1.2 Types of business entities

Full video class on YouTube, summary and notes on Instagram, class extracts on TikTok, text below. Have fun!

The main idea of this class is to help you understand what is the best form/type of business in any given situation. Let’s say, you want to start a business, you have already studied 1.1 and you even have a business plan ready, but you don’t know what brings more benefits to you: registering as a sole trader? Or as a company? Maybe a cooperative? Study this class to figure out what’s best.

Sector in this class refers to part of the economy, just like in 1.1, but the sectors we are about to study are not sectors of industry, they are sectors of ownership. If you want to divide all businesses in any economy into four sectors of industry, you consider what this businesses are doing, i.e nature of activity. If you want to divide the same businesses in an economy into 2 sectors (private and public), you consider who they belong to. Thus, any business is in two types of sectors at the same time. For example, Volkswagen manufactures cars and belongs to shareholders, which means it’s in secondary sector (of industry) and private sector (of ownership). BBC (British Broadcasting Corporation) is providing TV programmes and belongs to the UK government, which means that it’s in tertiary and public sector. The illustration below summarises the main idea of this paragraph:

So, once we’re clear about the difference between sectors of industry and ownership sectors, let’s focus on public sector. Public sector refers to part of the economy that is comprised of organisations that are created and run by governments to provide public services, for example police, public transport, healthcare, education, infrastructure. Public sector organisations are mostly funded by tax revenue. They exist to make people’s lives better and they are not supposed to make profits. Even if they charge customers (for example, when you pay for a stamp in the post office) and make profits, these profits are not used to compensate to the owners of these organisations, because there are no owners/shareholders as such. These organisations belong to the government, i.e. to everyone, to all citizens. That is why, these “profits” are actually called surplus — the positive difference between revenues and costs in public sector organisations, that is reinvested in order to improve the services provided to citizens.

The best thing about public sector organisations is that they are so socially-oriented and their essence is to help people. However, they are funded by taxes and they do not face much competition, so they tend to be quite inefficient most of the time. Public sector organisations do not have to fight for their existence and compete with other businesses because very often they are monopolies and are supported by tax revenues. Some examples of public sector organisations would be British Broadcasting Corporation (BBC) and National Health Service (NHS) in the UK and United States Postal Service (USPS) and National Aeronautics and Space Administration (NASA) in the US.

Private sector refers to all organisations that are owned and created by individuals or group of people in order to satisfy needs and wants and provide goods and services. Most organisations in private sector are created to make money to their owners, which means that they are for-profit. However, there are organisations in private sector that are non-profit and are aimed at helping people, just like in public sector. Even though from mathematical perspective profit is the same as surplus (the positive difference between revenues and costs), we say “profit” when we talk about private sector, and we say “surplus” when we talk about public sector.

The best thing about private sector organisations is that they are efficient and innovative. They are forced to be efficient, innovative and creative, because if they aren’t, they’ll go bankrupt and they’ll be pushed out of the market by competitors and there is no one to back them up. Thus, they work hard to provide the best product to their customers and make sure everyone’s needs and wants are satisfied in the best possible way. However, most organisations in private sector are money-driven. They do not care about people as much as about profits. This trend is changing though and more and more organisations in the private sector commit to social goals. We will talk about it in more detail in the last part of this class. An example of private sector organisation can be pretty much any company you know: Apple, Google, Coca-Cola, Netflix, Burger King, etc.

Check out the list of countries by public sector size here. Spoiler: Cuba's public sector is 77.7% of their economy

Can you please read the objective of this part of class again? Thanks. The objective is to learn to evaluate the features of different organisation types. Key words here are “evaluate” and “features”, which means that it is not enough to just understand what these organisation types are, it’s important to learn to express your opinion about them and justify it with facts. That is why, before we dive into the four types of organisations, we’ll learn how to evaluate them.

When we talk about any kind of organisation, we can use the same criteria to judge/evaluate them. For example, number of owners, reasons to choose the given type of organisation, how long it takes to register it, how risky and expensive it is, which documents are required for registration, how easy it is to raise funds, how difficult it is to control organisations and make decisions, what the chances of continuity are in case of owner’s absence and simply advantages and disadvantages. All of these are self-explanatory. In addition to the things mentioned above, there are a few more things that require a little bit more attention: liability, legal identity, incorporation, transparency, accountability and set-up costs. Why they require special attention? Because every year students ask me the same questions about these things and even if they don’t I can see that understanding of these terms could be improved. It might not apply to you personally, but I will still walk you through these terms.

Liability is the extent to which you risk losing your personal possessions in case of the business failure, it can be limited and unlimited. Unlimited liability means that you personally are completely, 100%, totally, fully, etc responsible for all the business debts and losses. Let’s say if (God forbid) your business goes bankrupt and you are unable to pay back $1000 to the bank where you took a business development loan, then the bank will make sure someone comes to your house and takes your personal belongings (TV, couch, PlayStation, etc) to make sure there is enough to compensate for that $1000 loan. Of course this is a simplified explanation and example, but it’s perfect to illustrate what unlimited liability is for people who have just happened to read this term. It might sound scary, but unlimited liability usually refers to smaller businesses and people rarely end up losing their personal possessions. However, if you aim at long-term growth and building a multinational corporation, unlimited liability is clearly not the best option. Limited liability means that your responsibility for business losses is restricted by your initial investment, i.e your liability is limited by initial investment. For example, you buy some shares of Amazon today and costs you $500. If tomorrow Amazon (again, God forbid) goes bankrupt, you just lose a chance to get your $500 back, but nobody’s going to come to your house and take your personal belongings. If it does go bankrupt though and if it is unable to pay for its loans, then the bank will make sure someone comes and takes Amazon company’s belongings (office chairs, computers, building, etc). In other words, company’s assets will be seized, not personal assets of people who worked for Amazon. That’s all you need to know about liability at this point.

Legal identity is the formal registration of a human or non-human entity. For example, you are a real human being but unless you have a passport or another form of ID, you don’t exist from the legal perspective. So, some businesses, for example sole traders, do not have legal identity. Sole trader’s legal identity equals to the person’s legal identity. But companies, on another hand, have their own separate legal identity. Steve Jobs had his own identity, and Apple has its own. If you buy an iPhone and something doesn’t work the way it’s supposed to and you are refused a refund, then you will probably sue Apple, but not Steve Jobs, because Apple has its own legal identity. From the legal perspective, Apple is a real entity, as real as Steve Jobs. Now, if a business organisation does not have its own legal identity (just like sole traders), it means that they are unincorporated. If you buy a lemonade from a sole trader and get food poisoning, you will sue this sole trader personally, not his business, because from legal perspective this sole trader and his/her business is one and the same entity. Companies, however, are incorporated — they do have a separate (from their owners) identity. Fun fact: “incorporated” comes from Latin word “corpus”, which means “body”. So if business and person are one and the same body — we call it “unincorporated” (no extra body). If a business has its own body that is separate from its owners’ body — we say “incorporated” (extra body created). So, if you see “inc.” after a company name, you know what it means now.

There are just three more terms before we move to sole traders, partnerships and companies. Transparency — the extent to which businesses have to disclose their financial data. Some businesses are really private and not transparent, they keep all the accounts to themselves and only share with the tax authorities. Some businesses, like publicly held companies (Apple, Amazon, Google, etc) are super transparent: they have to publish all their financial data several times a year. Want to see how much money they made? Just go onto their website and download an annual report. Accountability is the degree to which a person or business is responsible or answerable to someone. Partnerships, for example, have high degree of accountability, all the partners are accountable to each other. And finally, set-up costs refer to how much money you need to start a business in this or that form. Spoiler: setting up a business as a sole trader is usually the cheapest, but setting up a business as a company is usually the most expensive.

Now we’re ready to learn about sole traders, partnerships and companies. As you read about them, you might want to copy the table below and take notes in a systematic manner. If you were in my class, I would make you do it, haha. And by the way, I have already mentioned some of the things, so you may fill in some parts of this worksheet already.

Sole traders are people who run their businesses alone. This type of business does not have a separate legal identity, the owner and the business is the same entity, which means that sole traders are unincorporated. They also have unlimited liability, so sole traders are personally liable for all business losses with their own possessions. Sole traders do not usually focus on long-term growth, very often these are just people who do not want to work for anyone and want to control their life-work balance themselves. Very often they are also quite inexperienced, so the chances of failure for sole traders are pretty high due to lack of experience. Setting a business as a sole trader is relatively easy in most countries and only requires very few documents. Owners also get to keep all the profits and the tax is usually pretty low, or in some countries sole traders who earn less than a certain amount are completely tax-free.

Raising funds for this type of business is pretty difficult. Banks are reluctant to provide loans because they know that sole traders are likely to fail due to lack of experience. Mostly, sole traders are funded by personal savings. Sole traders are quite private, they do not have to disclose how much they earn to the public, thus they are not transparent. In terms of continuity, if something happens to the owner, then the business shuts down. No owner, no business. Sole traders cannot compete with large corporations because they cannot afford that kind of competition. However, sole traders can enjoy local monopoly. For example, if there is a small store in your neighbourhood and you want a drink and some snacks, you are very much likely to go to that little store. So this store will be a monopoly, but only within your neighbourhood.

Partnership is an association of two or more (usually up to 20) people who run a business together, sharing the risks, workload and profits. The most important document for a partnership is called partnership agreement (or deed of partnership), which is like a constitution, but for a partnership: it states how workload and profit are distributed among partners, what the procedure is for entering or leaving a partnership. Deed of partnership is signed by all partners. Some partners prefer not to run a business at all, but just to invest some money in exchange for a portion of profits. This type of a partner is called sleeping partner (or silent partner).

There are different types of partnerships but most of them have unlimited liability, which means, as you remember, that all partners are personally liable for losses of their business. They are also unincorporated, so the business’s identity is a combination of the owners’ identities, no new entity is created. Even though workload and risks are shared among all partners, so is decision-making and profits. The degree of accountability is relatively high and for a decision to be made all partners have to agree first.

Finance is still pretty difficult to acquire and banks are still quite reluctant to loan money to partnerships, but there is more finance available to partnerships than to sole traders simply because it is a numbers game: more people, more money. The main source of finance is still personal savings. Chances of continuity for this type of business are also higher than for sole traders because, again, there are more people involved.

Very often partnerships are a group of people who share similar expertise and who see synergy in working with others. For example, some dental school graduates might form a partnership and run a small clinic together: one of them could specialise in orthodontics, another one in surgery, the third one in dental hygiene. Altogether they can offer a varied service to their patients and at the same time they can share expenses for rent, electricity and equipment.

Companies are limited liability incorporated organisations. They have their own legal identity (owner ≠ business) and are a subject of law independently from their owners and people who work for them. The number of owners is in theory unlimited. Technically, every single person on earth can be an owner of the same company, which has never been the case in reality. Owners of companies are called “shareholders”. From now on, when I say “owner”, it implies sole traders and partnerships, when I say “shareholders”, it implies companies. The biggest risk for shareholders is losing their initial investment (the benefit of limited liability, remember?), that is why it is so easy for companies to raise funds (attract money) and grow, compared to sole traders and partnerships. People are not afraid of becoming shareholders as much as joining a business with unlimited liability. The price that companies have to pay for it is higher transparency, more procedures in registration and strict control from the government. Otherwise, companies would easily raise money by making people believe in them and then claim bankruptcy, spreading money among majority shareholders. As I mentioned earlier, in case of bankruptcy, company’s assets are seized, but shareholders’ and workers’ personal belongings have nothing to do with it.

Speaking of registration, the two most important documents for companies are Memorandum of Association and Articles of Association. The former includes all the conditions that are needed to register a company and the latter is like a constitution of a company, it states the main rules of the company. In addition to these two documents, companies are only allowed to start trading after they are provided with the Certificate of Incorporation, which is basically a trading license that allows companies to conduct business activity. The date it is issued is the official birthday of the company.

Shareholders do not have to run a business. If you buy Apple’s shares tomorrow, it does not mean you have to go to the office 8am tomorrow. However, some employees might also be shareholders at the same time. People who run the business on the top strategic level are Board of Directors (BOD) and Chief Executive Officer (CEO). BOD usually includes either some of the managers selected by shareholders, or majority shareholders (i.e. those who have most of the company’s shares), or people from outside the organisation who are selected by shareholders to represent their interests. What matters is that the job of BOD is to represent shareholders' interests. Board gets together once a year for Annual General Meeting (AGM) to determine the long-term strategic plan for company development, but they also get together for Extraordinary General Meeting (EGM) in case an emergency requires directors’ attention. The person is in charge of actually running the company on a day-to-day basis is CEO.

Shareholders are eligible to a portion of company’s profits — dividends. However, dividends do not have to be paid at all, or do not have to be paid regularly, it all depends on the legislation and company. Since shareholders have limited liability and companies are incorporated, the chances of continuity for companies are the highest among all companies. Even though Steve Jobs passed, Apple is still working. You might be surprised to know that Steve Jobs was once kicked out from his own company, because BOD was not happy with how he ran the company. Eventually, it was not a good idea and they hired him back, but the point is, continuity of the company is really high and does not depend on the absence of shareholders.

There are two main types of companies: privately held companies and publicly held companies. The key difference between them is that the former sell shares privately, only to those businesses and/or people they want to sell them to, but the latter trade their shares on the stock exchange and potentially any human being of the legal age can become a shareholder. This is how Steve Jobs lost his job, even though he created the company. Once you become a publicly held company, you risk losing control to outsiders, who can buy the majority stake and tell you what to do. Mark Zuckerberg managed to avoid that by retaining the majority stake (the largest proportion of shares). By the way, it is a common misconception that the majority stake is 51% of company shares. It is the ultimate majority stake, but it is not a majority stake in most cases. Most of the time, it is enough to have more shares than other shareholders in order to have the final say, and it does not have to be 51% as long as it is more that other shareholders have.

Privately held companies, due to lower transparency and not having to publish that much financial data to the public, usually have a relatively low number of shareholders, compared to publicly held companies. They are very often owned by families. For example, Lego has been a privately held family business since 1932. Even though Christiansen family could have gone public many times, they prefer to retain control in the family and have not changed their type of business entity since 1932. Even though the transparency is relatively low and control over privately held companies is not likely to be lost to outsiders, it is quite difficult for shareholders to “cash out” if they want to leave the company and sell their stake. For publicly held companies, you just contact your broker and sell shares, but for privately held companies it has to be a private business deal, that is more difficult to arrange. Some examples of privately held companies are Lego, IKEA, Virgin Group, Chanel, Mars.

Publicly held companies cannot just become publicly held out of nowhere. All the publicly held companies were privately held prior to “going public” — making their shares available for purchasing by anyone. After making a decision to go public, privately held companies have to go through initial public offering (IPO) — the process of selling their shares to the public for the first time. After IPO there is no direct control over share price. Share price is determined by the market laws of supply and demand. This process where shares are sold freely on the stock exchange is called flotation. So, publicly held companies have the greatest access to capital among all types of business entities, but at the same time they are the most transparent type of business organisation. Examples of publicly held companies are Apple, Coca-Cola, China Mobile, HSBC, Microsoft, Nike, etc.

Watch the full video class for this topic to learn some fun facts about IPO or watch an extract about companies on my Instagram or TikTok. If you know something fun and interesting about companies in your country or all over the world, please share in the comments below.

Keep in mind that even though this part of class is just called “social enterprises”, there are two objectives (see above) and there are two different types of social enterprises: for-profit and non-profit. To make it clear and easy to understand, look at the picture below:

Very often students thing that social enterprise and non-profit organisation is the same thing. Or, they think that there are 4 types of business entities: sole traders, partnerships, companies and social enterprises. None of these two misconceptions are right. Social enterprise is an organisation that has social wellbeing as its main goal, instead of making profits. That is why it is not the same as non-profit organisation. Social enterprises can make profits, or cannot, what matters is just the social wellbeing bit. Is social enterprise the fourth type of business entity in addition to sole trader, partnership or company? Wrong! Social enterprise can take any form: some social enterprises are sole traders, some are partnerships, some are companies. Cooperatives, that we’ll talk about in a moment, are social enterprises by their nature, because they are created for the benefit of certain communities. So, to recap, social enterprise is not a legal type of business entity (sole trader, partnership, company), it is a characteristic of an organisation.

Now, back to Figure 7 and the first type of social enterprise — for-profit private sector companies. By now, you should already understand what for-profit private sector company is, so I am not going to define it. If you are struggling with understanding what it is, it’s totally okay, just scroll up and read again or try another way of perception and watch the video class for this topic. So, we’re not just talking about for-profit private sector companies now, we’re only talking about those of them, that are social enterprises.

These companies make profits, even though it is not their prior objective. Profits are used more as a tool to achieve socially important aims and compensate to owners at the same time. Other than that, these organisations have the same features as private sector companies.

The example of this type of social enterprise is Smenka Show and Geek Teachers that are run by two social entrepreneurs — Arina and Masha. Smenka Show is a social enterprise that raises money to renovate classrooms in schools. In the illustration below you can see the “before and after” pictures. Geek Teachers organise events for teachers to inspire positive change in education. So, what Masha and Arina do is a business, it earns profits, but community benefits from this business as much as (or even more than) Masha and Arina. I also asked the girls about the pros and cons of running a social enterprise and I will share it with you a bit later when we talk about theoretical pros and cons, so that we can compare these with what real entrepreneurs say. So keep reading.

The second type of social enterprises is for-profit public sector companies. Again, you should understand what it means by now. These organisations are the same as private sector companies that we’ve just discussed, but they operate in public sector, which means that they are created and run by government, which also means that most of them are focused on public services: medicine, infrastructure, transport, education, etc. The example of a for-profit public sector companies could be waste sorting and recycling plants in Sweden. As you probably know, in Sweden they are aiming at recycling as much as possible and at having zero waste, so there are a lot of waste management companies. Read this to learn more. They:

• are trying to benefit everyone by recycling waste,
• make profits,
• are created or funded by the government,

which means that they have all the essential features of for-profit public sector companies.

The last type of for-profit social enterprise is cooperatives — “an autonomous association of persons united voluntarily to meet their common economic, social and cultural needs and aspirations through a jointly owned and democratically controlled enterprise” (definition from International Cooperative Alliance). So, basically, a group of people decide that they need an organisation that will make their lives better. This is the key feature of a cooperative, by the way — it is created and run by its members for their benefit. For example, people in the neighbourhood decide that they need an organisation that will take care of maintenance, waste management, provision of internet and cleaning in their neighbourhood. So all the neighbours join this organisation, run this organisation, and enjoy the benefits of this organisation. That would be an example of a residential (housing) cooperative. There are also agricultural, consumer, financial and many other types of cooperatives. What all of them have in common is that they are created and run by their members for their own benefit and they are run in a democratic manner: votes for decisions are taken directly or through representatives, which is great on the one hand, but prolongs decision-making, on the other hand. I’m quite sure you heard about SWIFT (Society for Worldwide Interbank Financial Telecommunication) — it is a cooperative of banks that created a messenger to make money transfers easy and simple for their own benefit, which also benefits the clients as well.

The last type of a social enterprise is non-profit and it is NGOs (non-governmental organisations). This term first appeared shortly after the Second World War in the United Nations and there is no universal fixed definition for NGOs, so the understanding of NGOs differs from country to country. What all NGOs have in common is that they are usually non-profit, they have public trust, they usually address public well-being issues, such as health, environmental protection, human rights. NGOs can also be lobbying groups and political parties. And of course the main feature is that they are not run by the governments. Some examples of NGOs could be Greenpeace, Amnesty International and Oxfam. Check out the websites of these organisations to learn more.

So, now you know the four types of social enterprises, three of which are for-profit and one of which is non-profit. Now it’s time to look back at objective and do what it asks: evaluate. The advantages of social enterprises are:

• they result in customer loyalty, because people to buy something from “good companies” because it makes them feel good when they do so, it makes them feel they contribute to something good too by supporting social enterprises.
• In addition, social enterprises are by definition socially and economically sustainable which impacts communities and environment positively, or at least there is no harm. And lastly, social enterprises bring positive change.

On the other hand, social enterprises might experience high compliance costs (costs of being ethical). For example, you are a committed social enterprise and you have a choice of two suppliers: one is using eco-friendly materials but charges more and another uses plastic but charges less. You are very much likely to go for the expensive option because it is in line with social entrepreneurship principles, i.e the costs of being a social enterprise might be higher. In addition, very often social enterprises are not really economically sustainable and rely on donations and irregular funding. And lastly, social enterprises are usually transparent and democratic, which might result in prolonged decision-making.

The advantages and disadvantages above are too general, theoretical, and they do not necessarily apply to all social enterprises. In order to give you a more practical perspective, I asked Arina and Masha from Smenka Show and Geek Teachers what the pros and cons and opportunities and challenges for them personally as social entrepreneurs are and here’s what they said:

The benefits are opportunity to have an impact on people’s life quality and inspiring people for positive change. However, the first drawback is that traditional promotion and targeting do not work, you have to reach people. If you sell shoes, it’s pretty easy to understand who your customers are and target ads for them in social media, for example. But with renovating classrooms, you have to reach teachers, school principals and community and you start from scratch with every new school. In addition, income is hard to forecast. Also, even though you’re doing something good and you are socially focused, some people don’t need it and they say “we’re fine the way it is, we don’t care”. And lastly, people do not always understand why they should pay for some good deeds. They think that all good things should be free, for some reason.

I hope that was really helpful and I really appreciate the comment that Arina and Masha gave. Donate to Smenka!

That is the end of 1.2.

Make sure you can define all of these:

1. Public sector
2. Private sector
3. Surplus
4. Profit
5. Liability
6. Limited liability
7. Unlimited liability
8. Legal identity
9. Incorporated
10. Unincorporated
11. Transparency
12. Accountability
13. Sole trader
14. Partnership
15. Deed of partnership
16. Sleeping (silent) partner
17. Privately held company
18. Publicly held company
19. Shareholders
20. CEO
21. BOD
22. AGM
23. IPO
24. Flotation
25. Stock exchange
26. Dividends
27. Memorandum of association
28. Articles of association
29. Certificate of incorporation
30. Social enterprise
31. Private sector company
32. Public sector company
33. Cooperative
34. NGO
35. Compliance costs