After reading this chapter, you should be able to answer these questions:
- What are the advantages and disadvantages of the sole proprietorship form of business organization?
- What are the advantages of operating as a partnership, and what downside risks should partners consider?
- How does the corporate structure provide advantages and disadvantages to a company?
- What other options for business organization does a company have in addition to sole proprietorships, partnerships, and corporations?
- What makes franchising an appropriate form or organization for some types of business, and why does it continue to grow in importance?
- Why are mergers and acquisitions important to a company’s overall growth?
- What current trends will affect the business organizations of the future?
This chapter discusses sole proprietorships, as well as several other forms of business ownership, including partnerships and corporations, and compares the advantages and disadvantages of each.
With a good idea and some cash in hand, you decide to start a business. But before you get going, you need to ask yourself some questions that will help you decide what form of business organization will best suit your needs. Would you prefer to go it alone as a sole proprietorship, or do you want others to share your burdens and challenges in a partnership? Or would the limited liability protection of a corporation make more sense?
There are other questions you need to consider too: Will you need financing? How easy will it be to obtain? Will you attract employees? How will the business be taxed, and who will be liable for the company’s debts? If you choose to share ownership with others, how much operating control would they want, and what costs would be associated with that?
Most start-up businesses select one of these major ownership forms. In the following pages, we will discover the advantages and disadvantages of each form of business ownership and the factors that may make it necessary to change from one form of organization to another as the needs of the business change. As a company expands from small to midsize or larger, the form of business structure selected in the beginning may no longer be appropriate.
4.1 Going It Alone: Sole Proprietorships
What are the advantages and disadvantages of the sole proprietorship form of business organization?
Jeremy Shepherd was working full-time for an airline when, at the age of 22, he wandered into an exotic pearl market in China, searching for a gift for his girlfriend. The strand of pearls he handpicked by instinct was later valued by a jeweler back in the States at 20 times what he paid. Jeremy cashed his next paycheck and hurried back to Asia, buying every pearl he could afford. Founded in 1996, his company Pearl Paradise was brought online in 2000. Shepherd chose the sole proprietorship form of business organization—a business that is established, owned, operated, and often financed by one person—because it was the easiest to set up. He did not want partners, and low liability exposure made incorporating unnecessary.
Fluent in Mandarin Chinese, Japanese, and Spanish and immersed in Asian culture, Shepherd believed the internet was the way to market his pearls (http://www.pearlparadise.com). Offering a wide range of pearl jewelry through 14 websites worldwide, his company sells as many as 1,000 items per day. The recent addition of an exclusive Los Angeles showroom allows celebrity customers to shop by appointment. With $20 million in sales annually, PearlParadise.com is the industry leader in terms of sales and volume.1
Advantages of Sole Proprietorships
Sole proprietorships have several advantages that make them popular:
- Easy and inexpensive to form. As Jeremy Shepherd discovered, sole proprietorships have few legal requirements (local licenses and permits) and are not expensive to form, making them the business organization of choice for many small companies and start-ups.
- Profits all go to the owner. The owner of a sole proprietorship obtains the start-up funds and gets all the profits earned by the business. The more efficiently the firm operates, the higher the company’s profitability.
- Direct control of the business. All business decisions are made by the sole proprietorship owner without having to consult anyone else.
- Freedom from government regulation. Sole proprietorships have more freedom than other forms of business with respect to government controls.
- Taxed once. Sole proprietorships do not pay special franchise or corporate taxes. Profits are taxed as personal income as reported on the owner’s individual tax return.
- Ease of dissolution. With no co-owners or partners, the sole proprietor can sell the business or close the doors at any time, making this form of business organization an ideal way to test a new business idea.
Disadvantages of Sole Proprietorships
Along with the freedom to operate the business as they wish, sole proprietors face several disadvantages:
- Unlimited liability. From a legal standpoint, the sole proprietor and the company are one and the same, making the business owner personally responsible for all debts the company incurs, even if they exceed the company’s value. The owner may need to sell other personal property—their car, home, or other investments—to satisfy claims against the business.
- Difficulty raising capital. Business assets are unprotected against claims of personal creditors, so business lenders view sole proprietorships as high risk due to the owner’s unlimited liability. Owners must often use personal funds—borrowing on credit cards, second-mortgaging their homes, or selling investments—to finance their business. Expansion plans can also be affected by an inability to raise additional funding.
- Limited managerial expertise. The success of a sole proprietorship rests solely with the skills and talents of the owner, who must wear many different hats and make all decisions. Owners are often not equally skilled in all areas of running a business. A graphic designer may be a wonderful artist but not know bookkeeping, how to manage production, or how to market their work.
- Trouble finding qualified employees. Sole proprietors often cannot offer the same pay, fringe benefits, and advancement as larger companies, making them less attractive to employees seeking the most favourable employment opportunities.
- Personal time commitment. Running a sole proprietorship business requires personal sacrifices and a huge time commitment, often dominating the owner’s life with 12-hour workdays and 7-day workweeks.
- Unstable business life. The life span of a sole proprietorship can be uncertain. The owner may lose interest, experience ill health, retire, or die. The business will cease to exist unless the owner makes provisions for it to continue operating or puts it up for sale.
- Losses are the owner’s responsibility. The sole proprietor is responsible for all losses, although tax laws allow these to be deducted from other personal income.
The sole proprietorship may be a suitable choice for a one-person start-up operation with no employees and little risk of liability exposure. For many sole proprietors, however, this is a temporary choice, and as the business grows, the owner may be unable to operate with limited financial and managerial resources. At this point, the owner may decide to take in one or more partners to ensure that the business continues to flourish.
4.2 Partnerships: Sharing the Load
What are the advantages of operating as a partnership, and what downside risks should partners consider?
Can partnerships, an association of two or more individuals who agree to operate a business together for profit, be hazardous to a business’s health? Let’s assume partners Ron and Liz own a stylish and successful beauty salon. After a few years of operating the business, they find they have contrasting visions for their company. Liz is happy with the status quo, while Ron wants to expand the business by bringing in investors and opening salons in other locations.
How do they resolve this impasse? By asking themselves some tough questions. Whose view of the future is more realistic? Does the business actually have the expansion potential Ron believes it does? Where will he find investors to make his dream of multiple locations a reality? Is he willing to dissolve the partnership and start over again on his own? And who would have the right to their clients?
Ron realizes that expanding the business in line with his vision would require a large financial risk and that his partnership with Liz offers many advantages he would miss in a sole proprietorship form of business organization. After much consideration, he decides to leave things as they are.
For those individuals who do not like to “go it alone,” a partnership is relatively simple to set up. Offering a shared form of business ownership, it is a popular choice for professional-service firms such as lawyers, accountants, architects, stockbrokers, and real estate companies.
The parties agree, either orally or in writing, to share in the profits and losses of a joint enterprise. A written partnership agreement, spelling out the terms and conditions of the partnership, is recommended to prevent later conflicts between the partners. Such agreements typically include the name of the partnership, its purpose, and the contributions of each partner (financial, asset, skill/talent). It also outlines the responsibilities and duties of each partner and their compensation structure (salary, profit sharing, etc.). It should contain provisions for the addition of new partners, the sale of partnership interests, and procedures for resolving conflicts, dissolving the business, and distributing the assets.
Types of Partnerships
There are two basic types of partnerships: general and limited. In a general partnership, all partners share in the management and profits. They co-own the assets, and each can act on behalf of the firm. Each partner also has unlimited liability for all the business obligations of the firm. A limited partnership has two types of partners: one or more general partners, who have unlimited liability, and one or more limited partners, whose liability is limited to the amount of their investment. In return for limited liability, limited partners agree not to take part in the day-to-day management of the firm. They help to finance the business, but the general partners maintain operational control.
Partnership video: https://youtu.be/7zRGxjZW8QU
Advantages of Partnerships
Some advantages of partnerships come quickly to mind:
- Ease of formation. Like sole proprietorships, partnerships are easy to form. The partners agree to do business together and draw up a partnership agreement. For most partnerships, applicable provincial laws are not complex.
- Availability of capital. Because two or more people contribute financial resources, partnerships can raise funds more easily for operating expenses and business expansion. The partners’ combined financial strength also increases the firm’s ability to raise funds from outside sources.
- Diversity of skills and expertise. Partners share the responsibilities of managing and operating the business. Combining partner skills to set goals, manage the overall direction of the firm, and solve problems increases the chances for the partnership’s success. To find the right partner, you must examine your own strengths and weaknesses and know what you need from a partner. Ideal partnerships bring together people with complementary backgrounds rather than those with similar experience, skills, and talents. In Table 4.1 you’ll find some advice on choosing a partner.
- Flexibility. General partners are actively involved in managing their firm and can respond quickly to changes in the business environment.
- No special taxes. Each partner’s profit or loss is then reported on the partner’s personal income tax return, with any profits taxed at personal income tax rates.
- Relative freedom from government control. Except for provincial rules for licensing and permits, the government has little control over partnership activities.
Disadvantages of Partnerships
Business owners must consider the following disadvantages of setting up their company as a partnership:
- Unlimited liability. All general partners have unlimited liability for the debts of the business. In fact, any one partner can be held personally liable for all partnership debts and legal judgments (such as malpractice)—regardless of who caused them. As with sole proprietorships, business failure can lead to a loss of the general partners’ personal assets.
- Potential for conflicts between partners. Partners may have different ideas about how to run their business, which employees to hire, how to allocate responsibilities, and when to expand. Differences in personalities and work styles can cause clashes or breakdowns in communication, sometimes requiring outside intervention to save the business.
- Complexity of profit sharing. Dividing the profits is relatively easy if all partners contribute equal amounts of time, expertise, and capital. But if one partner puts in more money and others more time, it might be more difficult to arrive at a fair profit-sharing formula.
- Difficulty exiting or dissolving a partnership. As a rule, partnerships are easier to form than to leave. When one partner wants to leave, the value of their share must be calculated. To whom will that share be sold, and will that person be acceptable to the other partners? If a partner who owns more than 50 percent of the entity withdraws, dies, or becomes disabled, the partnership must reorganize or end. To avoid these problems, most partnership agreements include specific guidelines for transferring partnership interests and buy–sell agreements that make provision for surviving partners to buy a deceased partner’s interest. Partners can also purchase special life insurance policies designed to fund such a purchase.
Business partnerships are often compared to marriages. As with a marriage, choosing the right partner is critical. So if you are considering forming a partnership, allow plenty of time to evaluate your and your potential partner’s goals, personality, expertise, and working style before joining forces.
4.3 Corporations: Limiting Your Liability
How does the corporate structure provide advantages and disadvantages to a company?
When people think of corporations, they typically think of major, well-known companies, such as Apple, Alphabet (parent company of Google), Netflix, IBM, Microsoft, Boeing, and General Electric. But corporations range in size from large multinationals with thousands of employees and billions of dollars in sales to midsize or even smaller firms with few employees and revenues under $25,000.
A corporation is a legal entity subject to the laws of the province in which it is formed, where the right to operate as a business is issued by provincial charter. A corporation can own property, enter into contracts, sue and be sued, and engage in business operations under the terms of its charter. Unlike sole proprietorships and partnerships, corporations are taxable entities with a life separate from their owners, who are not personally liable for its debts.
When launching her company, Executive Property Management Services Inc., 32-year-old Linda Ravden realized she needed the liability protection of the corporate form of business organization. Her company specialized in providing customized property management services to mid- and upper-level corporate executives on extended work assignments abroad, often for three to five years or longer. Taking care of substantial properties in the million-dollar range and above was no small responsibility for Ravden’s company. Therefore, the protection of a corporate business structure, along with carefully detailed contracts outlining the company’s obligations, were crucial in providing Ravden with the liability protection she needed—and the peace of mind to focus on running her business without constant worry.
Sole Proprietorship vs Incorporation video: https://youtu.be/b6d_WUoT5Qc
The Incorporation Process
Setting up a corporation is more complex than starting a sole proprietorship or partnership. Registration procedures, fees, taxes, and laws that regulate corporations vary from province to province.
A firm does not have to incorporate in the province where it is based and may benefit by comparing the rules of several provinces before choosing a province of incorporation. Incorporating a company involves five main steps:
- Selecting the company’s name
- Writing the articles of incorporation (see Table 4.2) and filing them with the appropriate provincial office
- Paying required fees and taxes
- Holding an organizational meeting
- Adopting bylaws, electing directors, and passing the first operating resolutions
The province issues a corporate charter based on information in the articles of incorporation. Once the corporation has its charter, it holds an organizational meeting to adopt bylaws, elect directors, and pass initial operating resolutions. Bylaws provide legal and managerial guidelines for operating the firm.
The Corporate Structure
As Exhibit 4.2 shows, corporations have their own organizational structure with three important components: stockholders, directors, and officers.
Stockholders (or shareholders) are the owners of a corporation, holding shares of stock that provide them with certain rights. They may receive a portion of the corporation’s profits in the form of dividends, and they can sell or transfer their ownership in the corporation (represented by their shares of stock) at any time.
Stockholders can attend annual meetings, elect the board of directors, and vote on matters that affect the corporation in accordance with its charter and bylaws. Each share of stock generally carries one vote.
The stockholders elect a board of directors to govern and handle the overall management of the corporation. The directors set major corporate goals and policies, hire corporate officers, and oversee the firm’s operations and finances. Small firms may have as few as 3 directors, whereas large corporations usually have 10 to 15.
Corporate structure video: https://youtu.be/wtMORWO5h9Y
The boards of large corporations typically include both corporate executives and outside directors (not employed by the organization) chosen for their professional and personal expertise. Outside directors often bring a fresh view to the corporation’s activities because they are independent of the firm.
Hired by the board, the officers of a corporation are its top management and include the president and chief executive officer (CEO), vice presidents, treasurer, and secretary, who are responsible for achieving corporate goals and policies. Officers may also be board members and stockholders.
Advantages of Corporations
The corporate structure allows companies to merge financial and human resources into enterprises with great potential for growth and profits:
- Limited liability. A key advantage of corporations is that they are separate legal entities that exist apart from their owners. Owners’ (stockholders’) liability for the obligations of the firm is limited to the amount of the stock they own. If the corporation goes bankrupt, creditors can look only to the assets of the corporation for payment.
- Ease of transferring ownership. Stockholders of public corporations can sell their shares at any time without affecting the status of the corporation.
- Unlimited life. The life of a corporation is unlimited. Although corporate charters specify a life term, they also include rules for renewal. Because the corporation is an entity separate from its owners, the death or withdrawal of an owner does not affect its existence, unlike a sole proprietorship or partnership.
- Tax deductions. Corporations are allowed certain tax deductions, which reduces their taxable income.
- Ability to attract financing. Corporations can raise money by selling new shares of stock. Dividing ownership into smaller units makes it affordable to more investors, who can purchase one or several thousand shares. The large size and stability of corporations also helps them get bank financing. All these financial resources allow corporations to invest in facilities and human resources and expand beyond the scope of sole proprietorships or partnerships. It would be impossible for a sole proprietorship or partnership to make automobiles, provide nationwide telecommunications, or build oil or chemical refineries.
Disadvantages of Corporations
Although corporations offer companies many benefits, they have some disadvantages:
- Double taxation of profits. Corporations must pay federal and provincial income taxes on their profits. In addition, any profits (dividends) paid to stockholders are taxed as personal income, although at a somewhat reduced rate.
- Cost and complexity of formation. As outlined earlier, forming a corporation involves several steps, and costs can run into thousands of dollars, including provincial filing, registration, and license fees, as well as the cost of attorneys and accountants.
- More government restrictions. Unlike sole proprietorships and partnerships, corporations are subject to many regulations and reporting requirements.
The Canadian Comparison
“Incorporation: Tax savings, but more paperwork”, a 2017 article in The Globe and Mail, puts incorporation in to the Canadian perspective:
- In Ontario, an incorporated business pays a tax rate of 15 per cent on the first $500,000 of income each year, thanks to the small business tax deduction, and 26.5 per cent for anything beyond that. Rates vary by province. A lower tax rate is one of the key advantages to incorporating a business. However, accountants make the distinction that the taxes aren’t being saved, but instead deferred. That’s because, when the money is taken out of the corporation for personal use, through salary or dividends, the individual winds up paying approximately the same tax rate as if they were a sole proprietor. It’s known as the “theory of integration” in the Canadian tax system.
- Most accountants recommend business owners incorporate if they can afford to leave money in the company longer-term with the goal of watching the value of the assets grow.
- Another tax advantage comes when it’s time to sell the business. The shares of most Canadian private corporations are eligible for a lifetime capital-gains exemption. In 2016, that exemption amounts to the first $824,176 of capital gains from personal income tax, per shareholder. If the business were a sole proprietorship, any gain from the sale of a private corporation would be taxed.
- Another advantage to incorporating is the opportunity to use income splitting among family members. If one spouse makes more money, you can income-split. Over all, both spouses will be in a lower income-tax bracket.
4.4 Specialized Forms of Business Organization
What other options for business organization does a company have in addition to role proprietorships, partnerships, and corporations?
In addition to the three main forms, several specialized types of business organization also play an important role in our economy. We will look at cooperatives in this section and take a detailed look at franchising in the following section.
A cooperative is a legal entity with several corporate features, such as limited liability, an unlimited life span, an elected board of directors, and an administrative staff. Member-owners pay annual fees to the cooperative and share in the profits, which are distributed to members in proportion to their contributions. Because they do not retain any profits, cooperatives are not subject to taxes.
Cooperatives video: https://youtu.be/acxwC4Qfrcs
There are currently 2.6 million cooperatives with one billion members employing more than 12.5 million employees in more than 145 countries worldwide.4 Cooperatives operate in every industry, including agriculture, childcare, energy, financial services, food retailing and distribution, health care, insurance, housing, purchasing and shared services, and telecommunications, among others. They range in size from large enterprises such as Fortune 500 companies to small local storefronts and fall into four distinct categories: consumer, producer, worker, and purchasing/shared services.
Cooperatives are autonomous businesses owned and democratically controlled by their members—the people who buy their goods or use their services—not by investors. Unlike investor-owned businesses, cooperatives are organized solely to meet the needs of the member-owners, not to accumulate capital for investors. As democratically controlled businesses, many cooperatives practice the principle of “one member, one vote,” providing members with equal control over the cooperative.
Cooperatives are fairly common in the agricultural community. Co-ops also exist outside agriculture. For example, MEC (Mountain Equipment Co-op), which sells quality outdoor gear, has more than 5 million members across the country, who have each paid $5 for their lifetime memberships. The company shares its financial success with its members and also gives back 1% of its sales to maintain participation in the outdoors.
In a joint venture, two or more companies form an alliance to pursue a specific project, usually for a specified time period. There are many reasons for joint ventures. The project may be too large for one company to handle on its own, and joint ventures also afford companies access to new markets, products, or technologies. Both large and small companies can benefit from joint ventures.
In 2005, South Korea’s Hyundai Motor Company announced it signed a $1.24 billion deal to form a joint venture with China’s Guangzhou Automobile Group. The arrangement gave the South Korean automaker access to the commercial vehicle market in China, where its passenger cars are already the top selling foreign brand. Each side will hold equal stakes in the new entity, named Guangzhou Hyundai Motor Company. The new plant began production in 2007 with an annual capacity of 200,000 units producing small to large trucks and buses as well as commercial vehicles. According to Reuters, Hyundai made plans to build a fifth factory in China. With five factories in operation, Hyundai’s annual Chinese production capacity will be 1.65 million vehicles.3
4.5 Franchising: A Popular Trend
What makes franchising an appropriate form of organization for some types of business, and why does it continue to grow in importance?
Franchising is a form of business organization that involves a franchisor, the company supplying the product or service concept, and the franchisee, the individual or company selling the goods or services in a certain geographic area. The franchisee buys a package that includes a proven product or service, proven operating methods, and training in managing the business. Offering a way to own a business without starting it from scratch and to expand operations quickly into new geographic areas with limited capital investment, franchising is one of the fastest growing segments of the economy. If you are interested in franchising, food companies represent the largest number of franchises.
A franchisor (the company that sells the franchise) grants the franchisee (the buyer—you) the right to use a brand name and to sell its goods or services. Franchises market products in a variety of industries, including food, retail, hotels, travel, real estate, business services, cleaning services, and even weight-loss centers and wedding services. Table 4.4 lists the top ten franchises according to Entrepreneur magazine for 2018. Franchises apply to be on the list and are then assessed using Entrepreneur’s five pillars.
A franchise agreement is a contract that allows the franchisee to use the franchisor’s business name, trademark, and logo. The agreement also outlines rules for running the franchise, services provided by the franchisor, and financial terms. The franchisee agrees to follow the franchisor’s operating rules by keeping inventory at certain levels, buying a standard equipment package, keeping up sales and service levels, taking part in franchisor promotions, and maintaining a relationship with the franchisor. In return, the franchisor provides the use of a proven company name and symbols, help in finding a site, building plans, guidance and training, management assistance, managerial and accounting systems and procedures, employee training, wholesale prices for supplies, and financial assistance.
Franchising video: https://youtu.be/EmjA6O2HIus
In Canada, 1 out of every 14 workers is directly or indirectly employed by the franchise industry and there are an estimated 1,300 franchise brands operating in Canada. Individual investments vary widely – from $10,000 to millions. KFC franchises, for example, require a total investment of $1.3 million to $2.5 million each. This fee includes the cost of the property, equipment, training, start-up costs, and the franchise fee—a one-time charge for the right to operate as a KFC outlet. McDonald’s is in the same price range ($1 million to $2.3 million). SUBWAY sandwich shops offer a more affordable alternative, with expected total investment ranging from $116,000 to $263,000.
Advantages of Franchises
Like other forms of business organization, franchising offers some distinct advantages:
- Increased ability for franchisor to expand. Because franchisees finance their own units, franchisors can grow without making a major investment.
- Recognized name, product, and operating concept. Consumers know they can depend on products from franchises such as Pizza Hut, Hertz, and Holiday Inn. As a result, the franchisee’s risk is reduced and the opportunity for success increased. The franchisee gets a widely known and accepted business with a proven track record, as well as operating procedures, standard goods and services, and national advertising.
- Management training and assistance. The franchisor provides a structured training program that gives the new franchisee a crash course in how to start and operate their business. Ongoing training programs for managers and employees are another plus. In addition, franchisees have a peer group for support and sharing ideas.
- Financial assistance. Being linked to a nationally known company can help a franchisee obtain funds from a lender. Also, the franchisor typically gives the franchisee advice on financial management, referrals to lenders, and help in preparing loan applications. Many franchisors also offer short-term credit for buying supplies, payment plans, and loans to purchase real estate and equipment. Although franchisors give up a share of profits to their franchisees, they receive ongoing revenues in the form of royalty payments.
Disadvantages of Franchises
Franchising also has some disadvantages:
- Loss of control. The franchisor has to give up some control over operations and has less control over its franchisees than over company employees.
- Cost of franchising. Franchising can be a costly form of business. Costs will vary depending on the type of business and may include expensive facilities and equipment. The franchisee also pays fees and/or royalties, which are usually tied to a percentage of sales. Fees for national and local advertising and management advice may add to a franchisee’s ongoing costs.
- Restricted operating freedom. The franchisee agrees to conform to the franchisor’s operating rules and facilities design, as well as inventory and supply standards. Some franchises require franchisees to purchase from only the franchisor or approved suppliers. The franchisor may also restrict the franchisee’s territory or site, which could limit growth. Failure to conform to franchisor policies could mean the loss of the franchise.
Many of today’s major franchise brands, such as McDonald’s and KFC, started in the 1950s. Through the 1960s and 1970s, many more types of businesses—clothing, convenience stores, business services, and many others—used franchising to distribute their goods and services. Growth comes from expansion of established franchises—for example, Subway, Pizza Hut, and Orangetheory Fitness—as well as new entrants such as those identified by Entrepreneur and Franchise Gator among other sources. According to Entrepreneur magazine, the top three new franchises in 2017 are (1) Mosquito Joe, (2) Blaze Fast-Fire’d Pizza, and (3) uBreakiFix, whereas according to Franchise Gator, the top three new franchises in 2017 are (1) Mosquito Joe, (2) Digital Doc, and (3) Nurse Next Door Home Healthcare Services. On both rankings, Mosquito Joe ranks at the top.
Mosquito Joe provides mosquito control treatment services for both residential and commercial clients.4
Changing demographics drive franchise industry growth, in terms of who, how, and what experiences the most rapid growth. The continuing growth and popularity of technology and personal computing is responsible for the rapidly multiplying of eBay drop-off stores, and tech consultants such as Geeks on Call are in greater demand than ever. Other growth franchise industries are the specialty coffee market, children’s enrichment and tutoring programs, senior care, weight control, and fitness franchises.
The Next Big Thing in Franchising
All around you, people are talking about the next big thing—Subway is the new miracle weight-loss solution, the workout at Orangetheory Fitness is the answer to America’s fitness needs—and you are ready to take the plunge and buy a trendy franchise. But consumers’ desires can change with the tide, so how do you plan an entrance—and exit—strategy when purchasing a franchise that’s a big hit today but could be old news by tomorrow? Table 4.5 outlines some tips on purchasing a franchise.
Like other forms of business, franchising is part of our global marketplace economy. As international demand for all types of goods and services grows, most franchise systems are already operating internationally or planning to expand overseas. Restaurants, hotels, business services, educational products, car rentals, and nonfood retail stores are popular international franchises.
Franchisors in foreign countries face many of the same problems as other firms doing business abroad. In addition to tracking markets and currency changes, franchisors must understand local culture, language differences, and the political environment. Franchisors in foreign countries also face the challenge of aligning their business operations with the goals of their franchisees, who may be located half a globe away.
Is Franchising in Your Future?
Are you ready to be a franchisee? Before taking the plunge, ask yourself some searching questions: Are you excited about a specific franchise concept? Are you willing to work hard and put in long hours? Do you have the necessary financial resources? Do you have prior business experience? Do your expectations and personal goals match the franchisor’s?
Qualities that rank high on franchisors’ lists are passion about the franchise concept, desire to be your own boss, willingness to make a substantial time commitment, assertiveness, optimism, patience, and integrity. Prior business experience is also a definite plus, and some franchisors prefer or require experience in their field.
So what can you do to prepare when considering the purchase of a franchise? When evaluating franchise opportunities, professional guidance can prevent expensive mistakes, so interview advisers to find those that are right for you. Selecting an attorney with franchise experience will hasten the review of your franchise agreement. Getting to know your banker will speed up the loan process if you plan to finance your purchase with a bank loan, so stop by and introduce yourself. The proper real estate is a critical component for a successful retail franchise, so establish a relationship with a commercial real estate broker to begin scouting locations. Doing your homework can spell the difference between success and failure, and some early preparation can help lay the groundwork for the successful launch of your franchised business.
If the franchise route to business ownership seems right for you, begin educating yourself on the franchise process by investigating various franchise opportunities. You should research a franchise company thoroughly before making any financial commitment.
Would-be franchisees should also check recent issues of small-business magazines such as Entrepreneur, Inc., Startups, and Success for industry trends, ideas on promising franchise opportunities, and advice on how to choose and run a franchise. The International Franchise Association website at http://www.franchise.org has links to Franchising World and other useful sites.
4.6 Mergers and Acquisitions
Why are mergers and acquisitions important to a company’s overall growth?
A merger occurs when two or more firms combine to form one new company. For example, in 2016, Johnson Controls, a leading provider of building efficiency solutions, agreed to merge with Ireland’s Tyco International, a leading provider of fire and security solutions, resulting in a company that will be a leader in products, technologies, and integrated solutions for the building and energy sectors. The merger is valued at $30 billion, with new Johnson Controls PLC to be based in Ireland. Currently, AT&T and Time Warner have an $85.4 billion merger pending. “Once we complete our acquisition of Time Warner Inc., we believe there is an opportunity to build an automated advertising platform that can do for premium video and TV advertising what the web search and social media companies have done for digital advertising,” AT&T’s CEO Randall Stephenson said in a prepared statement. Mergers such as this one, in a well-established industry, can produce winning results in terms of improved efficiency and cost savings.5
Difference between merger and acquisition video: https://youtu.be/g-v8SKvXPpc
An acquisition, on the other hand, occurs when a company purchases the assets of another business (such as stock, property, plants, equipment) and usually permits the acquired company to continue operating as it did prior to the acquisition. Acquisition usually refers to a purchase of a smaller firm by a larger one. Sometimes, however, a smaller firm will acquire management control of a larger and/or longer-established company and retain the name of the latter for the post-acquisition combined entity.
In an acquisition, a corporation or investor group finds a target company and negotiates with its board of directors to purchase it. In Verizon’s recent $4.5 billion acquisition of Yahoo, Verizon was the acquirer, and Yahoo the target company.6
Types of Mergers
The three main types of mergers are horizontal, vertical, and conglomerate. A horizontal merger occurs between companies in the same industry. This type of merger is essentially a consolidation of two or more businesses that operate in the same market space, often as competitors offering the same good or service. Horizontal mergers are common in industries with fewer firms, since competition tends to be higher, and the synergies and potential market-share gains are much greater in those industries. In a horizontal merger, companies at the same stage in the same industry merge to reduce costs, expand product offerings, or reduce competition. Many of the largest mergers are horizontal mergers to achieve economies of scale. Its $1.25 billion acquisition of trucking company Overnite allowed UPS, the world’s largest shipping carrier, to expand its heavy freight delivery business, thus expanding its product offerings.8
Facebook + Instagram = Horizontal Merger
When Facebook acquired Instagram in 2012 for a reported $1 billion, Facebook was looking to strengthen its position in the social-media and social-sharing space. Both Facebook and Instagram operated in the same industry and were in similar positions with regard to their photo-sharing services. Facebook clearly saw Instagram as an opportunity to grow its market share, increase its product line, reduce competition, and access new markets.
In a vertical merger, is characterized by the merger of two organizations that have a buyer-seller relationship or, more generally, two or more firms that are operating at different levels within an industry’s supply chain. Most often the logic behind the merger is to increase synergies by merging firms that would be more efficient operating as one. Buying a supplier of raw materials, a distribution company, or a customer service company gives the acquiring firm more control. A good example of this is Google’s acquisition of Urchin Software Corp., a San Diego based company that sells web analytics software and services that help companies track the effectiveness of their websites and online advertising. The move enables Google to bolster the software tools it provides to its advertisers.9
Types of mergers video: https://youtu.be/wlLdX0fs6hE
The Canadian Landscape
A conglomerate merger brings together companies in unrelated businesses to reduce risk. Combining companies whose products have different seasonal patterns or respond differently to business cycles can result in more stable sales. The Philip Morris Company, now called Altria Group, started out in the tobacco industry but diversified as early as the 1960s with the acquisition of Miller Brewing Company. It diversified into the food industry with its subsequent purchase of General Foods, Kraft Foods, and Nabisco, among others. Later spinning off many businesses, current product categories include cigarettes, smokeless tobacco such as Copenhagen and Skoal, cigars, e-vapor products such as MarkTen, and wines.
In June 2013, Shoppers Drug Mart, Canada’s biggest pharmacy chain merged with Loblaw, Canada’s largest grocery retailer, in a 12.4 billion dollar deal. Rather than cutting into each other’s market share, the deal allows the two companies to play on each other’s strengths. Shoppers has about $1 billion in food sales annually, versus Loblaw’s $30 billion. But Loblaw’s share of the pharmacy market is only five per cent, so adding Shoppers health products and services to Loblaw grocery stores allows the food retailer to expand its services in what it sees as a growing sector: health, wellness, and nutrition (www.cbc.ca). Contrast this merger with an acquisition in that same year. Sobey’s acquired 200 Safeway stores in Western Canada under a 5.8 billion dollar deal. According to news reports, along with 213 Safeway grocery stores — more than 60 percent of which are in Calgary, Vancouver, Edmonton and Winnipeg — Sobeys will also acquire:
- 199 in-store pharmacies;
- 62 gas stations;
- 10 liquor stores;
- primary distribution centres and a related wholesale business; and
- 12 manufacturing facilities.
Sobeys will also get $1.8 billion worth of real estate in the deal.
Motives Behind Mergers and Acquisitions
Although headlines tend to focus on mega-mergers, “merger mania” affects small companies too, and motives for mergers and acquisitions tend to be similar regardless of the company’s size. The goal is often strategic: to improve overall performance of the merged firms through cost savings, elimination of overlapping operations, improved purchasing power, increased market share, or reduced competition.
Company growth, broadening product lines, acquiring technology or management skills, and the ability to quickly acquire new markets are other motives for acquiring a company. Yahoo Inc.’s $1 billion cash purchase of a 40 percent stake in China’s biggest e-commerce firm, Alibaba.com, instantly strengthened its ties to the world’s second largest internet market.12
Purchasing a company can also offer a faster, less risky, less costly option than developing products or markets in-house or expanding internationally. Amazon’s 2017 purchase of Whole Foods Market, an upscale grocery chain, for $13.7 billion was a move to enter the retail grocery sector. In addition to the new product market, this move offers Amazon opportunity to sell Amazon tech products in the grocery stores as well as access to an entirely new set of data on consumers.13
Companies are motivated to merge or acquire other companies for a number of reasons, including the following:
- Gain Complementary Products
- Shoppers Drug Mart began to sell President’s Choice products in its merger with Loblaw.
- Loblaw is able to add Shoppers health care products to its shelves.
- Sobey’s gains Safeway’s gas stations and liquors stores in its acquisition.
- Attain New Markets or Distribution Channels
- Sobey’s acquired access to 12 manufacturing facilities, 4 distribution centres, and a related wholesale business.
- Loblaw increases access to urban centres where Shoppers are already located, bringing a wider variety of products to customers in densely populated areas.
- Realize Synergies
- Integration of the companies’ loyalty programs will provide the two with a vast knowledge base of consumers’ buying habits and provide economies of scale — which, the companies estimate, will translate into savings of about $300 million annually.
- Loblaw’s share of the pharmacy market is only five per cent. Adding Shoppers health products and services to its grocery stores will allow the food retailer to expand its services in what it sees as a growing sector: health, wellness, and nutrition.
4.7 Trends in Business Ownership
What current trends will affect the business organizations of the future?
As we learned earlier, an awareness of trends in the business environment is critical to business success. Many social, demographic, and economic factors affect how businesses organize. When reviewing options for starting or organizing a business or choosing a career path, consider the following trends.
“Baby Boomers” and “Millennials” Drive Franchise Trends
We all hear and read a great deal about the “graying of Canada,” which refers to the “baby boomer” generation heading toward retirement age. This unprecedented demographic phenomenon—in 2006 the first of the members of the baby boomer generation turned 60—is driving the ongoing battle to stay young, slim, and healthy. Every day, there are thousands of boomers turning 65, and the trend is likely to continue until 2030.
Boomers have transformed every life stage they’ve touched so far, and their demographic weight means that business opportunities are created wherever they go.
With their interest in staying fit, Boomers are contributing to the growth of fitness and weight-loss franchises. In just the past year, this category in Entrepreneur’s Franchise 500 has grown to over 50 franchisors.
Another area of boomer-driven franchise growth is eldercare. Founded in 1994, Home Instead Senior Care is recognized as one of the world’s fastest growing franchise companies in the eldercare market, with a network of over 1,000 independently owned and operated franchises in 12 countries. And as the world’s population continues to age, the need for its unique services will continue to increase.
Home Instead Senior Care provides a meaningful solution for the elderly who prefer to remain at home. Compared with the annual cost for a nursing home placement ($72,000–$92,000), home care, at around $45,000–$60,000 a year, is somewhat more affordable. Elder quality of life is enhanced by Home Instead Senior Care’s part-time, full-time, and around-the-clock services, designed for people who are capable of managing their physical needs but require some assistance and supervision. Home Instead Senior Care provides meal preparation, companionship, light housekeeping, medication reminders, incidental transportation, and errands. These services make it possible for the elderly to remain in the familiar comfort of their own homes for a longer period of time.17
But the best deal yet may be adult day services, one of the fastest-growing franchises and “still one of the best-kept secrets around” according to Entrepreneur magazine. Based on the concept of day care services for children, Sarah Adult Day Services Inc. offers a franchising opportunity that meets the two criteria for a successful and socially responsible business: a booming demographic market with great potential for growth, and excellent elder care. Programs such as SarahCare are highly affordable for its clients, costing around $17,900 a year. The SarahCare franchise allows entrepreneurs to become part of an expanding industry while restoring a sense of dignity and vibrancy to the lives of older adults.18
Millennials—individuals born between 1980 and 2000—are the largest living generation in the United States, according to Pew Research. Millennials spend more money in restaurants per capita than any previous generation. They have been recognized as changing the restaurant scene by looking for brands that offer customized food choices, quality ingredients, freshness, authenticity, transparency, and environmental and social responsibility. According to Forbes magazine, 72 percent of millennials would like to be their own boss, 74 percent want flexible work schedules, and 88 percent want “work–life integration.” When it comes to owning a franchise, growth potential and meeting a flexible, fulfilling lifestyle are both something that attracts Millennials. A survey by the CT Corporation found that 60 percent of college graduates wanted to start a business after graduation, 67 percent lacked the know-how, 45 percent didn’t think they could come up with a name, and 30 percent were not knowledgeable about how to market the business. Franchising is the perfect solution to these issues. For example, Chicago area native and millennial Sal Rehman grew up working in his family’s diner. Sal had a dream of operating his own restaurant, and he decided to take the franchising path. In 2015, at the age of 27, Sal opened his first Wing Zone store in suburban Glendale Heights, Illinois. He currently owns five Wing Zones.19
Boomers Rewrite the Rules of Retirement
At age 64, Bob Drucker could be the poster child for retirement except that the concept makes him recoil. Drucker is living his dream. He and his wife have a large house on Long Island where Drucker kicks back by floating in his pool when he’s not spoiling his granddaughters with trips to Disneyland.
“The only way you can get me out of here is to carry me out,” Drucker says, referring to RxUSA, the online pharmacy he founded and runs in Port Washington, New York. “I love my work, and I cannot imagine sitting home and doing nothing.”
Drucker is not alone. Today’s boomers are working longer at their jobs and embracing postretirement second careers, which often means starting their own small business.20As retirees opt to go into business for themselves, they are choosing different forms of business organizations depending on their needs and goals. Some may start small consulting businesses using the simple sole proprietorship form of business organization, while couples or friends might choose to become partners in a retail or franchise venture.
The more healthy and energetic the baby boomer generation remains, the more interested it is in staying active and engaged—and that may mean postponing retirement or not retiring at all. The annual retirement survey by Transamerica Center for Retirement Studies found that as this record number of Americans approaches retirement age, many are not slowing down. In fact, 51 percent of boomers plan to work in some capacity during their retirement years, and 82 percent indicated that they will not retire at or before age 65.21
Mergers and Foreign Investment Boom Too
There is a new merger wave. In 2016, North American companies announced deals totaling almost $2 trillion. Many of these deals were large ones, with the largest deal, announced in 2016, AT&T’s merger with Time Warner for over $85 billion. In addition, foreign merger activity has reached a new high. Worldwide deal volume in 2015 was 44,000 transactions totaling $4.5 trillion. In 2016, the number of transactions increased to over 48,000, one of the most active periods of merger activity to date. The increase is the result of improving economic growth and better stock prices.22 Whether these new mergers will be good for the global economy remains to be seen. Transactions that lead to cost savings, streamlined operations, and more funding for research and capital investment in new facilities will have positive effects on profitability. Many deals, however, may fail to live up to the acquirers’ expectations.
Summary of Learning Outcomes