fin-3610 · Foundations
The Corporation and Financial Markets
Forms of business organization, the agency problem between shareholders and managers, and how primary and secondary financial markets channel saving to investment.
Learning objectives
- Distinguish between sole proprietorships, partnerships, LLCs, and corporations on liability, taxation, and governance.
- Explain the separation of ownership and control and identify the agency costs it creates.
- Describe the difference between primary and secondary markets and why both matter for capital formation.
The four types of firms
Before any finance gets done, someone has to choose a legal structure to do it in. The four standard US forms:
| Form | Liability | Taxation | Continuity |
|---|---|---|---|
| Sole proprietorship | Unlimited personal | Pass-through to owner | Ends with owner |
| Partnership | Joint and several (general); limited for limited partners | Pass-through to partners | Dissolves on partner exit |
| LLC (limited liability company) | Limited to capital contributed | Pass-through by default | Perpetual if structured so |
| Corporation (C-corp) | Limited to capital invested | Double taxation (corporate + dividend) | Perpetual |
The corporation gets the most attention in this course because it’s the form that dominates large-scale capital formation. Three features make it special: limited liability (your downside is capped at what you put in), perpetual existence (the firm survives ownership changes), and transferable shares (you can sell your stake without asking anyone’s permission).
That third feature is what makes a stock market possible.
The separation of ownership and control
In a sole proprietorship, the owner runs the business. In a small partnership, the partners run it. In a large corporation, the shareholders own it but the managers (CEO, CFO, division heads) run it. Apple has roughly 17 million different shareholders; Tim Cook makes the day-to-day decisions.
This separation is enormously productive. It lets capital come from anywhere and management come from talent. But it creates a problem finance calls the agency problem: managers act as agents for the shareholders, but their interests don’t always align.
Examples of agency costs:
- Empire-building. A CEO grows the firm through acquisitions because they enjoy running a bigger company, even when shareholders would do better with a dividend.
- Perks and pay. Lavish corporate jets, plush offices, generous pay packages: funded by shareholders, enjoyed by managers.
- Excessive caution. Managers fear being fired more than shareholders fear modest losses, so they avoid value-creating risk.
- Short-termism. Quarterly results affect the CEO’s bonus, so long-term R&D gets cut.
A lot of corporate finance (capital structure choices, payout policy, executive compensation design) is in part an answer to “how do we keep agency costs low?”
How markets channel money
Take a step back. Where does the money for a new factory, a new biotech drug, a new chip fab come from? Three sources, in increasing order of distance from the firm:
- Internal funds: earnings the firm keeps rather than paying out.
- Bank loans: borrowing from intermediaries that pool depositor funds.
- Public capital markets: selling stocks or bonds directly to investors.
For large or rapidly-growing firms, source 3 dominates. Two kinds of public-market transactions:
- Primary market: the firm issues new securities (an IPO, a follow-on equity offering, a corporate bond sale). The proceeds go to the firm. This is where real capital formation happens.
- Secondary market: investors trade existing shares with each other (NYSE, Nasdaq). No money goes to the firm. This is what people usually mean by “the stock market.”
Why does the secondary market matter to the firm, if no money flows to them? Two reasons:
- Liquidity. Investors will only buy in the primary market if they can sell later. A vibrant secondary market makes the primary market work.
- Price discovery. The market price tells managers what the firm is worth, useful when planning a new equity issue, an acquisition, or executive compensation.
A note on Tim Cook’s day
Apple’s CEO doesn’t think about the stock price every minute, but the governance structure he operates inside is shaped by everything we just covered. He’s appointed by a board accountable to shareholders. His compensation is heavily equity-based (so his interests align with share-price growth). When he calls the lawyers about a new product launch, those lawyers are paid out of profits the corporation can retain partly because of its perpetual-existence and limited-liability features. The plumbing matters.
Where this leads
Every later lesson in this course assumes you can answer two questions: “who owns the firm?” and “who controls it?” When the answers diverge (as they do for every large public company) finance has tools to narrow the gap. Capital structure, payout policy, and corporate governance are all answers to that puzzle.