CHAPTER THREE
BUSINESS FORMATION
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INTRODUCTION
A business formation deals with the formalization
and actual implementation of business ideas in to
practice.
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3.2 The Concept of Small Business Development
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: Include number of employees and
startup capital and doesn’t always reflect
the true nature of an enterprise as
qualitative characteristics also used to
differentiate small business from other
business.
• The economic/control covers market
share, independence
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Con’t…
• Micro and small enterprises (MSEs) play an
important role in both developed and
developing economies.
• Ethiopia is no exception and MSEs could
occupy a prominent position in the
development of the Ethiopian economy.
• Less capital, enjoy quick returns and have
the flexibility to handle the vagaries
(change) of the market.
• , they have to face many problems like
lack of finance, poor operations
management, lack of experience, poor
financial management,
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etc,.
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3.3 Forms of Business organizations
There are three basic legal forms of
businesses.
Proprietorship
Partnership and
Corporation
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Description of Legal Forms of Business
• The legal forms are classified based on
• Ownership
• Liability
• Start-up costs
• Continuity
• Transferability of interest
• Capital requirements
• Management control
• Distribution of profits or losses
• Attractiveness for raising capital.
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3.4 Definition and Role/Importance of SMEs
in Developing Countries
3.4.1 Definition of MSEs
1. Size Criteria approaches
Though the criteria used to measure the
size (scale of operation) of businesses vary.
The most widely used yardsticks are;
The 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
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Con’t…
The general criteria are suggested by
Small Business Administration (SBA).
Owned and financed by one individual or a
small group/ 15 or 20 owners in a rare
case/.
The firm’s operations are geographically
localized.
The business is small Compared to the
biggest firms in the industry
The number of employees in the business is
usually fewer than 100.
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2. Economic/control criteria
approach.
Covers four characteristics :
Small market share: it is not large enough
and unable to influence the prices of
national quantities of goods sold to any
significant extent.
Independence: ,the owner control the
business himself/herself.
Personalized Management: little
delegation/ the owner actively participates
in all aspects of the management of the
business
Limited geographical area of operation;
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3.4.2 Role/Importance of MSEs in Developing
Countries
(Reading Assignment)
Large Employment Opportunities:
Balanced Regional Development/
Removing Regional Imbalance
Equitable Distribution of Wealth and
Decentralization of Economic Power
Unregulated Growth of Large-scale
industries
Dispersal over Wide Areas
Higher Standard of Living
Mobilization of Locals
Resources/Symbols of National Identity
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Con’t…
Innovative and Productive /Simple
Technology
Less Dependence on Foreign Capital/
Export Promotion
Promotion of Self Employment
Protection of Environment
Shorter Gestation Period
Facilitate Development of Large Scale
Enterprises
Individual Tastes, Fashions, and
Personalized Services
More Employment Creation Capacity
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3.5 Setting up Small Scale Business
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:
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Environmental Analysis
For an analysis of the environment of
entrepreneurship you would be required
to develop an understanding of
macroeconomic and industry/sector
specific factors.
Macro Environment
Consists of the political, technological,
social, legal and economic environments.
Sectoral Analysis
Study the sector or industry conditions in
which the entrepreneur proposes to launch
a venture.
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SWOT Analysis
• A SWOT analysis helps the
entrepreneur to clearly identify
his/her own strengths and
weaknesses as well as the
opportunities and threats in the
environment.
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con’t…
Macro
Environmental Analysis
Sectoral Analysis
SWOT Analysis
Product/Service
Fig 3.2 Hierarchical Environmental Analysis
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3.6 Small Business Failure and Success Factors
3.6.1 Small Business Failure Factors
What Is Business Failure?
1) Actions such as bankruptcy, foreclosure,
or voluntary withdrawal from the
business with a financial loss to a
creditor or
2) A Court action such as receivership
(taken over involuntarily) or
reorganization (receiving protection
from creditors).
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Causes of Business Failure
The most common causes are
inadequate management and financing.
I. Inadequate Management;
• 89 % of failure of the businesses is
internal factors (controllable factors)
Adequate capital
Cash flow
Facilities/equipment
Inventory control
Human resources
Leadership
Organizational structure
Accounting systems
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II. Inadequate Financing:
Includes improper managerial control
as well as shortage of capital.
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.
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.
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Con’t…
In General, There are various causes of
failure ;
Extend too
Much credit
Fail to plan for the future
Overinvest in fixed assets
Hire the wrong people.
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Business Termination VS Failure
• A termination occurs when a business
no longer exists for reasons of getting
opportunity to sell for a profit, to
move on to a new business , to retire,
or lost interest in the business.
• If market for product have changed or
become saturated, owner decided it
would be more appealing to work for
someone else.
• A business failure occurs when a
business closes with a financial loss to
a creditor.
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Mistakes Leading to Business Failure
The most common mistakes are;
Neglect to plan for the future
Lack of commitment and hard work
No delegation/ not hiring additional
employees
Inaccurate estimates of cash flow and
capital requirements.
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3.6.2 Small Business Success Factors
• Identifying failure factors can discover
ways to tilt the scales towards success.
These success factors are categorized
as:-
i. Conducive Environment;
ii. Adequate Credit Assistance;
iii. Markets and Marketing Support.
i. Conducive Environment
Political, economic, technological and
socio-cultural factors
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ii. Adequate Credit Assistance
Adequate and timely supply of credit
Special financing programs such as lower
interest rates; less collateral requirements and
lower equity ratio;
Various assistance schemes such as preparing
the project study; etc.
[Link] and Marketing Support
Small enterprises can sell their products as
one body through closely-knit associations or
organizations.
The government assist small groups of
entrepreneurs in selling their products.
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Table 3.2. Improved definition of MSE
Level of Sector Human Power Total Asset
Enterprise
Industry ≤5 Br ≤100,000
Micro
Enterprise Service ≤5 Br ≤50,000
Small Industry 6-30 Br ≤1,500,000
Enterprise
Service 6-30 Br ≤500,000
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• Priority Sectors and Sub-Sectors for
MSEs Engagement In Ethiopia
Manufacturing Sector
Construction Sectors
Trade Sectors
Service Sectors
Agriculture Sector (Urban Agriculture)
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Levels of MSEs in Ethiopia
• Start-up
• Growth Level
• Maturity Level
• Growth- Medium Level
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3.8 Main Supporting Packages for MSEs Development in Ethiopia
(Reading Assignment)
In Ethiopia supporting packages for MSEs includes;
• 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;
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Bookkeeping and audit services.
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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 Manaye
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Con’t…
• 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
usually outdated. Because of their poor
financial position they are not able to buy new
equipment, consequently their productivity
suffers.
• How ever, Small business’s owner can avoid
some of the common by knowing the business
in depth; developing a solid business plan;
managing financial resources; understanding
financial
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3.10 Organizational Structure
and Entrepreneurial Team
Formation
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. It is unacceptable
for the entrepreneurs to try to draw a large salary out of the
new venture, and investors may perceive any attempt to do
so as a lack of psychological commitment to the business.
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3.10.2 Designing the Organization
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. These expectations are
grouped into five areas:-
• Organization structure
• Planning, measurement, and evaluation
schemes
• Rewards
• Selection criteria
• Training
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3.9.3 Building the Management Team and a Successful Organization Culture
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.
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Con’t…
• Important considerations and
strategies in recruiting and assembling
an effective team and creating an
effective and positive organization
culture.
1. The entrepreneur’s desired culture must
match the business strategy outlined in
the business plan.
2. The leader of the organization must
create a workplace where employees are
motivated and rewarded for good work.
3. The entrepreneur should be flexible
enough to try different
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Con’t…
4. It is necessary to spend extra time in
the hiring process.
5. The entrepreneur needs to understand
the significance of leadership in the
organization.
Generally, finding the most effective team
and creating a positive organization
culture is a challenge for the entrepreneur
but is just as critical as having an
innovative, marketable product. It is an
important
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