Different Forms of Business (AQA A-Level Business): Revision Notes
Different Forms of Business
Understanding business structures
When setting up or running a business in the UK, one of the most important decisions is choosing the right legal structure. There are several different forms a business can take, each with its own advantages and disadvantages. The structure you choose will affect how the business is managed, how much tax is paid, and what happens if things go wrong.
Public sector organisations
Public sector organisations are a distinct form of business structure where ownership and control rest with the government or local authorities rather than private individuals or companies. These organisations operate to provide essential services to the public.
Examples of Public Sector Services in the UK
In the UK, the public sector includes major services such as:
- The National Health Service (NHS)
- Local council services (such as rubbish collection)
- State schools and universities
These organisations are funded through taxation and operate to serve the public interest rather than generate profit.
Historically, the public sector was much larger and included key industries and utilities such as coal mining, steel production, water supply, and telecommunications. These were known as nationalised industries because they were owned by the nation (the government on behalf of the public).
Privatisation
Over recent decades, many of these nationalised industries have been sold to private sector businesses through a process called privatisation. This means converting government-owned and controlled industries or businesses into privately owned companies.
Privatisation in Practice
British Telecom and many water companies were once publicly owned but are now private businesses owned by shareholders. This transfer of ownership means these companies now operate for profit rather than as public services, though they remain regulated by government bodies.
The key distinction: unincorporated and incorporated businesses
The fundamental choice when selecting a business structure is whether to operate as an unincorporated or incorporated business.
Understanding Unlimited vs Limited Liability
Unincorporated businesses (such as sole traders and partnerships) are the simplest forms. In these structures, the business and the owner are legally the same entity. This means the owner has unlimited liability for any debts the business incurs.
Incorporated businesses (such as private limited companies and public limited companies) are separate legal entities from their owners. The business can own assets, enter into contracts, and be sued in its own name. Most importantly, the owners benefit from limited liability, meaning their personal assets are protected if the business fails.
Reasons for choosing different forms of business
Several factors influence which business structure is most appropriate for a particular venture. Let's examine the main considerations:
Formalities and expenses
The ease and cost of establishing a business varies significantly between structures.
Sole traders and partnerships can be set up quickly with minimal paperwork and low costs. There are few legal formalities to complete, making these structures ideal for small businesses such as independent joiners, electricians, and corner shops. This simplicity allows entrepreneurs to start trading almost immediately without significant administrative burden.
Quick Start for Small Businesses
An electrician wanting to start their own business could become a sole trader in just a few days:
- Register as self-employed with HMRC
- Arrange basic insurance
- Start trading immediately
This contrasts with forming a limited company, which requires:
- Registering with Companies House
- Creating articles of association
- Appointing directors and a company secretary
- Additional accounting and reporting requirements
Size and risk
The intended size of the business and the level of risk involved play a crucial role in choosing the right structure.
If a business plans to remain small with little risk, then a sole trader or partnership may be the most suitable option. Many corner shops, joiners, and electricians operate successfully as sole traders for their entire existence because they carry minimal risk and generate sufficient income at this scale.
However, if the business carries significant risk or plans to grow substantially, an incorporated structure becomes more attractive. The limited liability protection means that if the business fails, the owners' personal assets (such as their homes and savings) are protected. This makes incorporation particularly important for businesses that require substantial investment or operate in high-risk sectors.
Risk Assessment and Structure Choice
Consider two scenarios:
Low Risk Scenario: A freelance graphic designer working from home with minimal equipment and no employees might operate comfortably as a sole trader, as the potential losses are limited to business income.
High Risk Scenario: A construction company taking on large projects worth hundreds of thousands of pounds would benefit from limited liability protection. If a project fails or legal issues arise, the directors' personal assets remain protected.
Objectives of the owners
What the business owners want to achieve significantly influences the choice of structure.
When business owners aim to expand and grow their venture, forming an incorporated business is usually more appropriate. Incorporation provides several advantages for growth:
- Greater access to capital through selling shares
- Limited liability reduces personal risk for owners
- Enhanced credibility with suppliers and customers
- Easier to attract investors
Growth Through Incorporation
A small café owner who dreams of opening multiple locations nationwide would likely benefit from incorporating the business to access the funding needed for expansion. As a limited company, they could:
- Attract investment from business partners by selling shares
- Protect their personal assets while taking on larger loans
- Present a more professional image to suppliers and landlords
- Build a brand that could eventually be sold or franchised
Reasons for changing business form
Many businesses don't maintain the same structure throughout their existence. There are several common reasons why a business might change its legal form:
Circumstances and growth
As a business grows and circumstances change, the original structure may no longer be suitable. For instance, due to significant growth and expansion, the owner or owners may wish to become incorporated to benefit from limited liability protection. This is particularly common when a successful sole trader wants to expand but recognises the increased risks that come with growth.
Raising capital
Access to funding is a major driver of structural change. The owners of a business may find it easier to raise capital by becoming incorporated, or by transitioning from a private limited company to a public limited company if it is currently privately held. Public limited companies can raise substantial sums by selling shares to the general public through the stock market.
The Power of Going Public
When a company "goes public" by listing on the stock exchange, it can raise millions or even billions of pounds from investors. This capital can fund major expansion, research and development, or acquisition of competitors. However, this comes at the cost of increased regulation, reporting requirements, and pressure from shareholders.
Acquisition or takeover
Sometimes external events force a change in structure. A business may be acquired by another company, causing a structural transformation. For example, a private limited company might be taken over by a public limited company, effectively changing its status and ownership structure.
While businesses typically change from private limited to public limited companies, the reverse can also occur. A business might move from public to private ownership to escape the constant scrutiny from investors and the pressure of short-term shareholder objectives.
Richard Branson's Virgin Group
A notable UK example is Richard Branson's Virgin Group, which moved from public to private ownership. Branson took the company private to avoid the pressure of quarterly earnings reports and short-term thinking from public shareholders, allowing him to focus on long-term strategic goals rather than immediate profits.
Exam Tip: Context-Specific Recommendations
When deciding on the most appropriate legal structure for a business, always base your recommendation on the specific circumstances of that business. Consider:
- The individual objectives of the owners
- The size and scale of operations
- The product or service offered
- The level of risk involved
- The need for capital and growth potential
A one-size-fits-all approach doesn't work in business structure decisions. Always justify your answer with reference to the specific case study or scenario provided.
The role of shareholders in limited companies
Shareholders are the owners of a limited company. They can be individuals, other companies, or institutions that own at least one share in the business.
What is share capital?
When someone becomes a shareholder, they invest money in a company by purchasing ordinary share capital. This capital is permanent funding – it never has to be repaid to the owners by the company. If shareholders want their money back, they must sell their shares through the stock market to another investor, rather than asking the company to buy them back.
Private individuals can invest in both private and public limited companies, becoming shareholders and part-owners of the business. However, in public limited companies listed on the stock market, individual private shareholders typically own only a small fraction of the total shares. The largest shareholders are usually financial institutions such as pension funds and insurance companies.
Institutional vs Individual Investors
In most major public limited companies (PLCs) listed on the London Stock Exchange, the majority of shares are held by institutional investors like:
- Pension funds managing retirement savings
- Insurance companies investing premiums
- Investment funds and asset managers
Individual private investors might own shares, but their combined holdings typically represent a minority of total ownership. This concentration of ownership among institutions gives these large investors significant influence over company decisions.
Rights and responsibilities of shareholders
Shareholders have specific rights and an important role in running a business. Major decisions that significantly impact shareholders must be approved by them at a general meeting called by the directors.
The Main Role of Shareholders
Shareholders have the power to:
- Attend shareholder meetings (Annual General Meetings)
- Discuss items on the agenda and question directors
- Ensure directors don't exceed their powers
- Vote on certain actions such as:
- Removing directors
- Changing the company name
- Approving major acquisitions or sales
- Authorizing the issuance of new shares
This system of corporate governance ensures that those who own the company can hold management accountable for their decisions.
Why people invest in shares
There are two primary reasons why individuals and financial institutions invest in shares:
Income through dividends: Shareholders are entitled to receive a share of company profits, known as a dividend. This is a portion of the after-tax profit distributed to shareholders according to the number of shares they hold. The total amount given to shareholders is determined by the board of directors and can vary, but investors hope the return will increase over time.
Understanding Dividend Income
If a company earns $10 million in after-tax profit and decides to distribute 50% to shareholders:
- Total dividend payment: $5 million
- An investor owning 1,000 shares in a company with 10 million total shares would receive:
- (1,000 ÷ 10,000,000) × $5,000,000 = $500 in dividends
Many investors, particularly those in retirement, rely on dividend income as a steady source of returns from their investments.
Capital growth: Shareholders hope that the value of their shares will increase over time. If the company performs well and becomes more valuable, the share price should rise, allowing shareholders to sell their shares for more than they originally paid.
Total Return on Investment
Successful investors look at both dividend income and capital growth to calculate their total return:
- Dividend yield: The annual dividend as a percentage of the share price
- Capital appreciation: The increase in share price over time
- Total return: Dividend yield + capital appreciation
For example, if you buy shares for $10 each, receive $0.50 in dividends annually, and the shares rise to $12 over a year, your total return would be:
- Dividend return: 5% ($0.50 ÷ $10)
- Capital growth: 20% (($12 - $10) ÷ $10)
- Total return: 25%
Remember!
Key Points to Remember:
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Business structures fall into two main categories: unincorporated (sole traders and partnerships) and incorporated (limited companies), with the key difference being limited liability protection.
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Public sector organisations are owned and controlled by the government or local authorities, though many have been privatised over recent decades through the transfer of ownership to private shareholders.
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Choosing a business structure depends on three main factors: the formalities and expenses involved, the size and risk of the business, and the objectives of the owners.
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Businesses often change structure as they grow, typically moving from sole trader to partnership, then to private limited company, and sometimes to public limited company to access more capital and support expansion.
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Shareholders are the owners of limited companies who invest money by buying shares and receive returns through dividends (income from profits) and capital growth (increase in share value), while also having the right to vote on major business decisions.