Corporations: Are They Needed?

Photo by Cheryl Empey from FreeImages

Whether it be Skynet or the Umbrella Corp, corporations today are Hollywood’s preferred go-to villain, a distinction previously reserved for rogue nations and diabolically evil madmen. Recall that it was Virtucon Industries, a multinational conglomerate corporation controlled by Number Two, that funded Dr. Evil’s efforts to take over the world. Q.E.D.

Why is it that the reputation of corporations has become so tarnished? Perhaps something to do with their relentless quest for profit?

What are corporations? Do we need them? Would the world be safer without them?

Even if there were no corporations, there would still be companies. While all corporations are companies, not all companies are corporations. Corporations are a special type of a company, exclusively owned by its shareholders. In comparison, a non-corporate company such as a sole proprietorship usually has a single owner, who is probably the person running the company.

Why not just non-corporate companies? They have yet to run amok in a blockbuster film.

A corporation is unique in that it is a separate legal entity, insulated from the shareholders, the management, and the employees. As a separate legal entity, a corporation can own property, control assets, open a bank account and incur debt. This legal separation implies that its shareholders, management, and employees, under normal circumstances, cannot be held personally liable for debts and liabilities incurred by the corporation.

This turns out to be a particularly desirable characteristic for startups.

To allow for the development of new technologies and products, a healthy economic system must promote entrepreneurism, encouraging investors to invest some of their wealth into risky startups. The reality is that most startups in a competitive environment will fail and can easily have outstanding debts at the time of failure. Given that this is the expected outcome, should the investors be penalized twice? Once for losing their invested wealth, twice if they were forced to forfeit some of their personal wealth. If such a double financial jeopardy were in place, who in their right mind would invest in a startup? Who in their right mind would be an entrepreneur?

Without entrepreneurs and investors, we would still be using typewriters. So to encourage entrepreneurism, the personal financial liability for the founders and the investors must be minimized, if not zero.

Which is one reason that it is desirable that corporations are separate legal entities, because as so, they are solely responsible for the debts they incur and any credit they owe. This implies that the personal financial assets of the founders and shareholders are legally protected.

This is referred to as the “corporate veil,” as in partially concealed. Not veal, that is bovine in nature.

But there is more!

Like individuals, companies usually must establish credit worthiness to borrow needed wealth.

It makes no sense to transfer wealth to a startup via a traditional bank loan. The risk is too high for banks, their method of collecting revenue via interest fees will not compensate for excessive loan defaults.

Which explains why startups, without collateral or a reputation, without the luxury of time required to establish a good “business credit score,” often must turn to the issuing of stock, i.e., relinquishing ownership of the company, to raise needed wealth.

It is this opportunity of ownership that presents the investor with a return commensurate with the high risk. Corporations, and their ability to issue stock for shared ownership, presents both the investor and the entrepreneur with an opportunity, an investment option for excess wealth for the first, and the opportunity to pursue a dream for the second.

This ability to raise wealth at the early stages of a company’s life cycle is a powerful benefit of stock and is perhaps the primary reason for the existence and proven success of corporations.

In addition, without the corporate veil, the risk would be much higher, resulting in the investors demanding a greater share of ownership at the expense of the entrepreneur’s share, upsetting the balance. The result would be far less startups, as most entrepreneurs are willing to invest their time only if the possible reward justifies their own personal sacrifice.

In summary, the corporate legal structure allows entrepreneurs to raise needed early-stage funding and provide investors with a high risk / high return investment option, understanding that most startups will fail. But some startups will succeed, so there needs to be a mechanism for the investors to “cash out” on their risky investment, to make up for all their other startup investments that failed.

Which brings us to dividends and buybacks, the two methods by which a successful, profitable corporation returns wealth to its shareholders, including the investors that assumed the early risk.

Without corporations, stock, and the corporate veil, there would be fewer startups. With fewer startups, there would be less innovation, less economic evolution, and less wealth created.

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Eric Johnson is a husband, father, engineer, pilot, surfer, investor and amateur astronomer who has read a lot of books on economics.