Part 2 – Lesson 1

Overview


Part 1 of this investment guide provided an introduction to financial accounting, and in Part 2, we will cover present value, valuation methods, and the basics of financial modeling.  Before moving on to these topics, we will review how businesses in the US are organized.

 

Legal Structures


Sole Proprietorships – Sole proprietorships are businesses that are owned and operated by a single individual.  Depending on the state where the sole proprietor lives, the business may not even have to register with the State or draft any legal documentation.  Additionally, sole proprietorships take on unlimited liability for the debts associated with the business.  The owner of the sole proprietorship pays the taxes of the business through his or her personal tax return.

Partnerships – Partnerships are divided into general partnerships and limited partnerships.  General partnerships consist of one or more general partners that share in the profits and loss of the business and share in the decision making of the organization.  In a limited partnership, there are one more general partners who manage the decision making of the partnership and one or more limited partners, who typically provide capital to the organization but do not participate in the operations of the business.

Limited partners, in addition to having limited involvement, also enjoy limited liability.  In other words, limited partners are only on the hook for the amount of money they have invested into the partnership, so they can’t lose more than their original investment.  Limited partnerships are commonly used in law firms, accounting firms, and investment funds to name a few.

In a partnership, each partner pays their individual share of taxes based on their ownership share of profits that the partnership generates.  The partnership will file its own tax return and distribute K-1s to each of its individual partners.  This K-1 will outline how much profit each partner earned as a result of their ownership in the partnership.  The individual partners will then provide this K-1 document to their tax accountant for inclusion in his or her personal return.

Limited Liability Company (LLC) – LLCs are a form of organization where the individual owners (“members”) enjoy limited liability and taxes are also passed through to the individual members.  Sole proprietorships, partnerships, and LLCs are all considered “pass through” entities since the entity does not pay taxes, but the individual owners pay taxes based on their share of the income of the business.

If an LLC has more than one member, it will file a tax return for the entity and then distribute K-1s to each of the individual members, very much like a partnership.  The primary difference between an LLC and a partnership is that all LLC members enjoy limited liability, whereas only limited partners in a partnership enjoy limited liability.

Due to the ease of formation and limited liability, LLCs are used extensively in real estate and small businesses.

Corporations – Corporations are a legal organization used commonly amongst large companies in the United States.  Like LLCs, corporations also provide limited liability to its owners.

One of the primary differences of corporations vs. other organizations is in the management.  Corporations have a board of directors, elected by the shareholders, who make the major decisions of the company, including the hiring of the management team (CEO, CFO, COO, etc).  Since many corporations sell equity to many thousands of shareholders, it is important for these shareholders to have a vote in electing a board of directors to represent their interest.

Another difference (and advantage) of a corporate structure is the manner in which the company has to account for its owners.  With an LLC, the company must track the capital accounts for each of its individual owners, which means that the LLC needs to track the size of each owner’s investment, their share of net income, and distributions received by the investor.  The LLC must then provide a K-1 to each individual owner detailing this information.  Additionally, interests in an LLC are illiquid.  If an LLC owner wants to sell their membership interest, they must find a buyer and then enter into an LLC membership purchase agreement.

A corporation does not track capital accounts for each individual owner in this manner.  Since large corporations can have thousands and sometimes millions of shareholders, it is difficult to maintain capital accounts for each individual owner.  Instead, a corporation issues a set number of shares to the public, which allows for investors to buy and sell these shares continuously on a stock exchange.

Similar to LLCs and partnerships, a corporation will file its own tax return, but a corporation will not distribute K-1s to its investors.  Instead, the corporation will pay any taxes due at the entity level (which is why K-1 distribution to its owners is not necessary).  The shareholders of the corporation only end up paying taxes when they receive dividends.

This leads us to the primary disadvantage of corporations, referred to as “double taxation.”  The corporation must pay its own entity level tax, and the shareholders must pay taxes again when they receive distributions.

Despite the double taxation disadvantage, many large organizations are formed as corporations due to the advantages in governance and ability for shareholders to freely trade shares of the corporation.

 

Management of a Corporation


When an LLC or partnership is formed, the management of the organization is decided by the members/partners, and management can be changed typically through the action or vote of the members/partners.

The management of a corporation is typically decided by the board of directors.  Since many corporations have thousands of investors, it is often most efficient for these shareholders to elect a board of directors, who essentially act as their representatives in the governance of the corporation.  The board of directors is then charged with appointing a chief executive officer (CEO), chief financial officer (CFO), chief operating officer (COO), etc.

The executive team appointed by the board of directors is referred to as the management team of the company.  Every company’s management team has a “fiduciary responsibility” to act in the best interest of the shareholders that they represent.

Since many public companies consists of shareholder bases with thousands of small investors who likely have little ability to influence the strategic direction of the company, the governance procedure of a corporation is an important factor in making investment decisions.  Most investors, who will not have an active role in the company, want to invest in corporations that have a board of directors that truly represent the shareholders and a management team that is highly competent and working toward increasing shareholder value.

All too often, investors may run into situations where management teams are complacent, are collecting excessive pay packages for sub-par performance, or are more interested in empire-building rather than shareholder value.  This is why we often see superior valuation multiples awarded to management teams with strong CEOs who have great track records.

For example, companies like Netflix (led by CEO, Reed Hastings), Facebook (led by CEO, Mark Zuckerburg), and Amazon (led by CEO, Jeff Bezos) are all examples of corporations that are awarded premium valuation multiples by investors due to the confidence that investors have in these CEOs.