Lesson 16
AOF Applied FinanceLesson 2Financial ConceptsStudent ResourcesResourceDescriptionStudent Resource 2.1Reading: Memo From Eduardo CisnerosStudent Resource 2.2Diagram: Business Life CycleStudent Resource 2.3Reading: Business Life CycleStudent Resource 2.4Reading: ECPakStudent Resource 2.5Anticipation Guide: An Introduction to CapitalStudent Resource 2.6Reading: An Introduction to CapitalStudent Resource 2.7Note-Taking Guide: Legal Forms of Business Ownership Student Resource 2.8Reading: Legal Forms of Business OwnershipStudent Resource 2.9Pros and Cons Chart: Forms of Business OwnershipStudent Resource 2.1Reading: Memo From Eduardo CisnerosTo: AOF Applied Finance StudentsFrom: Eduardo Cisneros, CEO of ECPak CompanyDate: June 9, 2013Subject: Expertise NeededMy name is Eduardo Cisneros and I am the founder of ECPak Company. My company specializes in making affordable and user-friendly MP3 players. I am writing to you today to ask for your help with some business-related issues.As applied finance students, I have been told that your class is currently studying some common business issues that are similar to what my company is up against. With this in mind, I would like to pose this challenge to you. ECPak is currently undergoing many changes. Due to the incredibly fast-paced technological climate and consumer demand for my product, our company is growing at a swift rate. Here’s my problem. I am an engineer and music lover and not very business savvy. I have found myself confused with some of the issues that I am faced with. Because of this, I am asking for advice in the following areas:Forms of business ownership Cash flow challengesFinancial record keeping and budgeting adviceFinancing optionsEmployee benefit issuesTaxes and a few ethical issues that seem to be affecting my company on a daily basisI have heard from many different sources that I should get some consulting advice, and I have decided to start with you. Please accept this challenge and realize that in turn you will gain valuable career experience. Feel free to contact me if you have any questions, comments, or concerns.Sincerely, Eduardo CisnerosCEO, ECPak CompanyStudent Resource 2.2Diagram: Business Life CycleStudent Resource 2.3Reading: Business Life CycleImagine that one day you have a brainstorm about creating a new product that you think will hit the market like a firecracker. You make up a prototype (a sample of the product) in your garage workshop, start showing it around, and find everyone wants one. Suddenly, you’ve got a business.Many businesses start just this way, but they don’t often continue to operate in their owners’ garages. They grow and mature, and their needs change. Eventually, many will also go out of business.Every business has a life cycle. And there is no predetermined length of time for each of the life cycle’s stages—it varies for every company. Those companies that survive a competitive marketplace are run by people who know about the stages of business life and make plans for dealing with each one: StartupThis is the entrepreneur-in-the-garage stage. You may be working another job to get money to start your business-in-the-garage. You’re probably not breaking even yet. Your focus is on refining your product or service, getting it noticed, and selling your idea to investors or banks if you want to raise capital to help you expand.Growth/TakeoffYour product has taken off. You are seeing a sharp increase in sales, and you’re making a small profit. You find you have to make a major investment in hiring staff and purchasing raw materials to keep up with demand. You start finding it harder to keep tabs on every detail of the business yourself and have to start delegating and training your staff in parts of your operation. You are now both owner and manager and are probably working many more hours each day than if you worked for someone else.MaturityThe rapid growth in sales has leveled out, and you are now focused on maintaining your market share and making profits. Your focus has shifted to such management issues as controlling costs and making the operation more efficient. You are now more manager than product maker and may find that you are getting bogged down with paperwork, accountants, and lawyers, and you are no longer thinking in terms of innovation. If you got your energy from being in the startup phase, you may get bored at this point.DeclineYour business has lost its edge against the competition. Sales are dropping, and it is hard to look at new ways of doing things. You may blame the government, your staff, or others for the loss of profits, but in fact your business may simply be unable to make a shift or change to regain its marketplace position. Changes in the economy, society, or marketplace can make this into a crisis. You have to make a decision: Sell the business? Fold? Try to revitalize and survive?Cessation of OperationLet’s say that you have decided to try to sell your company. In order to sell, you must first have a valuation of the business so you know what your company might be worth to a buyer. Second, you must find an interested buyer and come to an agreement on price and terms. You also need to consider what will happen to your employees. Can you strike a deal with the buyer to keep at least a core staff on? Can you afford to offer buyouts to employees who might be near retirement anyway? What about your own future? Will the buyer want you to stay on for some period to help manage the operation, or do you need to find another job? If you cannot sell, you will have to liquidate (sell off) the business assets and close.Student Resource 2.4Reading: ECPakThe BeginningEduardo Cisneros was an engineer who loved music of all kinds. The problem was that he was working in his first engineering job after graduating from college, and money was a little tight. He really wanted an MP3 player, but the best ones were very expensive. Eduardo also noticed that manufacturers quickly introduced major changes in these units, causing older models to become obsolete. He did not want to pay a lot of money for a unit that would be obsolete in a few years. Out of both necessity and engineering curiosity, he decided to create his own MP3 player.What Eduardo came up with was a unit that:Was modular; replacing just a small portion of the hardware could produce a major upgradeWas inexpensive to purchaseCould be upgraded inexpensively with more memory by the userHad software that could be upgraded easily; could have features added with the click of a computer mouseThis MP3 player was designed to be the only one Eduardo would ever have to buy. To upgrade its features, all he would have to do would be to make an inexpensive change to the unit.That was the start of a long, exciting, and incredibly profitable journey.The first working unit was nothing more than a bunch of electronic parts installed in a full-sized plastic CD/DVD case held together with gray duct tape.He started to use the player at work, and it received a lot of attention from the other engineers because it was so different. Pretty soon they were asking him to build units for them, and Eduardo sold them at his cost plus a profit for his time.The units Eduardo made for his work friends attracted attention from their friends, and Eduardo sold even more players. Pretty soon he was making almost as much money selling MP3 players as he made working as an engineer. He decided to establish a small company to manufacture and market the units.Sole ProprietorshipEduardo needed a name for his device. After some thought, he came up with the name ECPak, which is pronounced “easy pack.” The letters E and C stand for Eduardo Cisneros. He called his sole proprietorship the ECPak Company.To be a commercial success the unit needed to have a sleek, functional plastic case. Eduardo spent all of his profits to pay for a custom case design and the special tools needed to make it. He also paid a company to make the cases. The internal parts were standard components he could buy from suppliers, so he did not have to design and make his own.He was still working as an engineer to pay his bills, and he worked for himself nights and weekends. He quickly realized that he needed a partner to help make his idea a market success. He also needed money to invest in the business. At this point all of the units were made in his apartment.PartnershipMary Ann Chang had been a close friend of Eduardo’s since high school. She was a marketing manager for a local company. Mary Ann had received a large inheritance when her parents passed away. She was fascinated with the commercial possibilities of the ECPak and owned one of the original units (one of those held together with duct tape) herself. Eduardo asked Mary Ann to become his partner, and she accepted immediately.Mary Ann invested most of her inheritance in the ECPak Partnership. It grew and grew, and pretty soon both Eduardo and Mary Ann quit their regular jobs to work on making the ECPak a commercial success.For a while, Eduardo and Mary Ann assembled the units in both of their apartments. Very quickly, though, they moved into a small building and started to hire employees. They could not seem to make units fast enough.Limited Liability CompanyEduardo and Mary Ann quickly realized that the business would continue to grow. They were earning some serious money and became uneasy that they might lose it if the partnership was sued for some reason. There were just too many people making too many decisions. Something would go wrong eventually, they felt, and they needed to protect themselves. A limited liability company (LLC) protects the nonbusiness assets of business owners because of what is called limited liability. This means investors can lose only what they have invested in the business, not private property such as houses or cars.The ECPak Partnership was restructured to become ECPak LLC. The business continued to grow, and it was soon selling MP3 players throughout the United States. It seemed as if everyone wanted one.CorporationA year later, ECPak LLC became ECPak Incorporated. Why? An LLC is licensed to do business by the state in which it is formed. Some states restrict the ability of owners to sell their personal interest in a business. Unfortunately, the state in which ECPak LLC was registered had this restriction.Eduardo and Mary Ann wanted the ability to raise money by selling all or a portion of their ECPak stock to the public. Becoming a corporation would make it possible to sell stock to investors, thereby raising funds to expand. It would also allow any investor to sell shares easily for any reason.Student Resource 2.5Anticipation Guide: An Introduction to CapitalStudent Name:_______________________________________________________ Date:___________Directions: For each of the statements below, circle whether you agree or disagree and write one reason to explain your guess. Then take notes on what you learn about this topic in the assigned reading (Student Resource 2.6).The simplest form of capital is cash.My guess:I agree I disagreeMy reason:I learned:Capital must be tangible.My guess:I agree I disagreeMy reason:I learned:All businesses need capital in order to operate.My guess:I agree I disagreeMy reason:I learned:Seeking money from private investors is the best way to raise capital.My guess:I agree I disagreeMy reason:I learned:Student Resource 2.6Reading: An Introduction to CapitalWhat is capital?Capital is any form of wealth that can be used to create more wealth.The simplest form of capital is cash. It can be contributed in the form of investments, earned through profits, or “rented” in the form of borrowed money. This cash is then invested in productive assets (which are capital) that create profits (which are also capital).Sometimes business owners contribute property they already own to the business. This, too, is capital.Property may be tangible or intangible. Examples of tangible property are machinery, buildings, and raw materials used to produce a product. Intangible property includes ideas, concepts, and creative works like a new product idea or the next hot song.Intellectual property is another form of capital. It can be thought of as original ideas or creative works. Examples are the idea for a new product or a song written by a musician.Why do businesses need capital?All businesses need capital in order to operate. They need money to pay their employees and to rent or buy a building to house the business. Capital enables a business to get things done, which eventually leads to profits.A business’s need for capital depends on its unique circumstances:A company might sell products or provide services. Either way, it needs capital.If the company is selling a product, that product may be either intangible or tangible. Tangible products generally require more capital outlay than intangible products.The number of employees and the amount of equipment and building space a business requires are also factors in the amount of capital it needs. The more staff, machinery, and facilities a business has, the more capital that business needs.The product or service-development cycle has a big impact on the amount of capital a business needs because the early stages of the process consume, rather than create, capital.The larger a business’s market, the more sales it will make. More sales require more products or services to sell and, in turn, more capital to keep business operations going.A market that is farther from the business’s location will mean higher transportation costs and potentially more capital spent.How do businesses raise capital?When we talk about raising capital, we are really talking about getting more cash. This is because even though property and cash are both considered capital, cash is the form of capital needed to fund business operations.To get more cash, businesses usually do one of the following:Receive additional funds from owners’ personal accounts. Owners or partners can contribute additional money to the business from their personal savings. In order to keep the ownership of the business the same as it was prior to any contributions, the owners should contribute pro rata amounts (partnerships and LLCs).Take out a loan from a bank. Banks and other financial institutions provide loans for businesses to expand or continue their operations—especially small businesses. Businesses must pay back the original loan amount—called principal. Additionally, for the privilege of borrowing the money, the borrower must also pay a fee—called interest. Interest is the cost of using money.Seek money from private investors. An investor might be a friend, a family member, or someone not affiliated with the business. Investors risk their money because they believe they will make much more money in return. They are willing to accept the risk of loss if the business goes bankrupt. Venture capital firms are businesses that specialize in providing startup funding for new (and sometimes risky) companies.Issue stock or bonds (if the business is a corporation). By selling stock, companies trade part ownership of the firm for cash that can be used to grow the business. Companies can also issue securities called corporate bonds, which return the investor’s original money plus interest when they mature. Note that small firms that are not incorporated never have the choice to sell stock or bonds.Sell equipment or property they have. Of course, liquidating assets may limit a business’s ability to produce more goods or services in the future. It might be done because management changes the firm’s strategy and some assets are no longer needed. At worst, it can be done by creditors (like a firm’s banker) when the business cannot meet other required financial obligations.Student Resource 2.7Note-Taking Guide: Legal Forms of Business OwnershipStudent Name:_______________________________________________________ Date:___________Directions: Use this note-taking guide as a way to organize the information you learn from the presentation or the reading on legal forms of business ownership. While learning about each form of business ownership, fill in the blanks with the appropriate answers.Sole ProprietorTypical size: _________________A sole proprietor is a(n) _____________ conducting a business and not as an employee.The sole proprietor is the ______________ of a sole proprietorship.All business debts are the responsibility of _________________.The sole proprietor is responsible for _____________ actions taken in the name of the business.A sole proprietorship is the _________________ regulated of all business forms.A sole proprietorship can hire employees, but the owner ______________ be an employee.______________ profits are taxed as regular income to the proprietor. The sole proprietorship itself pays _________________taxes as a business entity.Typical examples of sole proprietorships include _______________, _______________, _______________, _______________, _______________, and _______________.PartnershipTypical size: _________________A partnership is _______________ people conducting a business and not as employees._______________ business debts are the personal responsibility of the partners._________ are responsible for all actions taken in the name of the business by all other partners.A partnership is based on a document called the ___________________________.The partnership can hire employees, but _______________ be employees._____________ profits are taxed as income to the partners. The partnership itself pays no taxes.CorporationTypical size: ________________A corporation is _______________ people conducting a business and not as employees.Business debts are _______________ the personal responsibility of the owners (limited liability).The _______________ is responsible for all actions taken in the name of the business.The corporation is among the _______________ business forms.A corporation is a legal person in the eyes of the law and can _______________ property, make money, and be sued just like a(an) _______________.A corporation can hire employees, who _______________ include the owners.All profits are taxed _______________, once as _______________and again as _______________.A corporation is the only legal form that can issue _________________ to raise capital.Limited Liability CompanyTypical size: _____________________A limited liability company (LLC) involves _______________ people conducting a business and not as employees.All business debts are _______________ the personal responsibility of the owners (limited liability).The _______________ is responsible for all actions taken in the name of the business.An LLC is among the _______________ of business forms.An LLC is a legal person in the eyes of the law and can _______________ property, make money, and be sued just like a(n) _______________ (and just like a corporation).An LLC can hire employees, who may _____________ include the owners.An LLC may choose to be taxed as either a(n) _______________ or a(n) _____________ under IRS rules.Student Resource 2.8Reading: Legal Forms of Business OwnershipSince every business is different, there isn’t one form of ownership that fits them all. As an owner, you need to understand how each legal structure works and then select the one that meets your needs the best. Sometimes this isn’t obvious, and you need to consult an accountant or lawyer for guidance.The main forms of ownership are sole proprietorship, partnership, limited liability company, and corporation. These will be explained later in this presentation. Each of these has advantages and drawbacks when looking at liability for taxes and financial responsibility.There is one other form of business, a cooperative. This is a grassroots business owned and controlled democratically by its members. Consumer cooperatives are sometimes formed to run food stores to offer food to members at reduced prices; artists may form a co-op to sell their arts and crafts. Cooperatives are not available in every state; the office of your state’s secretary of state may have information on this.Individuals just starting up a small business may choose to operate as a sole proprietorship. This is typically a very small business, owned and operated by one person.The owner may hire employees but may not be an employee. Small shopkeepers, artists and crafts workers, carpenters, consultants, and writers are usually sole proprietors. Lawyers and accountants who work alone or with very few employees may also select this form of business.Two conditions must be satisfied to choose a sole proprietorship: first, the business should be unlikely to be sued; and second, the owner should not plan to borrow much money to operate the business.Creating and operating a sole proprietorship is easy and inexpensive. It is the least regulated of all the forms of business ownership we will look at in this presentation.For income tax purposes, the owner and the business are the same: All profits (and losses) are reported on the owner’s personal income tax return. The business does not exist as a separate organization. That is not the case with more complicated forms, such as the corporation.The downside to operating as a sole proprietorship is that the owner alone is personally responsible for everything the business does. That includes paying business debts with personal assets—home, car, personal investments, and so forth.When two or more people start a business together, they may choose to have a general partnership. (There is also a limited partnership, but that is used mostly for investing in real estate and it operates differently.) A partnership operates like a sole proprietorship in that partners are personally liable for business expenses, and they report partnership income on their personal income tax returns. Partnerships are somewhat more regulated than sole proprietorships.However, they also have a written partnership agreement (usually drawn up by a lawyer) that sets out what type of business it is, the names of the partners and the amount of their contributions, how profits and losses are distributed, and what each partner’s powers and responsibilities are. It also covers what happens if a partner leaves, dies, or becomes unable to take part in the business.Like a sole proprietorship, a general partnership is easy and inexpensive to set up.Partners receive income from the business in the same proportion as their investment. For example, if a partner put $100,000 into the business, out of total capital of $500,000, he or she would receive one-fifth of the profits. Similarly, if the business suffered losses, the partner would be liable for one-fifth of the amount of the losses.As with any group of coworkers, partners sometimes disagree about how to operate the business. This is especially true if one partner’s action increases the financial liability of the other partners and may put their personal assets in jeopardy.This is one of the main reasons partnerships have written agreements; they set out what to do if a serious disagreement arises about the future of the partnership.Although we usually think of corporations as being very large, with multiple factories and hundreds or thousands of employees, that isn’t always the case. Even small businesses may select this form of ownership for a simple reason: liability. The owners of the business are not personally liable for the corporation’s debts.Owners may also be employees, and their employee benefits may be taken as a business deduction on the corporation’s tax return, thereby lowering its tax liability.The corporation exists under the law separate from its owners. (Remember the sole proprietorship? It was the same as its owner.) It can hold title to assets, make profits, and in many other ways operate like a person.Because the corporation has its own identity, it is responsible for actions taken in its name. The owners are not ordinarily held personally responsible (there are exceptions, and you might want to research the Enron scandal to read about one of them). The same thing is true for the corporation’s business debts—the owners don’t have to pay out of their own pockets; their liability is limited.Most importantly, the corporation can issue stock to raise money for capital expenditures (buying new land, buildings, and equipment). Members of the public buy this stock and, in turn, receive a small return periodically (a dividend). Although most stock is sold in large blocks through brokers, a few companies sell directly to individuals.The drawbacks to having a corporation are that they are heavily regulated by both the state and federal governments; also, setting them up and doing the ongoing paperwork can be time-consuming, detailed, and costly.Another disadvantage is that the corporation is taxed on its profits, and then the investors (the stockholders) are also taxed on what they receive from the corporation. In effect, the profits are taxed twice.A limited liability company (LLC) is a form of business ownership that has become increasingly popular (especially with small to medium-sized businesses) within the last 10 years. In fact, all 50 states now recognize LLCs as a legal form of business ownership. LLCs combine aspects of both a partnership and a corporation in that they operate and are taxed as a partnership or sole proprietorship but have limited liability for the owners. The profits and losses of the LLC pass through the owners’ personal income tax return, which means that LLCs allow their owners to avoid double taxation. The biggest advantage of forming an LLC is that the liability of the owners is limited to their investments. This means that owners cannot be held personally liable for the company’s debts. Another advantage of forming an LLC is that, unlike for a corporation, the profits are only taxed once. The IRS doesn’t assess taxes on the company itself. Although LLCs are more expensive to create than a partnership or a sole proprietorship, they are not as expensive to create as a corporation. By forming an LLC, business owners avoid much of the time-consuming, complex paperwork and hefty fees that are typically associated with corporations. One of the main disadvantages of forming an LLC is that it may be more difficult to raise capital. In addition, many states impose special taxes on LLCs. Because businesses grow and change, you as an owner need to re-evaluate the legal form of ownership from time to time. The law allows you to change how the business is organized as its needs change. You can start out as a sole proprietorship or a partnership and, later, if your business grows or the risk of personal liability increases, you can convert to a corporation.This periodic re-evaluation should be built into your long-range business plan.Student Resource 2.9Pros and Cons Chart: Forms of Business OwnershipStudent Name:_______________________________________________________ Date:___________Directions: Choose one type of legal form of business ownership to study. Using information from the presentation and from your notes, list four pros and four cons of this type of ownership.The form of business ownership that I would like to evaluate is: _____________________________ProsCons1.2.3.4.1.2.3.4.Directions:After completing your pros and cons chart, write a reflective piece that illustrates the pros and cons of one form of business ownership. Use the following frame to help organize your writing.There are many different forms of business ownership. The most common forms include sole proprietorship, partnership, corporation, and limited liability company. As an individual who may someday own my own business, I have decided to evaluate (insert form of business ownership).This form of business ownership is…Some examples of businesses that operate under this form of ownership could include…The advantages of this type of ownership include…It also…Some of the disadvantages of this type of ownership are…In addition to…In conclusion…Make sure your assignment meets or exceeds the following assessment criteria:The reflection begins with an introductory statement that clearly and correctly describes the form of business ownership you have chosen to investigate.It provides examples of relevant businesses that most likely operate under this type of ownership.It includes at least two well-explained and accurate advantages of that particular type of business ownership.It includes at least two well-explained and accurate disadvantages of that particular type of business ownership.The work is neat and legible, and uses proper spelling and grammar. ................
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