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Economics Notes

Limited Liability

Many well-known businesses these days have grown to become very large organisations, which require huge amounts of capital to operate. To raise this capital, they may have to ask a wide range of people and institutions to invest in them. Institutions might be banks, building societies, pension companies, insurance companies and venture capitalists. To persuade these people to invest what are often large sums of money into businesses, a legal form of business is used, called joint stock companies. Joint stock companies are businesses where individuals and institutions contribute a joint stock of capital to finance the firm. Joint stock companies can be in the form of private limited companies (Ltd) and public limited companies (PLC).

Joint stock companies exist because individuals are often prepared to contribute a small amount to help finance a firm. Together, the sums of capital raised by such organisations can be considerable. This helps businesses grow to sizes where they can gain a number of advantages, which can be of benefit to both the business and consumers. To encourage individuals to do this, legal conditions have to be in place to protect investors and the consumer. Copyright: Puiu Adriana Mirabela, from stock.xchng.

In the case of public limited companies, investors might be contributing millions of pounds into the company to help it carry out its activities. If we compare this to a sole trader, the picture is very different. A sole trader can set themselves up in business relatively easily. They need much less money to set up, and it often comes from either the individual's own savings or from relatively small bank loans.

The headquarters of oil group Royal Dutch Shell PLC - a massive multi-national business with a market capitalisation (number of shares issued times the price of the shares at a point in time as at January 22nd 2007) of £47,968 million. Without limited liability, firms like this would be unable to raise such massive sums of money. Copyright: Biz/ed team.

The Position of Sole Traders

If a sole trader was to have difficulties with their business, eventually closing down, they might owe various people money - suppliers, the bank, owners of property that they might be renting, as well as Her Majesty's Revenue and Customs. If this occurred, the sole trader might try to sell off any assets that they owned, such as fixtures and fittings, stock and so on. If this was not sufficient to cover their debts, they could be forced to sell off their personal possessions in order to settle their debts. This is called unlimited liability.

What it means is that the individual is liable (responsible) for the debts of the business. The 'unlimited' part means that there is no limit to what they can be expected to have to give up to pay off those debts.

Ownership and Control

For large public limited companies, the situation is different. They can have many thousands of owners, who each contribute a relatively small sum to the overall capital of the business, but who each own a small share of the business. Because of the way that such businesses are organised, it is unlikely that many shareholders will be in a position to take any direct involvement in the running of the company. Instead, the day-to-day affairs are handled by a board of directors who are elected by the shareholders to run the firm on their behalf. There is what is called a 'divorce between ownership and control' - those who own the business are not necessarily in control of it.

In such circumstances, and because many of these organisations are so big, it would be very difficult to persuade potential investors to put money into the business if they risked losing everything. So, there is a huge amount of trust placed in the directors to manage the investors' money and the business in an appropriate manner. If an investor thought they could lose everything, it is unlikely that they would ever be persuaded to invest any money in such businesses.

If a business is forced to close down and has limited liability, the owners have some protection against the risk of losing all their personal possessions to pay off any debts of the business. Copyright: Biz/ed team.

Unlimited Liability

A sole trader comes in many shapes and sizes. For many, there might be good reasons for being a sole trader and it might not be appropriate to become a limited company. Copyright: Felipe Skroski, from stock.xchng.

Unlimited liability is a significant disadvantage to businesses such as sole traders and partnerships. The risk they take is very high. However, that is not to say that businesses would rather set themselves up differently. Many individuals setting up in business will look at the different options open to them. They will weigh up the risk in setting up with unlimited liability and balance this against the benefits they get.

• A sole trader might choose to set themselves up in this form of business organisation rather than any other way for tax reasons. It may be that they are liable to pay more tax if they set up as a limited company.
• It might be harder for them to get credit from suppliers if they are a limited company. For example, if a sole trader closes their business, a supplier can legally expect the individual to sell all personal possessions to raise enough cash to pay them what they are owed, if necessary. If the business had limited liability, the supplier might not get paid.
• Setting up as a sole trader is also much easier than setting up as a limited company. The administration, paperwork and legal fees involved might all be relatively expensive and time-consuming.

As with many businesses, therefore, it is all about calculating risk and weighing up the costs and benefits. When setting up a business, there is no 'right' type of organisation; it depends purely on what is perceived as being the best situation for the individual or business.

Summary of the main types of business organisation:

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