choosing form for simplicity can cost more than money Incorporation will not protect a firm s owners from liability Piercing the Corporate Veil situation in which the courts conclude that incorporation has been used to perpetuate a fraud, skirt a law, or commit some wrongful act, and thus remove liability protections from the corporate entity No form of organization can protect from all forms of liability Most banks and many suppliers will require small business owners to sign a personal guarantee before loaning money or extending credit regardless of the form of organization Continuity of Business Transferability of Ownership Management Control Attractiveness for Raising Capital Income taxes Sole proprietorship Partnership C Corporation Have students discuss each of these criteria and indicate which are the most important to them and tell why they are important. 4 Specialized Forms of Organization Describe the unique features and restrictions of five specialized organizational forms. The Limited Partnership partnership with at least one general partner and one or more limited partners General partner A partner who has unlimited liability and remains personally liable for debts of the business Limited partners A partner who is not active in its management and has limited personal liability. The S Corporation (Subchapter S Corporation) Type of corporation that offers limited liability to its owners but is taxed by the federal government as a partnership Must meet specific requirements No more than 100 stockholders allowed All stockholders must be individuals or certain qualifying estates and trusts Only one class of stock can be outstanding Fiscally, the corporation must operate on a calendar-year basis 80

4 Shareholders may not include nonresident aliens The Limited Liability Company Form of organization in which owners have limited liability buy pay personal income taxes on business profits Major advantage is the liability protection Usually the best choice for new businesses Ability to pass taxable income on to shareholders Easier to set up More flexible Significant tax advantages Better to us a C corporation if you want to: Provide extensive fringe benefits to owners or employees Offer stock options to employees Go public or sell out at some time in the future Eventually convert to a C corporation The Professional Corporation Form of corporation that shields owners from liability and is set up for individuals in certain professional practices Does not protect a practitioner from his/her own negligence or malpractice Applies to narrow range of enterprises Many states require this form of organization before a practice can operate The Nonprofit Corporation Form of corporation for enterprises established to serve civic, educational, charitable, or religious purposes but not for generation of profits Most become 501[c](3) organizations IRS will not allow this option for an individual or partnership Organizational test verification of whether a nonprofit organization is staying true to its stated purpose 5 Forming Strategic Alliances Understand the uses of strategic alliances in small businesses. An organizational relationship that links two or more independent business entities in a common endeavor Strategic Alliances with Large Companies Alliances created with both other large corporations and small businesses Exhibit 8-6Most Popular Small Business Alliances by Type Strategic Alliances with Small Companies Provides mutual competitive strength Allows them to reach goals that would otherwise be too costly or too difficult for small businesses to accomplish on their own Setting Up and Maintaining Successful Strategic Alliances Challenging to find a suitable partner Spreads the risk of entering new markets Helps small players with unattractive balance sheets appear stable to the end buyer 81

5 Steps to help succeed Establish a healthy network of contacts Identify and contact individuals within a firm who are accessible Do your homework, and you will win points just for being prepared Learn to speak and understand the language of your partner Make sure any alliance offer is clearly a win-win opportunity Continue to monitor the progress of the alliance to ensure that goals and expectations are being met, and make changes as they become necessary 6 Making the Most of a Board of Directors Describe the effective use of boards of directors and advisory councils. The governing body of a corporation, elected by the stockholders Contributions of Directors May help with long term strategic decisions Reviews major policy decisions Advises on external business conditions and proper reaction to the business cycle Provide informal advice on specific problems Offers access to important personal contacts Selection of Directors Firm s attorney, banker, accountant, local management consultants, and other business executives available, but lack independence needed to look at firm critically Outside directors more objective in decisions and advice Nature and needs of business help determine qualifications required for directors Compensation of Directors Compensation varies greatly Some pay no fees at all May be annual retainer, board meeting fees, pay for committee work Money may not be their primary motivation for serving on the board An Alternative: An Advisory Council A group that serves as an alternative to a board of directors, acting only in an advisory capacity Qualified outsiders serve Functions much like board of directors SOURCES OF VIDEO AND OTHER INSTRUCTIONAL MATERIALS 82 The SBA at offers information on incorporation and permits and licensing. You can also check your state government Web site for small business and incorporation information. ANSWERS TO END-OF-CHAPTER DISCUSSION QUESTIONS 1. Why would investors tend to favor a new business led by a management team over one headed by a lone entrepreneur? Is this preference justified?

6 Investors are concerned that management has a blend of important management skills and that the founder has the ability to perform in a professional way. They realize that the typical idea person who starts a business is deficient in some area of management. This preference appears justified for most ventures of substantial size. 2. Discuss the merits of the three most basic legal forms of organization. Sole proprietorship is the most widely used form of organization. However, the corporation is the most important form when the volume of business activity is considered. Why is this true? Most small firms are proprietorships, but most big firms are corporations. Reasons for dominance of the corporate form among big firms are the feature of limited liability and the possibility of acquiring large amounts of capital. The third legal form of organization is the partnership (with general and limited options), but most entrepreneurs contend that the drawbacks of this form outweigh its advantages. 3. Does the concept of limited liability apply to a sole proprietorship? Why or why not? The concept of limited liability that applies to the corporate form of organization does not apply to a proprietorship because the business is considered an extension of the individual and not a separate entity. This means that creditors can take the owner s personal assets outside the business if the business fails. 4. Suppose a partnership is set up and operated without a formal partnership agreement. What problems might arise? Explain. If articles of partnership are not put in writing, disagreements and misunderstandings may arise about the respective responsibilities of the partners, the way in which profits are to be distributed, and many other matters. This can seriously interfere with the normal profitable operation of the business. By reducing understandings to written form, partners can minimize misunderstandings, differences in viewpoints, and overlooked issues. 5. Evaluate the three major forms of organization in terms of management control by the owner and sharing of the firm s profits. In a proprietorship, the owner has complete and absolute control. In a general partnership, an owner must share control with the other partner or partners, and each partner generally has the power to make commitments binding on the partnership. In the corporation, control must be shared with other stockholders. This may not be a problem, however, if the majority owner controls practically all of the stock. Indeed, if one owner has as much as 51 percent of the stock, in most states 83

7 that owner can name the board of directors. However, the majority stockholder usually has some concern about, as well as some legal obligations to, minority stockholders. Hence, dilution of ownership control is a feature of the corporate form of business organization. In a sole proprietorship, all profits go to the proprietor. In a partnership, however, profits are shared equally unless the articles of partnership stipulate an unequal sharing ratio. In a corporation, profits legally belong to the corporation, but directors (usually named by the majority stockholder) can declare dividends so that stockholders get a share of the earned profits. 6. What is an S corporation, and what are its principal advantages? The S corporation is taxed as a partnership and thus avoids the corporate income tax. Depending on the circumstances of the corporation and the owners, this can create significant tax savings. Its use is limited to small firms. 7. Why are strategic alliances helpful to many small businesses? What steps can an entrepreneur take to create strategic alliances and to prevent their failure? According to strategic alliance experts, strategic alliances are becoming crucial in building businesses of all kinds and at an earlier stage than ever before. They can decrease cycle time by allowing startups to access another firm's resources. Since an opportunity will often go to the entrepreneur who is fast enough to exploit it, many now see strategic alliances as an essential part of their plan for growth. Such partnerships represent one way to cope with the rapid change of today's business environment. Two-thirds of all alliances run into serious problems within two years of their creation, and 70% of them do not survive, which shows that alliances are hard to manage. Taking some basic steps can help entrepreneurs establish healthy alliances and reduce the risk of their failure. These are (1) establish a healthy network of contacts, (2) identify and contact individuals within the firm who are likely to return your call, (3) outline the partner's continuing financial benefits from the alliance, (4) show the partner that your firm can deliver value to the alliance across several fronts, and (5) learn to speak and understand the "language" of your partner. Despite sound planning and execution, many strategic alliances fail, but some upfront planning can head off unnecessary failures. 8. How might a board of directors be of value to management in a small corporation? What qualifications are essential for a director? Is ownership of stock in the firm a prerequisite for being a director? 84

8 In the small corporation, a properly selected board of directors can be of real value to the entrepreneur. The board members can be called on to advise the entrepreneur on the solution of major problems; that is, they can act as de facto management consultants. They can also assist with policy formulation and redefinition of business strategy. The business owner should select outside board members on the basis of their interest in and potential contributions to the organization. Many individuals are potentially good board members, and the best available talent should be selected. The purchase of stock should not be required, although such an agreement might make service on the board of directors an attractive proposition for a capable director. 9. What may account for the failure of most small companies to use boards of directors as more than rubber stamps? What impact is this likely to have on the business? There are no doubt many reasons. Many small business owners have never even thought about the possibility. Some owners are confident of their own abilities and see no benefit in having a board. Others have misconceptions concerning difficulty in attracting board members and levels of compensation. Probably the greatest reason is lack of assurance that a board would be of real value. If an entrepreneur uses a board of directors as merely a rubber stamp, his or her small business stands to lose the insights of directors who can help the entrepreneur look beyond the next few months to make important, long-term strategic decisions. A well-selected board of directors can also bring supplementary knowledge and broad experience to corporate management. By virtue of their backgrounds, directors can fill gaps in the experience of a management team. The board should meet regularly to provide maximum assistance to the chief executive. In board meetings, ideas should be debated, strategies determined, and the pros and cons of policies explored. In this way, the chief executive is assisted by the experience of all the board members. Their combined knowledge makes possible more intelligent decisions on issues crucial to the firm. By utilizing the experience of a board of directors, the chief executive of a small corporation is in no way giving up active control of its operations. Instead, by consulting with and seeking the advice of the board s members, he or she is simply drawing on a larger pool of business knowledge. A group will typically make better decisions than will a single individual working in isolation. An active board of directors serves management in several important ways: by reviewing major policy decisions, by advising on external business conditions and on proper reaction to the business cycle, by providing informal advice from time to time on specific problems that arise, and by offering access to important personal contacts. With a strong board, a small firm may gain greater credibility with the public, as well as with the business and 85

9 financial communities. All this potential advantage is lost when an entrepreneur does not use his or her board of directors as they were meant to be used. 10. How do advisory councils differ from boards of directors? Which would you recommend to a small company owner? Why? An advisory council is similar to a board, but members generally do not have a legal liability to the stockholders. Some individuals may be reluctant to accept directorships if they entail legal liability. Either system can function effectively. The advisory council system should be used if necessary to attract qualified contributors to the business. Also, advisory councils appear less threatening to some owners. COMMENTS ON CHAPTER YOU MAKE THE CALL SITUATIONS Situation 1 1. How relevant are the individual personalities to the success of this entrepreneurial team? Do you think Green and Stroder have a chance to survive their partnership? Why or why not? Personalities of partners are extremely relevant to the success of a business. The fact that Green and Stroder were close friends as teenagers suggests that they will be able to get along with each other. Since they have agreed to have Stroder do all the work, there should not be many opportunities for a personality clash. This should be a fair arrangement. If not, problems may arise regardless of the personalities involved. 2. Do you consider it an advantage or a disadvantage that the members of this team are the same age? In most cases it is probably an advantage. World views often vary from age to age, and they can influence individual priorities regarding money, family, and life in general. However, the amount of experience, which usually comes with age, is about the same for each of these young entrepreneurs, and this may prove to be a major limitation of the team On balance, is it good or bad that the company will be started by two men who are very close friends? What are the potential benefits and drawbacks of mixing business and friendship in this case?

10 As long as the friends create a partnership agreement that carefully outlines the duties and responsibilities for each of the partners and which they each have their personal lawyer review before they sign, the partnership could be a good choice. Their personalities may balance each other and help improve the business itself. For example, since Green is only supplying cash, and he would be the limited partner. It appears that he has greater personal assets than Stroder, and this arrangement would limit Green s exposure to liability claims that might arise through activities of the business. Situation 2 1. What are the advantages and disadvantages of running the business as a sole proprietorship? As a C corporation? Matthew Freeman must decide whether to remain organized as a sole proprietorship or incorporate his business. Because he is already operating as a sole proprietorship, this would place the least administrative burden on him. He would have fewer reporting requirements. Taxes on his business income would be reported on Schedule C of his personal income taxes. He would also be required to file quarterly estimated tax payments. As a sole proprietorship, however, he has unlimited personal liability for any debts incurred by the business and any lawsuits brought against the business. Thus, his personal property (e.g., house, cars) is at risk. In his particular situation, he will also lose some business if he remains a sole proprietorship because some large companies will not deal with a sole proprietor. Furthermore, Freeman is not considered an employee and cannot enjoy tax-free fringe benefits such as insurance and hospitalization. And when organized as a sole proprietorship no other person can conduct business for the company. These disadvantages of a sole proprietorship can be overcome by incorporating. If incorporated, Freeman will enjoy limited liability and his personal assets will not be at risk. As an employee of the corporation, he will be entitled to certain fringe benefits. As a corporation, his business may also have greater legitimacy in the eyes of other organizations, including large corporations and lending institutions. Incorporation will, however, involve costs and administrative burdens to establish the corporation. He must draw up legal documents (e.g., articles of incorporation) and issue stock to begin the corporation. This process is usually done in consultation with a lawyer and/or a Certified Public Accountant. The on-going reporting requirements for a corporation are more burdensome than for a sole proprietorship. Corporate records must be maintained and accounts must be kept separate from all personal accounts. Depending on the type of corporation chosen (see notes for next question), Freeman may be subject to double taxation. 2. If Freeman decided to incorporate his business, which types of corporations can he form? Which type would you recommend? Why? 87

11 Freeman may choose either a "C corporation" or an "S corporation". Each of these offers the advantage of limited liability and the legitimacy needed for constituents that would prefer not to deal with a sole proprietorship. In choosing between the options, then, other issues should be considered. The primary consideration seems to be the tax implications. A " C corporation" must pay corporate income taxes on any income. If dividends are declared, the corporation first pays corporate income tax on these and then individual shareholders pay personal income tax on the dividends. An "S corporation" allows a business to have the benefit of limited liability while being taxed as a partnership. Taxable income and losses are passed to the stockholders rather than the corporation paying corporate income taxes. Thus, dividends are not subject to double taxation. An "S corporation" is limited in many other respects (e.g., no more than 75 shareholders, only one class of stock, corporation must be domestic), but none of these are relevant for Freeman s decision. Thus, it appears that the "S corporation" provides the necessary benefits with the least tax burden. Situation 3 1. Would you accept the investment and the conditions that go along with it, or refuse it and go a different direction? Perhaps Patton and Marks should look for outside financing using a different source. If their financial records are strong enough and they have developed a relationship with their banker, they may be able to borrow if they need additional funds to expand. 2. Can one outside member on a board of three make any real difference in the way the board operates? 88 Unless Patton and Marks develop a strong set of corporate bylaws or partnership agreement depending on the business form, the angel could wield pressure in the form of withholding funds if he doesn t agree with decisions. This could certainly undermine their control. 3. If you were the owners, whom would you include on the board? If a board of directors is formed, it should include both owners and the angel as well as at least one outsider who has no connection with the angel. This would allow advice independent of all parties. The choice of this person should be carefully researched possibly using someone like the strategic alliance matchmakers. 4. If Patton and Marks decide to form a board of directors, what will determine its usefulness or effectiveness? Do you predict that it will be helpful? Why or why not?

12 The corporate bylaws would determine whether the board would be useful or effective. Bylaws should be carefully reviewed to be sure they would not be a hindrance to the operation of the business. Such a board could be very helpful in adding to the experience and ability of Patton and Marks. On the other hand, the board could prove to be a roadblock if the angel uses it to force the business to run as he wants rather than understanding that Patton and Marks know their business and should be given credence in terms of their ability and experience in running this particular business. SUGGESTED SOLUTION TO CASE 8: D ARTAGNAN 1. How would you describe the entrepreneurial team of Daguin and Faison? Was it ever a balanced team? What did each member bring to the business? Can you see gaps in their skills and capabilities that should have been covered in some way? The company founders never really worked as a team. They fought things out. Each member brought special skills to the business: Daiguin brought the food business know-how while Faison brought the business skills. Gaps in their skills include people skills. The lack of these skills appeared throughout their association with each other and their methods of handling their employees. For example, employees took sides as the business suffered before Daguin finally purchased the company from Faison. 2. What does this case reveal about the critical factors that can determine the success or failure of a business that is led by more than a single entrepreneur? What was the beginning of the end: for Daguin and Faison s working relationship? Establishing specific responsibilities, developing partnership agreements, etc. are vital for business operations. The beginning of the end appears to be the listeria bacteria problem that caused retailers to become angry with D Artagnan. However, the beginning of the business probably was the beginning of the end due to the incompatibility of the two individuals involved in the business. 3. What form of organization did Daguin and Faison choose for D Artagnan? Assess the advantages and disadvantages of the major organizational forms mentioned in Chapter 8 and decide which one would have been the best choice for D Artagnan. 89

13 90 Basically D Artanan was a partnership as defined in the case. Exhibit 8-4 is a comparison of the basic legal forms of organization and provides the basis for this discussion. Sole Proprietorship: Advantages: no registration or filing fees, ownership of company name and assets may be transferred easily, absolute management freedom Disadvantages: unlimited liability, business continuity poor, raising capital difficult, income from the business is taxed as personal income to the owner General Partnership: Advantages: generally no registration or filing fee, Disadvantages: unlimited liability, without partnership agreement dissolved upon withdrawal or death of partner, ownership transfer requires the consent of all partners, majority vote of partners required for control, raising capital limited to partners ability and desire to contribute capital, income taxed as personal income to the partners C Corporation: Advantages: liability limited to investment in company, continuity of business unaffected by shareholder withdrawal or death, Ownership easily transferred by transferring shares of stock, usually the most attractive form for raising capital Disadvantages: Most expensive and greatest requirements for organization, compliance with state regulations for corporations required, shareholders have final control but usually board of directors controls company policies, taxed on income and stockholder taxed on any dividends received D Artagnan probably should have been a partnership with a partnership agreement. Since the lawyer caused them to sign a buy-sell agreement that included a shotgun clause and they took out life insurance, the business operated and changed hands with a pre-ordained plan. Students answers will vary. Regardless of the structure they choose, they need to provide a rationale for their choice in terms of the concepts and discussions from the chapter. 4. Would a formal board of directors have made a difference in the relationship between Daguin and Faison and the operation of D Artagnan? Draw up a profile of an ideal board for the company. A formal board might have made a difference because it could have developed a communication link between the partners and helped to avoid the employee problems. However, a board could also have taken sides and caused even more

14 problems for the business. The type of board might have made a difference. If the board were paid for performance, they probably would have made decisions based on the best practices for the business. Again, students answers will vary, but should be based on concepts and discussions from the chapter. 91