CHAPTER THREE

BUSINESS FORMATION

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 Objectives
Explain the Concept of Business
Development;
Identify the Forms of Business
Ownership;
Discuss the Importance/Role of MSEs;
Describe how to set Up Small Scale
Business;

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 Objectives…
Distinguish the Failure and Success
Factors of MSEs;
Identify the Problems of Small Scale
Business in Ethiopia; and
Discuss how to develop Organizational
Culture.

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 INTRODUCTION
• A business formation deals with the
formalization and actual implementation of
business ideas in to practice.
 Concepts of Small Business
 Legal forms of business
 MSEs in the Ethiopian and international
context
 Roles of MSEs
 Organizational design & entrepreneurial
team, …

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 The Concept of Small Business
Development
 Definition of small business is
arbitrarily, because different people
use different criteria to define it.
 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.

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 Cont’d
Size: Include number of employees and
startup capital.
• But, size based definition doesn’t always
reflect the true nature of an enterprise
as qualitative characteristics also used
to differentiate small business from
other business.

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 Cont’d
Economic/control covers market share,
independence and personalized
management.
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.

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 Cont’d
While entrepreneurs start small
business with 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, etc,.

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 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

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 Cont’d
Transferability of interest
Capital requirements
Management control
Distribution of profits or losses
Attractiveness for raising capital.

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 Governed by the Partnership
agreement

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 Definition and Role/Importance of
MSEs in Developing Countries
3.4.1 Definition of Small Business
1. Size Criteria approaches
 Though the criteria used to measure
the size (refers to scale of operation)
of businesses vary.
 The most widely used yardsticks are;
 The number of employees

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 Cont’d
 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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 Cont’d
 The general criteria suggested by Small
Business Administration (SBA) are.
 Owned & financed by one individual or a
small group/>15 or 20 owners is a rare
case/.
 The firm’s operations are geographically
localized except for marketing function.
 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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 Cont’d
2. Economic/control criterion approach.
Covers the following characteristics :
 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.

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 Cont’d
 Personalized Management: little
delegation/ the owner actively
participates in all aspects of the
management of the business
 Technology: Small business is generally
labor intensive & few are tech. intensive
 Geographical area of operation; The
operation of a small firm is often local.

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 Role/Importance of MSEs in
Developing Countries
(Reading Assignment)
 Large Employment Opportunities
 Economical Use of Capital
 Balanced Regional Development/
Removing Regional Imbalance
 Equitable Distribution of Wealth and
Decentralization of Economic Power

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 Cont’d
 Dispersal over Wide Areas
 Higher Standard of Living
 Mobilization of Locals
Resources/Symbols of National
Identity
 Innovative and Productive /Simple
Technology
 Less Dependence on Foreign Capital/
Export Promotion
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 Cont’d
 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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 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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 s2Environmental 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.

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 .
 Sectoral Analysis
• Study the sector or industry conditions
in which the entrepreneur proposes to
launch a venture.
 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
EnvironmentalAnalysis

Sectoral Analysis

SWOT Analysis

Product/Service

Fig 3.2 Hierarchical Environmental Analysis

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 s1Small Business Failure and
Success Factors
3.6.1 Small Business Failure Factors
What Is Business Failure? It means
Business closes as a result of either:
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;
• Lack of experience
• Internal factors accounted for 89% of
failure: these factors include;
 Lack of Adequate capital
 Poor Cash flow management
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 Cont’d
 Lack of Facilities/equipment
 Poor Inventory control
 Lack of Human resources
 Poor Leadership
 Poor Organizational structure
 Poor Accounting systems

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 Cont’d
II.Inadequate Financing: failure due to
inadequate financing is:
 Caused by 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.

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 Cont’d
 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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 Cont’d
There are also various causes of failure
 Extend too much credit
 Fail to plan for the future/Fail to
have strategic direction
 Overinvest in fixed assets
 Hire the wrong people.

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 Business Termination Vs Failure
 A business failure occurs when a business
closes with a financial loss to a creditor.
 A termination occurs when a business no
longer exists for any reason.
 Reasons of termination: selling for a profit,
move on to a new business or to retire, or
lost interest in the business, to change form.
• If market for product have changed or
become saturated, owner decided it would be
more appealing to work for someone else.
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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
 Not hiring additional employees/Not
using existing employees (no
delegation) effectively
 Inaccurate estimates of cash flow
and capital requirements.
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 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.

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 Cont’d
i. Conducive Environment
 Political, economic, technological and
socio-cultural factors
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.
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 Cont’d
iii. Markets and Marketing Support
 Small enterprises can sell their
products as one body through
closely-knit associations or
organizations.
 The government assists small
groups of entrepreneurs in selling
their products.

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 Table 3.2. Improved definition
(classification) of MSEs in Ethiopia
• . Level of Sector Human Power Total Asset
Enterprise

Industry ≤5 Br ≤100,000
Micro
Enterprise Service ≤5 Br ≤50,000

Industry 6-30 Br ≤1,500,000

Small
Enterprise Service 6-30 Br ≤500,000

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 Cont’d
Priority Sectors and Sub-Sectors for
MSEs Engagement In Ethiopia
 Manufacturing Sector e.g., textile &
garment
 Construction Sectors e.g., building
materials
 Trade Sectors e.g., retail sale
 Service Sectors e.g., tourism service
 Agriculture Sector (Urban
Agriculture) e.g., bee production
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 Levels of MSEs in Ethiopia
 Start-up: enterprise begins production
and service
 Growth Level: enterprise become
competent in price, quality and supply and
profitable using the support provided.
 Maturity Level: enterprise able to be
profitable and invest further by fulfilling
the definition given to the sector and using
the support provided.
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 Main Supporting Packages for MSEs
Development in Ethiopia(Reading
Assignment)
In Ethiopia supporting packages for SMEs
include;
Awareness creation about the sector;
Provision of legal services to form legal
business enterprises;
Providing technical and business
management training;

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 Cont’d
Financial support based on personal
saving, 20/80 (the beneficiaries save
20% and the MFIs provide 80% loan of
the projects);
Facilitate working premises;
Industry extinction services provision;
Bookkeeping and audit services.

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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.
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 Cont’d
 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.

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 Cont’d
 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.

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 Cont’d
However, Small business owner can
avoid some of the common pitfall by:
 knowing the business in depth;
 developing a solid business plan;
 managing financial resources;
 understanding financial statements;
 learning to manage people effectively.

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 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 organization.
Also significant to potential investors is
the management team and its ability
and commitment to the new venture.

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 Cont’d
• 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.

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 Cont’d
• 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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 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: defines
members’ jobs and the communication
and relationship
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 Cont’d
Planning, measurement, and evaluation
schemes: goals and objectives, how they
are achieved, measured, & evaluated
Rewards: promotions, bonuses, praise,
and so on
Selection criteria: set of guidelines for
selecting individuals for each position.
Training: on or off the job, must be
specified
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 Building the Management Team and
a Successful Organization Culture
•There are some important issues to
address before assembling and building
the management team.

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 Cont’d
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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 Cont’d
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 & rewarded for good
work.
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 Cont’d
3. The entrepreneur should be flexible
enough to try different things.
4. It is necessary to spend extra time
in the hiring process. (Right people)
5. The entrepreneur needs to
understand the significance of
leadership in the organization.

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 Cont’d
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 ingredient in an
organization’s success.

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