2.1.3 Liability and Finance

Liability and Finance

Key Definitions

Liability: 

Debt: Liabilities that can potentially overwhelm a business owner's personal finances as well as their business finances.

Unlimited Liability: There is one legal identity for the owner and the business, so if the business goes into debt the owner could have to repay using both business and personal assets, putting the owner at risk of personal bankruptcy as well as business bankruptcy.

Limited Liability: The owner of the business has a separate legal identity for their personal life and their business, so if the business goes into debt the owner would only have to pay the bank back from the business assets, not personal assets.

Bankrupt: A form of business involving just one person with unlimited liability, such as a window washer or a cleaner.

Creditors: The people who are owed money by a business, such as bankers or suppliers.

Debtors: Those who owe money to a business, such as companies that give bonds.

Sole Trader: A form of business involving just one person with unlimited liability, such as a window washer or a cleaner

Implications of Unlimited Liability

Unlimited liability means that the finances of the business are treated as inseparable to the personal finances of the business owner. This means that if the business were to lose £1 million then so would the owner, and they could be forced to pay the money back by selling their car, house or other personal assets. If the owner cannot pay this then they would be personally bankrupt. There are 2 types of business with unlimited liability: sole traders and partnerships. 

Implications of Limited Liability

Limited liability means that the legal identity of the business is separate to the personal legal identity. This means that if the business were to lose £1 million the company assets could be lost, but there is no personal liability for the debts. Limited liability can give business owners the confidence to push their business forward and expand. The expansion can be financed by bank loans without threatening the well-being of the owner's family. Without the legal protection of limited liability economies would struggle to grow. 

Despite this there is a downside to limited liability, as it gives huge potential scope for fraud. A business could be started and take customer money, but the company could be put into liquidation before a customer receives what they paid for - and if this can be proven to be intentional then this would be a case of fraud. There is little doubt that many scams go unpunished as it is hard to distinguish between fraud and just plain failure. 

Finance Appropriate for Unlimited Liability Businesses

By definition, unlimited liability businesses are not strictly speaking businesses. This means that they have no access to share capital, meaning that they must be financed in the following ways instead:

• Owner's Capital
  In the case of a partnership an agreement might be drawn up basing the proportionate ownership of the business on the amount of capital invested by each partner.
  
• Bank Finance - either a loan or overdraft
  It is often easier for an unlimited liability business to obtain finance from the bank because even if the business fails the bank can regain the cash from the personal assets of the owners.
  
• Leasing
  Signing an agreement to rent a specific asset for a specific agreed time period, therefore avoiding the cash drain caused by purchase.
  
• Trade Credit
  Similarly to bank finance, suppliers would prefer to deal with a sole trader or partnership as they know they can regain any debts from the individual owners if the business fails.

It is important to remember that the most important form of capital comes from within the business through its trading profit. 

Finance Appropriate for Limited Liability Businesses

Companies have access to more types of finance than unlimited liability businesses. Both private and public limited companies have access to the following forms of finance:

• Share Capital
  Part of this is under the control of the business founder, and part of this is sold on to family and friends, and also widely avaliable to the general public.
  
• Bank Finance
  Bank loans would need to be backed by specific collateral, especially for small companies, and the same for overdrafts. It is highly unlikely that a small business would need to provide a personal guarantee for the bank.
  
• Angel or Venture Capital - often a combination of share and loan capital
  The founder suffers dilution of control over the business, and the company will most likely find that the loan capital comes at a higher interest rate than a bank loan.
  
• Peer-to-Peer Funding and/or Crowdfunding
  Both of these tend to keep control of the business more effectively in the hands of the business founder.

• Leasing and Trade CreditBoth are also open to limited liability businesses.

For limited companies, even giant PLCs, the biggest source of capital for expansion comes from within the business through its trading profit.