Most people have a decent concept of what a company is. They could tell you that there are lots of them, they make lots of money, most work for one, and typically that they sell a particular thing or provide a range of services. Most people even know that many companies have “pty ltd” next to their name and some of those people realise that it stands for proprietary limited.
If however, you were to ask someone to define what a company is or what “proprietary limited” actually meant, you may find a few more blank faces. Ultimately, it probably doesn’t matter to the majority of the population, but it is quite critical to understand what defines a company and what distinguishes it from other business forms before considering more complex legal and corporate issues.
The central themes that will continue to arise when thinking about companies are liability, ownership, financing, legal obligations and succession especially in the event that the company can no longer pay its debts when they fall due (insolvency).
Liability is the legal obligation imposed on a member of a business to pay the debts of the company and in most cases liability is either limited by the member’s shares or unlimited. If a member or shareholder of a business enjoys limited liability, his debt to the company is limited to the number of shares he has bought in the company. Unlimited liability ….
Alternative business structures
Without going too far into the history of the corporate form and its alternatives, lets firstly examine the alternatives in terms of the liability placed on the members or shareholders:
- Sole trader – the business is run by one person, all decisions are made by this person but staff can still be hired. Sole traders do not enjoy limited liability and personally liable for all debts of the business.
- Partnership – the relationship that exists between people carrying on business in common with a view to a profit. Robert Clark (US corporate academic) said the essence of partnership is all for one and one for all. As an examples, law firms are typically partnerships and need to trust partners because they will be personally liable for the mistakes of other partners.
- Joint ventures – An entity formed between 2 or more parties where there is no continuing business but there is a specific project in mind. It is an essentially contractual model and joint ventures can be incorporated or unincorporated. A good example of a joint venture is Sony and Ericsson forming Sony Ericsson. Since a joint venture can be entered into by anyone is more a purpose than a business form, liability is varied in joints ventures.
With the alternatives in mind, We’ll now consider what defines the modern corporate form and why it is seen as the most appropriate business structure. To see a comparison of corporations and partnerships click here.
Companies are ‘creatures of law‘
A corporation is a ‘creature of the law’, that is, a corporation exists from the day specified on the certificate of registration.After the steps leading to incorporation have been taken and a certificate issued, a new legal entity is created, separate from its members.
This creature of law was described in Salomon v Salomon and Co  AC 22, an early case concerning the liability of a shareholder to pay his company’s dets upon liquidation
“A company is a distinct legal entity, separate from those who created it and its members. This legal entity is a legal fiction in the sense that it is not organic, it is created by people and it is recognised [as a separate entity] by the law”
The assets of the company are not the assets of its members and the contracts entered into by the company will create rights and liabilities which only vest in the company; not in its members.
It is best to think of a company as a different person to its shareholders and directors. In many cases, directors can be liable for the debts of a company but this will be discussed in a later blog. It is crucial to note that in a limited liability company, shareholders will always only be liable to the value of their shares. This fact is one of the main factors that has driven the popularity of the modern corporate form.
Lets now look at the 5 factors that truly define and distinguish the modern corporate form from its alternatives:
Characteristics of a corporation
1.Limited liability – limit participant’s liability for the obligations of the enterprise by insulating members’ other assets from claims against the company.
2.Perpetual succession – the company is invested with the legal capacity and powers of an individual but unaffected by death or bankruptcy of a member or the transfer of ownership interests (these events would dissolve a partnership).
3.Financing – Unincorporated forms of business organisation don’t have the power to create a floating charge over its assets or to make a public issue of its shares or debt interests.
4.Cost, formality and continuing obligations – Corporations must undergo formal procedures and continuing disclosure of information in many cases. Partnerships are much more flexible (no formality for its creation or dissolution, capital may be freely withdrawn from the firm).
5.Taxation – Originally double taxation consequences existed for companies and their members. This has been largely eliminated these days by anti-double taxation provisions (dividend imputation).
A later blog in this series will examine the different types of companies (public companies and proprietary companies) and their different forms.
If you are interested in another James Cox finance blog on fundraising and investment through ipos and private equity, click here.