CHAPTER THREE

BUSINESS FORMATION
 Learning objectives

After completing this chapter, you will be able to:

 Identify the forms of business ownership;

 Analyze the importance/role of MSEs;

 Set up small scale business;

 Distinguish the failure and success factors of MSEs

 Forms of business
 There are three basic legal forms of business formation
with some variations available depending on the
entrepreneurs’ needs.
1. Proprietorship
2. Partnership, and
3. Corporation
 Forms of business
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
 Forms of business …
5

 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
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 Definition of MSEs
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 SMEs, or small and medium-sized enterprises, are

defined differently around the world
 There are two approaches to define small business.

 They are:

 Size Criteria, and

 Economic/control criteria.
 Size Criteria
 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.
 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.
 NB: number of employees or capital investment or both has been
used as the basis for defining MSEs in many countries
 Size Criteria definition of MSEs
10

Based on size criteria MSEs are suggested by Small

Business Administration (SBA) as,
 Is business financed by one individual or a small group
(only in a rare case would the 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.
 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

 Personalized management

 Geographical area of operation

 Technology
 Economic/Control Criteria
12

 Market share: - it is not large enough and can’t influence

the prices of national quantities of goods sold
 Independence: - means that the owner has control of the
business himself/herself.
 Personalized management: - 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
 Technology: - is generally labour intensive
 Geographical area of operation: - the area of operation
of a small firm is often local.
 Classification of Micro and Small Enterprises
13

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 birr 100,000 and
operates with 5 people including the owner.

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

machinery of birr 100,000 and up to Birr 1.5 million; and
operates with 6-30 persons.
 Classification of micro and small
enterprises
14

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 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 not more than Birr 500,000; and
operates with 6-30 persons.
Classification of micro and small
enterprises
 Priority sectors and sub-sectors for MSEs
engagement in Ethiopia

 Manufacturing Sector
 Textile and garment
 Leather and leather products;
 Food processing and beverage
 Metal works and engineering
 Wood works including furniture and ornaments service;
 And agro-processing.
 Priority sectors and sub-sectors for MSEs
engagement in Ethiopia
 Construction sectors-
 Building materials

 Traditional mining works

 Cobble stone

 Infrastructure sub-contract; and

 Prestigious goods subcontract

 Trade sectors-
 Whole sale of domestic products

 Retail sale of domestic products and raw materials

supply.
 Priority sectors and sub-sectors for MSEs
engagement in Ethiopia
 Service Sectors-
 Small and rural transport service
 Café and restaurants
 Tourism service
 Canning/packing service
 Management service
 Product design & development service
 Maintenance service
 Beauty salon
 Electronics software development
 Decoration and internet café
 Priority sectors and sub-sectors for MSEs
engagement in Ethiopia
19

 Agriculture Sector (Urban Agriculture)

 Modern livestock raring

 Bee production

 Poultry

 Modern forest development

 Vegetables and fruits

 Modern irrigation and

 Animal food processing

 Role/Importance of MSEs in Developing
Countries

 Large employment opportunities- are labour-intensive

 Economical use of capital- need small amount of
capital.
 Balanced regional development/ removing regional
imbalance- are located in village and small towns.
 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.
 Less dependence on foreign capital/ export promotion
 Protection of environment- reducing the problem of
 Role/importance of mses in developing
countries
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 Dispersal over wide areas

 Higher standard of living- MSEs bring higher national
income, higher purchasing power of people in rural and
semi-urban areas.
 Mobilization of locals resources/symbols of national
identity- The spreading of industries in small towns and
villages would encourage the habit of saving and
investment among the people of rural areas
 Innovative and productive /simple technology
 Role/Importance of MSEs in Developing
Countries

 Less dependence on foreign capital/ export promotion

 Promotion of self employment
 Facilitate development of large scale enterprises
 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.
 Individual tastes, fashions, and personalized services-
Small businesses have the flexibility to adapt quickly to
changes in the business or technological environment
 Levels of MSEs in Ethiopia
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1. Start-up:- It is a level where an enterprise begins

production and service under legal framework or legal
entity.
2. Growth Level: - is when an enterprise become competent
in price, quality and supply and profitable using the support
provided.
3. Maturity Level: - is when an enterprise able to be
profitable and invest further
4. Growth- Medium Level:- the enterprise is transformed
from small to medium level of growth and become
competent in price, quality and supply using the support
given to the medium level.
 Setting up small scale business
24

 The 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:
 Environmental Analysis
25

 Entrepreneurship does not exist in a vacuum.

 It is affected by and affects the environment.
 Macro Environment
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 The macro environment of an entrepreneur consists of

 Political

 Economic environments

 Social

 Technological

 Legal

 All of these are not immediate part of the entrepreneur’s

venture yet they have an impact on his/her enterprise
 Sectorial Analysis
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 Study the sector or industry conditions in which the

entrepreneur proposes to launch a venture.
 The purpose of industry analysis is to determine what
makes an industry attractive
 For such analysis one should study the
 History of the industry, the future trends, new products
developed in the industry, forecasts made by the
government or the industry.
 Existing or potential competition, threat of substitutes
and entry barriers.
 SWOT Analysis
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 Is used to identify his/her own strengths and weaknesses

as well as the opportunities and threats in the environment
 Strengths are positive internal factors that contribute to
an individual’s ability to accomplish his mission and
goals
 Weaknesses are negative internal factors that hinder an
individual’s ability to accomplish his mission and goals
 Opportunities are positive external options that an
individual could exploit to accomplish his mission and
goals
 Threats are negative external forces that hinder an
individual from accomplishing his mission and goals
 SWOT example

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 Small business failure factors

• Business failure is a business that closes as a result of

either
1) actions such as bankruptcy, foreclosure, or voluntary
withdrawal from the business with a financial loss
2) a court action such as receivership (taken over
involuntarily) or reorganization (receiving protection
from creditors).
 Couses of business failure
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The most common factors are

a) Inadequate management-lack of experience
b) Inadequate financing
 Improper managerial control
 Shortage of capital
 Extend too much credit
 Overinvest in fixed assets or
 Hire the wrong people.
 Courses of business failure
32

Other common causes of business failure include

a) Neglect - occurs whenever an owner does not pay a
due attention to the enterprise.
b) Fraud- involves intentional misrepresentation or
deception
c) Disaster- refers to some unforeseen happening. E.g.
fires, burglaries, robberies, or extended strikes
 Business termination versus failure
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 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,
 The owner may have an opportunity to sell her business to someone
else for a healthy profit, move on to a new business or retire or lost
interest in the business
 The market for the business’s product may have changed or become
saturated.
 The owner has decided it would be more appealing to work for
someone else.
 Businesses may change form. A partnership may be restructured as a
corporation, or a business may move to a new location.
 Mistakes leading to business failure
34

 Neglect to plan for the future because planning

seems too hard or time-consuming.
 Lack of commitment and hard work
 Not hiring additional employees soon enough or not
using existing employees effectively.
 Inaccurate estimates of cash flow and capital
requirements
 Small business success factors
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a) Conducive environment
b) Adequate credit assistance
c) Markets and marketing support
 Small business success factors
36

Conducive environment
 Political, economic, technological and socio-cultural
factors
 Positive and encouraging measures by government like

liberal or non restrictive investment policy, creation of

industrial parks and free trade zones and availability of
low-cost loan capital
 Technological advances

 Society acceptance
 Small business success factors..
37

Adequate Credit Assistance

 Adequate and timely supply of credit

 Special arrangements like lower interest rate than the

prevailing commercial rates, less collateral requirements

and lower equity ratio
Markets and Marketing Support
 The government too can take an active part in marketing

specific products or assisting small groups of

entrepreneurs in selling their products.
 Main Supporting Packages for MSEs
Development in Ethiopia
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 When entrepreneurs are deciding to involve and develop

MSEs in 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

 BDS provision

 Bookkeeping and audit services

 Problems of Small Scale Business in Ethiopia
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Small-scale businesses have not been able to contribute

substantially to the economic development due to
 Lack of adequate finance and credit has- major problem

 Difficulty to get raw materials of good quality at

reasonable prices
 adopting out-dated techniques of production

NB: Small business’s owner can avoid some of the

common pitfalls by knowing the business in depth;
developing a solid business plan; managing financial
resources; understanding financial statements; and learning
to manage people effectively
 Organizational structure and entrepreneurial team
formation
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 Designing the Organization

 A process for shaping the way the organization operates, to
help to pursue strategies and meet goals
 It includes
a) Organization structure- defines members’ jobs and the
communication and relationship these jobs have with
each other. These relationships are depicted in an
organization chart.
b) Planning, measurement, and evaluation schemes
c) Selection criteria
d) Training