What is a corporation?

Ahead of teaching corporate finance each year, I like to try to explain what a corporation actually is.

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A corporation is a particular way of organising economic activities. What is called a corporation in the US is called a company in the UK. Other countries have other names. We also often use the word “firm” interchangeably. Here I’ll try to say what makes a corporation different and why it is such a common feature of capitalist economies. 

When people work together they can achieve far more than when they work separately. Evolution tells us that early humans worked together to hunt, and that group cooperation is a fundamental part of what it is to be human. 

Creating organisations for achieving some common purpose goes back thousands of years. In his fascinating book For Profit: A History of Corporations, William Magnuson tells us that during the Roman Republic, in the centuries BCE, the societas was created, an organisation that was recognised as separate and apart from its owners, which could negotiate and contract with others on its own behalf. 

It could also issue shares, which gave an ownership interest in the societas, and that could be bought and sold.  

This early form of corporation developed a form of separation between those who wanted to actively run the societas, and those who wished to be passive owners, simply hoping to benefit from the profits. This was the beginning of the separation between the managers and the owners which is the normal state of modern corporations, at least in the advanced economies, and which gives rise to the agency problem, namely how to make sure the managers act on behalf of the owners? (In many countries, family owned companies remain the norm, where this problem is, if not entirely eliminated, considerably reduced.)

Magnuson’s book takes us through the evolution of the corporation in western history, including the famous, and notorious, East India Company, which pioneered the joint-stock principle by which modern corporations operate. The core of that principle is that the company’s operations produce an overall profit (or loss), and the shareholders, then called stockholders, as they still are in the US, share equally in that profit or loss, in proportion to how many shares they own.  

The key innovation here was that stock or share ownership brought limited liability. An investor might buy a share for £5 and at worst lose all of his or her money. That investor was not liable for any further debts that the company might have incurred. 

This was quite a radical principal, that for many people offended natural justice. If the company couldn’t pay its debts, the creditors were left with a loss. Surely this was wrong? 

But the value of attracting investors who could be sure that their maximum loss or downside risk was known and finite, was that companies could mobilise far greater amounts of capital. 

So today’s corporation or company is the main way in which economic activity is organised in today’s capitalist economies. Its three key features are: 

1. Limited liability 

2. Shares that are sold to outside investors; and  

3. A group of managers who are in general not the same people as the shareholders, so there is a separation between ownership and control. 

Today’s great companies, whether Apple or Alibaba, broadly follow this pattern. There are some companies where there are some large, even dominant shareholders such as Meta or Reliance. But the typical company has many shareholders, the majority of them large financial institutions such as pension funds, insurance companies and mutual funds, whose money in turn comes from the ordinary general public. So, indirectly the great companies are mostly owned, ultimately by ordinary people. 

There are other ways of organising economic activity. Partnerships, in which the ownership of the firm is restricted mainly to the key employees, are common in business services such as law and accountancy. There is felt to be a good fit here with the fact that those employees are overwhelming responsible for the success of the business and should therefore own it.  

Originally partnerships had unlimited liability, which meant that if one partner defrauded the firm and ran off with the money, the other partners were legally (and many would say, morally) obliged to make good the losses. In the 19^th century, most British banks were partnerships and occasionally led their partners to ruin, because of unlimited liability for losses. John Kay’s excellent new book The Corporation in the 21st Century tells us that:

In 1878 the City of Glasgow Bank, which had expanded internationally and opened over a hundred branches, collapsed. the bank had emphasised the unlimited liability of its 1,800 shareholders – to their cost, as over 80% of them were bankrupted. [This] was the death knell for unlimited liability in retail banking in the UK.

Today you can have a limited liability partnership, which allows for much larger partnerships to survive. 

At the smaller end, you can have a simple business that is unincorporated: it cannot sell shares and has no practical separation between the owner and the operator. For a simple business operation, this works fine. If the business grows, it can turn into a limited liability company, and then start issuing external shares. 

And finally a lot of economic activity is done by government organisations. These are sometimes structured as corporations, but where the government owns most or all of the shares. EDF, the French electricity company, was originally an entirely French government company, which for several years was then quoted on the London and Paris stock exchanges, where outside private investors were able to buy shares. It always remained majority owned by the French state and in 2023, returned to 100% state ownership.  Whether it gained anything from being partially private for those years is unclear, but it wasn’t a success for the private shareholders.

Other government enterprises may be structured as government departments or parastatal enterprises, depending on the legal and constitutional arrangements of the country concerned. 

Governments are good at doing some things, companies are good at doing others. Often it is the amount of market competition that really matters: monopolies, whether private or state owned, are liable to do a poor job because they know that customers have no choice. 

Corporate finance is about the financial decisions of corporations, which are privately owned companies. But many of the lessons of how best to make these decisions are also applicable to partnerships and to government owned enterprises.