Incentive Problems These Exist in Every Organization What Kind of Organization to Choose? Many Conflicts Exist 1

Business Entities Face Principal-Agent Issues How do the owners ensure that employees act in the owners’ interests? 2

Solve This Problem Ralph and Tom are interested in opening a restaurant together. Tom prepares a business plan: – $100,000 to start restaurant – Ralph to work full time as manager, salary of $35,000/year – Ralph to invest $10,000 and receive 20% ownership share – Tom will be part time accountant/book-keeper, no salary. After first year he can bill the business for time over 10 hours per month; will invest $10,000 and receive 20% ownership share – Mary, Tom’s sister, will invest $80,000; wants a 10% return but knows there are no guarantees. She does not wish to work in the day to day business. She does want some control of overall business decisions and a veto on major decisions but wants no exposure beyond her investment. She receives a 60% ownership share. – Ralph and Tom have the option to buy an additional 10% each at any time in first 4 years for $40,000. What are the issues in structuring this business that must be resolved in organizing a business entity? 3

Issues about Participants Do owners share common interests or are their interests different? Do owners also manage the business? Do owners have relationships outside of the business? 4

Issues about Management Who will manage the business? Who decides who will manage? What if managers disagree? What if owners disagree with managers? Are some owners active and some passive? 5

How much funding is needed? How will in-kind contributions be valued? Where will funding come from? How long before a profit appears? What if the business needs more money? Funding 6

Retained earnings Borrowing (debt) Equity Potential Sources of Financing 7

Finance Incentive Issue Fundamental finance principle: – A business proposal – a new investment, the acquisition of another company, or a restructuring plan - creates value only if the present value of the future stream of net cash benefits the proposal is expected to generate exceeds the initial cash outlay required to carry out the proposal. How do investors ensure managers only accept proposals that satisfy this principle? 8

How will profits and losses be shared? If the business fails, how will assets be divided? Dividing Gains & Losses 9

Limited Liability: Will the participants be personally liable to third parties for the debts of the business? Tax considerations: “Double taxation” vs. “Pass through taxation” Management / “Governance”: How will the business be governed? How will the attributes of ownership (rights to profits, assets, control) be divided? Legal Issues 10

How do the participants in the business expect to make money from the business? Will they receive salaries? Will they receive dividends? Will they sell their interest? What if an owner dies? Every Business Comes to an End: Exit Strategy 11