The Legal forms of Organization

Sole proprietorship
Three major forms:
One person undertakes a business
The sole proprietorship
The individual and the business are the same
The partnership for tax and legal liability purposes
The limited liability corporation
Legal claimants can pursue the personal
property of the proprietor, not simply the
Note: There are also hybrid forms assets which are utilised in the business

Partnerships Partnerships

A partnership is a voluntary association of The amount and nature of their respective

capital contributions
two or more persons to carry on as co-
The allocation of the business profits and
owners of a business
losses
Salaries and drawings against profits
The partners have to resolve and set down
Management responsibilities
in writing their agreement on a number of
Consequences of withdrawal, retirement,
issues: disability, or death of a partner
Dissolution and liquidation of partnership

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 Partnerships
A partnership is treated like a
proprietorship for liability purposes
Each of the partners is jointly and
severally liable
A damaged party may pursue the partners
singly or jointly for any amount the
claim may not be proportional to invested
capital or the distribution of earnings
Limited Liability Corporation
Major innovation
Allows even small investors to be part-
owners in large corporations
Limited Liability Corporation
Stakes in ownership are sold as shares
There is limited liability of shareholders
That is, firms owners are personally
protected from liability
Their liability is limited to the extent of
investment in the firm
Separation of control from ownership
A.A. Berle and G.C. Means: The Modern
Corporation and Private Property (1932)
For many firms the number of
shareholders is large, with many holding a
very small percentage of the overall value
of the firms equity
Such shareholders do not themselves run
a company
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 Separation of control from ownership
Shareholders
| The objectives of the CEO/MD may not be
Board of Directors
| Managers can pursue their own goals
CEO/MD
Ownership shareholders
Control CEO/MD + middle management
Separation of control from ownership
transactions costs: even if shareholders
can see that management is under
performing, it remains difficult and costly
for them to do much about it
Shareholders would like to maximize
profits
- dividends come out of profits
- profits dividends market value of
shares capital gains
Separation of control from ownership
Principal-agent problem
the same as that of the shareholders
because of
- imperfect and asymmetric information:
managers typically know much more than
shareholders about firms operations and
performance capabilities
Managerial discretion models
Managerial discretion models:
What would a managers objective be?
Various goals have been suggested:
- Sales revenue maximization (Baumol)
- Expense preference model (Williamson)
- Growth maximization (Marris)
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 Other theories A Simple Model
Behavioral theories: Managers utility function:
Firm as a coalition of participants U = U(Q, )
Bargaining between the participants Given the demand and cost conditions, the
determines the goals of the firm constraint is
T(Q, ) = 0
Satisficing models: or Q)
The firm is too large, too complex and Maximize U = U(Q, )
operates in too uncertain an environment subject to T(Q, ) = 0
- Optimizing behavior not possible

A Simple Model A Simple Model

Example:
P=aQ
C(Q) = cQ,
Then
= PQ cQ = (a c)Q Q2
When Q = 0 or Q = a c, = 0.
d/dQ = (a c) 2Q
> = < 0 according as
Q < = > (a c)/2
Points to note:
1. Only if U(Q, ) = , will profit be
a > c> 0
maximized.
2. In general, Q > (a c)/2, the profit
maximizing level.
3. Baumol: Maximize Q subject to a
minimum profit constraint

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 Checks on managerial discretion
Are there some mechanisms to check
discretionary behavior on the part of
managers?
Checks on managerial discretion
2. Market for managers
A manager under whom a firm does poorly,
will command lower price on this market

1. Survival of the fittest argument

If a firm is not maximizing profit, it is either But:
foregoing some revenue opportunities or - It is difficult to disentangle managerial
not cutting down on costs cannot input from random shocks
survive in the long run

Checks on managerial discretion Capital market control

But:
3. Capital market controls 1. Managers have developed takeover defenses
Poor performance will lead to hostile ("shark repellents" )
takeover and managers will be fired - White knight
- Poison pill
Poor performance poor dividends low - Scorched earth policies
share price raider buys controlling - Greenmail
interest changes management - Golden parachutes
improved performance higher share - Etc.
price

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 Greenmail
Greenmail occurs when a large block of
stock is held by an unfriendly company or
raider, who then forces the target company
to repurchase the stock at a substantial
premium to destroy any takeover attempt.
This is also known as a "bon voyage
bonus"
Golden Parachute
A golden parachute measure discourages an
unwanted takeover by offering lucrative benefits
to the current top executives, who may lose
their jobs if their company is taken over by
another firm.
Golden parachutes can be worth millions of
dollars and can cost the acquiring firm a lot of
money, therefore becoming a strong deterrent
to proceeding with their takeover bid
White Knight
A white knight is a company (the "good
guy") that gallops in to make a friendly
takeover offer to a target company that is
facing a hostile takeover from another
party (a "black knight").
The white knight offers the target firm a
way out; although it will still be acquired, it
will be on more favorable terms or at
least, terms more to its liking.
Poison Pill
With this strategy, the target company aims at making its
own stock less attractive to the acquirer.
The flip-in poison pill allows existing shareholders (except
the bidding company) to buy more shares at a discount.
This type of poison pill is usually written into
the companys shareholder-rights plan. The goal of
the flip-in poison pill is to dilute the shares held by the
bidder and make the takeover bid more difficult and
expensive.
The 'flip-over' poison pill allows stockholders to buy the
acquirer's shares at a discounted price in the event of a
merger. If investors fail to take part in the poison pill by
purchasing stock at the discounted price, the outstanding
shares will not be diluted enough to ward off a takeover.
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 Macaroni Defense
In this tactic, the target company issues a
large number of bonds that come with the
guarantee that they will be redeemed at a
higher price if the company is taken over.
It's called a macaroni defense because the
redemption price of the bonds expands, like
macaroni in a pot of boiling water.
The target company must be careful it
doesn't issue so much debt that it cannot
make the interest payments.
Capital market control
2. Free-riding problem (Grossman and Hart)
Each shareholder, anticipating a rise in
share price, will refuse to sell shares at
the existing, low market price
Rational for each shareholder
But raider will not find any incentive for
takeover
So price of shares will remain low

Incentives
4. Incentives
Try to align the interests of managers and
shareholders by designing proper
incentive schemes

- Profit shares, bonuses

May promote short-termism
(profits may be inflated by not keeping
adequate provision for growth)

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 Incentives
- ESOPs (employee stock option plans)
Aim is to induce managers to work for
long-term profitability

To be distinguished from issue of stocks at

below prevailing price
In what type of structures does this work?
Problem no downside risk