What’s it: Limited liability means the owner is not obligated to pay off the business debts. Together with unlimited liability, it is about how much responsibility the owners have for the company.
Unlike unlimited liability, a limited liability waiver business owner does not have full responsibility for the business’s debts. They only incur losses equal to the money they invested in the company or partnership.
The company is a legally separate entity from the owners. The company can sue or be sued on its own behalf, control its assets, and be responsible for the debts it causes. Thus, business debts are not the responsibility of the owner personally.
So, if a company is sued, the plaintiff only has the right to sue the company’s assets, not the owner’s. Then, the owners only lose the money they invested in the company if the business goes bankrupt. Thus, they avoid personal bankruptcy and do not have to sell their assets or assets to pay off the company’s debts.
Why is limited liability important for shareholders/owners?
There is no personal obligation to pay off business debts. The main reason is that. Limited liability prevents owners from losing personal assets.
In contrast, under limited liability, the owner could lose more money than he has when creditors force the company to pay off the debt. The potential for loss is significant because the business needs debt or loans to grow.
Therefore, many investors prefer to acquire equity ownership in limited liability companies. When businesses fail, their loss is as significant as the money they invested.
Take a simplified case. A company has a debt-to-equity ratio of 2 times. This ratio shows the company’s debt is twice the money investors (shareholders) invested. Thus, losses can be multiplied if shareholders have unlimited liability.
Limited liability examples
Some business organizations have limited liability. Private limited companies are an example. Other examples are:
- Public limited company
- Limited Partnership (LP)
- Limited Liability Partnership (LLP)
- Limited Liability Limited Partnership (LLLP)
A private limited company is a business organization where the owners have limited liability, and the shares are not sold to the public. So, when you invest in stocks, you won’t find the shares traded on an exchange. Sometimes, we call it a closed company or a private company.
Public limited companies also have limited liability. But, unlike private limited companies, they offer to sell shares to the public through the stock exchange. So, the public can trade it.
When a private limited company offers its shares to the public for the first time, we call it an initial public offering (IPO). They usually do it to raise funds for needs such as investments. After being officially listed on the stock exchange, the company becomes public (public limited company).
Limited Partnership (LP) refers to a business organization formed by several parties, referred to as business partners, to achieve a common goal. Business partners are divided into two, namely, general partners and limited partners.
The general partner’s liability is unlimited. Meanwhile, limited partners are under limited liability, generally only contribute investment capital, and are not involved in day-to-day operations.
Limited Liability Partnership (LLP) is a partnership where each partner has limited liability. They are actively involved in managing and running the business. Financial and legal misconduct by either partner is not the other partner’s responsibility.
A limited liability limited partnership (LLLP) is similar to a Limited Liability Partnership (LLP). LLLP has general partners and limited partners. However, unlike a limited partnership, general partners have some protection against liability.
Limited liability vs. unlimited liability
We differentiate organizational arrangements and legal status into two based on the extent to which the owners are personally liable for the company’s debts. Both are:
- Unlimited liability
- Limited liability
Limited liability business organizations often contrast with sole proprietorships, where owners have unlimited liability. Under a sole proprietorship, one person is responsible for the business’s operations, profits, liabilities, and risks.
As the name suggests, the owner is responsible for the business’s debts under an unlimited liability arrangement. They can lose personal assets to pay off debts. The reverse is true for limited liability.
Another business organization with unlimited liability is a partnership. An example is a general partnership. Another example is multiple partners in a limited partnership, as mentioned earlier.
Advantages and disadvantages of limited liability
Preventing owners from losing personal assets is a key advantage. The owner is personally confident if the business takes on debt to support business expansion.
So, if a company goes bankrupt, they are not responsible for its debts. They don’t have to sell personal assets to help pay off debts or company obligations. So, their total wealth is not affected. Other advantages are:
Organizational structure. Limited liability companies usually have a more organized business structure. And they have more established resources than partnerships or sole proprietorships. Therefore, they have a better competitive capacity than the other two.
Risk transfer. A greater risk of default is transferred from the owner to the creditor. For this reason, creditors are very interested in a company’s performance and financial position to see its ability to pay. They will not see how wealthy the owner is when they decide to lend to the company.
Separate entity. Limited liability companies are legally recognized as separate entities from their owners. So, if the company is sued, the owner has no legal obligation. They are not sued, but only their company.
Continuity. If an owner or director dies or quits, it does not cause the company to cease operations or dissolve. The company’s operations are not affected and continue to run.
Meanwhile, limited liability disadvantages are related to the company’s profits. Owners or shareholders obtain a return on investment through dividends distributed to them.
Then, if the company is a public company, the owners or shareholders can also profit from the increase in the share price. They can realize capital gains by selling the stock at a higher price than the purchase price.
However, unlike organizations with unlimited liability, such as sole proprietorships, profits do not belong 100% to shareholders. The company may decide not to distribute dividends and keep them as internal capital (retained earnings). As a result, there is no return for shareholders.
In common practice, companies distribute dividends at a certain percentage of net income. The distribution may be as regular as in mature firms. Or it is irregular, where sometimes it is shared and sometimes not.
Conversely, if operating as a sole proprietorship, the business profits are 100% for the owner, even if he has unlimited liability.
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