On the other hand, even though they both intend to assist the borrower in this regard they have different consequences for a borrower’s credit and financial situation

Throughout the following article we will study how each of them work and which are their main implication for individuals and households.

What is Bankruptcy?

Bankruptcy is a legal process through which a borrower declares himself (voluntarily or by court order) unable to meet his financial obligations and the court is in charging of analyzing his financial situation to take appropriate measures that ensure the repayment of the financial commitments.

Bankruptcy procedures may involve the liquidation of a portion of the borrower’s assets (Chapter 7 bankruptcy) or they could result in the reorganization of the debts (Chapter 13 bankruptcy). In both cases, the ultimate goal is to ensure that the borrower meets his obligations by any means possible.

What is Debt Consolidation?

Debt consolidation is a process through which a borrower who holds many different credit accounts merges these accounts into a single debt instrument that usually provides more favorable or flexible terms.

This is commonly achieved through a debt consolidation loan, which can be granted by a financial institution or any other financial business with the sole purpose of paying off the rest of the debts to simplify the borrower’s debt commitments to only one instrument.

Key Takeaways

Key Differences Between Bankruptcy and Debt Consolidation

Complexity

Bankruptcy procedures are usually significantly more complex than debt consolidation transactions, as they require the involvement of lawyers, judges, and other parties who will oversee the valuation of the assets and debts involved.

A bankruptcy procedure may take between 6 months (Chapter 7) and up to 5 years (Chapter 13) while a debt consolidation operation can be done in a few days, even though the repayment of the debt consolidation loan may take many years.

Effect on Credit score

Bankruptcy dramatically reduces a person’s credit score, in some cases by even more than 200 points at once. Debt consolidation loans, on the other hand, the ultimate impact on the borrower’s scores will be determined by how punctually he pays off the debt consolidation loan.

Monthly payment changes

Bankruptcy procedures usually do not suspend or modify the monthly installments of the outstanding debt, even though the bankrupted party may have already stopped paying them. Through bankruptcy, creditors often seek compensation from the liquidation of the borrower’s assets to cover for any accumulated losses.

In contrast, debt consolidation loans often involve the modification of monthly payments to fit the debtor’s current financial situation and budget.

Debt elimination vs debt reduction – bankruptcy can erase some debts leaving the debtor debt free while consolidation lumps debts together in a new loan that the debtor still owes.

As a result of bankruptcy, some or all of the debts held by the borrower may be eliminated or pardoned by the court, even though this may have a devastating effect on the individual’s credit score.

Debt consolidation, on the other hand, does not alter the amount owed by the borrower as the process essentially reduces the number of credit instruments to a single one that has the same outstanding balance as the combined old credit accounts.

Tax effects

Any debt forgiven as a result of bankruptcy is not taxable as income, even though any other form of debt relief is. On the other hand, any taxes owed by the debtor are generally refunded and the outstanding balance is brought to zero.

As for debt consolidation, there is no impact on a borrower’s tax bill.

Pros and Cons of Debt Consolidation and Bankruptcy

Advantages of bankruptcy

• As a result of bankruptcy procedures the borrower may be pardoned of all or most of his debt commitments.
• The primary residence of the bankrupted individual is usually protected from creditors.
• Any pending taxes might be refunded and the relief of the debt is not taxed.
• Debtors are usually granted with certain flexibility to reorganize their financial situation before they start making payments again.

Disadvantages of bankruptcy

• Credit scores are significantly diminished as a result of bankruptcy procedures.
• The borrower will face many hardships to obtain funding once the procedure is completed.
• As a result of bankruptcy, some of the borrower’s assets may be liquidated to pay off a portion of the debts.

Advantages of debt consolidation

• The process is fairly simple as it mainly involves getting approved for a debt consolidation loan to pay off old credit accounts.
• The conditions of the debt consolidation loan are usually more favorable compared to the conditions and borrowing costs of the previous credit accounts.

Disadvantages of debt consolidation

• Studies show that borrowers who take debt consolidation loan tend to end up being more indebted as they use the credit limit of the previous accounts that is now free as a result to the debt consolidation process.

Examples

Carl has been facing many challenges to find a suitable job as a physician in the state where he lives. As a result, he has been struggling to pay off his debt commitments every month and has consulted a financial planner about his alternatives.

This professional indicated Carl that based on his current situation he would be better off by taking the bankruptcy path unless he can secure a job within the next 2 weeks. If he manages to do so, Carl could take a debt consolidation loan to pay off the $26,000 he currently owes under more favorable conditions such as a longer credit term.

On the other hand, if securing the job is not possible during that time frame Carl is contemplating the alternative of filing for Chapter 7 bankruptcy.

This process requires the involvement of a bankruptcy lawyer and the court will evaluate his situation to determine which assets have to be liquidated to pay off the debt and any outstanding balance that may still exist after that will be pardoned and Carl’s credit score will be negatively affected as a result.

Bottom Line

Bankruptcy and debt consolidation are two different strategies that intend to help individuals in managing their debt.

Bankruptcy can be seen as a harsher process due to the significantly negative consequences that result from it while debt consolidation is often seen as a more flexible path that alleviates the burden of the debt by simplifying various debt instruments into one with more favorable conditions.

Frequently Asked Questions

What are the key differences between filing for bankruptcy and opting for debt consolidation?

Filing for bankruptcy is a legal process that may discharge or reorganize your debts under court supervision, significantly impacting your credit and financial standing. Debt consolidation combines multiple debts into a single loan with a lower interest rate, simplifying payments without the legal ramifications of bankruptcy.

How does choosing bankruptcy over debt consolidation affect my credit score?

Bankruptcy can severely damage your credit score for 7 to 10 years, making it challenging to obtain new credit, while debt consolidation may have a temporary negative effect but can ultimately help improve your credit score if payments are made consistently.

Can debt consolidation prevent me from filing for bankruptcy?

Debt consolidation can be an effective way to manage and pay off debt, potentially preventing the need for bankruptcy by making debts more manageable through a single monthly payment and reduced interest rates.

What should I consider when deciding between bankruptcy and debt consolidation?

Consider your ability to repay debts in the long term, the total amount owed, your credit score impact, and potential asset loss with bankruptcy, versus the discipline required for debt consolidation without reducing the debt amount but potentially

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What is the Average Percentage Rate (APR)?

The Annual Percentage Rate (APR) is a calculation that incorporates the impact of additional fees and transaction costs to the baseline interest rate, also known as Nominal Interest Rate, in order to give the borrower a better estimate of the actual cost of the debt.

Lenders in the United States are required by law to disclose the APR along with the Nominal Interest Rate offered for a particular loan, credit card or line of credit.

What is the Average Percentage Yield (APY)?

The Annual Percentage Yield (APY) is a calculation that is mostly employed to estimate the actual return produced by an investment considering the effect of compounding interest.

Nevertheless, it can also be used to understand the cost of borrowing if the borrower doesn’t intend to pay for the balance of the loan before it matures.

Key Takeaways

APY vs APR Formulas

The formula to calculate both the Annual Percentage Rate (APR) and the Annual Percentage Yield (APY) are:

APR = [[(F + I + T) / P] / n] * 100

And;

APY = [(1 + r)ⁿ – 1] / n

Where:

F: The total fees involved in the operation during its lifetime.

I: The total interest charged or earned during the loan or investment’s lifetime.

T: The total transaction costs associated to the operation during its lifetime.

P: The principal amount of the loan or the

n: The number of years or time periods associated to the loan or investment.

r: The nominal interest rate paid or earned.

The result in both cases is expressed as a percentage and they can be compared among each other to understand the cost of borrowing or the potential profitability of the investment from different perspectives.

Key Differences between APY and APR

The Annual Percentage Return (APR) provides a more realistic measure of the cost of borrowing a loan as it incorporates the effect of any fees, transaction costs, and other expenses charged by the lender into the mix. On the other hand, the APR can also help in standardizing the cost of borrowing to allow the borrower to compare among different loans to pick the cheapest one.

Compounding Interest

Nevertheless, the APR fails to incorporate the effect of compounding interest into the calculation. This means that interest rates can ultimately be higher than the APR if the borrower doesn’t pay for the interest charged after each time period and, instead, lets it accumulate over time. The actual interest charge will be higher as the principal will be increased by the unpaid interest.

From the perspective of an investment, the APR could provide a better estimation of the percentage earned on a fixed income investment such as a Certificate of Deposit (CD) or a bond. By using the APR, the investor can deduct any fees involved in the transaction, even though the effect of compounding will not be considered. This latter characteristic of the APR makes it a less frequently used metric to analyze investment operations.

On the other hand, the Annual Percentage Yield, provides a better estimation of the potential profitability of an investment by considering the effect of compounding. If an investor decides to invest in a Certificate of Deposit that compounds on a monthly basis and the CD offers a nominal interest rate of 12% per year, the ultimate interest rate produced by the end of the year will be higher due to the monthly compounding feature.

Usage

Furthermore, the APY could also be employed for loans, yet the formula leaves out the effect of any fees or transaction costs associated to the instrument. While it incorporates the effect of compounding, the fact that it leaves out these important costs makes it a less reliable metric to estimate the cost of borrowing.

In most cases, the APR and the APY by themselves fail to portrait the actual cost of borrowing or the actual return earned on an investment and, therefore, while they are very useful, they should be analyzed along with other similar metrics to get a broader picture.

APR and APY Examples

Matthew is currently looking to invest money in a business a friend proposed to him. He doesn’t have the cash to make the investment but he is confident he can secure a loan from his financial institution and, therefore, he wants to estimate the Annual Percentage Rate (APR) charged by his lender with the potential Annual Percentage Yield (APY) produced by the investment to see if it would be profitable to finance the venture with a loan.

The amount of the investment would be $100,000 and his lender is charging an annual nominal interest rate of 6.54%. He also has to pay a 3% flat fee to take out the loan and transaction costs add up to $560 for the lifetime of the loan. The credit term offered by the lender is 36 months (3 years).

With this information we can calculate the APR for this loan as follows:

APR = [[($3,000 + $10,402 + $550) / $100,000] / 3] * 100 = 4.65%

The investment proposed to Matthew consists of a $100,000 invested that will be paid a nominal interest rate of 7% per year, compounded monthly. In this case the APY for this operation would be:

APY = [(1 + (0.07/12))^{(3 * 12)} – 1] / 3 = 7.76%

This means that Matthew will earn a net return of approximately 3.21% per year on this operation as the APY produced by the invest is higher than the APR that he would have to pay for the loan.

Bottom Line

Calculating the APR manually is useful for investors, especially due to the fact that many lenders have found legal ways to exclude certain fees from the official calculation of the APR. Therefore, in some cases, lenders could underestimate the advertised APR by relying on these loopholes.

Frequently Asked Questions

How does APR differ from APY in terms of interest calculation?

APR represents the annual rate charged for borrowing or earned by an investment without compounding, while APY includes the effects of compounding interest annually, providing a more comprehensive measure of the actual interest rate.

Why is APY higher than APR when comparing the same financial product?

APY accounts for the compounding of interest within a given year, which can increase the total amount of interest earned or paid, making APY higher than APR for the same product.

Can APR and APY affect the total cost of a loan differently?

Yes, the APR provides the base interest rate of a loan, but the APY can show a higher cost due to compounding, especially in products where interest compounds more frequently than annually.

When comparing savings accounts, why should I look at APY instead of APR?

APY gives a more accurate representation of what you will actually earn on your savings due to compounding interest, making it a better metric for comparison than APR, which does not account for this effect.

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In the complex world of financial markets and corporate accounting, the term “round-trip transactions” often surfaces amidst discussions of financial ethics, regulatory compliance, and corporate governance.

These transactions, while not inherently illicit, tread a fine line between strategic financial management and the murky waters of manipulative practices.

This comprehensive guide aims to unravel the intricacies of round-trip transactions, shedding light on their purposes, risks, and the legal and ethical considerations they entail.

Round-Trip Transactions Meaning

Round-trip transactions refer to a series of transactions in which a company sells an asset to another party with the agreement that the asset will be bought back at a later date, usually at a similar or predetermined price.

This cycle creates the appearance of genuine business activity without any substantive change in the company’s financial position or the asset’s ownership. While round-trip transactions span various industries, they are notably prevalent in the energy sector and financial markets, where companies might engage in these deals to inflate revenue figures or to create a facade of heightened market activity.

The distinction between legitimate and manipulative uses of round-trip transactions hinges on intent and disclosure. Legitimate uses are typically transparent and aim to achieve lawful financial or operational objectives, such as hedging against price fluctuations. Conversely, manipulative practices are designed to deceive stakeholders or regulatory bodies about a company’s true financial health or market activity.

Key Takeaways

The Purpose of Round-Trip Transactions

Round tripping is often used to artificially inflate a company’s revenue and trading volume, creating the appearance of a higher level of business activity than actually exists.

This practice can be employed to meet financial targets, influence stock prices, or enhance the attractiveness of the company to investors by manipulating financial statements. By artificially inflating revenue, a company can appear more financially robust and liquid than it truly is, potentially influencing stock prices and investor perception.

The allure of round-trip transactions lies in their ability to temporarily enhance a company’s financial standing without necessitating actual business growth or operational improvements. This can make a company more attractive to investors, lenders, and analysts in the short term, albeit at significant risk.

How is Round Tripping Used?

Companies might engage in round-trip transactions in several different ways. Here are the most common round-trip transactions:

Inflating Revenue: A company may engage in round-tripping by selling an asset to another entity and buying it back at a similar price. These transactions can be recorded as legitimate sales and purchases, artificially inflating the company’s revenue and sales volume without any real change in its economic situation, misleading stakeholders about the company’s financial performance.

Boosting Asset Turnover: By repeatedly selling and repurchasing assets in round-trip transactions, a company can give the impression of higher asset turnover than is actually the case. This can make the company appear more efficient in its use of assets, potentially misleading investors about its operational effectiveness.

Manipulating Market Activity: In the case of publicly traded companies, round-trip transactions can be used to create an illusion of heightened trading activity for the company’s shares. This can influence stock prices by suggesting a higher demand for the shares than actually exists, potentially attracting more investors based on misleading information.

Round Tripping Example

An example of round-tripping involves a company, Company A, selling an asset to Company B for $1 million. Shortly thereafter, Company B sells the same asset back to Company A for approximately the same price, say $1.01 million.

This sequence of transactions makes it appear as though Company A has engaged in $1 million worth of sales, thereby inflating its revenue figures, even though there has been no real change in the economic position of either company.

This practice can be used to manipulate financial statements and give an inflated impression of the company’s financial health and trading volume, potentially misleading investors and regulators.

The Risks and Implications of Round-Trip Transactions

The primary risk associated with round-trip transactions is the potential for legal repercussions and loss of investor trust. Regulatory bodies in many jurisdictions scrutinize such practices closely, and companies found guilty of using round-trip transactions to manipulate financial outcomes can face hefty fines, legal sanctions, and reputational damage.

Notable incidents, such as the Enron scandal, highlight the catastrophic impact that deceptive financial practices can have on stock prices, market stability, and investor confidence.

Moreover, round-trip transactions can distort market perceptions, leading to inefficient capital allocation and undermining the integrity of financial markets. The artificial inflation of activity or liquidity can mislead stakeholders about market demand, price stability, and the true value of assets involved.

Legal and Regulatory Framework

The legal status of round-trip transactions varies by jurisdiction, but there is a growing trend towards stricter regulation and oversight. Financial regulatory bodies worldwide have implemented guidelines and reporting requirements to curb the abuse of such transactions.

The role of auditors and financial regulators is pivotal in detecting manipulative practices, necessitating rigorous examination of financial records, transaction trails, and disclosure statements.

Ethical Considerations of Round Trip Transactions

Beyond legal implications, round-trip transactions pose significant ethical dilemmas. The fine line between creative accounting and outright fraud is often blurred, challenging companies to maintain integrity and transparency in their financial reporting.

Ethical business practices and robust corporate governance structures are crucial in mitigating the temptation to engage in deceptive financial maneuvers.

Companies must foster a culture of honesty and accountability, ensuring that all stakeholders can rely on the veracity of financial statements and market activities.

Detecting and Preventing Round-Trip Transactions

For investors and regulators, identifying potential round-trip transactions involves scrutinizing sudden spikes in revenue or trading volume without corresponding changes in market conditions or company operations. Vigilance and due diligence are essential in assessing the authenticity of reported financial health and operational activity.

Companies, on their part, can prevent misuse by adopting transparent accounting practices, regularly auditing financial records, and ensuring that all transactions are conducted at arm’s length and properly disclosed. As the financial landscape evolves, so too must the strategies for maintaining fairness and integrity in corporate reporting and market transactions.

Summary

Round-trip transactions, while a legitimate tool in certain contexts, present a complex challenge in the realm of financial ethics and regulation. As companies navigate the pressures of financial performance and market competitiveness, the temptation to engage in such practices underscores the importance of robust regulatory frameworks, corporate governance, and ethical leadership.

The future of round-trip transactions will undoubtedly be shaped by ongoing efforts to balance financial innovation with transparency and integrity, ensuring the stability and trustworthiness of markets and corporate institutions. In this ever-changing environment, the collective responsibility of companies, regulators, and investors to foster transparency and integrity has never been more critical.

Frequently Asked Questions

What exactly defines a round-trip transaction in financial terms?

A round-trip transaction refers to a set of transactions where an asset is sold and subsequently repurchased by the original seller, often at a similar price, to artificially inflate volume or revenue without any real change in asset ownership.

Why might a company engage in round-trip transactions?

Companies may use round-trip transactions to meet financial targets or create the illusion of increased business activity, thereby enhancing their financial statements or market valuation temporarily.

What are the potential risks of engaging in round-trip transactions?

Round-trip transactions can lead to legal penalties, reputational damage, and a loss of investor trust if used to manipulate financial statements or deceive stakeholders.

How can round-trip transactions be identified or prevented?

Identifying round-trip transactions involves scrutinizing financial records for transactions that inflate company activity without real economic substance, while prevention requires transparent accounting practices and rigorous financial oversight.

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What Does Unencumbered Mean?

In real estate, properties with no encumbrance attached, such as a mortgage, an easement or any other, are easier to transfer than those that have any of these elements. The value of such properties is often higher than their encumbered counterparts as there are no strings attached or obstacles if a purchase is intended.

On the other hand, if an immediate sale is required, the owner of an unencumbered asset has the sole right to put a price that suits his needs. This is not the case for mortgaged assets, for example, where lenders might establish minimum pricing requirements in order to approve a sale.

From a business standpoint, employing loans to acquire new assets is a common practice within companies, but acquiring assets through financing, in instances where the asset is also the collateral for the loan, will limit the available options for a company that is struggling with cash flow and needs to dispose the asset as soon as possible.

Example

Margaret is a recently graduated student that is currently working for a big pharmaceutical firm. Recently, an opportunity presented to her to acquire a small two-bedroom apartment in the city and she took it by using some of her savings and a loan that her bank approved for the purchase. After a few years, the property increased its value tremendously and Margaret wanted to take advantage of it.

Nevertheless, the property was encumbered, which made it difficult for her to transfer it. She decided to ask her mom for the remaining balance of the mortgage, to free the property from it and, after paying the bank, he had an unencumbered property that she was able to sell easily.

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What Does Encumbrance Mean?

An encumbrance can be either financial or non-financial, depending on its nature. A financial encumbrance involves a charge over the property. The best example of this is a mortgage or a tax penalty.

On the other hand, a non-financial encumbrance might be an easement, which is a right given to a third party to employ certain spaces of a property. In any of these scenarios, an encumbrance might restrict the possibility to transfer the property or it could also diminish its value, due to the claim. There are also some situations where legal actions against the property owner are considered encumbrances.

In this case, property value will be severely affected since it opens the door for a potential seizure of the asset. Contrary to this, an unencumbered property is one that can be freely used and disposed by the owner, since there is no claim against it, as is the case for properties that have no mortgage or were bought in cash.

Example

A gas company called Pipers Co. is currently offering easement agreements to home owners living in certain town, as part of their effort to build new pipelines to serve other locations. The property owners are worried that these easements could reduce the value of their real estate and, they don’t want to have an encumbered property in their hands, since according to certain reports this type of properties are much more difficult to sell than unencumbered ones.

In order to persuade the owners, Pipers offered them a 35,000 one-time payment that will offset this potential loss and they will also obtain a monthly compensation for the easement. This created the necessary incentive for the owners to agree to allow the building of new pipelines under their property’s ground.

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What Does Corporate Red Tape Mean?

The term red tape, applied to organizational behavior, comes from a procedure employed in the past where documents were grouped and stacked with a red tape to point out their higher degree of importance. This practice led to the concept of red taping as a way to describe unnecessary formalities that reduced productivity and response times.

In business environments, red tapes should be avoided because they affect the business negatively by holding down crucial decisions and actions that need to be taken in order to successfully deal with day-to-day operational issues.

Modern management techniques include organizational design as a key task to identify and reduce corporate red tape by cutting redundant procedures or keeping the work load of certain job positions properly balanced. On the other hand, a less centralized management style is also advantageous to keep red tape at a minimum by delegating different responsibilities to a wide range of staff members to increase the speed of decision-making processes.

Example

Galaxy Cinema Co. is a company that has more than 20 movie theaters located across England. They have a Content Department that is in charge of proposing potential films to be displayed at each of Galaxy’s facilities. Last year the company experienced a decline in the number of tickets sold and according to an independent consultant’s research, the reason for this sales decline was that the company was unable to update their film chart faster than the competition.

After investigating the matter, the consultant identified that it took more than 20 days to approve the purchase of a new film, due to an excessive red tape in the procedure. The Content Department had to get 7 different signatures from other departments and this always delayed the process and made it very tedious. After analyzing the problem, the consultant came up with a new procedure that involved only essential approval requirements and this change led to an increase of 30% in the company’s last quarter revenues.

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What Does Common Law Mean?

Different from statute law, which is the legal framework established by legislative authorities, such as the laws enacted by the U.S. Congress., common law is a system that is based on the rulings of different judges, to set precedents that can be applied to similar situations presented in other cases.

These laws have the same judiciary weight of statutory laws, and they should be considered whenever a similar case is being attended. On the other hand, common law is different from civil law to the extent that the latter is more rigid and originates in statutory laws. The origins of common law can be traced back to the 12^th century in England, where secular tribunals were established.

In modern times it has evolved to be complemented by statute laws but it still operates in cases where a clear interpretation of the law is required to be issued by certain judge.

Example

Marcus and Lorrain have a legal dispute over a potential trespassing situation. Their houses are next to each other and it seems that a tree located in Lorrain’s property has grown and it has bend towards Marcus property, occupying part of his backyard’s aerospace. Marcus is annoyed by this situation because during the autumn season the tree’s leafs start to fall and he has to be constantly cleaning his backyard because of the tree.

The judge was a little bit concerned with the fact that no housing law specifically applied to such situation and in order to issue a ruling he has to go through similar past cases to gather some precedents for his upcoming decision. He found that in 1939 a similar claim was filed within a municipal court and the judge ruled back then that the property that possessed the tree had to cut the branches that trespassed the other person’s property. By using this precedent, the judge could issue the same ruling, according to common law.

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What Does Installment Loan Mean?

These sorts of loans are frequently employed to finance large-value items such as cars, furniture or appliances. Financial institutions offer lower interest rates than consumer credit, such as credit cards, and they are granted for a specific purchase, instead of being discretionary.

The monthly installment is calculated through a financial formula, and interest rates are charged according to the monthly remaining balance. At the beginning of the loan, the interest expense will be big but it will be reduced until it gets to zero at the last payment, this mean that as the time frame of the loan advances the principal portion of the installment will grow towards the end of the loan’s life spam.

In terms of collateral, installment loans often use the item being bought as the guarantee. If a default situation occurs the bank will repossess the merchandise and this scenario will affect the client’s credit score considerably.

Example

Martina is looking to buy a new car and she already researched many alternatives that fit her budget. She only has $3,000 for the upfront payment and her bank is willing to lend her at least 80% of the car’s value, which gives her the possibility to buy a car of at least $15,000. She decided for a small SUV of an American manufacturer and the bank informed her that she will be paying a monthly installment of $287 for 48 months with an interest rate of 7% per year.

Initially, the interest expense will be around $70 but after a year it will be around $50, which is the expected behavior of such expense in this type of loan. On the other hand, after 2 years, the capital amortization of her installment will represent at least 85% of the monthly payment.

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What Does Holding Company Mean?

Holding companies are very common in today’s economy. This kind of corporations might have advantages when there are diverse assets to own and manage. The holding company owns shares of other companies or subsidiaries, at least to a considerable extent, and the owners only have shares of the holding company.

The overall risk is diversified because of the various businesses involved while the relative strength of the parent company brings various benefits. Since the whole business is larger than each separate firm, the holding company can obtain higher benefits when negotiating with third parties or borrowing money.

Control over the subsidiaries and the application of corporate policies or strategies should be easier when supervising from a holding company in comparison of managing the firms separately.

Example

Jeremy Hills is a successful entrepreneur that inherited a large manufacturing firm and later created other four companies. Two of these firms provide services to the manufacturing firm although not exclusively. The remaining two firms are not related at all with the former three. Jeremy has found partners along the way for each venture and now faces a complex network of ownerships, Boards and internal controls.

He would like to take advantage of the overall size of his consolidated business and to simplify the monitoring and control process of the five firms. He therefore decided to create a holding company that would own these five subsidiaries. Mr. Hills and his partners would own the holding company. Mr. Hills now chairs the Board of Director of Hills Corporation and controls the various businesses from there. When asking for financing and bargaining with suppliers, he will now has the leverage of a large corporation.

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What Does Incorporated Mean?

When an individual has a business idea it often starts as a self-centered business, where the person employs its personal finances to fund the business’ operations and receives revenues as personal income.

Nevertheless, this structure is often very limited and as the business starts growing the company needs to detach from its owner to exist as a separate legal unit. This is the moment where the business becomes an incorporated business. The product of incorporating is a corporation. These newly created entities are formed through a document called articles of incorporation or articles of association, where the company’s legal structure is extensively described to cover matters such as Directors, Shareholders, Ownership Structure and Board Meeting’s dynamics, among other elements that must be presented to incorporate the business properly.

After these document are filed and approved the company will be able to act as a separate individual, assuming its own financial commitments and limiting the shareholder’s liability normally to the extent of the company’s financial capital.

Example

Roman recently started to produce bottled lemonade to sell in retail establishments located across the city. The business started as a very small idea but the flavor was so good that he started getting orders really fast. In a few months he had to increase its production capacity by moving to a commercial location, along with buying machines to produce the lemonade massively.

This also created the necessity to look for partners who could provide financial capital to keep expanding the business as demand keeps increasing. His lawyer advised him to incorporate the business to sell a certain percentage of it to external investors. Roman agreed to this suggestion, therefore creating Romonade LLC, which will be the legal entity that owns the lemonade’s brand and commercial property including its formula.

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