Handout 1 - Dans Doughnut Den PDF

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Course: Microeconomics (ECON15269G) “Dan’s Doughnut Dens” 1 Dan, an enterprising young man employed by a large multinational corporation, decided that he was tired of working for someone else and would go into business for himself. He found it quite simple to start up his own business – after obtaining a license from the municipal government; he rented an appropriate building and purchased equipment and supplies with $25000 of capital obtained from his own savings, a small inheritance, and some loans from his relatives. Before long, “Dan’s Doughnut Den” opened. The business was a sole proprietorship; that is, it was totally owned by Dan. At first, things went exceptionally well: enjoying his newfound freedom and independence, Dan worked harder than he ever had, and sales were good and the business seemed headed for success. As the business grew more complex, Dan was working very long hours, many of which were spent recruiting, training, and supervising staff, and dealing with his bank manager. Dan found financial matters a continual hassle – his bank manager was reluctant to provide as much credit as Dan felt he needed, and was always pestering Dan for financial information, which Dan was too busy to prepare carefully. Actually, keeping financial records for the business was a constant and time-consuming chore, and one at which Dan was not too skilled. Partly as a result of this problem, preparing his income tax return was a nightmare that tied up much of his time for about a month each year. Finally, he hired an accountant to sort it out, and was horrified to learn that he owed nearly $4000 in taxes, most of which he didn’t have – he had invested practically all of the earnings back into the business, including the opening of another Doughnut Den across town. The sales at the new location were good, too, but having two outlets put an even greater strain on Dan’s limited time and talents. For Dan, the crunch came when some of his suppliers and the Canada Revenue Agency (CRA) threatened to sue him for unpaid debts and taxes. Upon consulting his lawyer, Dan learned, to his dismay, that as the sole proprietor of a business he was subject to unlimited liability. That is, if the business went bankrupt, he could lose not only the assets of the business but also his personal assets, such as his house. Still, Dan thought, the business had a lot of promise, with strong sales at both locations. What was required, he concluded, was more than just hard work; he needed more management experience and more capital. So Dan decided to change the business from a sole proprietorship to a partnership. One of his new partners was Sally, an old high-school friend of Dan’s who had a diploma in Business Administration from Sheridan College. Due to the sudden accidental death of a relative, Sally was able to contribute $40 000 to the capital of the business. Perhaps more importantly, Sally brought a more systematic approach to the management of the business, which soon began to show up in the profit figures. These figures were calculated (much more 1

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Brian Lyons, “Canadian Microeconomics: Problems and Policies”, 10 Edition, 2011. Page 1 of 3

proficiently) by the other new partner, Ed, who also contributed $50 000 to the capital of the business. Ed kept the books, working on weekends and in the evening after working at his regular job in an accountant’s office. Unlike Dan and Sally, Ed took no active part in the management of the business and was therefore a limited partner: if the business went bankrupt, his liability was limited – all he could lose was the $50 000 he had invested. Dan and Sally, on the other hand, were general partners who had unlimited liability and could therefore lose their personal assets if the business went bankrupt. As is customary in partnerships, all of the partners took out life insurance policies on each other’s lives, so that if one died, the others would have sufficient cash from the insurance to buy the deceased partner’s share from his or her heirs. This practice ensured that the death of a partner would not force the business to dissolve. The three partners signed an agreement outlining their respective rights and responsibilities, and the proportions of the profits that each would receive. The infusion of new capital and managerial expertise improved the operation of the business considerably, and things went quite well for a while. However, after a period of time, disagreements began to develop among the partners. Dan continued to work almost as hard as before, and began to resent the share of the profits taken by the others who, he felt, weren’t working as hard as he was. He found this particularly hard to accept because he was the one who had undertaken the effort and risk necessary to start the business originally. Sally felt that, if anything, she was contributing more to the business than Dan, due to her superior business knowledge. Sally’s increasingly frequent reminders to Dan that her capital and know-how had saved the business only aggravated the situation (Sally’s grade in Human Relations at Sheridan had been a well-deserved low D, and she had fought with the teacher over it). Ed was annoyed by these attitudes on the part of his partners: while he didn’t work full-time at the business, his after-hours accounting tasks on their behalf made for many a long day for him. Furthermore, he knew that without the accounting data and analysis that he prepared, Sally couldn’t manage the business nearly as effective as she did. Also, he had contributed more money to the business than either of the other two (the $50 000). The disagreements came to a head when, after a heated exchange with Ed, Dan learned that Sally had signed certain long-term contracts on behalf of the business, which Dan believed to be unwise. Since Sally was a partner, there was no way Dan could cancel these contracts – he was bound by Sally’s decisions. Worse yet, as a partner, he was personally liable for the debts of the business. Dan was furious that unilateral decisions by someone else could possibly cause the bankruptcy of his business and the loss of his personal assets. The other two partners threatened to pull out of the partnership, which would almost certainly mean the end of the business. Dan went home that night wishing that there were some way that he could collect on the insurance on the lives of his partners. Finally, Dan decided that too much was enough; the partnership just couldn’t work over the long term. On the advice of his lawyer, Dan decided to change the form of the business into a corporation. As his lawyer explained to him, the corporation would be owned and controlled by shareholders, and would be a separate legal entity from the shareholders. This meant that if the corporation went bankrupt, the shareholders’ liability would be limited to their investment in the Page 2 of 3

corporation’s stock. Control of the corporation would lie with its board of directors, which would be selected by the shareholders, who would have one vote per share held. As the lawyer pointed out, Dan could control the board of directors, and thus the corporation, by owning (or controlling the votes of) 51 percent of the shares of the company. The corporation was set up so that Dan and his wife held 85 percent of the shares, with Dan owning 45 percent and the other 40 percent being registered in his wife’s name, in order to split their dividend income and reduce their total personal income taxes. A few family friends bought the other 15 percent of the shares. The friends were attracted not only by the prospects for the success of the business but also by the limited liability of shareholders and the tax treatment of the gains from their investments, since both dividend income from their shares and any capital gains realized from sales of their shares for a profit would be subject to favourable tax rates. In addition, as the lawyer pointed out, if the business were ever to expand, the corporate form of organization could prove advantageous for raising the necessary capital, because the corporation could sell shares to the public. The incorporation process was complex and quite costly, but it seemed like an excellent idea. The two partners were bought out, improved equipment was purchased, and the facilities were renovated. A qualified manager was hired, a website and online purchasing system was implemented, and a sophisticated sales promotion campaign was undertaken. Sales and profits rose, and there were bonuses for the managers and substantial dividends for the shareholders. Dan found that incorporation brought tax advantages to the business, too. When the business was first a sole proprietorship and then a partnership, its income (profit) was taxed as personal income, at personal income tax rates, which became quite high as the income of the owners rose. However, the profits of the corporation were taxed at corporate income tax rates, which were lower unless profits were quite low. (On the other hand, the shareholders were somewhat disappointed to find that they were subject to “double taxation” – not only were the profits of the corporation taxed, but the dividends they received out of after-tax profits were also taxed, although at reduced rates, as their personal income.) Bank credit became more available as the business prospered, with the opening of three more outlets. After talking to his investment advisor, Dan also considered selling an issue of shares to the public to raise capital to finance expansion into other provinces. While Dan found being president of a successful and rapidly growing corporation exciting (not to mention financially rewarding), he also found that, as president, he seemed to spend all of his time in his office, doing paperwork and meeting with managers, committees, and lawyers to talk about financing arrangements, short-, medium-, and long-range plans, reorganization plans, controls systems, and seemingly endless government regulations that had to be followed. At times, Dan longed for the days when he worked in the shop, where he had spent time talking with his customers, and when life was simple.

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