How Corporations Work, Part 1

 

For most people, corporations are businesses, plain and simple. This is not wrong. Corporations are in fact businesses, but this is like saying dogs are mammals. A true statement, but missing a lot of nuance. The point of this series is to explain how corporations are structured, how they work, and the nuances that make them more than just any old business.

 

At its base, corporations are legal structures. In fact, simply setting up a corporation doesn’t take much effort. All you’d need to do is draft an “Articles of Incorporation”, delineating the basic details of your company, the stock distribution, the directors, officers, and voila, you’re done (if you don’t know the difference between directors and officers, or if you’re fuzzy with what stock means, don’t worry, this will be explained later). By simply drafting and submitting this document, you’d have a corporation legally recognized by the state.

 

First, let’s start with why corporations exist, or are useful. Let’s say you have a business selling muffins, Muffin Inc.. What’s the advantage of setting up a corporation to sell your muffins when someone would still hand you a wad of cash if you weren’t incorporated? One of the main advantages of setting up corporations is limited liability. Let’s say one of your muffins were bad, and one of your customers got sick from them. That customer wants to sue you for all you’ve got, and they have a good case for it (let’s say they’re guaranteed a 100% win, to simplify things). Obviously, this isn’t good, but how the situation plays down depends on whether you have limited liability or not. If you don’t have limited liability, the customer could sue you directly. All your money would go to them, you’d go bankrupt, and you’d have to move in with your grandparents. Not a good look. However, if you had limited liability, the customer couldn’t sue you directly. They would have to sue your company, Muffin Inc. If that happens, Muffin Inc. would have to give all its assets to the sick customer. However, all the money in your bank remains protected, and while the loss would sting, you could still go on living, assuming you’ve saved up money. This is why limited liability is a big deal. It protects your personal assets, and separates your company’s legal troubles from your own.

 

However, limited liability isn’t the main reason why you’d want to create a corporation. You could establish limited liability with an LLC (limited liability company). The main perk of corporations is that they can issue stock. Stock represents ownership of the company, and people who own stock are shareholders of that company, and part owners. This is why limited liability is so important in a corporation context. If I own Wells Fargo stock, and Wells Fargo got into another one of its legal scandals, prosecutors can’t sue me directly. The advantage of stock for someone who starts a corporation, is that the stock can be sold to others to raise money, without going in debt. The advantage for someone who buys stock is that they obtain ownership in the company (what exactly ownership means, and why that would be useful, will be explained later) , and a potential cash-generating asset.

 

In its simplest form, corporations are companies that can issue stock, which represent ownership in the company. However, people who own the company don’t necessarily work for the company. If I own a share of Alphabet, that doesn’t mean I work for Alphabet. This distinction between employees, i.e. the soldiers who actually do things in the company, vs. shareholders, i.e. people who own the company, requires oversight. What if employees start abusing their positions, and using the company’s coffers for their own sole personal gain? Without some way to hold employees accountable, this could be a major problem. That’s where the board of directors come in. This board of directors is made up of people voted in by the shareholders, to make sure the employees are doing their job of making the company money. With this system, the employees who do the day-to-day operations have incentives linked to shareholders.

 

This is a basic rundown of how corporations work, and how they are structured. A more extensive look at individual components of corporations will be expanded on in later sequels to this series.

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