Sole Proprietorship and Business

Knowledge Integration Project

1A) Business owners must take a number of different factors into account when determining the form of business. They have to consider the sources and types of risk that the business takes, if there will be employees, and considerations about raising capital or splitting ownership, which can be quite a complex issue depending on the business. In addition, whether there will be any employees matters. Each jurisdiction has its particular issues, so where the business is situated might be a role in the decision. Certainly, the tax implications of the decision are going to be relevant. In some cases, the cost and ease of setting the entity up might matter -- though such costs can easily be outweighed by liability risks for most businesses.

1B) A sole proprietorship is easy to start, which is its main advantage. Because of that it is mainly a suitable form for someone in business for themselves, with no employees, and with limited risk. The sole proprietorship has flow-through taxation, so is taxed at the personal rate, which can be good or bad depending on income and location. Further, if the business is a side business, it can be a write-off against the proprietor's other income while they are not earning in the early stages, so sole proprietorship's tax implications are advantageous.

Sole proprietorships have a high level of liability, however, and usually the proprietor will need to have insurance to cover this. It is difficult for a sole proprietorship to raise capital, so it most suitable for businesses that have no real possibility of expansion. For this reason a sole proprietorship is usually a one-person business, such as an artisan or tradesperson. Some sole proprietorships will eventually convert to another business form if the proprietor sees growth potential, but during the one-person stage the simplicity of the form is usually preferred.

Partnerships also have flow through taxation, the merits of which depend on the situation. Partnerships are able to be fairly flexible in how ownership is split, and terms can be customized in the partnership agreement. Partners also take on full legal risk of the entity. For some types of businesses, this ends up being a benefit -- for example at a law firm the partners are basically sharing risk associated with practice, which is beneficial to them, and one of the reasons they are selective about who is made partner. Partnerships do not necessarily limit growth -- they have difficulty raising capital, but partnerships are often unwound and reformed when partners leave or are added.

Corporations have the most flexibility. While they are the most complex and costly entity to establish, they have the benefit of having limited risk -- the liability for a corporation typically only extends as far as the investment a person makes in it. This form is a unique legal entity, and as such has the easiest time raising capital. The corporate form makes it easier to share ownership. Corporations are taxed on their earnings, which is usually at a lower rate than individual taxes, but this comes at a cost because any time dividends are paid or capital gains won, those are also taxed, so corporate earnings are taxed twice. There are different types of corporations, too, including those that have flow-through taxation (S corporations). The S. corporation form is for small, closely-held firms, and there are rules regarding what can and cannot be an S. corporation.

Limited liability forms are interesting. They have no tax implication at the federal level, so the business has to have some other form of organization (usually a corporation). But they do allow for limited liability. Legal firms tend to be legal liability partnerships (LLP), for example, where the liability is different than in a traditional partnership. A

1C) Collegiate Code is a classic example of a corporation. The business has scalable potential, which means that the benefits of incorporating are going to be needed. First, the company is going to want to hire people, which all but rules out the logic of a sole proprietorship. The partnership format makes governance more difficult because the partners each will have their degree of power-sharing. Further, as the business grows it might need to raise capital, and that will be much easier as a corporation. So the underlying logic is entirely that this company should be a corporation, to allow for easier scaling and the ability of the owners to have the right degree of control over the business.

There is no second-best here. I do not see S. corporation as viable here because of the need for Collegiate Code to have access to capital. That form of closely-held corporation with flow-through taxation is more appropriate for a small, stable, family-run business. Any company with strong upside potential will not be able to maintain S. corporation status for too long in its growth stage. Only if the company is not genuinely thinking growth beyond a few shareholders should it consider this form -- it is a poor second choice for Collegiate Code, in my opinion. The other forms, sole proprietorship and partnership, and entirely inappropriate.

I do not understand the question about constraints. There are no constraints to incorporating -- if they cannot afford to incorporate then they simply do not have enough money to start the business. The issues here are the ability to raise capital, which they need to maintain, and liability, which they need to minimize. Even if only one person owns Collegiate Code, incorporation is the only logical choice to minimize risk and gain access to capital in the future. I have no idea what inheriting the business has to do with anything -- when you're starting a business the first thought should probably be making sure it gets off the ground, not daydreaming about the day junior takes over. Putting the cart before the horse is not good business practice -- do what is right for the foreseeable future, build a viable business, and worry about succession planning later.

1D) The real life focus is on growing revenue. This is critical because revenue drives the business, and without sales, there is no business in the early stages. The company will become non-viable quickly. And that is regardless of what the business's cost structure is. Cutting costs is not necessarily part of the plan -- a lot of companies invest heavily without concern for costs because there is a business case for growing the business as rapidly as possible. Companies like Amazon or Tesla did not focus on cutting costs because of the need for first-mover advantage and the realization that building share in a new business is actually more important than turning a profit in the short run, because of how share influences long-run profit. But revenue -- that is important because that's what keeps the lights on.

It is important to gain a basic understanding of the choices of business organization, even before launching, because of the issues of capital and liability. Those are critical factors even for very young businesses, and should be resolved prior to launch ideally to protect the owner and to best position the entity for growth. There may be situations where a sole proprietorship or partnership is good initially, but once an idea proves viable and expansion beyond the initial proprietors is planned, the business should be incorporated so as to take advantages of the liability and capital benefits of the corporate form.

Question 2:

2A) The duties of a corporate officer in general are to increase shareholder value. How that is framed is up to the Board, for example to emphasize short-term or long-term returns. In general, long-run returns are preferred. Shkreli did not conform to those duties and obligations. Raising the price surely gave the company a short-term bump in profit, but also attracted the attention of regulators and garnered the company negative attention. Competitors might enter the market because the opportunity became well-publicized. Shkreli's actions did not conform to building long-run shareholder value, only short-run.

2B) The directors of the company are loyal to the shareholders. Their obligations are to ensure that management is acting in the best interests of the shareholders. This usually means focusing on building shareholder wealth, in particular earning returns that are positive on a risk-adjusted basis.

The Board of Valeant carried out their obligations by forcing the resignation of Pearson, but there's a caveat to that. If this was his standard operating procedure, then they should have hired him in the first place. However, the question was about his dismissal and that was the right move. Essentially, what Valeant did with Seconal was "common practice" but ultimately it was a move that could attract the attention of Congress. There are significant long-run risks of raising the ire of Congress, up to and including laws that curtail the ability of companies to do this in the future. Further, attracting public attention to a controversial issue like assisted death is not going to sit well with Congress. The Board has to protect the long-run interests of shareholders, and those interests are not served by committing acts that put the golden goose under the Congressional ax. In the short run, Pearson did the right thing, but in the long-run, he increased risk of both legal action and new competitors entering the market.

Under the business judgment rule, the Board members are not technically immune from legal action but are de facto immune. This rule essentially means that Board members are given wide latitude from legal action if they are seen to be acting in the best interests of the corporation. Dismissing a CEO for increasing firm risk may end up viewed by some as controversial, but would not likely bring the Board in violation of the business judgment rule.

2C) I have no idea about Scott's leadership and management skills -- the case said nothing about those. The case was about his ethics. Of those, I have a negative opinion. He committed a fraud, taking tax-free donations and public money, and then funnelling those funds through his business entities. Apparently, those entities provided little in terms of fair value for their services. This constitutes fraud, for which he was investigated and fined.

The acts discussed in the case tell a story of Scott not serving EHS well. A non-profit's obligations are to a variety of different stakeholders, including in this case the students, to donors and to government. Scott did not fulfill these obligations. He misspent the charity's money, funnelling it away from the activities that were used to sell it to donors, and away from the beneficiaries who were supposed to be helped by the organization. As such, the needs of the relevant stakeholders were not met, which means that Scott did not serve EHS well.

The rationale here is clearly quite different from that of a for-profit director or officer. In a for-profit entity, there are a number of stakeholders, but it can and has been argued that the primary obligation that directors and officers have is to the shareholders, specifically to increase their profits. This view is somewhat controversial and has been challenged by a number of stakeholder-based theories, but ultimately increasing profit for the long-run is a central goal of a corporation, but not of a non-profit. At the non-profit, only the needs of other shareholders matter, and so profit is not a consideration. The directors and officers still have stakeholder obligations but these stakeholders are different and the obligations are not related to profit.

2D) This is not an example of "right vs. right"; this is an example of fraud. When you read about this case, it is pretty obvious that Volkswagen developed the cheat that allowed them to get back into the American market. It was Winterkorn that developed the cheat, and he was rewarded with the CEO job. I would need it explained what the "right" part of what Volkswagen did might be. What's the upside of defrauding US regulators? I'm missing that angle. Who on earth wonders if a fraud that exposes the company to $49 billion in legal action is "right"?

2E) The right vs. right framework is designed for right vs. right dilemmas. Volkswagen isn't even close to that. What ethical standard does one have to think that this was a right vs. right dilemma. First, what are the consequences? That the US regulators would discover a fraud perpetrated several hundred thousand times? The chances of getting away with this were pretty much zero. The consequences are a fired CEO, billions in fines and legal action and a permanently damaged reputation. Whose rights do you have to respect? It doesn't matter -- nobody's rights were respected by the actions Volkswagen undertook. What messages does the company send? Not good ones. What's going to work? Getting away with a fraud committed 500,000 times -- was that really going to work?

The only right choice here was to not commit the fraud in the first place. That's how everybody's interests are met here. You don't commit the fraud.

2F) The interesting thing about Bagley's decision tree is that it misses a key branch. First, Turing and Valeant acted legally, EHS didn't. So let's drop EHS from this -- Scott's actions were criminal and unethical. The second branch of the tree here is where Bagley misses the point. The question is "Does is maximize shareholder value?" and this isn't as simple a question as that. There is short-run value and long-run value. These two companies sought to maximize value for the short-run. In the long run, their actions did not maximize shareholder value, which is why this is an important question to consider. The shareholders actually have a say in whether they want the firm to pursue short-run value or long-run, and we don't know in either case which the shareholders preferred. In both cases, the actions the company's took increased the risk of public backlash, reputation loss, legal action and increased competition (monopolies that make a lot of money always attract competition). Further, ethics is much more complex an issue that Bagley presents, as she assumed that a) consequentialism is the only way to view ethics and b) that consequentialist calculus is easy. If it is assumed that shareholder value is being maximized, Turing was unethical by way of its actions resulting in death and suffering. Valeant's actions would not cause death (the opposite, in fact), but would cause some suffering. Still, Valeant's actions were far less damaging and while dirty might not be considered unethical because of limited harm and the fact that the damage is not ongoing. Turing's actions were still unethical, since death is pretty much an ethical trump card when performing consequentialist calculus.

3A) Globalization is a concept describing the increasing transportation, communication, migration and trade linkages between the nations of the world. Essentially, each factor is seeing the removal of barriers, and that is bringing about more interaction on all of these fronts. To protect yourself requires understanding South African law -- get a lawyer who can advise you about ensuring your interests will be defended in the local legal system. The legal system is basically the British system, so is reasonably familiar to Americans, but local representation is required to minimize risks that arise from the differences that exist, in the event of dispute.

3B) Location advantages refer to advantages that are specific to a particular place. The best advice to deal with feelings of unease are to get the facts. Being uneasy about the political situation is meaningless -- you need to know the facts before your emotional responses have any merit. So take the time to learn about whether expropriation is actually a risk, what systems are in place to mitigate such risk, and how robust are those systems. As for civil unrest, definitely this is where talking to locals, reading news, and generally learning matter. Civil unrest is unpredictable by nature, but the risk of it can be understood through learning and communication.

3C) I'm not nuts about either of these, since they address imaginary pain points, but diarize.me is the one I would choose, if I had to choose one. PetHeaven solves no genuine pain points, and will have a high cost structure for delivery, making it tough to extract good margins and tougher still to scale. Diarize.me has some issues, not the least is offering little that your Apple or Google calendar doesn't offer, but because it's mobile and SaaS, it can be scaled very easily, anywhere in the world.

Multidomestic view is strategy developed for each individual market, based on local market conditions. Legal conditions aren't really part of that -- multidomestic view is more about operations and marketing. But no question the company needs to have local legal representation because the legal environment in South Africa, while not totally unfamiliar, is still different. Provisions in contracts have to reflect local laws -- good luck limiting legal disputes. The key is to understand the legal environment so that you can make sure you don't do anything to bring about needless disputes, and that you clearly understand how counterparties are going to interpret the contract.

3D) These provisions don't favor the interests of anybody. A contract is the result of negotiation between counterparties -- you can't just make up your own stuff and stick it in the contract. The counterparties have lawyers, too. The key is to make sure everybody in on the same page, and the onus falls on me for investing in a foreign country to get up to speed with its laws, and the interpretation thereof. There's no magic want to pretend that foreign companies in a foreign country won't have legal rights.

3E) As noted above, no. Whatever is in a contract won't save you from legal action in a foreign country, and it is strongly advised that any company operating in a foreign country retain legal counsel in that country to ensure full knowledge of, and compliance with, local laws and regulations, in addition to understanding the way contracts are handled by that country's legal system.

3F) Provisions that aren't part of a contract, as in they are not in writing, don't mean much. At least not in South Africa, which has a legal system inherited from the British.

3G) The best way to protect your interests is to not go through a guy on Craigslist who charges in Bitcoin. So start with not being stupid -- you are the best defense against downside risk by way of not being stupid. If you're that dumb, you deserve to get ripped off, and it won't happen just once.

You need a legal contract to protect your interests, and you'll want to pay in either dollars or rand. Without a legal contract, you don't have protection for your interests, regardless of what those interests are.