CHAPTER 3: BUSINESS FORMATION

3.1 INTRODUCTION
A business formation deals with the formalization and actual
implementation of business ideas in to practice. In today’s economic
development/transformation, small businesses are creating new jobs
even as large businesses continue eliminating jobs and they are more
flexible than large ones in the products and services they offer. This
chapter discusses the issues of business development and the different
legal forms of business.
 3.2 The Concept of Small Business Development
• Specifying size and standard to define small business is necessarily
arbitrary, because people adopt different standards for different
purposes.
• Based on socio- economic conditions, countries define small
business differently. But all may use size and economic criteria as a
base to define small business.
• Size criteria include number of employees and the startup capital.
 Cont….
3.3 Forms of Business (A Short Explanation)
• There are three basic legal forms of business formation with some
variations available depending on the entrepreneurs’ needs.
The three basic legal forms are:-
1) Proprietorship,
2) Partnership, and
3) Corporation, with variations particularly in partnerships and
corporations.
 Cont….

Legal Forms of Business Description

1) Proprietorship Form of business with single owner who has

unlimited liability, controls all decisions, and receives all

profits.

2) Partnership Two or more individuals having unlimited liability who have

pooled resources to own a business

3) Corporation Separate legal entity that is run by stockholders having limited

liability
 Cont…

• These three basic legal forms are compared with regard to

ownership, liability, start-up costs, continuity, transferability of
interest, capital requirements, management control, distribution of
profits, and attractiveness for raising capital.

• It is very important that the entrepreneur carefully evaluate the pros

and cons of the various legal forms of organizing the new venture.
This decision should be made before the submission of a business
plan and request for venture capital.

• The comparison for the three basic legal forms against the
aforementioned factors is briefly presented in the table below:-
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• There is a difference between small business owners and
entrepreneurial ventures as well. An entrepreneurial venture often is
a growth-oriented innovative company with product or service
offerings that are new to the market. Small businesses could be
entrepreneurial ventures. Most entrepreneurial ventures start as a
small business. Most small businesses’ owners work with known
products and services aimed at incremental growth, and their
innovation is focused on sales, marketing, and market expansion.
 Cont…
• There are two approaches to define small business. They are: Size
Criteria, and Economic/control criteria.
1. Size Criteria
• Even the criteria used to measure the size of businesses vary; size
refers to the scale of operation. Some criteria are applicable to all
industrial areas, while others are relevant only to certain types of
business. For instance, some of the criteria used to measure size are:
number of employees; volume, and value of sales turnover, asset
size, and volume of deposits, total capital investment, volume/value
of production, and a combination of the stated factors.
 Cont….
• To provide a clearer image of the small firms, the following general
criteria for defining a small business are suggested by Small
Business Administration (SBA).
• Financing of the business is supplied by one individual or a small
group. Only in a rare case would the business have more than 15 or
20 owners.
• Except for its marketing function, the firm’s operations are
geographically localized.
• Compared to the biggest firms in the industry, the business is small.

• The number of employees in the business is usually fewer than 100.

 Cont…

• This size criteria based definition of SMEs varies from country to

country. All over the world, number of employees or capital

investment or both has been used as the basis for defining SMEs.

2. Economic/Control Criteria.

• Size does not always reflect the true nature of an enterprise. In

addition, qualitative characteristics may be used to differentiate small

business from other business. The economic/control definition covers:

• Market Share,

• Independence, and
 Cont….

• Personalized Management.

• Geographical Area of Operation.

• All four of these characteristics must be satisfied if the business is to

rank as a small business.

I) Market Share: - The characteristic of a small firm’s share of the

market is that it is not large enough to enable it to influence the prices

of national quantities of goods sold to any significant extent.

II) Independence: - Independence means that the owner has control of

the business himself/herself.

 Cont…

It, therefore, rules out those small subsidiaries which though in

many ways fairly autonomous, nevertheless have to refer to major
decisions (e.g., on capital investment) to a higher level of authority.
III) Personalized Management: - It is the most characteristics factor
of all. It implies that the owner actively participates in all aspects
of the management of the business, and in all major decision-
making process. There is little delegation of authority and one
person is involved when anything material is involved.
IV) Technology: - Small business is generally labor intensive and
only few are technology intensive.
 Cont…

V) Geographical Area of Operation: - The area of operation of a small

firm is often local.

• Generally, small business is a business that is privately owned and

operated, with a small number of employees and relatively low
volume of sales.

3.4.2 Role/Importance of MSEs in Developing Countries

• Small and medium enterprises (SMEs) cover a wider spectrum of

industries and play an important role in both developed and
developing economies.
 Cont…

• Some of the contributions of small business in Ethiopia are

hereunder.

1) Large Employment Opportunities:

2) Economical Use of Capital: MSEs need relatively small amount of

capital.

3) Balanced Regional Development/ Removing Regional Imbalance/:

4) Equitable Distribution of Wealth and Decentralization of Economic

Power: It removes the drawbacks of capitalism, abnormal profiteering,
concentration of wealth and economic power in the hands of few etc.
 Cont….

5) Unregulated Growth of Large-scale industries results in concentration

of economic power in the hands of a few; and consequently, gross

inequalities in the distribution of income and wealth will occur. On the
other hand; income generated in a large number of small enterprises is
dispersed more widely and its benefit is derived by the large segments of
the society.

6) Dispersal over Wide Areas- SMEs has a tendency to disperse over

wider areas and they play a key role in the industrialization of a developing
country.

7) Higher Standard of Living: MSEs bring higher national income, higher

 Cont…

8) Mobilization of Locals Resources/Symbols of National Identity:

The spreading of industries even in small towns and villages would
encourage the habit of thrift and investment among the people of rural
areas.
9) Innovative and Productive /Simple Technology:
New but simple techniques of production can be adopted more easily
by MSEs without much investment.
10) Less Dependence on Foreign Capital/ Export Promotion:
MSEs use relatively low proportion of imported equipment and
materials.
 Cont….
11) Promotion of Self Employment:
12) Protection of Environment:
13) Shorter Gestation Period: In these enterprises the time-lag
between the execution of the investment project and the start of flow of
consumable goods is relatively short.
14) Facilitate Development of Large Scale Enterprises:
15) Individual Tastes, Fashions, and Personalized Services:
16) More Employment Creation Capacity: This is because small and
medium scale enterprises are labor intensive and thus create more
employment with a given level of capital.
 Cont….

3.5 Setting up Small Scale Business

 Steps for Setting up the Entrepreneurial Venture

• The entrepreneurial process of launching a new venture can be

divided into three key stages of: Discovery; Evaluation; and
Implementation. These can be further sub-divided into seven steps as
shown below:
 Cont…

• Discovery: The first stage of discovery is to identify opportunities

that may form the basis of an entrepreneurial venture. It requires
creative thinking to identify issues that can benefit from an
entrepreneurial vision. This stage can be divided into two steps:

Step 1 Discovering your entrepreneurial potential - the first step is to

know more about your personal resources and attributes through some
self-evaluation

Step 2 Identifying a problem and potential solution – a new venture has

to solve a problem and meet a genuine need.
 Cont…

• Evaluation: The next stage evaluates if this all adds up to a feasible

business in two further steps:

Step 3 Evaluating the idea as a business opportunity– find out

information about the market need.

Step 4 Investigating and gathering the resources – How will the

product/service get to market? How will it make money? What
resources are required?
 Exploitation: The next stage is to make the final preparations and

launch it into the market. It can be developed in three further steps:

Step 5 Forming the enterprise to create value – set up a business entity

 Cont…
and protect any intellectual property.
Step 6 Implementing the entrepreneurial strategy – activate the
marketing, operating, and financial plans.
Step 7 Planning the future – look ahead and visualize where you want
to go.
• After this the entrepreneur should make environmental Analysis:
The hierarchical approach to environmental analysis is given below.
Cont….
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3.6 Small Business Failure and Success Factors

3.6.1 Small Business Failure Factors

• What Is Business Failure?

• Causes of Business Failure: small business are fail mainly due to

insufficient capital suggests inexperienced management.

• Inadequate Management: - Business management is the efficient

and effective use of resources. For small business owners,
management skills are especially desirable—and often especially
difficult to obtain. Lack of experience is one of their most pressing
problems. Small business owners must be generalists; they do not
 Cont…

luxury of specialized management.

On the one hand, they may not be able to afford to hire the full-time

experts who could help avert costly mistakes. On the other hand, their

limited resources will not permit them to make many mistakes and stay

in business. As a small business manager, you will probably have to

make decisions in areas in which you have little expertise.

Inadequate Financing: - Business failure due to inadequate

financing can be caused by improper managerial control as well as

shortage of capital.
 Cont….

• On the one hand, if you don’t have adequate funds to begin with,

you will not be able to afford the facilities or personnel you need to
start up the business correctly.

• On the other hand, if you do possess adequate capital but do not

manage your resources wisely, you may be unable to maintain

adequate inventory or keep the balance needed to run the business.
 Other common causes of business failure include Neglect, Fraud,

and Disaster.

• Neglect occurs whenever an owner does not pay a due attention to

the enterprise.
 Cont…
• The owner who has someone else managing the business while s/he
goes fishing often finds the business failing because of neglect.

• Fraud involves intentional misrepresentation or deception. If one of

the people responsible for keeping the business’s books begins
purchasing materials or goods for himself or herself using the
business's money, the business might find itself bankrupt before too
long.

• Disaster refers to some unforeseen happening. If a hurricane hits the

area and destroys the property in the company's yard, the loss may
require the firm to declare bankruptcy. The same is true for fires,
burglaries, robberies, or extended strikes.
 Cont….

Business Termination versus Failure

• There is a difference between a business termination and a business

failure. A termination occurs when a business no longer exists for

any reason. A failure occurs when a business closes with a financial

loss to a creditor.

• Reasons for a termination abound. The owner may have an

opportunity to sell her business to someone else for a healthy profit,

or be ready to move on to a new business or to retire, or s/he may

have simply lost interest in the business.

 Cont…
• The market for the business’s product may have changed or become
saturated. Perhaps the owner has decided it would be more appealing
to work for someone else.
• In other cases, businesses may change form. A partnership may be
restructured as a corporation, or a business may move to a new
location. Businesses that undergo such changes are considered
terminated even though they continue in another form.
 Cont….
3.6.2 Small Business Success Factors

• When large and small businesses compete directly against one

another, it might seem that large businesses would always have a
better chance of winning. In reality, small businesses have certain
inherent factors that work in their favor. You will improve your
chances of achieving success in running a small business if you
identify your competitive advantage, remain flexible and innovative,
cultivate a close relationship with your customers, and strive for
quality.

• It may come as a surprise, but big businesses need small businesses

 Cont…
a symbiotic relationship exists between them. For instance, John Deere
relies on hundreds of vendors, many of which are small, to produce
component parts for its farm equipment. Deere’s extensive network of
3,400 independent dealers comprising small businesses provides sales
and service for its equipment. These relationships enable Deere, the
world’s largest manufacturer of farm equipment, to focus on what it
does best, while at the same time creating economic opportunity for
hundreds of individual entrepreneurs.
• Small businesses perform more efficiently than larger ones in several
areas.
 Cont…
• generally entrepreneurs success factors are categorized as:-

1. Conducive Environment;
2. Adequate Credit Assistance;
3. Markets and Marketing Support.
1. Conducive Environment
• Successful small enterprises do not emerge, and thereafter survive
and grow unless the environment is conductive. Political, economic,
technological and socio-cultural factors in the environment impinge
upon the life of the small enterprises and generate much of the needs
required for their existence.
 Cont….

• Political Climate

• The Economic Environment

• Technology

• Socio-Cultural Environment:

2. Adequate Credit Assistance

Adequate and timely supply of credit is critical for new entrepreneurs to

emerge especially from a wide base.

3. Markets and Marketing Support

Market for a small enterprise in a developing country can be quite a

problem.
 Cont…
3.7 Classification of Enterprises in Ethiopian Context

1. In Case of Manufacturing Enterprise (Manufacturing,

Construction and Mining):

a) A Micro Enterprise is one in which the investment in plant and

machinery (total asset) does not exceed birr100, 000 (one hundred

thousand); and operates with 5 people including the owner.

b) Small Enterprises is one in which the investment in plant and

machinery (a paid up capital of total asset) of birr100, 000 (one hundred

thousand) and not more than Birr 1.5 million; and operates with 6-30
 cont…
2. In Case of Service Enterprise (Retailing, Transport, Hotel and
Tourism, ICT and Maintenance):
• a) A micro enterprise is one with the values of total asset is not
exceeding Birr 50,000(fifty thousands); and operates with 5 persons
including the owner of the enterprise.
• b) Small Enterprises is one in which the total asset value or a
paid up capital of of birr100, 000 (one hundred thousand) and not
more than Birr 1.5 million; and operates with 6-30 persons.
• More clearly, the improved definition of MSE is presented in the
table below.
Cont….
 Cont….
• When ambiguity is encountered between manpower and total assets
as explained above, total asset is taken as primary yardstick.
• Priority Sectors and Sub-Sectors for MSEs Engagement In Ethiopia

1. Manufacturing Sector-
2. Construction Sectors-
3. Trade Sectors-
4. Service Sectors-
5. Agriculture Sector (Urban Agriculture)
 Cont…
Levels of MSEs in Ethiopia

• Start-up:- Start up level refers to enterprises that incorporate people

who are interested to establish MSE and those who completed the
required profession/skill from various institutions and innovated by
legally either in the form of association or private. It is a level where an
enterprise begins production and service under legal framework or legal
entity.

• Growth Level: - An enterprise is said to be at growth level when an

enterprise become competent in price, quality and supply and profitable

using the support provided. At this level, the enterprise man power and
 Cont….

• Maturity Level: - Maturity level means when an enterprise able to

be profitable and invest further by fulfilling the definition given to

the sector and using the support provided.

• Growth- Medium Level:- An enterprise is said to be transformed

from small to medium level of growth is when it enabled to be

competent in price, quality and supply using the support given to the

level.

3.8 Main Supporting Packages for MSEs Development in Ethiopia

• When entrepreneurs are deciding to involve and develop MSEs in

 Cont…

Ethiopia, they are more likely entitled with some supporting packages
which include awareness creation about the sector; provision of legal
services, to form legal business enterprises; providing Technical and
business management training; financial support based on personal
saving, 20/80 (the beneficiaries are save 20% and the MFIs provide
Loan 80% of the projects); facilitate working premises; industry
extinction services and BDS provision; bookkeeping and audit
services.
 Cont…

3.9 Problems of Small Scale Business in Ethiopia

• Small-scale businesses have not been able to contribute substantially

to the economic development, particularly because of financial,

production, and marketing problems. These problems are still major

handicaps to their development. Lack of adequate finance and credit

has always been a major problem of the Ethiopian small business.

• Small-scale units do not have easy access to the capital because they

mostly organized on proprietary and partnership basis and are of

very small size.

 Cont…

• They do not have easy access to industrial sources of finance partly

because of their size and partly because of the fact that their

surpluses which can be utilized to repay loans are relatively small. .

Because of their size and partly because of the limited profit, they

search for funds for investment purposes. Consequently, they

approach traditional money lenders who charge extra high rate of

interest hence small enterprise continue to be financially weak.

• Small scale enterprises find it difficult to get raw materials of good

quality at reasonable prices in the field of production. Furthermore,

the techniques of production, which the enterprises have adopted, are

 Cont…

usually outdated. Because of their poor financial position they are not
able to buy new equipment, consequently their productivity suffers.

• Small business’s owner can avoid some of the common pitfalls that
lead to business failure by knowing the business in depth;
developing a solid business plan; managing financial resources;
understanding financial statements; and learning to manage people
effectively.

3.10 Organizational Structure and Entrepreneurial Team

Formation
 Cont…

3.10.1 Introduction

• We can perceive from the experiences of companies the importance

of employees and their loyalty and commitment to the organization.

• Also significant to potential investors is the management team and

its ability and commitment to the new venture.

• Investors will usually demand that the management team not attempt
to operate the business as a sideline or part-time venture while
employed full time elsewhere. It is assumed that the management
team is prepared to operate the business full time and at a modest
salary.
 Cont…
3.10.2 Designing the Organization

• Generally, the design of the initial organization will be simple. In fact,

the entrepreneur may find that he or she performs all the functions of the
organization alone. This is a common problem and a significant reason
for many failures.

• The entrepreneur sometimes thinks that he or she can do everything and

is unwilling to give up responsibility to others or even include others in
the management team. In most cases when this occurs, the entrepreneur
will have difficulty making the transition from a start-up to a growing,
well-managed business that maintains its success over a long period of
time.
 Cont…
• The design of the organization will be the entrepreneur’s formal and
explicit indication to the members of the organization as to what is
expected of them. Typically, these expectations can be grouped into
the following five areas:-
• Organization structure-
• Planning, measurement, and evaluation schemes
• Rewards
• Selection criteria
• Training
 Cont…

3.10.3 Building the Management Team and a Successful

Organization Culture

• In conjunction with the design of the organization, the entrepreneur

will need to assemble the right mix of people to assume the
responsibilities outlined in the organization structure.

• Some of the issues identified in the organization design will be

revisited here since they are not only critical to the building of the
team but are just as important in establishing a positive and
successful organization culture.

• This strategy must be maintained through the stages of start-up and

 Cont….

growth of the enterprise. There are some important issues to address

before assembling and building the management team. In essence, the
team must be able to accomplish three functions:-
• Execute the business plan;

• Identify fundamental changes in the business as they occur; and

• Make adjustments to the plan based on changes in the environment

and market that will maintain profitability.
 Let us explore some of the important considerations and strategies in
recruiting and assembling an effective team and hence in creating an
effective and positive organization culture.
.
 Cont…
• First, the entrepreneur’s desired culture must match the business
strategy outlined in the business plan. It can be done by working
with his/her staff to develop the Core Family Values that represent
the key elements of the firm’s culture and strategy.
• Second, the leader of the organization must create a workplace
where employees are motivated and rewarded for good work.
• Third, the entrepreneur should be flexible enough to try different
things. This is not always possible in a very small organization but
has been the successful strategy in the growth of Google.
 Cont…
• Fourth, it is necessary to spend extra time in the hiring process.
There is sometimes a tendency to want to hurry the process of
finding the appropriate skills to fill the organization’s needs.

End

Thank you!!!