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Corporations and limited liability

Video transcript

We've all come in contact with corporations. You might work for a corporation. You might buy something from a corporation. You might, I don't know, you might own shares in a corporation. So we kind of have a sense of what they are, but I want to make that sense a little bit more precise in this video and also give an understanding of why corporations even exist. And so a corporation, and you might already kind of have a feeling for this, it's a legal entity. It's a legal entity that can kind of act ... that can act, that can act like a person ... like a person, I put the act in quotes because obviously there's some things that a person can do that a corporation can't. A person can smile. I guess one can debate whether a corporation can. When I say act, I mean legally. So a corporation can sue another corporation or person. A corporation can be sued by another corporation or a person. A corporation can own things, just like a person owns things. A corporation can owe other people or corporations things, so that's what I mean by "act". A corporation can't jump like a person or laugh like a person. Well, that ... maybe that'll be a a philosophical discussion for another video. But what I want to focus on, other than just what a corporation is, is why they exist. So what's the "why" of a corporation? And in my mind, there's two big reasons and the first reason and this is the real biggest one is limited liability. Sounds like a very fancy word, but we'll see it with an example, it's not too ... it's not too fancy. So there is limited liability and there's also kind of transferrable share ownership. Share ownership. But what I want to do in this, which is you know essentially more than one person can own the corporation, they can transfer the shares between people, they can trade them. But what I want to focus on is the limited liability because even if there's only one person who owns the corporation, if they own the whole thing. It still makes sense for them to create it because of limited liability. And to understand this, let me give you a little example. Let's say that ... Let's, let's say that there's some guy. Let's say he's Bill. Let's say it's Bill's ,,, Bill's assets right over here and let's say that he has a house. Let's say that he has a house that is worth $500,000. Let's say he has a car, maybe he has a very nice car. Let's say he has a car that is worth 100 ... No, that's too much for a car. That's very ... Well, cars can cost that much but let's be ... that's ... $50,000 is still a nice car. Let's say that he has some investments, some investment properties or maybe some stocks that are worth another ... another $500,000 and let's say that he's interested, you know, he looks around his town, he sees that there's a lot of people who could use a ride. So to make some extra money, he wants to start a cab or car service business. So he goes out there and he doesn't think about starting a corporation and he just goes out there and he buys a car, let me call a cab, plus licenses. A cab plus licenses. And these things are actually much more expensive than what you would imagine. You could ... could talk to a, the next time you're in a cab, it costs much more than the cost of the car, which would probably be $20,000 or $30,000. It comes up close to six figures, but let's say that it costs him $80,000. And let's say that he spends $1,000, at least for this first year. Let's say he spends $1,000 on insurance, on liability insurance. He realizes, "Hey look, maybe you know, "maybe something bad happens." "This is a cab I could run into somebody" "and I get sued. So, I want to get liability insurance." So this is liability insurance, in case anything like that happens and let's say that it is a ... Let's say that it is a $100,000 policy. He says, "You know, how can I ...", you know, he ... he's maybe a little bit optimistic and he thinks that no one can sue him for more than $100,000. So it's a $100,000 ... It is a $100,000 policy. Now, he goes out there. He starts driving that cab around, picking up people, dropping them off and by accident one day, he rolls over someone's foot and that person whose foot he just crushed happened to be a ... you know, a world-class soccer player. So he ruined this person's career. He ruined the career. So right here, here's the soccer ... the soccer player right over here, whose career is ruined or if you're watching this outside of the United States, a futbol player. But anyway, you have this soccer player. His crushed ... His foot is crushed. And so he sues Bill because Bill owns the cab. And the court ... so he sues. Let me write it. He sues Bill ... sues Bill for $1,000,000. $1,000,000 because it ruined his career. In fact, that's probably ... probably deservers more than that if he was a world-class player. And the court, you know, rightfully says, "Look, you crushed this guy's player." "You ... you ... you were kind of ... this guy's foot," "you were kind of negligent." "You got a little bit too close to the curb." "His foot was crushed." So it rules in the soccer player's favor. And so essentially, now Bill's on the line for the entire $1,000,000. So Bill is going to have to sell his house. He's going to have to see his car. Well, he wouldn't have to sell his car because he has investments, sell his investments and give his house or the proceeds from his house and investment to the soccer player. And so now all Bill is left with is a car and a cab and not much else, so what did this ... this cab business didn't work out too well for Bill. It's a small part of his portfolio. He didn't even have a chance to make much money from it and it really just wiped him clean. Now, what Bill should have done is create a separate corporation, is create a separate corporation called ... called Bill's ... Bill's Car Service ... Car Service, Inc. and transferred enough money so that the cab, the licenseses and the insurance could be owned by this legal entity, by this corporation. So here you would have the cabs ... cab + the license. So he would have transferred $80,000 to the corporation and the corporation would have bought it in the corporation's name. Remember, it can act like a person. It can buy things in its name. The owner of this cab is Bill's Car Service not Bill. It could also get the insurance, the $100,000 of insurance, maybe this is what people think is a reasonable amount for anyone who is running a cab business. You have to have at least $100,000. The reality is probably it's a much larger number than that and he spends $1,000 to have that policy and remember, this is $100,000 of liability insurance. Now, let's play out the same situation. The cab still rolls over the soccer player's foot. The soccer player's foot gets crushed, can't play soccer anymore, sues whoever owned that cab for a $1,000,000. But now the owner of that cab is no longer Bill. It's Bill Car Service. So he sues this, sues Bill's Car Service and let me make it clear. In this reality, Bill's assets wouldn't include the cab, the licenses and the insurance anymore. It would now include, 100% ownership ... ownership of car service, of Bill's Car Service. So the asset is now the shares, the 100% ownership in this but this is a separate legal entity. So now the soccer player sues the cab service for $1,000,000. The court rightfully says, "Hey, yeah you owe this dude $1,000,000." "You ruined his career.", but unfortunate for the player and I guess fortunate for Bill, I don't want to take sides here. This is just how reality is set up and this is what limited liability is, is that now all the car service can produce is ... Well, they could sell ... They could sell maybe these assets for $80,000 and they'll get $100,000 ... They'll get $100,000 from the insurance, so all this corporation will be able to do is give the guy $180,000 and then the cooperation is just going to go bankrupt. So it's going to declare corporate bankruptcy. It's going to go bankrupt. So this thing that Bill owed, this car service which maybe originally he could write on his books as being worth $81,000, had insurance policy and all this other stuff. It's now worth 0. The corporation's worth 0, but the soccer player can't go after anything else. We'll talk about in the future, of reasons why they can. If he didn't have enough insurance or if he didn't ... if he was running this like his own personal business. If this car service didn't have its own bank account or if it didn't ... if it was undercapitalized, if it didn't have enough money in it, then maybe the court would let the soccer player or kind of "pierce the corporate veil" they say, which is a very fancy way of still going after the owners of the corporation. But as long as this corporation was reasonably capitalized, and I'm just made up these numbers here, the soccer player will only be able to go after this corporation. So what you see here is that Bill's liability was limited. This was limited liability. The most he could lose as long as he ran the car service properly and had enough insurance and had enough money in the actual organization. As long as he ran it in the right way, the most he could lose is the value of the organization. If this organization, you know, hits somebody or rolled over their foot, and ... but he ran the organization properly, they can;t go over the rest of his assets. So this is the number one reason why people have corporations, for the limited liability.