How do companies work?

When we hear the word ‘company’, we all think we know what the person is talking about. We deal with companies every day. Most of us work for a company, and we certainly buy things from them.

But companies are actually a strange thing.

Let’s start with a bit of a history lesson.

Sensible ‘risk taking’

Back in the day (about 400 years ago) before companies existed, the law recognised ‘people’ – you and me. If you wanted to do something, for example, hold property or start a business, you had to do it personally. In your own name. This meant you got all the rewards, but it also meant you had all the responsibility. Back in those days, responsibility meant responsibility. If you didn’t pay all of your debts you went to debtors prison.

If you wanted to do things with other people – for example, send a boat half way around the world to pick up some spices and bring them back to Mother England, you would form a ‘partnership’. The bad news about partnerships is that you’re not only responsible for your own debts – but you also become responsible for your partner’s debts. So if your ship sunk, at least you had friends in debtors prison!

This ‘personal liability‘, and the consequences of business failure, meant people were pretty careful about the risks they would take. It also meant they only went into business with people they knew very well and trusted (like the Earl down the road).

But the Queen and Parliament realised that a lot of good things can come from sensible risk-taking. England was doing quite well out of global trading expeditions, and wanted to encourage more people to get involved.

So the concept of the ‘company’ was born.

A legal fiction

At its heart, the company is a ‘legal fiction’. Meaning you can’t pick up a company, you can’t hold it or kick it. It exists only on paper as a result of Government law.

The legal fiction is a really strange one. Basically, the law says that a company is a ‘person’, like you and me. It can do things, it can own things, it can sue and be sued. But the big (and important) difference is that a company is only responsible to the extent of its ‘capital’. The capital is the resources people have agreed to put into the company. Another cool thing about a company is that it can’t die – provided the company doesn’t run out of money, it can live forever. (Companies that have been around for over 400 years include Twinings Tea, Beretta, Grolsch, Lloyd’s of London, Haig Whisky, the London Gazette and Sotheby’s.)

With the advent of the company, trade and other risk-taking activities boomed. Finally, people could contribute huge amounts of capital to a venture, take on a reasonable level of risk, and not lose everything if things didn’t work out.

Today, companies have become so commonplace that we often forget the important social role they play – in enabling us to pool massive amounts of cash to undertake risky activities for the social good. Some say we would still be hanging out in forests, firing arrows at each other, were it not for the company.

From a practical perspective, companies have a number of moving parts.

The mobilised masses

First, companies have shareholders or ‘members’. These are the people who agree to put resources into the company. In return, they get ‘shares’ or ‘stock’. A share is what it sounds like – a share of the profits and any capital return.

A shareholder is not responsible for what happens to the company. They are only responsible for the capital they agreed to contribute. Their ‘liability is limited’. If a shareholder agrees to put in $1, then that is where their responsibility ends.

The concept of the limited liability of shareholders is at the heart of the usefulness of companies in business and investment structures.

Shareholders only get a very limited say in what the company does. They get to set the ‘ground rules, but they don’t get to play. They set the rules in two ways. First, they write a set of rules for the company, called a Constitution. This document lists what the company can and can’t do. Secondly, they get to vote as a group on high-level issues every now and then in a ‘general meeting’. One of the important things shareholders get to vote on is who will be appointed as a ‘director’.

Lords of the manor

Companies also have directors. The shareholders appoint the directors to manage the capital of the company on their behalf. Often in small companies the shareholders and directors are the same people. But in larger companies there may be thousands of shareholders and only a handful of directors. In many respects, directors are like politicians, representing the shareholders. The directors act as a group, which is referred to as the ‘board’.

Technically, directors are also not responsible for what happens to the company. But this only goes so far. Because the directors are making the day-to-day decisions on behalf of the company, the law says they need to be personally responsible for some things, otherwise they would be completely irresponsible. Over time, the list of things for which a director can be personally responsible has grown to over 700 possibilities. Some argue that the pendulum has swung too far and that this is now discouraging sensible risk-taking on the part of directors.

The workhorses

The board of directors then appoint another group of people to actually get the work done. These people are know as the ‘executives. Once again, sometimes the directors are also executives (known as ‘executive directors’), but in larger companies the executives are separate, and report to the board.

Common executives include the Chief Executive Officer (the CEO, aka the big boss), the Chief Financial Officer (or CFO: the big boss’ treasurer), the Chief Operating Officer (the COO), the Chief Information Officer (the CIO). You’re probably getting the idea now.

The board delegates the day-to-day running of the company to the executives. The board is responsible for setting the parameters in which the executives must act, and then monitoring them to make sure they do a good job. If the executives mess up, the board is likely to sack them. In turn, if the directors make a string of poor decisions, the shareholders are likely to sack the directors.

How do I get involved?

Since the modern company was first born over 400 years ago it has gone through many ups and downs, much like a person. It has matured, been over-extended, reined-in, refined, over-extended again, and then patched-up and updated. While many people signal the coming end of the company, the reality is they now walk among us almost unobserved. They have become so common that we often forget why they exist at all.

So getting back to basics – there are a number of reasons why you might want to set up a company. The main ones are:

  • ‘Pooling’ your capital with others; and
  • Putting in place a firewall between the risk in your enterprise and your personal assets.

There are also some potential tax benefits.

If you would like to explore how to properly use a company in your business structure, contact us on 1300 654 590 or by email.

Getting a little more educated

If we have whet your appetite for a deeper understanding of companies, you may like to explore the following books:

The Corporation that Changed the World by Nick Robins, a history of the East India Company.

The Influence of Sea Power Upon History: 1660-1783 by Alfred Thayer Mahan, an examination of how naval power is a critical link between political, cultural, military and business forces.

The Lever of Riches by Joel Mokyr, a compelling model and account of how technological change drives the evolution of civilizations, through monotonic, path-dependent accumulation of changes.

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