Investors and Other Stakeholders: formula sheet

Key formulas

Sole proprietorship

One owner; unlimited liability; profit taxed as the owner's personal income

Owner and business are not separate legally. Capital is limited and life of the firm depends on the owner.

General partnership

2+ owners; unlimited liability for all partners

Partners are usually jointly and severally liable. Profit is generally taxed in the partners' hands.

Limited partnership / LLP

General partner(s): unlimited liability; limited partners: liability capped at investment

Limited partners usually cannot manage. LLP rules vary by jurisdiction, so rely on the stated facts.

Corporation

Separate legal entity; limited liability; transferable ownership; possible double taxation

Easiest for raising large capital. Private: no public trading. Public: listed, more disclosure, more liquidity.

Order of claims on a firm's cash flows

Creditors (fixed claim) → then shareholders (residual claim)

Shareholders are paid only after creditors, so they bear the most risk and have the highest potential reward.

Shareholder vs creditor risk preference

Shareholders: upside unlimited, downside limited → may accept higher risk. Creditors: upside capped at interest and principal → prefer lower risk

This is the usual reason for conflict over risky projects and extra debt.

Principal-agent relationship

Principals (shareholders) → hire agents (managers) → agents may act in own interest

The conflict is managers' self-interest versus owners' wealth maximisation.

Agency costs

Agency costs = monitoring costs + bonding costs + residual loss

Three components. Residual loss is what remains after monitoring and bonding.

Principal-agent link

Principal (owner) → hires → Agent (acts for principal)

Shareholders are principals and managers are agents. Boards are the shareholders' monitors.

Shareholder-creditor conflict

Shareholders: upside unlimited, downside limited. Creditors: upside capped (interest + principal), loss if firm value falls below the debt, but rank ahead of shareholders.

This difference drives shareholders toward riskier choices than creditors prefer.

Main mitigation tools

Managers: pay, board, audit, takeover threat. Creditors: covenants, collateral. Minority holders: voting rights, disclosure, independent directors.

Match the tool to the conflict.

Legal infrastructure

Laws + courts + enforcement of rights

Examples: company law, bankruptcy law, shareholder right to sue. Applies to all stakeholders in a jurisdiction.

Contractual infrastructure

Agreements between the company and a specific stakeholder

Examples: bond covenants, employment contracts, supplier agreements. Tailored to the parties and fills gaps in the law.

Organizational infrastructure

Board + committees + internal controls + policies + disclosure

Internal to the company. The board oversees management on behalf of shareholders.

Governmental infrastructure

Regulators + exchanges' listing rules + public supervision

External oversight that sets minimum standards and can sanction violations.

Core logic of governance

Weak governance → higher agency costs and risk → higher required return → lower value

This is a general qualitative chain, not a numerical formula. Strong governance works in the reverse direction.

ESG components

ESG = Environmental + Social + Governance

Each is a factor that can affect risk and return. Governance is part of ESG, not separate from it.

Shareholder activism tools

Proxy voting, resolutions, engagement, public campaigns, board seat nominations

Activists act through shareholder rights, usually to change strategy, governance or capital allocation.

Quick revision

• A sole proprietorship has one owner with unlimited liability; a corporation is a separate legal entity with limited liability for shareholders.
• Partnerships share profits and, in general partnerships, liability among the partners.
• Stakeholders are anyone affected by or able to affect the company, not only shareholders.
• A principal-agent conflict arises when the agent acts for the principal but has different interests.
• Shareholders can conflict with managers, and shareholders can conflict with creditors.
• Creditors prefer safety and stable cash flows; shareholders may accept more risk for higher returns.
• Stakeholder management means identifying, prioritising and engaging stakeholders.
• Good corporate governance aligns managers' actions with the interests of owners and other stakeholders.
• Monitoring, incentives and transparency are common ways to reduce agency costs.
• ESG stands for environmental, social and governance factors.
• Match each scenario to a concept by asking: who is the principal, who is the agent, and what is the clash?
• There is no penalty for wrong answers, so always pick one of the three options.

Common mistakes

• Saying a limited partner has unlimited liability. Fix: Only general partners have unlimited liability. Limited partners are liable up to their investment.
• Treating a private company as a sole proprietorship or small partnership. Fix: A private company is still a corporation with limited liability. It simply has no publicly traded shares.
• Treating shareholders as the only stakeholders. Fix: Remember that stakeholders include anyone affected by or able to affect the firm, including creditors, employees, customers, suppliers and governments.
• Saying creditors benefit when the firm takes on riskier projects. Fix: Creditors get only interest and principal. More risk raises their chance of loss without raising their payoff.
• Saying managers are the principals and shareholders are the agents. Fix: The principal is the one who hires. Shareholders (through the board) hire managers, so managers are agents.
• Thinking higher leverage always hurts shareholders in a creditor conflict. Fix: Extra debt or risky projects can raise shareholder value at creditors' expense. Creditors are the ones harmed, and they respond with covenants.
• Calling a bond covenant legal infrastructure. Fix: Covenants are terms agreed between issuer and creditor. They are contractual infrastructure.
• Treating the board of directors as governmental or external. Fix: The board is part of the company's own structure. It is organizational infrastructure.
• Treating governance as separate from ESG Fix: Remember that G is one of the three ESG factors. Board quality, pay and ownership structure are governance issues.
• Assuming good governance removes all risk Fix: Good governance reduces some risks, such as fraud and agency costs. It does not guarantee returns, and it has costs.

Exam tips

• Memorise the liability of each form. Most questions on this topic are answered by that one feature.
• Watch for the word limited. It can attach to a partner, a partnership or a company, and each means something different.
• Public vs private is about whether shares trade publicly, not about size or whether the owners are government.
• Expect statements that overstate a rule, such as all owners always face double taxation. Eliminate absolutes.
• Questions are standalone with three options, so find the fact in the stem that rules out two choices.
• Match each group to its core claim first: residual for shareholders, fixed for creditors. Most items reduce to this.
• Expect scenario stems about debt, risk, dividends or pay and ask who gains or loses. Trace the effect on each group before reading options.
• Each item has three options and one best answer. Choose the group whose core claim is most directly affected by the action in the stem.