CHAPTER ONE

Entrepreneurship: An Overview

Learning objectives

After reading this chapter, you should be familiar with:

 The definitions and meanings of entrepreneurs and entrepreneurship
 The historical development of entrepreneurs and entrepreneurship
 The myths of entrepreneurship
 The entrepreneurial process and challenges
 The types of entrepreneurs and entrepreneurship
 The contributions of entrepreneurship to the economy
 The relationship between entrepreneurship and innovation

Introduction

The definition of an entrepreneur has evolved over time as the world’s economic structure
has changed and become more complex. From its beginning in the middle ages, where it was
used in relation to specific occupations, the notion of the “entrepreneur” has been refined and
broadened to include concepts that are related to the person rather than the occupation. Risk
taking, innovation, and creation of wealth are examples of the criteria which have been
developed as the study of new business creations has evolved.

The words entrepreneur and entrepreneurship have acquired special significance in the
context of economic growth in a rapidly changing socio-economic and socio-cultural
climates, particularly in industry, both in developed and developing countries. Questions:
Who is an entrepreneur? What is entrepreneurship? And what is entrepreneurial process? Are
asked more and more frequently, reflecting the increased national and international interest in
the field. However, in spite of all these interests, universally accepted definitions have not yet
emerged.

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 The concept of entrepreneur and entrepreneurship vary from country to country as well as
from period to period and the level of economic development thoughts and perceptions.
Although there are hundreds of definitions for entrepreneur and entrepreneurship, the
following are considered in this course.

1.1 Definitions of the terms Entrepreneur and Entrepreneurship

Dear students, the starting point for any reading material on entrepreneurship must be the
concept of entrepreneurship and entrepreneurs, and our understanding of them. What exactly
is meant by the terms entrepreneurs and entrepreneurship? What is your understanding when
the terms “entrepreneurs and entrepreneurship” are mentioned. Do you have any idea? The
following section presents the definition of entrepreneurs and entrepreneurship in detail.

1.1.1 Definitions of an Entrepreneur

The term entrepreneur is defined in the variety of ways. Yet, no consensus has been
arrived at on precise and universally accepted definition that states the skills and abilities
that makes a person a successful entrepreneur. The following are few of the definitions
given by different authors:

 An Entrepreneur is an individual who, propelled by an idea, personal interest,

goals, and ambition, brings together the financial and human resources,
equipment, facilities to establish and manage a business enterprise (Donnely)
 An Entrepreneur is one who incubates new ideas, starts a business based on these
ideas, and provide added value to the society on his/her independent initiative.(H.
Molt)
 According to Schumpeter, entrepreneur is defined from two perspectives:
developed and developing economics. The entrepreneur in an advanced economy
is an individual who introduces something new in the economy. New in the
economy can be a method of production not yet tested by experience, a product
with which consumers are not yet familiar, a new source of raw material or a new
market and the like. On the other hand, an entrepreneur in a developing economy

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 is one who starts an industry (old or new), undertakes risk, bears uncertainties and
also performs the managerial functions of decision making and coordination.
 An entrepreneur is an “energetic, single minded” person having mission and a
clear vision he/she intends to create out this vision a business that produces and
provides product or service that improves the lives of million. (David Silver)

1.1.2 Definitions of entrepreneurship

- Dr. C.B. Gupta defines entrepreneurship as the process of identifying opportunities in

the market place, marshalling the resources required to pursue these opportunities and
investing the resources to exploit the opportunities for long term lap gains. It involves
creating wealth by bringing together resources in new ways to start and operate an
enterprise.

- “Entrepreneurship is the process of creating something different with value by devoting

the necessary time and effort assuming the accompanying financial psychic, and social
risks, and receiving the resulting rewards of monetary and personal satisfaction.”
(Hisrich)

- Entrepreneurship is the process of initiating a business venture, organizing the necessary

resource and assuming the associated risks and rewards. (Daft)

- “Entrepreneurship is creating and building of value form practically nothing, that is, it is
a process of creating or seizing an opportunity and pursuing it regardless of the sources
currently controlled.” (Timmos)

- Entrepreneurship is the process of identifying, developing, and bringing a vision to life.

The vision may be an innovative idea, an opportunity, simply a better way to do
something. The end result of this process is creation of a new venture, formed under
conditions of risk and considerable uncertainty.

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Furthermore the historical development of entrepreneurship shows the extent that the definition
of an entrepreneur has evolved overtime as the world’s economic structure has changed and
becomes more complex. The following section explains the historical development of
entrepreneurship.

ACTIVITY

 Who are entrepreneurs and what is entrepreneurship?

Commentary: When you describe the concepts entrepreneurship and entrepreneur include
critical points in your definitions of entrepreneurship and entrepreneurs like its nature as a
process, opportunity identification, hard working, risk taking, fundamental rewards associated
with the process and initiative taking.

1.2 A Historical Perspective of Entrepreneurship

The word “entrepreneur comes from the French verb enterpredre, which means “to undertake.”
Through the ages, the concept of entrepreneurship has shown a significant development and
change in terms of scope.

In the early period an “entrepreneur” was a merchant adventurer who signs a contract with a
money person to sell his goods. During that time, a common contract provided a loan to the
merchant adventurer at a 22.5 percent rate. The merchant adventurer traveled great distances to
find a market for the goods and played the active role in selling the goods.

During the middle age, the term entrepreneur was given to both an actor and a person who run
large production projects. This individual did not take any risk but simply administered the
project using the resource provided by the government of the country. The typical entrepreneur
was the cleric who was responsible for the construction of great building such as castles and
cathedrals. Also in the early 1600s, French man who organized and led military expeditions were
called “Entrepreneur.”

The concept of risk in the notion of entrepreneurship developed in the 17 th century, with an
entrepreneur being viewed as a person who entered a contractual arrangement with the

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government to perform a service or supply stipulated products. Since the contract price was
fixed, any resulting profits or losses reflected the efforts of the entrepreneurs.

Finally, in the 18th century the person with capital was differentiated from one needing capital. In
other words, the entrepreneurial role was distinguished from the capital providing role. The latter
role is the basis for the present day venture capitalist. A venture capitalist is a professional
money manager who invests in risky investments from a pool of equity capital to obtain a high
rate of return on the investments (Ibid)

In the late 19th and early 20th centuries, entrepreneurs were frequently not distinguished from
managers and were mainly viewed from economic perspective:

“Briefly stated, the entrepreneur organizes and operates an enterprise for personal gain.
He pays current prices for the materials consumed in the business, for the use of land, for
the personal services he employs, and for the capital he requires. He contributes his own
initiative, skill and ingenuity in planning, organizing, and administrating the
organization. He also assumes the chance of loss and gain consequent to unforeseen and
uncontrollable circumstances. The net residue of the annual receipts of the enterprise
after all costs have been paid, he retains for himself.” (Hisrich, 1989:8)

In the middle of the 20th century, the notion of an entrepreneur as an innovator was established:

“the function of entrepreneurs is to reform or revolutionize the pattern of production by

exploiting an invention or, generally, an untried technological possibility for producing a
new commodity or producing an old in a new way, opening a new source of supply of
materials or a new out let for product, by reorganizing a new industry.”

The concept of innovation and newness as an integral part of entrepreneurship is at the heart of
this definition. Indeed, innovation, the act of introducing something new, is one of the most
difficult tasks for the entrepreneur. It takes not only the ability to create and conceptualize but
also to understand all the forces at work in the environment. The newness can be anything from a

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new product to a new distribution system or to simply a new organizational structure. This ability
to innovate is an instinct that distinguishes human beings from other creatures.

In almost all the definitions of entrepreneurship, there is agreement that basic elements such as :
i) risk taking, ii) initiative taking, iii) organizing and reorganizing, iv) vision, and v) wealth
creation are involved. And more than these the definition for the concepts entrepreneur and
entrepreneurship include: a) decision making; b) using available resources in novel ways; c)
action oriented; d) the ability to see business opportunities, the ability to gather resources to take
advantage of them and the ability to take action; and e) the ability to search for change, respond
to it, and exploit it.

Although there are many definitions of entrepreneur and entrepreneurship, no one of these
definitions is complete to include all we know from experience. Some of the definitions may
exclude those we feel from our experience about entrepreneurs and entrepreneurship and may
include those we don’t think are for entrepreneurs and entrepreneurship. Basically,
entrepreneurship refers to what an entrepreneur does. The concepts of entrepreneur and
entrepreneurship cannot be treaded separately. “The concepts of entrepreneur and
entrepreneurship incorporate basic qualities of leadership, innovation, enterprise, hard work,
vision, risk taking and maximization of profit.” (Vasant) These concepts have evolved over time
as the world’s economic structure has changed and become more complex.

To sum up, entrepreneur and entrepreneurship are two different but related terms. An
entrepreneur is an individual who undertakes entrepreneurship activities (vasant)

1.3 The Myths of Entrepreneurship

Throughout the years many myths have arisen about entrepreneurship. These myths are the
results of a lack of research on entrepreneurship. As many researchers in the field have noted, the
study of entrepreneurship is still emerging, and thus “folklore” will tend to prevail until it is
dispelled with contemporary research findings. Ten of the most notable myths with an
explanation to dispel each myth appear next.

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Myth 1: Entrepreneurs are Doers, Not Thinkers

Although it is true entrepreneurs tend toward action, they are also thinkers. Indeed, they
are often very methodical people who plan their moves carefully. The emphasis today
on the creation of clear and complete business plans is an indication that “thinking”
entrepreneurs are as important as “doing” entrepreneurs.

Myth 2: Entrepreneurs are Born, Not Made

The idea that the characteristics of entrepreneurs cannot be taught or learned, that they
are innate traits one must be born with, has long been prevalent. These traits include
aggressiveness, initiative, drive, a willingness to take risks, analytical ability, and skill
in human relations. Today, however, the recognition of entrepreneurship as a discipline
is helping to dispel this myth. Like all disciplines, entrepreneurship has models,
processes, and case studies that allow the topic to be studied and the knowledge to be
acquired.

Myth 3: Entrepreneurs are Always Inventors

The idea that entrepreneurs are inventors is a result of misunderstanding and tunnel
vision. Although many inventors are also entrepreneurs, numerous entrepreneurs
encompass all sorts of innovative activity. For example, Roy Kroc did not invent the
fast-food franchise, but his innovative ideas made McDonald’s the largest fast-food
enterprise in the world. A contemporary understanding of entrepreneurship covers more
than just invention. It requires a complete understanding of innovative behavior in all
forms.

Myth 4: Entrepreneurs are Academic and Social Misfits

The belief that entrepreneurs are academically and socially ineffective is a result of
some business owners having started successful enterprise after dropping out of school
or quitting a job. In many cases such an event has been blown out of proportion in an
attempt to “profile” the typical entrepreneur. Historically, in fact, educational and social
organizations did not recognize the entrepreneur. They abandoned him or her as a
misfit in a world of corporate giants. Business education, for example, was aimed
primarily at the study of corporate activity. Today the entrepreneur is considered a hero

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 – socially, economically, and academically. No longer is he or she a misfit, the
entrepreneur is now viewed as a professional.

Myth 5: Entrepreneurs Must Fit the “Profile”

Many books and articles presented checklists of the characteristics of the successful
entrepreneur. These lists were neither validated nor complete; they were based on case
studies and on research findings among achievement-oriented people. Today we realize
that a standard entrepreneurial profile is hard to compile. The environment, the venture
itself, and the entrepreneur have interactive effects, which result in many different types
of profiles. Contemporary studies conducted at universities across the United States
will, in the future, provide more accurate insight into the various profiles of successful
entrepreneurs.

Myth 6: All entrepreneurs Need is Money

It is true that a venture needs capita to survive; it is also true that a large number of
business failures occur because of a lack of adequate financing. Yet having money is
not the only bulwark against failure. Failure due to a lack of proper financing often is
an indicator of other problems: managerial incompetence, lack of financial
understanding, poor investments, poor planning, and the like. Many successful
entrepreneurs have overcome the lack of money while establishing their ventures. To
those entrepreneurs, money is a resource but never an end in itself.

Myth 7: All Entrepreneurs Need is Luck

Being at “the right place at the right time” is always an advantage. But “luck happen
when preparation meets opportunity” is an equally appropriate adage. Prepared
entrepreneurs who seize the opportunity when it arises often seem “lucky.” They are, in
fact, simply better prepared to deal with situations and turn them into success. What
appears to be luck really is preparation, determination, desire, knowledge, and
innovativeness.

Myth 8: Ignorance is Bliss for entrepreneurs

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 The myth that too much planning and evaluation lead to constant problems – that over
analysis leads to paralysis – does not hold up in today’s competitive markets, which
demand detailed planning and preparation. Identifying a venture’s strengths and
weaknesses, setting up clear timetables with contingencies for handling problems, and
minimizing these problems through careful strategy formulation are all key factors for
successful entrepreneurship. Thus careful planning – not ignorance of it – is the mark
of an accomplished entrepreneur.

Myth 9: Entrepreneurs Seek Success but Experience High failure Rates

It is true that many entrepreneurs suffer a number of failures before they are successful.
They follow the adage “If at first you do not succeed, try, try, and try again.” In fact,
failure can teach many lessons to those willing to learn and often leads to future
successes. This is clearly shown by the corridor principle, which states that with every
venture launched, new and unintended opportunities often arise.

Myth 10: Entrepreneurs are Extreme Risk Takers (Gamblers)

The concept of risk is a major element in the entrepreneurial process. However, the
public’s perception of the risk most entrepreneurs assume is distorted. Although it may
appear that an entrepreneur is “gambling” on a wild chance, the fact is the entrepreneur
is usually working on a moderate or “calculated” risk. Most successful entrepreneurs
work hard through planning and preparation to minimize the risk involved in order to
better control the destiny of their vision.

These ten myths have been presented to provide a background for today’s current thinking on
entrepreneurship. By sidestepping the “folklore,” we can build a foundation for critically
researching the contemporary theories and processes of entrepreneurship.

1.4 The entrepreneurial process and challenges:

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This part presents the activities involved in the entrepreneurial process and the main problems
associated with the process.

1.4.1 The entrepreneurial process

The prospective entrepreneur, in order to establish and run a successful business, goes through a
process known as the entrepreneurial process. During this process the entrepreneur carries out a
number of activities that lead to the successful establishment and management of the business.
The entrepreneurial process, which is made up of related activities, consists of the following
phases.
1. Identifying and evaluating a business opportunity.
2. Developing the business plan.
3. Determining the resources required for the business and
4. Managing the resulting enterprise.
These activities overlap, meaning an activity will be started before the one that has already been
started is completed. Therefore, the entrepreneur may need to consider the third or the fourth
phase while still carrying out phase one. For instance, to evaluate the profitability of the business
opportunity well, the entrepreneur needs the cost of the resources required to establish business.

i. Identifying and Evaluating the Business opportunity

This phase is the first and the most difficult since most business ideas do not suddenly appear.
Generally a new business opportunity may be the result of a technological change, market shift,
government regulation, or competition. Good business opportunities are often the results of the
entrepreneur being alert to the environment or extra effort in establishing opportunity
identification mechanisms. Most entrepreneurs do not have formal mechanisms to identify new
business opportunities. However, there are some sources such as consumers, members of
distribution channels, and technical people that are generally fruitful. Often, the most and best
business ideas come from customers. Complaints and remarks such as ‘I wish there were a better
product …’ or ‘I wish I could find a product that is specially made for …” may result in the
inception of a new business idea and a new product.

Distribution channel members such as whole sellers, distributors and retailers are also good
sources of business ideas. Their proximity to consumers of the product gives them the

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opportunity to better see a market gap or a demand for a better product. Technical people are also
good sources of ideas for a new business. Technical people are also working on various projects,
may come across a new or better way to manufacture a product. Regardless of its source,
however, a newly generated business idea must be carefully examined. This evaluation of the
business idea is perhaps the most critical of the entrepreneurial process, as it is the phase in
which the profitability of the business idea will be determined.

The evaluation phase deals with the assessment of the opportunity for its length, its real and
perceived value, its risks and returns, its differential advantage in its competitive environment,
and its fit with the personal skills and goals of the entrepreneur. Here it is very important to note
that the opportunity must also fit the personal interests of the entrepreneur, a person, without the
necessary interest or skill to start a new venture, may not become a successful entrepreneur even
if he or she has a brilliant business idea.

At this particular phase, as a matter of formal procedure, the entrepreneur may prepare an
opportunity assessment plan. The plan, also referred to as opportunity analysis, focuses on the
issues that enable the entrepreneur to make the decision whether to act on the opportunity or not.
Focusing entirely on the opportunity, this plan includes a description of the product or service; an
assessment of the entrepreneur, the team and the opportunity; specifications, of all the activities
and resources needed to translate the opportunity into a viable business venture; and the sources
of capital to finance the establishment of the venture as well as its growth.
The assessment of the opportunity is not an easy task, however. In fact, it is the most difficult
and critical aspect of the opportunity analysis. Through the assessment analysis, the entrepreneur
answers questions such as ‘What market need does the product satisfy?’, ‘What resources from
which sources will be required to convert the business opportunity in to a business venture?’ ‘Is
the entrepreneur fit to act on the opportunity?’, ‘How fierce is the local and international
competition?’

Remember that a business idea is not a business opportunity until it is assessed objectively and
judged to be feasible. You may wish to choose one of the ideas that seem most promising for

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more detailed study. Trying to consider too many would make your focus on only one business
idea, you are more likely to fall in love with it, and could lose your objectivity.

ii. Developing a Business Plan

Once a business idea is selected, the concept must be sharpened by an in depth planning process.
The result of this step is a comprehensive business plan – the “blueprint” for the implementation
process.

A business plan is a document the entrepreneur prepares before going to the implementation
stage. It details every aspect of the business including the marketing, financial, organizational
and operational plans. Developing the business plan is often difficult because the required
resources for the plan may not be readily available and/ or the entrepreneur may not have rich
experience in business plan preparation. This will be dealt in greater depth in chapter four.

iii. Determining the Required Resources

The entrepreneur needs to identify the resources required for the business before embarking on
the business opportunity. The entrepreneur starts this phase with an assessment of the present
resources. Then, carefully identifies all the resources required to get the business on its feet and
run it successfully. Here, the entrepreneur must be careful not to understate the quality and
quantity of the required resources. The entrepreneur also needs to classify the required resources
in to two: the ones that are vital and the ones that are just helpful. It is also important to evaluate
the impact of insufficient or inappropriate resources on the business. The next step will be to
acquire the needed resources in the right quality and quantity on a timely basis. The resources
needed may be finance, machinery, raw materials etc…

iv. Managing the Venture

Once the required resources for the business have been acquired, the entrepreneur will deploy
them through the implementation of the business plan. At this stage, the entrepreneur examines
the operational problems of the growing enterprise, a task that involves the implementation of an
effective management approach and structure. An effective control mechanism also needs to be
set up in order to identity and tackle emerging problems and challenges on time. Some

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entrepreneurs find managing and leading the venture they created very difficult – a distinction
between entrepreneurs and managers.

1.4.2 Challenges of Entrepreneurial Process

Entrepreneurial problems are divided into two groups: external and internal. External problems
are those which usually result from factors beyond the control of the entrepreneur like political,
social, technological, and other related problems; while internal problems are those which are not
influenced by external forces. The internal problems affecting entrepreneurs relate to
organization, structure, production channel, distribution channel, technical know-how, training,
industrial relations and inadequacy of management, etc. However, both kinds of problems are not
mutually exclusive, they are co-related.

From the moment an entrepreneur conceives the idea to start his own business; he has to work
against various problems. Some of the internal and external factors which hinder the
development of entrepreneurship are:

1. Management deficiency: It could be said that management deficiency is one of the biggest
reasons for poor performance of small scale units. The new entrants, in many cases did not
have any prior training or background in management of their enterprises and were adverse
to innovations and changes.

In the beginning of business development, management problem may not be so critical but
with growing sophistication and modernization of market requirements for the items
produced by the small-scale sector, it has become very important for small entrepreneurs to
employ modern methods of management be it in the field of advanced technology or
marketing.

2. Limited access to finance: Financial inadequacy is one of the most inhibiting factors in the
growth of entrepreneurship. The following are some of the limiting factors in accessing
business finances:

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 i) New is too risky: Entrepreneurial businesses are generally viewed as risky investment
due to their newness and smallness. Consequently, financial institutions resist
providing loans for entrepreneurs.
ii) No preferential interest rates: most entrepreneurs are unable to afford the high
interest rates charged by banks and other financial institutions.
iii) Longer loan processing time: The processing time for loan applications by
entrepreneurs tends to be long. The approval procedures are slow, often times leading
to slower disbursements.
iv) Lack of collateral demanded by lenders: Since the entrepreneurial activities are
considered to be risky businesses, the collateral demanded by banks is often
inhibiting. Usually the collateral demanded is higher than the value of the loan.

3. Technological forces: Technological forces are often the most abrupt and unpredictable
part of an entrepreneurial environment. The knowledge behind a technological change may
take several years to develop, but the impact of the breakthrough in to an actual product or
a process makes it seem more like a revolution than evolution when the application of
technology actually occurs.

4. Limited access to market: Another important factor in the development of

entrepreneurship is the availability of market for the products offered. Entrepreneurs face
overall limitations on penetrating and servicing their markets. The cost of penetrating the
existed or the new market is relatively high for the newly developed business of an
entrepreneur.

5. Political factors: A variety of forces can be at work in the political arena of an

entrepreneurial environment. Entrepreneurs more and more must anticipate and adjust to
changes in regulation, directives, and laws form various levels of government and
governmental agencies.

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The following table summarizes the various problems encountered by entrepreneurs:

Problems of Entrepreneurs
A) Internal B) External
1- Choice of an idea 1- Infrastructure
2- Feeble structure i) Location
3- Faculty planning ii) Power
4- Poor project implementation iii) Water
5- Poor management iv) Post office
6- Poor production v) Communication
7- Poor quality 2- Financial
8- Marketing i) Capital
9- Financial crunch ii) Working capital
10- Labor problems iii)Long term funds
11- Capacity utilization iv)Recovery
12- Lack of vertical horizontal integration 3- Marketing
13- Inadequate training 4- Taxation
14- Poor and loose organization structure 5- Raw material
15- Lack of strategies 6- Industrial financial regulations
16- Lack of vision 7- Technology
17- Inadequate connections 8- Government policy
18- Lack of motivation 9- Competitive volatile environment
10- Political environment
Source: Vasant Desal, (1999), Dynamics of entrepreneurial development and management.

Generally, the problems of entrepreneurs are multidimensional. These can be solved by the
coordinated efforts of entrepreneurs, coordinated functioning of promotional agencies, and
governmental assistance without red tape or bureaucratic delays. The entrepreneur has to be
educated, and he/she should have a proper training in acquiring the necessary skill in running an
enterprise within these various forces.

1.5 THE DARK SIDES OF ENTREPRENEURSHIP

A great deal of literature is devoted to extolling the rewards, successes, and achievements of
entrepreneurs. However, a dark side of entrepreneurship also exists. This aspect of the
entrepreneurial perspective has a destructive source that exists within the energetic drive of
successful entrepreneurs. In examining this dual-edged approach to the entrepreneurial
personality, experts have acknowledged the existence of certain negative factors that may
envelop entrepreneurs and dominate their behavior. Although each of these factors possesses a

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positive aspect, it is important for entrepreneurs to understand the potential destructive vein of
these factors.

It should be noted that “people who successfully innovate and start businesses come in all shape
and size. But they do have a few things others do not. In the deepest sense, they are willing to
accept risk for what they believe in. They have the ability to cope with a professional life riddled
by ambiguity, a consistent lack of clarity. Most have a drive to put their imprint on whatever they
are creating. And while unbridle ego can be a destructive thing, try to find an entrepreneur whose
ego is not wrapped up in the enterprise.”

Entrepreneurs face a number of different types of risk. These can be grouped into four basic
areas.
Financial risk: In most new ventures the individual puts a significant portion of his or her
saving or other resources at stake. This money or these resources will, in all likelihood, be lost if
the venture fails. The entrepreneur may be required to sign personally on company obligations
that far exceed his or her personal net worth. The entrepreneur is thus exposed to personal
bankruptcy. Many people are unwilling to risk their savings, house, property, and salary to start a
new business.

Career risk: A question frequently raised by would-be entrepreneurs is whether they will be
able to find a job or go back to their old job if their venture should fail. This is a major concern
to managers who have a secure organizational job with a high salary and a good benefit package.

Family and social risk: Starting a new venture uses much of the entrepreneur’s energy and time.
Consequently, his or her other commitments may suffer. Entrepreneurs who are married, and
especially those with children, expose their families to the risk of an incomplete family
experience and the possibility of permanent emotional scars. In addition, old friends may vanish
slowly because of missed get-togethers.
Psychic risk: The greatest risk may be to the well-being of the entrepreneur. Money can be
replaced; a new house can be built; spouse, children, and friends can usually adapt. But some
entrepreneurs who have suffered financial catastrophes have been unable to bounce back, at least
not immediately. The psychological impact has proven to be too severe for them.

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1.6 TYPES OF ENTREPRENEURSHIP
There are different kinds of entrepreneurs and entrepreneurship on the basis of the criteria used
to classify entrepreneurs and entrepreneurship. The following are the most common criteria
among others used for classifying entrepreneurs and entrepreneurship.

Source of capital

Based on the source of capital entrepreneurship can be divided into two as private and collective
entrepreneurship. The first one is a form of entrepreneurship that is carried out by an individual
on the basis of his or her own property. Collective entrepreneurship is carried out by two or
more entrepreneurs on the bases of collective property, that is, capital contributed by the
entrepreneurs.

Business idea generation

Entrepreneurship can be divided into three as – technological, geographical and sociological

based on the business idea generation. A technological entrepreneur invents a new technology to
produce new products or new processes for producing old products. A geographical entrepreneur
moves technology, the products and processes that goes with it from one place to another,
usually from the developed world to the developing world. A sociological entrepreneur finds a
new situation in which to sell an old product.

Reason for start up

Entrepreneurship can be classified into opportunity driven and necessity driven based on the
drive that led the entrepreneur to start the business. Opportunity driven entrepreneur starts a
company because he or she sees clear market opportunities to exploit. On the other hand the
necessity driven entrepreneur goes into business to create self employment and his or her
primary concern is survival. Generally, opportunity driven entrepreneurs are more growth
oriented than necessity driven entrepreneurs.

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1.7 THE ROLE OF ENTREPRENEURSHIP IN THE ECONOMY
The entrepreneur is the catalyst that plays a crucial role in developing a country’s economy.
Following are some contributions of the entrepreneur.

1. Creation of Job Opportunities

The hard work of the entrepreneur often results in the formation of a small business that opens
job opportunities to many others in addition to the entrepreneur himself or herself. According to
the US Small Business Administration, small businesses, many of which are entrepreneurial,
comprise more than 99 percent of employers, employ 51 percent of all private – Sector workers
and provide about 74 percent of new jobs in the USA.

2. Better Production Methods and Products

Entrepreneurs often introduce better production methods in terms of processing speed, quality of
output, energy consumption, etc. Improved production methods in turn result in better goods and
services. The improvement may be in terms of price, quality, location, ease of use, packaging,
effectiveness of the product, etc.

3. Identification of Business Opportunities and Markets

Entrepreneurs always keep their eyes open to identify and exploit market opportunities. Once
they identify an exploitable market opportunity, they devote themselves to satisfying the market
gap. However, in real situation their act brings the opportunity for others to establish their own
similar businesses and meet rest of the markets need.

4. Conservation of Natural Resources.

Some people became successful entrepreneurs because they managed to invent production
methods that consumed less energy and raw materials. Such technologies result in the
conservation of natural resources.

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 5. Abolition of Monopoly and Enhancement of Competition

Entrepreneurs often bring an end to monopolies that have existed for long. Such entrepreneurs
discover the key knowledge or secrete technology that has endured a monopoly. Or they create
alternative methods that can supply similar or substitute goods and services. Similarly, by
supplying substitute goods and services, entrepreneurs foster keener competition in many
markets, which naturally results in lower prices for consumers.

6. Development of Complementary Goods Producers

Complementary goods are products that are used together. Tea and sugar are good examples. For
instance, the entrepreneur that establishes a local car manufacturing company that will sell its
cars locally will indirectly contribute to the establishment of a number of local car repair shops.

7. Increase in Per Capita Output and Income

Entrepreneurial business activities result in increased income for the entrepreneur, his or her
employees and other related businesses. The supply of goods and services in the economy will
also be increase. This eventually leads to an increase in per capital output and income in the
economy.

8. Generation of Foreign Currency

Entrepreneurs that are in the export business generate significant amount of foreign currency
(dollar) to their home countries. This situation indirectly contributes to the development of the
countries’ economy by making more foreign currency available for increased volume of imports.

9. Better Utilization of Resources

Some entrepreneurs become successful by inventing methods and processes that enable the
production of goods out of resource that have been ignored and labeled as “useless”. Such
initiative leads to improved use of neglected resources and conservation of the ones already in
use.

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 10. Improvement of Business Policies and Procedures

Entrepreneurs create businesses that involve new transactions which do not fit into the existing
business regulatory system and thus require the development of new business systems, laws,
rules and policies. Such businesses instigate the revision of the existing business policies and
procedures and lead to the development of new ones which ultimately result in better and safer
business environment.

11. Positive Externalities

Externalities are the good (eg. New road constructed) or bad (e.g pollution) byproducts of a
business which the nearby community will enjoy or be exposed to. The entrepreneur, while
establishing his or her business, may develop infrastructure such as streets, electricity and water
– wells that will be shared by the community as well.

12. Business Opportunity for Suppliers.

The entrepreneur needs to acquire inputs such as employees and raw materials to produce goods
and services. In most cases the entrepreneur will not be able to supply these inputs for the
business on his or her own. Therefore, these resources have to be supplied by other businesses, a
situation that results in a business opportunity for suppliers.

ACTIVITY

 How do you explain the challenges and rewards of entrepreneurship?

Commentary: Most challenges of the entrepreneurial process are stemmed from the nature and
size of the businesses created through the entrepreneurial process. Businesses which are created
through the entrepreneurial process are new and at the same time they are small in size. When
businesses are new and small in size they may experience challenge in management of the entire
operation, obtaining finance, attracting large number of consumers and changes in technology.

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1.8 INNOVATION AND ENTREPRENEURSHIP

Innovation is a key function in the entrepreneurial process. Most researchers and authors in the
field of entrepreneurship are, for the most part, in agreement with Drucker about the concept of
innovation:
Innovation is the specific function of entrepreneurship …. It is a means by which the
entrepreneur either creates new wealth-producing resources or endows existing
resources with enhanced potential for creating wealth.

Innovation is the process by which entrepreneurs convert opportunities into marketable ideas. It
is a means by which they become catalyst for change. It is important to recognize the role of
creativity in the innovative process. Creativity is the generation of ideas that result in the
improved efficiency or effectiveness of a system. Two important aspects of creativity exist:
process and people. The process is goal-oriented; it is designed to attain a solution to a problem.
The people are the resources that determine the solution. The process remains the same, but the
approach that the people use will vary.

The Nature of the Creative Process

Creativity is a process that can be developed and improved. Everyone is creative to some degree.
However, as is the case with many abilities and talents, some individuals have a great aptitude
for creativity than others. Also, some people have been raised and educated in an environment
that encouraged them to develop their creativity. They have been taught to think and act
creatively. For others the process is more difficult because they have not been positively
reinforced, and, if they are not creative, they must learn how to implement the creative process.

The creative process has five commonly agreed-on phases or steps. Most experts agree on the
general nature and relationship among these phases, although they refer to them by a variety of
names. Experts also agree that these phases do not always occur in the same order for every
creative activity. For creativity to occur, chaos is necessary but a structured and focused chaos.
We shall examine this five-step process using the most typical structural development.

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Phase 1: Idea Germination

The germination stage is a seeding process. It is not like planting seed as farmer does to grow
crown, but more like the natural seeding that occurs when pollinated flower seeds, scattered by
the wind, find fertile ground to take root. Exactly how an idea is germinated is a mystery; it is
not something that can be examined under a microscope. However, most creative ideas can be
traced to an individual’s interest in or curiosity about a specific problem or area of study.

Phase 2: Preparation
Once a seed of curiosity has taken from as a focused idea, creative people embark on a conscious
search for answer. If it is a problem they are trying to solve then they begin an intellectual
journey, seeking information about a problem and how others have tried to resolve it. If it is an
idea for a new product or service, the business equivalent is market research. Inventors will set
up laboratory experiments, design will begin engineering new product ideas, and marketers will
study consumers buying habits. Any individual with an idea will consequently think about it,
concentrating his or her energies on rational extensions of the idea and how it might become a
reality. In rare instances, the preparation stage will produce result. More often, conscious
deliberation will only overload the mind, but the effort is important in order to gather and
knowledge vital to an eventual solution.

Phase 3: Incubation
Incubation is a stage of “mulling it over” while the subconscious intellect assumes control of the
creative process. This is a crucial aspect of creativity because when we consciously focus on a
problem, we behave rationally to attempt to find systematic resolutions. When we rely on
subconscious processes, our minds are untrammeled by limitations of human logic. The
subconscious mind is allowed to wander and to pursue fantasies, and it is therefore open to
unusual information and knowledge that we cannot assimilate in a conscious state. This
subconscious process has been called the art of synectics, means a joining together of different
and often unrelated ideas. Therefore, when a person has consciously worked to resolve a problem
without success, allowing it to incubate in the subconscious will often lead to a resolution.

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Phase 4: Illumination

The fourth stage, illumination, occurs when the idea resurfaces as a realistic creation. The
important point is that most creative people go through many cycles of preparation and
incubation, searching for that incident as a catalyst to give their idea full meaning. When a cycle
of creative behavior does not result in a catalytic event, the cycle is repeated until the idea
blossoms or dies. This stage is critical for entrepreneurs because ideas, by themselves, have little
meaning. Reaching the illumination stage separates daydreamers and tinkerers from creative
people who find a way to transmute value.

Phase 5: Verification

An idea once illuminated in the mind of an individual still has little meaning until verified as
realistic and useful. Entrepreneurial effort is essential to translate an illuminated idea into a
verified, realistic, and useful application. Verification is the development stage of refining
knowledge into application. This is often tedious and requires perseverance by an individual
committed to finding a way to “harvest” the practical result of his or her creation. During this
stage, many ideas fall by the wayside as they prove to be impossible or to have little value. More
often, a good idea has already been developed, or the aspiring entrepreneur finds that competitors
already exist. Inventors quite often come to this harsh conclusion when they seek to patent their
products only to discover similar inventions registered.

THE INNOVATION PROCESS

Most innovations result from a conscious, purposeful search for new opportunities. This process
begins with the analysis of the sources of new opportunities. Drucker has noted that because
innovation is both conceptual and perceptual, would-be innovators must go out and look, ask,
and listen. Successful innovators use both the right and left sides of their brains. They look at
figures. They look at people. They analytically work out what the innovation has to be to satisfy
the opportunity. Then they go out and look at potential product users to study their expectations,
values, and needs.

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Most successful innovations are simple and focused. They are directed toward a specific, clear,
and carefully designed application. In the process they create new customers and new markets.
Above all, innovation often involves more work than genius. As Thomas Edison once said,
“Genius is 1 percent inspiration and 99 percent perspiration.” Moreover, innovators rarely work
in more than one area. For all his systematic innovative accomplishment, Edison worked only in
the electricity field.

Type of Innovation

Four basic types of innovation exist. These extend from the totally new to modifications of
existing products or services. In order of originality, the following are the four types:
 Invention: The creation of a new product, service, or process, often one that is novel or
untried. Such concepts tend to be “revolutionary.”
 Extension: the expansion of the product, service or process already in existence. Such
concepts make different applications of current idea.
 Duplication: The replication of an already existing product, service, or process. The
duplication effort, however, is not simply copying but adding the entrepreneur’s own
creative touch to enhance or improve the concept to beat the competition.
 Synthesis: the combination of existing concepts and factors into a new formulation. This
involves taking a number of ideas or items already invented and finding a way so that
together they form a new application.

Sources of Innovation

Innovation is a tool by which entrepreneurs typically exploit change rather than create change.
Although some inventions have created change, these are rare. It is more common to find
innovations that take advantage of change. The internal and external areas that serve as
innovation sources are presented next.

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Unexpected Occurrences: These are successes or failures that, because they were
unanticipated or unplanned, often end up proving to be a major innovative surprise to the
firm.

Incongruities: These occur whenever a gap or difference exists between expectation and
reality. For example, when Fred Smith proposed overnight mail delivery, he was told, “If
it were that profitable, the U.S. post office would be doing it.” It turned out Smith was
right. An incongruity existed between what Smith felt was needed and the way business
was currently conducted.

Process need: These exist whenever a demand arises for the entrepreneur to innovate and
answer a particular need. The creation of health foods and time-saving devices are
examples.

Industry and Market Changes: Continual shifts in the marketplace occur, caused by
development such as consumer attitudes, advancement in technology, industry growth,
and the like. Industries and markets are always undergoing changes in structure, design,
or definition. An example is found in the health care industry, where hospital care has
undergone radical change and where home health care and preventive medicine have
replaced hospitalization and surgery as a primarily focus area. The entrepreneur needs to
be aware of and seize these emerging opportunities.

Demographic Change: These arise from trend changes in population, age, education,
occupations, geographic locations, and similar factors. Demographic shifts are important
and often provide new entrepreneurial opportunities. For example, as the average
population of Ethiopia has increased, land development, recreational, and health care
industries all have profited.

Perceptual Changes: These changes occur in people’s interpretation of facts and

concepts. They are intangible yet meaningful. Perception can cause major shifts in ideas

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to take place. The current fitness craze, caused by the perceived need to be healthy and
physically fit, has created a demand for both health foods and health facilities.

Knowledge-Based Concepts: These are the basis for the creation or development of
something brand new, trying into our earlier discussion of invention as a type of
innovation. Inventions are knowledge-based; they are the product of new thinking, new
methods, and new knowledge. Such innovations often require the longest time period
between initiation and market implementation because of the need for testing and
modification.

Major Innovation Myths

Presented next is a list of the commonly accepted innovation myths, along with reasons
why these are myths and not facts.

Myth 1: Innovation is fact and predictable: This myth is based on the old concept that
innovation should be left to the research and development department under a planned
format. In truth, innovation is unpredictable that may be introduced by anyone.

Myth 2: Technical specifications should be thoroughly prepared: Thorough

preparation often takes too long. Quite often it is more important to use a try/test/revise
approach.

Myth 3: Creativity relies on dreams and blue-sky ideas: Accomplished innovators are
very practical people and create from the opportunities left by reality- not daydream.

Myth 4: Big projects will develop better innovations than smaller ones: This myth
has been proved false time and time again. Larger firms are now encouraging their people
to work in smaller group, where it is often easier to generate creative ideas.

Myth 5: Technology is the driving force of innovation: Technology is certainly one

source for innovation, but it is not the only one. Moreover, the customer or market is the

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driving force behind any innovation. Market-driven or consumer-based innovations have
the highest probability of success.

Principles of Innovation

Potential entrepreneurs need to realize that innovation principles exist. These principles
can be learned and, when combined with opportunity, can enable individuals to innovate.
The following are the major innovation principles:
 Be action oriented: Innovators always must be active and searching for new
ideas, opportunities, or sources of innovation.
 Make the product, process, or service simple and understandable: People must
readily understand how the innovation works.
 Make the product, process, or service customer-based: Innovators always must
keep the customer in mind. The more an innovator has the end user in mind, the
greater the chance the concept will be accepted and used.
 Start small: Innovators should not attempt a project or development on a
grandiose scale. They should begin small and then build and develop, allowing
for planned growth and proper expansion in the right manner and at the right
time.
 Aim high: Innovators should aim high for success by seeking a niche in the
marketplace.
 Try/test/revise: Innovators always should follow the rule of try, test, and revise.
This helps work out any flaws in the product, process, or service.
 Learn from failures: Innovation does not guarantee success. More important,
failures often give rise to innovations.
 Follow a milestone schedule: Every innovator should follow a schedule that
indicates milestone accomplishments. Although the project may run ahead or
behind schedule, it still is important to have the schedule in order to plan and
evaluate the project.

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  Work, work, work: This is a simple but accurate exhortation with which to
conclude the innovation principles. It takes work – not genius or mystery – to
innovate successfully.

ACTIVITY

 What is Creativity?

Commentary: Creativity is defined as conceiving of something new. When you explain creativity
explain it in terms of the five stages of idea germination, preparation, incubation, illumination
and verification. Further consider the difference between creativity and innovation.

Summary

The concepts entrepreneur and entrepreneurship differ from economy to economy and period to
period. They have shown significant development in terms of scope in the past few centuries
alone. In the earliest period the entrepreneur was a merchant adventurer who sells goods of a
venture capitalist in faraway places by taking all the associated risks. During the middle ages, the
entrepreneur was one who simply administered funded projects without taking any risk. In the
17th century came the concept of risk as an important aspect of entrepreneurship. In the late 19 th
and early 20th century, entrepreneurs were often regarded as managers and in the mid 20 th century
the connection of innovation with entrepreneurship emerged.

One good definition describes entrepreneurship as “…. The process of identifying, developing,
and bringing vision to life…. The end result of this process is the creation of a new venture,
formed under conditions of risk and considerable uncertainty.” Entrepreneurship has been
defined in various ways, however, the four key elements found in most recent definitions are
vision, risk-taking, organizing skill and Innovation.

Similarly, entrepreneurship can be classified in many ways based on various grounds. Some of
the most common types are private or collective entrepreneurship; opportunity-driven or
necessity-driven entrepreneurship; and technological, sociological or geographical

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entrepreneurship. Another form of entrepreneurship is intrapreneurship, which is a form of
entrepreneurship within an existing organization.

Entrepreneurship is a significant catalyst in the development of a countries economy. Some of

the most important contributions of entrepreneurship to the economy include creation of jobs,
development of better products and production methods, abolition of monopoly and
enhancement of competition, increase in per capita output and income, and generation of foreign
currency.

Self Assessment Questions

1. Take two Ethiopian entrepreneurs and discuss their contribution to and roles in the
economy.
2. Consider business owners found in your surroundings. Do you think they meet the
criteria to be called an entrepreneur? Why or why not?
3. What are the major sources of innovation? Explain and give an example of each
4. What are the five steps involved in developing personal creativity?

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 Chapter Two
Entrepreneurial Background, Trait and Motivation

Learning objectives

After reading this chapter, you should be familiar with:

 the characteristics of a typical entrepreneur
 the motivations that drive entrepreneurs to start their own business
 the importance of role models and support systems to the entrepreneur
 the profiles of entrepreneurs
 the similarities and differences between male and female entrepreneurs.

Introduction

Every person has the potential and free choice to pursue a career as an entrepreneur. Exactly
their personal profile, their basic qualities and what motivate individuals to make choice for
entrepreneurship have not been identified. Researchers are and have been striving to learn more
about the attributes that best define the background of entrepreneurs, the traits experienced by
successful entrepreneurs and the different forces that lead individuals to become an entrepreneur.

In this chapter first we will try to describe the common variables that researchers found to
describe the profile of entrepreneurs followed by common qualities experienced by most
successful entrepreneurs. Furthermore we will see the positive and negative forces that inspire
individuals towards entrepreneurship. Finally, this chapter presents some success factors for
entrepreneurs.

2.1 THE ENTREPRENEURIAL BACKGROUND

All entrepreneurs are not the same. Different entrepreneurs have different cultural and
educational background, family structures and situations. They come from a variety of
professions, age groups and nationalities. An entrepreneur can be a male or a female, a young
man or an old woman, a nurse or an engineer. Therefore, there is no such thing as a ‘true

30
entrepreneurial profile’. Even though research as explored many aspects of entrepreneurs’
background; it has discovered only a few areas that differentiate the entrepreneur form the
average person. The entrepreneur’s background areas investigated include childhood family
environment, education, personal values, age, and work history.

Childhood Family Environment

There are some hypotheses that hold being a firstborn or an only child to a family contributes to
the child’s receiving special attention and to the child’s development of more self- confidence.
One study found that out of the 408 female entrepreneurs surveyed, 50% were found to be
firstborn. However, there is no clear evidence that establishes this hypothesis.
Another related area in which research probed in to was the occupation of the entrepreneur’s
parents. Evidence strongly suggests that entrepreneurs tend to have self- employed or
entrepreneurial father. Having a self – employed parent provides a strong inspiration for the
entrepreneur. The independence and flexibility gained by the parent through self- employment is
ingrained at an early stage. The knowledge that will be shared form such an experienced family
member is also very important for the entrepreneur’s success. Parents of entrepreneurs, whether
they are entrepreneurs or not, must be supportive. They need to encourage responsibility,
achievement and independence through self-employment order to establish the interest of
entrepreneurship in their children.

Generally, the support parents give, especially that of the father, appears to be the most important
for female entrepreneurs. Female entrepreneurs tend to posses similar personality as their fathers
and come from middle to upper- class environments where families are likely to be child
centered.

Education
Some people feel that entrepreneurs are less educated than the average non- entrepreneur.
However, research proves otherwise. In fact, most entrepreneurs were found to have at least a
college degree. Education was important in the entrepreneur’s upbringing. It has also been found
to play a vital role in helping the entrepreneur deal with daily challenges.

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Even though education is not a precondition to start up a business, it makes the entrepreneur’s
life easier in establishing and running the venture, especially, if it is related to the entrepreneur’s
engagement. Commonly, it is to the entrepreneur’s benefit to have some education in the areas of
finance, strategic planning, marketing, human resource management and communication.

Age
Most entrepreneurs launch their entrepreneurial careers between the age of 22 and 45. Why?
What makes this age range special? Well, it is true that entrepreneurs aging out of the above
range may emerge. However, this is often very unlikely, as the entrepreneur needs experience,
financial backing, courage and energy to start up and run a new business.
Research shows that there appears to be patterns of ages, specifically 25, 30, 35, 40, 45, 50, and
55 at which individuals are more inclined to emerge as entrepreneur. Generally, male
entrepreneurs launch their first significant venture in the early 30s, while female entrepreneurs
tend to do so in their middle and late 30s.

Work Experience
Work experience not only positively impacts a person’s decision to start an entrepreneurial
career but contributes significantly to the person’s struggle to lead the new venture to success.
Commonly lack of challenge and promotional opportunism, frustration and boredom with one’s
job encourage people to start up their own businesses. In any case, previous knowledge and
experience are important to launch the new business. Particularly exposure to the areas of
finance, product development, manufacturing, development of distribution channels and
marketing is advantageous. As the business increases in size, the business activities become
more complex and diverse, a situation that makes managerial and entrepreneurial experiences
and skills increasingly important.

Sex structure
Even though there has been significant growth in female self employment, men make up the
majority of people who start and own their own businesses. While very similar in overall
characteristics, women entrepreneurs possess very different motivations and occupational
backgrounds than their male counterparts. Factors in the startup process for business of male

32
entrepreneurs are different to that of females especially in such areas as source of funds, support
systems, business skill levels, and personality.
 Men are often motivated by the derives to control their own destinies. This derives often
stems from disagreements with their bosses or feelings that they run things better. In
contrast, women tend to be more motivated by independence and achievement arising
from job frustration. The reason for transition from the past occupation to the new
venture for men is often facilitated when the new venture is an outgrowth of a present
job, sideline, or hobby. Women, on the other hand, often leave a previous job with a high
level of job frustration and enthusiasm for the new venture.
 The background of male and female entrepreneurs tends to be similar, except that most
women are a little older when they start their venture and their educational backgrounds
are different. Men often have studied in technical or business related areas, while most
women have a liberal arts education.
 While males often get finance from investors, bank loans, personal loans, or personal
funds as a startup capital, women usually rely solely on personal asset or savings.
 In terms of support group men usually have outside advisors as more important
supporters with the spouse being the second. Women on the other hand consider their
spouse first, close friends second, business associations, trade associations, and women
groups third. They usually rely heavily on a variety of sources for support and
information.
 Although both groups tend to have experience in the fields of their venture, men have
attained competence in a variety of business skills. Men have experience in
manufacturing finance, construction, and high technical areas. In contrast, most women
entrepreneurs usually have administrative experience that is limited to middle level
management. They usually work-in service related areas such as education, secretarial
work, retail sales, public relations, etc.
 In terms of personality, there are strong similarities between male and female
entrepreneurs. Both tend to be energetic, goal oriented, and independent. However, men
are often more confident, less flexible, and more tolerant than women.

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 ACTIVITY

 What appears to be the role of the father in the establishment of entrepreneurial

tendencies?

Commentary: There are a number of factors that stimulate individuals to develop and
cultivate their entrepreneurial competencies. Of those major factors, parents especially the
father can play fundamental role in this regard. The role of the father can be explained in
terms of presenting himself as a role model, proving all the necessary inputs, allowing for
children freedom to do and control their daily activities, giving chance to say their mind and
etc.

2.2 ENTREPRENEURIAL TRAITS

Probably no other aspect of entrepreneurship has been studied more than the traits and
characteristics that make up the entrepreneurial personality. A number of studies have
been conducted to determine whether entrepreneurs distinctly differ from managers and
the public at large in personality and other characteristics. Studies have found that while
entrepreneurs have various characteristics that contribute to success only few make them
different from managers and the general populace.

As most argue, some of the characteristics which are commonly exhibited by successful
entrepreneurs are:

 Need for Achievement

Psychologists recognize that people differ in their need for achievement. Individuals with
a low need for achievement are those who seem to be contented with their present status.
On the other hand, individuals with a high need for achievement like to compete with
some standard of excellence and prefer to be personally responsible for their own
assigned tasks, i.e., need achievement a desire to succeed, where success is measured
against a personal standard of excellence.

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 According to Slavin, need for achievement is the desire to experience success and to
participate in activities in which success is dependent on personal effort and abilities. It is
a generalized tendency to strive for success and to choose goal – oriented success / failure
activities”

David C. McClelland is a leader in the study of achievement motivation. According to

him, people with high achievement motivation have the desire to do well, work harder at
certain tasks, tend to learn faster, do their best work when it counts for the record and not
for inventive or profits, choose experts over friends as working partners, like accurate
knowledge of activities (feedback), are responsive and make use of opportunities, and
have the urge to improve and do well.

Entrepreneurs tend to set themselves clear and demanding goals. They benchmark their
achievements against these personal goals. As the result, entrepreneurs tend to work to
internal standards rather than look to others for assessment of their performance. They set
themselves goals and targets, are self motivated and take pleasure in achieving these
goals.

“McClelland has discovered a positive correlation between the need for achievement and
entrepreneurial activity.” Hence, according to him, those who become entrepreneurs
have, on the average, a higher need for achievement than do members of the general
population.

 Risk Taking

Virtually all recent definitions of an entrepreneur indicate a risk – taking component.

Indeed, risk whether financial, social, or psychological, is a part of the entrepreneurial
process. “While entrepreneurs are often known as risk takers, they seem to be careful to
take only calculated risks.”

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The idea that entrepreneurs are risk – takers is one which reflects their popular image.
However we must be very careful to distinguish between personal risk and economic risk.
We may face personal risk by exposing ourselves to dangerous situations. But to an
economist, risk results from making an investment. Risk is the possibility that the return
from an investment may be less than expected, or, to be exact, might be less than could
have been obtained from an alternative investment that was available. So, acceptance of
risk is something that investors do, not entrepreneurs as such. However, the popular
impression that the entrepreneur is a risk-taker is not completely inappropriate. It
recognizes that entrepreneurs are good at managing in situations where risk is high; that
is, when failed with a situation of high uncertainty they are able to keep their head, to
continue to communicate effectively and to carry on making effective decisions.

The extent to which entrepreneurs have a distinctive risk taking propensity is still
debatable. Some studies, for example, have found entrepreneurs to be similar to
professional managers, while other studies found them to have a greater willingness to
assume risk. And even some studies found entrepreneurs scored lower on risk taking than
investor. This debate, however, does not obscure the fact that entrepreneurs must be
willing to assume various risks. They typically place a great deal on the line when they
choose to enter to business for themselves.

Running own business is risky. The entrepreneur assumes all possible risks of business
which emerge due to the possibility of changes in tastes of consumers, techniques of
production and new inventions, political and economical changes. If they materialize, the
entrepreneur has to bear the loss himself. Thus, risk bearing still remains as the most
important characteristic of an entrepreneur which he /she tries to reduce by his / her
initiative, skill and good judgment.

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 Hard Working

Entrepreneurs put a lot of physical and mental effort in to developing their ventures. They
often work long and anti social hours. After all an entrepreneur is their own most
valuable asset. Balancing the needs of the venture with other life commitment such as
family and friends is one of the great challenges of entrepreneurs but they manage it by
putting a lot of efforts.

Running a business allows entrepreneurs to stay for longer hours in their business. The
success of an entrepreneur demands the ability to work long hours for sustained periods
of time.

 Innovation

Innovation lies at the heart of entrepreneurship. Yet to believe in innovation we have to

see the world in a certain sort of way. We have to believe in a future that will be different
from the present. We have to believe that we can act to influence the world and change it
by our actions. Further, if we are to be encouraged to innovate, we must believe that it is
appropriate that we are rewarded for our efforts in developing innovation.

The successful entrepreneurial venture is usually based on a significant innovation. This

might be a technological innovation, it might be an innovation in offering a new service,
an innovation in the way something is marketed or distributed, or possibly an innovation
in the way the organization is structured and managed, or in the way relationships are
maintained between organizations.

Innovation is the specific tool of entrepreneurs, the means by which they exploit change
as an opportunity for different businesses or different services. It is capable of being
presented as a discipline, capable of being learned and practiced. Entrepreneurs need to
search purposefully for the sources of innovation, the changes and their symptoms that
indicate opportunities for successful innovation.

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 Entrepreneurs see changes as the norm and as healthy. Usually they may not bring the
change themselves. But entrepreneurs always search for change, respond to it, and exploit
it as an opportunity.

 Self Confidence

Individuals who possess self-confidence feel they can meet the challenges that confront
them. They have a sense mastery over the types of problems they might encounter.
Studies show that successful entrepreneurs tend to be self reliant individuals who see the
problem in launching a new venture but believe in their own ability to overcome
problems.
The entrepreneur must demonstrate that they not only believe in themselves but also in
the venture they are pursuing.

People who start and run a business must act decisively. They need confidence about
their ability to master the day – to – day tasks of the business. They must feel sure about
their ability to win customers, handle the technical details, and keep the business moving.
Entrepreneurs also have a general feeling of confidence that they can deal with anything
in the future; complex, unanticipated problems can be handled as they arise.

 Locus of Control

The task of starting and running a new business requires the belief that you can make
things come out the way you want. The entrepreneur not only has a vision but also must
be able to plan to achieve that vision and believe it will happen. Most entrepreneurs have
an internal locus of control, that is, they feel they have control over events that affect
their success. They can use initiative and drive to create opportunities and exploit them.

An internal locus of control is a belief by individuals that their future is within their
control and that other external forces will have little influence. For entrepreneurs,
reaching the future is seen as being in the hands of the individual. Many people, however,

38
 feel that the world is highly uncertain and that they are unable to make things come out
the way they want. An external locus of control is the belief by individuals that their
future is not within their control but rather is influenced by external forces.

While internal locus of control appears to differentiate entrepreneurs from the general
public, they may not differentiate entrepreneurs from mangers.

 Good health
Successful entrepreneurs are generally physically resilient and in good health. When they
get sick, they recover quickly, in small businesses, where there is no depth of
management, the leader must be always there. Especially in the beginning, the
entrepreneur may not afford to hire a support staff to cover all business function.
Therefore he or she needs to work long hours, and for that he or she needs to be healthy.

 Persona Values
Many studies indicate that personal values are important for the entrepreneur. However,
they often fail to indicate that entrepreneurs are different form managers or any other
person, as far as these values are concerned. For instance, both a manager and an
entrepreneur may be creative. But still personal values such as aggression, benevolence,
conformity, creativity, resource seeking and ethics are very important for the
entrepreneur. Studies have shown that entrepreneur’s attitude towards the nature of the
management process and the business in general differs. Hirsch and Peters write ‘The
nature of the enterprise, opportunism, institution, and individuality of the entrepreneurs
diverge significantly from the bureaucratic organization and the planning, rationality and
predictability of its managers.

 Sense of urgency
Entrepreneurs have a never – ending sense of urgency to develop their ideas. Inactivity
makes them impatient, tense and uneasy. They normally prefer individual sports such as
golf, skiing, or tennis over tea sports. They prefer games in which their own effort
directly influences the outcome and pace of game. They have drive and high energy
levels.

39
  Comprehensive Awareness
Successful entrepreneurs can comprehend complex situations that may include planning,
strategic decision making, and working on multiple business ideas simultaneously, they
are farsighted and aware of important details, and they continuously review all
possibilities to achieve their business objectives.
 Realism
Entrepreneurs accept things as they deal with them accordingly. They may or may not be
idealistic, but they are rarely unrealistic. They will change their direction when they see
that change will improve their prospects for achieving their goals.
 Conceptual Ability
Entrepreneurs possess the ability to identify relationships quickly, even in complex
situation. They identify problems and begin working on their solution faster than other
people do. Entrepreneurs are natural leaders and are usually the first to identify a
problem. If it is pointed out to them that their solution to a problem will not work for
some valid reason, they will quickly identify an alternative approach.

Table 2.1 Characteristics Often Attributed to Entrepreneurs

1. Confidence 21. Perseverance, Determination
2. Energy, diligence 22. Responsibility
3. Resourcefulness 23. Foresight
4. Ability to take calculated risk 24. Accuracy, thoroughness
5. Dynamism, leadership 25. Cooperativeness
6. Optimism 26. Profit orientation
7. Need to achieve 27. Ability to learn from mistakes
8. Versatility 28. Sense of power
9. Creativity 29. Pleasant personality
10. Ability to influence others 30. Egotism
11. Ability to get along well with people 31. Courage
12. Initiative 32. Imagination
13. Flexibility 33. Perceptiveness
14. Intelligence 34. Toleration to ambiguity
15. Orientation to clear goals 35. Aggressiveness
16. Positive response to challenges 36. Capacity for enjoyment
17. Independence 37. Efficacy
18. Responsiveness to suggestion and criticism 38. Commitment
19. Time competence, efficiency 39. Ability to trust workers
20. Ability to make decision quickly 40. Maturity, balance

Source: John A. Hornaday, “Research about living entrepreneurs,” 1982, 26-27

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 Status Requirements
Entrepreneurs find satisfaction in symbols of success that are external to themselves.
They like the business they have built, not themselves, to be praised. Symbols of
achievement such as position have little importance to them. Successful entrepreneurs
find their satisfaction of status needs in the performance of their business, not in the
appearance they present to the public. They postpone acquiring status items like a luxury
car until they are certain that their business is stable. Their personalities do not prevent
them from seeking facts, date and guidance. When they need help, they will not hesitate
to admit.

 Interpersonal Relationships
The average entrepreneur is more concerned with people’s achievements than with their
feelings. Entrepreneurs generally avoid becoming personally involved and will not
hesitate to sever relationships that could hinder the progress of their businesses. During
the business- building period, when resources are scarce, they seldom devote time to
dealing with satisfying people’s feelings beyond what is essential to achieving their
goals. As the business grows and assumes an organizational structure, the entrepreneurs’
need for control makes it difficult for them to delegate authority in the way that a
structured organization demands. Their strong direct approach induces them to seek
information directly from its source, by passing the structured chains of authority and
responsibility. Their moderate interpersonal skills, which are adequate during the start –
up phases, will cause them problems as they try to adjust to the structured or corporate
organization.
 Emotional Stability
Entrepreneurs have a considerable amount of self- control and can handle business
pressures. They are comfortable in stress situations and are challenged rather than
discouraged by failures. Entrepreneurs are uncomfortable when things are going well.
They will frequently find some new activity on which to vent their pent-up energy.

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Table 2.2 Twenty-First Centaury Characteristics of Entrepreneurs

The Top Ten Characteristics Today’s Entrepreneurs Share

 Recognize and take advantage of opportunities

 Resourceful
 Creative
 Visionary
 Independent thinker
 Hard worker
 Optimistic
 Innovator
 Risk taker
 Leader

Source: Soo Ji Min, “Made not born,” Entrepreneur of the year Magazine (fall 1999): 80.

 Attraction to challenges and Competition.

Entrepreneurs are attracted to challenges and competition by nature. Many were active in
sports and other competitions in high school and college. Others were competitive in
wanting to make good grades, earn the respect of their parents and achieve their goals.

 Money management
Entrepreneurs are careful about money. They always know how much money they have. They
know the value and cost of things and thus they can recognize a real bargain. Most
entrepreneurs earned money when they were teenagers-babysitting, mowing lawns, delivering
newspapers, sacking groceries, etc..

 Loners: Entrepreneurs are usually loners rather than team players. They prefer a solitary
work environment.

 Leisure Time: Entrepreneurs do set aside time for leisure activities and family. But their
principal form of relaxation is their work.

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 Self- Esteem: Entrepreneurs have a high sense of one’s own self-worth. Without that,
individuals will never undertake tough challenges.

 Screening for opportunity: Entrepreneurs screen incoming information in a different

way since they constantly seek new growth opportunities. They are like gold miners who
shift through tons of dirt to spot new market opportunities.

 Goal orientation: Entrepreneurs have a relentless drive to accomplish goals. They

understand what their priorities are and continue to work hard towards those goals.
Staying focused on a goal, however, is a very difficult thing to do, since life in the world
of business ends to distract us.

 Optimism: Underlying successful entrepreneurial leadership is a boundless optimism

that never seems to end. For entrepreneurs, a problem is simply a challenge. When faced
with an obstacle, they take it as a new direction, when told no, they say, “Maybe not now,
but I know you’ll change your mind soon.”

 Courage: Building a company form the ground up requires a great deal of courage.
Someone once said that large organizations function like “Womb” protecting employees
form a harsh and merciless environment to take a great deal of courage to leave a
corporate or government womb and join the cold, cruel would of business where one will
find him or herself all alone.

 Tolerance to Ambiguity: Entrepreneurs are not bothered by ambiguity and uncertainty.

They can clearly and comfortably see the fact and the relationship of things in a very
complicated situation or problem.

ACTIVITY

 What is need for achievement?

43
Commentary: Need for achievement is individuals’ desire to excel their standards of excellence.
People with high achievement have the desire to do well, work harder at certain tasks, tend to
learn faster, do their best work when it counts for the record and not for inventive or profits

2.3 ENTREPRENEURIAL MOTIVATION

What motivates an entrepreneur to take all the risks and launch a new venture, pursuing an
entrepreneurial career against the overwhelming odds for success? Although many people are
interested in starting a new venture and even have the background and financial resources to do
so, few decide to actually start their own business.

Given the sizable risks, time and energy requirements of entrepreneurship, why do so many
individuals take the entrepreneurial plunge every year? Entrepreneurs are motivated to launch
business for a number of reasons. While the motivations for venturing out alone vary greatly,
they can be grouped in to two broad categories: pull factors and push factors.

Pull Factors

Some individuals are attracted towards small business ownership by positive motive such as a
specific idea which they are convinced to work on. Pull factors are those which encourage
individuals to become entrepreneurs by virtue of the attractiveness of the entrepreneurial option.
Some important pull factors are the following:

Independence: "Being my own boss" is a powerful motivator for many entrepreneurs, who
seek the freedom to act independently in their work. As heads of business, they enjoy the
autonomy of making their own decisions, setting their own work hours, and determining what
they will do and when they will do it.

Need for independence has been suggested as a fundamental motivation of small business
owners. Entrepreneurs prefer to be their own boss, have often escaped from what they perceived
to be hierarchical regimes of the large corporation and to have realized a sense of purpose
through owning and managing their own business.

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The need for power or control: The need for power has also been suggested as a source of
motivation. Power has been defined variously either as an attribute of an individual or as a
structural phenomenon. People with a desire for power not only enjoy being in charge but also
accumulate all the symbols and emoluments of power. They prefer to work in a competitive
and status oriented situations and tend to be more concerned with gaining influence over others
and with their prestige than with effective performance.
Need for Achievement: Need for achievement is a desire to excel and achieve a particular
goal. The goal is set in relation to a standard and so the individual who is most motivated in
this way will strive to accomplish their goal through entrepreneurship.
Entrepreneurs characteristically like to take personal responsibility for finding solutions to
problems, they like repaid feedback and they aim to achieve moderately difficult tasks, that is,
tasks which have a challenge but not beyond their capabilities.

Profit: Many entrepreneurs are enticed by the hefty profits of a highly successful business,
although the odds in favor of such considerable success are slim. Others are motivated by
making their own money in business. Surprisingly, however, many entrepreneurs do not rate
money as a primary motivator for starting their own businesses.

Role Models: perhaps one of the most important factors influencing entrepreneurs in their
carrier choices is role models. Role models can be parents, brothers or sisters, other relatives,
or successful entrepreneurs in the surrounding community or nationally touted individual
entrepreneurs.

Highly visible role models seem to stimulate entrepreneurial activity. Watching others'
successes drive individuals to start their own business. Entrepreneurs often describe being
inspired to start their entrepreneurial career by another entrepreneur, a parent, a local business
person, or a famous entrepreneur.

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Push Factors
Push factors on the other hand are those which encourage entrepreneurship by making the
conventional option less attractive. Many people are pushed (forced) in to founding a new
business by variety of factors. Some of the push factors include:

An Alternative to a Dissatisfying Job: Many entrepreneurs are former executives and

employees of larger corporations who were highly dissatisfied with their jobs. Some were
bored with their work and frustrated with the corporation's disinterest in their ideas. Others
were frustrated by the slow decision making, the bureaucracy, and their limited autonomy as
managers in large companies.

An important factor that influences someone to start an entrepreneurial career is dissatisfaction

with traditional careers that involve working for someone else, often a large organization. Slow
career progress, the inability to effect quick changes within the organization, low wages, and
office politics are just some of the reasons cited for this dissatisfaction.

Job Insecurity: Given the substantial risks and uncertainty of entrepreneurship, personal
security may seem unlikely motivator. However, in a time of much corporate downsizing and
layoffs, some entrepreneurs view running their own business as a more secure alternative,
especially those in the middle and latter stages of their corporate careers.

Personal and Professional Growth: The challenges of building a business innately involve
individual growth. To be successful, an entrepreneur must be able to cope with risk,
uncertainty, and stress, handle many different interpersonal relationships, and manage a
business with limited resources. Many individuals become entrepreneurs to experience this
growth and the fulfillment gained from building a business in to a purposeful, productive
entity.

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Unemployment: Some individuals start their own business when they fail to get employment.
Self- employment is taken as the best alternative for those who are not employed. When
unemployment increases, many people start their own business and become entrepreneurs.

A need for seeking for refugee or to escape from environmental factors: There are a
number of environmental factors that "push" people to find new firms. These entrepreneurs are
motivated as much or more by entrepreneurial rewards than by an "escapist or refugee" mind
set. There are different types of refugees that become reasons for establishing their own
business.

 The foreign refugees: These are individuals who escape the political, religious, or
economic constraints of their homelands by crossing their national boundaries. These
individuals when they first enter into a new country they frequently face a lot of problems
and may not get salaried employment. As a result, many of them go into establishing
their own business.
 The corporate refugees: These are individuals who flee or leave the bureaucratic
environment of organizations by going into their business for themselves.
 The parental (paternal) refugees: are those who leave a family business to show the
parent that "I can do it alone."
 The feminist refugees: are those who experiences discrimination and decide (elect) to
start a firm in which they can free themselves from household responsibilities.
 The society refugees: are those who sense some alienation from the prevailing culture
and express it by indulging or entering in entrepreneurial activity.
 The educational refugees: are those who try an academic program and decide to leave and
enter the "real world" by going into a new business.

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 ACTIVITY

 What is the concept of entrepreneurial motivation?

Commentary: Entrepreneurial motivations are those factors that stimulate individuals toward
the activity of entrepreneurship. There are factors that attract individuals towards the activity of
entrepreneurship and on the other hand there are other factors that enforce people toward the
activity of entrepreneurship. Hence, you are required to describe the concept of entrepreneurial
motivation from these perspectives.

2.4 SUCCESS FACTORS FOR ENTREPRENEURS

Several success factors are apparent from research on innovation and entrepreneurship. We now
have fairly solid evidence of what it takes to succeed in a new venture, and although there will
always be exceptions; most new ventures succeed because their founders are capable individuals.
The following part tries to give brief account on success factors for entrepreneurs.

 The Entrepreneurial Team: At the top of the success factor list is the “entrepreneurial
team.” The term “team” is used because, more often than not, entrepreneurs do not start
business by themselves; they have teams, partners, close associates, or extensive
networks of advisors. An entrepreneurial team is usually headed by an individual who
provides the critical profile of success. This focal entrepreneur typically has an above-
average education, with about 35 percent of technical entrepreneurs holding graduate
degrees. Most entrepreneurs started their business when they were in their 30s, and they
had solid job experience. Most technical entrepreneurs tend to start business closely
related to what they did in previous career positions. Those in non technical areas often
leverage their experience in – marketing, merchandising, or a professional service area
such as insurance or finance. We can infer that success is closely tied to solid knowledge
base and substantial experience in related field of endeavor. They will also have well-

48
 developed social and business relationships, and therefore have a strong foundation for
building a team support network.

 Venture Product or Service: Nearly all successful ventures start small and grow
incrementally, few “gear-up” with substantial organizations for a big-bang start.
Incremental expansion of products and services also tend to stay within the bounds of
positive cash flow. Products tend to have strong profit potential with high initial margins
rather than small margins that requires substantial volume of sale to meet profit
objectives. Service businesses retain good margins by effective cost controls, and well-
monitored overheads.

In each instance, products and services tend to display a distinctive competency in their
industries. This is important because very few entrepreneurs start business in already
competitive situations. Entrepreneurs Corollary to this rule is that successful
entrepreneurs should “stick to their knitting” by concentrating initially on one distinct
product or service, making it successful before diversifying.

From an investor’s viewpoint, the product or service idea is secondary to the

entrepreneur. A popular expression among investors is that they would rather “back a
first-rate entrepreneur with a second-rate product than the other way round”. This
guideline does not mean the business concept can be weak, but it does suggest that
investors must have considerable confidence in the entrepreneurial team before buying
into the venture.

 Market and Timing: Successful entrepreneurs tend to have clear vision of both existing
and potential customers. A crucial aspect of planning is to have a well-documented
forecast of sales based on sensible projections at each stage of incremental growth. A
charismatic entrepreneur loaded with talent and a great idea will not convince investors
that a venture is viable without valid market research. There are no short cuts; and as
noted early, there are windows of opportunity that can lead to exceptional success.

49
  Business Ideology: from an entrepreneur’s perspective, every venture has an ideology, a
philosophy, or rationale for existing. Although the ideology may be extremely difficult to
quantify, it is nevertheless important. A business ideology is defined as a system of
beliefs about how one conducts an enterprise. These beliefs include – a commitment to
provide customers with value, the ability to take calculated risks, the determination to
grow and to control the fate the business, the propensity to elicit cooperation among team
members, and the perspective of creating wealth realistically. A business ideology may
not be entirely defined by these notions, but failure is often blamed on one of them. For
example, rarely do we hear that a business failed because the product was flawed, but
more often because the firm lost track of its commitment to customers.

Summary

All entrepreneurs are not the same with regard to their personalities and competencies, as they
come from different families, educational and cultural backgrounds. However, there are some
characteristics shared by most entrepreneurs.

Entrepreneurs generally tend to believe that their achievements are influenced by to a larger
extent by their effort. They also tend to be self-confident, self-reliant and calculated risk takers.
Even though there is no conclusive evidence, entrepreneurs tend to have self employed parents.
Unlike what is commonly thought, most entrepreneurs are well educated. In addition, most are
healthy, goal oriented and good forecasters. They have comprehensive awareness of business
issues, realistic outlook, a need to control and direct, ability to see the relationship of things
easily, low status requirement, high self esteem, and emotional stability.

Entrepreneurs have role models and supporters which greatly contribute to their success. The
role models inspire the entrepreneur and influence his or her career choice. The supporters can be
moral supporters such as parents, spouses and children or professional supporters such as
mentors, advisors, business associates and customers.

Finally, there are some differences between male and female entrepreneurs. For instance, often
male entrepreneurs launch their first significant business in their early 30s, while women

50
entrepreneurs tend to do so in their middle and late 30s. Furthermore, entrepreneurs are different
from inventors and managers. Entrepreneurs may be inventors or managers. But managers or
inventors are not necessarily entrepreneurs.

Self Assessment Questions

1. Is it true that most entrepreneurs have failed at some point in their business career?
Explain.
2. Entrepreneurship as a process is full of ups and downs. Though it is explained by a
number of challenges still today individuals are keen to become an entrepreneur. The
question is what are the different motives that stimulate people toward the activity of
entrepreneurship?
3. How do you explain the profile of entrepreneurs in terms of their educational
background?

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 Chapter Three
Alternative Business Ownership Opportunities

Learning objectives

After reading this chapter, you should be familiar with:

 the different alternative means for business ownership
 the basic nature and steps involved in starting a business from scratch
 the methods used for asset valuation
 franchise structure, benefits, and drawbacks

Introduction

People become entrepreneurs by launching an entirely new business (starting from scratch), by
purchasing an existing firm (acquisition), or by acquiring a franchised outlet (franchising). Each
of these ownership opportunities presents the entrepreneur with different set of advantages and
challenges. The objective of this chapter is to explore each of these opportunities one by one
with their advantages and disadvantages; and identify all the necessary steps required by the
entrepreneurs to reduce their weaknesses and to take advantage of their benefits.

3.1 CREATING AN ENTIRELY NEW BUSINESS

Building businesses from scratch (a start up) is the route most often thought of when discussing
new-venture creation. This requires the entrepreneur to identify a genuine business opportunity,
secure the necessary financial resource to create the venture, acquire labor, material and capital
resources, create an organizational structure by defining the authority and responsibility of each
person and position in the enterprise, and launch the business with the intention of creating an
enterprise which has its own public image and reputation.

The first impression most people have about this alternative is that it is difficult and involves a
whole lot of hard work. But in spite of its difficulty, it is preferable in certain situations:
 When the entrepreneur wants to avoid undesirable precedents, policies,
procedures, and legal commitments of existing firms

52
  When the entrepreneur wants to make the decision concerning the ideal location,
equipment, products or services, employees, suppliers, and bankers by him/herself
 When the entrepreneur has developed a new product or service that necessitates
new type of business

Advantages of starting a new business from scratch

Whatever the reason for starting an entirely new business might be, it offers the entrepreneur
with the following advantages:
 Greater leeway in deciding where his/her products or services will be marketed;
where the business will be located; and which individuals will be hired
 No preexisting equipments and inventory; the entrepreneur will choose only the
equipments and inventory that are necessary according to the particular needs of
the business
 Customer contacts and relationships are new; which permits the entrepreneur to
establish his/her own reputation and a unique image
 The entrepreneur can create a business that reflects his personality
 There is no previous ill will to contend with
 It gives the entrepreneur an opportunity to provide a unique product or service to
the market
 Credit connections are new; and a relationship with lenders can be developed
from the beginning
 Suppliers are not predetermined; which means they can be evaluated and chosen
according to the entrepreneur’s needs

Disadvantages of starting from scratch

Although this alternative has the above mentioned advantages, it poses the following
problems:
 Obtaining credit or getting investors for the business may be more difficult
because the business is not yet established

53
  Starting and organizing a new business will take more time and energy than
buying an existing business
 A customer base that has confidence in the company’s product or service will
have to be established, which might take time
 It is not certain that the business opportunity identified by the entrepreneur will be
both operationally and marketwise feasible
 Estimating costs and making other forecasts become very difficult because the
enterprise does not have a prior operational history. This in turn makes making
important operational decisions very difficult

Process of creating a new business from scratch

Creating an entirely new business is a complex process that involves a number of important
and highly interrelated activities and decisions that need to be performed step by step.
 Identifying a genuine business opportunity- The first step in the
business creation process is to identify a good business opportunity.
Entrepreneurs can generate a business idea from various sources that
might include: previous work experiences, personal interests/hobbies,
education/courses, chance happenings …and so on. Whatever the source
of the new idea maybe, it can fall under any of the following three general
categories:
 Type A ideas involve providing customers with a product or service that
does not exist in their market but already exists somewhere else
 Type B ideas involve a technically new process
 Type C ideas involve concepts for performing old functions in anew and
an improved way.
Whatever type of business opportunity is involved, it must be genuine. Meaning, the new
business must have some type of advantage that will provide a competitive edge. This special
edge is necessary because the market place does not generally welcome a new competitor. The
prospective entrepreneur must visualize some new product or service or location or ‘angle’ that
will not only “get the foot in the door” but keep it there.

54
  Developing a business plan- This is an important step in the venture
creation process which is usually overlooked by most entrepreneurs.
Developing a business plan helps the entrepreneur to critically analyze the
proposed venture to determine the genuineness of the opportunity, identify
potential problems and challenges that might be encountered in the
process, and develop various strategies that enable the entrepreneur exploit
the opportunity and deal with problems.
 Implementing the business plan- The third step in the new venture
creation process is to implement the plan by acquiring the necessary
resources, hiring employees, and creating an organizational structure
 Managing the enterprise created: At this stage, most of the decisions to
be made by the entrepreneur will become routine. The entrepreneur will be
responsible for supervising the day to day operation of the new enterprise.
He/she is also expected to deal with issues concerning expansion, merger
and acquisitions, legal challenges… and so on.

ACTIVITY

 What are the conditions under which we prefer to start a business from
scratch over other business ownership alternatives?

Commentary: starting a business from scratch is preferable in certain situations:

 When the entrepreneur wants to avoid undesirable precedents, policies,
procedures, and legal commitments of existing firms
 When the entrepreneur wants to make the decision concerning the ideal location,
equipment, products or services, employees, suppliers, and bankers by him/herself
 When the entrepreneur has developed a new product or service that necessitates
new type of business

55
 3.2 BUYING AN EXISTING BUSINESS (ACQUISITION)

Would be entrepreneurs may decide to buy an already existing business as an alternative to

starting a new business from scratch. But this decision must be preceded by a thorough
analysis of the advantages and disadvantages of this alternative.

Advantages of acquisition

Acquiring an existing business offers the following advantages to the entrepreneur:

 It reduces the time and cost associated with establishing a new business
 It reduces the uncertainty involved in launching an entirely new venture. A
successful going concern has demonstrated its ability to attract customers, to
control cost, and make a profit
 An existing business may be available at what seems to be a bargain price
 Existing records of the business are on hand and can be used as guides in running
the business
 The buyer of an existing business typically acquires its personnel, inventories,
physical facilities, established banking connections, and ongoing relations with
suppliers
 It provides a chance to eliminate one competitor.

Disadvantages of acquisition

 Ill-will may exist as a result of the way the business was managed
 The employees who are currently working for the business may be incompetent,
may not be able to adapt to the new management style employed by the
entrepreneur, or may resist change
 The business may be overpriced
 Acquisition of outdated inventory and obsolete equipments
 The business might have undesirable legal commitments with suppliers, trade
unions, customers, or employees

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  The personality of the business reflects its previous owner, as a result, it may take
a long time to change the personality of the business, especially, if it is bad

The acquisition process

Acquiring an existing business involves the following steps:

 Finding a business to buy- An entrepreneur can make use of different sources to
locate a business that is for sale which might include business brokers and
realtors, advertising, local chamber of commerce, trade publications and
newspapers, trade suppliers, accountants, attorneys, bankers… and so on.

 Evaluating the existing business to be bought- An entrepreneur, before he/she

decides to buy a business offered for sale, must carefully evaluate the business to
determine whether or not it is worth buying. In doing so, the entrepreneur needs to
have certain information:
 Reason for selling the business
 The business’s past performance and reputation
 The presence of any unfavorable legal obligations

The owner of the business can be a good source of information; but it is advisable that the
entrepreneur uses additional sources like customers, bankers, suppliers, employees, and
thoroughly investigating the internal records of the venture. When evaluating the
business, it is very important to seek the assistance of external professionals like
accountants and lawyers.

As part of the evaluation process, the entrepreneur is expected to estimate the value of the
business. To do this the entrepreneur can make use of different techniques which include:
 Book value method- This method uses a company’s financial statements to
establish the net worth of the firm. It is also called the “balance sheet method” and
the “net worth approach.” Using balance sheet data, liabilities are subtracted from
the value of tangible assets to derive the value of the business without considering

57
 good will. The book value of a business is not necessarily its market value or a
fair value for buying or selling it. All tangible assets must be evaluated in order to
correct inaccuracies that result from accelerated depreciation, bad debts,
obsolescence, and usefulness. Specifically, accounts receivable will seldom be
worth their face value because of overdue payments, uncollectible (i.e., bad debt
write-offs), and customer returns. Inventory is valued at full cost only when it is
entirely salable; more often, inventory is devalued to account for slow-moving
items, potentially obsolete stock, and allowances for breakage, poor quality, and
warranty replacements. Book value for equipments and facilities will be adjusted
to reflect market or useful value. Using the book valuation method also requires a
subjective evaluation of intangible assets
 Multiple of earnings method- When the buyer intends to continue an existing
business, the multiple of earnings method is used to capitalize net income. A
value is established by multiplying net annual income by a factor that accounts for
risk, future income potential, and the buyer’s expectations for investment pay
back. A risky business, one with low growth potential, may have a multiplier of
only 2. Consequently, a business that has generated on average $20,000 net
income during the past several years will be valued at $40,000. If the buyer puts
forward a $40,000 bid, he or she is saying, in effect, that the business is either too
risky or has too little potential, and the buyer wants a “payback” in two years.
 Discounted future earnings- This approach is also called the “present value”
model because it uses net present value (NPV) technique to derive a value based
on future earnings. Specifically, expectations for future net cash receipts are
“discounted” to reflect present values. These discounted future net cash receipts
are added to a projected future cash value of the enterprise to provide an offering
price.

These NPV techniques are used to estimate “present” value of “future” receipts,
and in order to do so, a discount rate must be established. The discount rate is a
risk adjusted return expected from a comparable investment. If, for example, a
person could earn 7% interest on a risk-free government security, and a relatively

58
 low-risk business opportunity seems to justify a small 2% premium, then the
discount rate for valuing the business would be 9%. If the business seems to be
risky, a large risk premium of 10% could be assigned, resulting in a 17%
discounting rate.

There are additional considerations that can raise or lower the purchase price. The present
value assumes, for example, a cash equity investment. In many instances, the buyer will
have to borrow most of the purchase price, and if the loan interest is substantial, the
discount rate will rise, thereby reducing the purchase prices, or, alternatively, interest
costs will be deducted from net cash flow. If the buyer will also operate the new business,
then allowance must be made for an equitable salary or draw against business profits.
This will further reduce net annual cash flow and the purchase price.

On the other hand, the seller may self-finance a significant portion of the purchase price
through a note or a profit-sharing contract. Payments to the seller may reduce cash flow,
but risk sharing by the seller can also reduce the discount rate. The lower discount rate
results in a higher net present value and higher purchase prices, therefore, how the
acquisition is structured and financed will influence decisions by both buyers and sellers.
In addition to the price of the business, the entrepreneur must consider other important
factors that include: competition, market (size and trends in the market), future
community developments (construction of public buildings, municipally operated parking
lots, or a public park; change from a two-way traffic flow to one way flow; and
discontinuance of bus routes that allow public transportation for customers and
employees), legal commitments, union contracts, building (the quality of the building
housing the business), future national emergencies (the impact of price and wage
controls, energy shortages, and human resource shortages), and product prices.

 Negotiating the purchase price and terms- Once the entrepreneur has some idea
about the probable selling price of the business, he/she can safely initiate the
negotiation process-the primary objective, of course, being to secure a low selling
price. But focusing on the final selling price of the business should not divert the

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 attention of the entrepreneur from other elements of the sale. These elements
include terms of payment, taxes, loan arrangements… etc.
 Closing the deal- As in the purchase of real estate, the purchase of a business is
closed at a specific time. The closing may be handled by a title company or an
attorney. Preferably, the closing should occur under the direction of an
independent third party. If the seller’s attorney is suggested as the closing agent,
the buyer should exercise caution. Regardless of the closing arrangements, the
buyer should never go through a closing without extensive consultation with a
qualified attorney.
A number of important documents are completed during the closing. These
include a bill of sale and agreements pertaining to future payments and related
guarantees to the seller.

ACTIVITY

 What are the principal sources of information for locating businesses offered for
sale?

Commentary: There are several sources of information for identifying businesses which are
offered for sale or bid. The source of information can be promotions released with different
medium of communication, financial institutions, government institutions like Ethiopian
privatization agency, banks, chamber of commerce and/or brokers.

3.3 FRANCHISING

It is the third business ownership alternative available for an entrepreneur and can be defined
as a business arrangement or opportunity whereby the manufacturer or sole distributor of a
trademarked product or service gives exclusive rights of local distribution to independent
retailers in return for their payment of royalties and conformance to standardized operating
procedures. The party offering the franchise is called the franchisor while the franchisee is
the party who purchases the franchise. And the legal arrangement between these two parties
is called the franchise.

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The United States Department of Commerce provides a broader definition: “Franchising is a
method of doing business by which a franchisee is granted the right to engage in offering,
selling, or distributing goods or services under a marketing format which is designed by the
franchisor. The franchisor permits the franchisee to use the franchisor’s trademark, name and
advertising.”

Franchising can be approached from the perspective of both the franchisor and the
franchisee. For a franchisor, franchising allows the expansion of a proven concept and
method of operation from a single unit to large operation with multiple locations and multiple
product or service offerings. The franchisee has the opportunity to use proven methods of
operation, large-scale, high impact advertising, recognized brands or trademarks, and the
continuing management and technical assistance. These advantages are not available to the
independent entrepreneur who may be selling the same product or service.

A franchisor uses the franchisee’s community goodwill, financial equity, business location,
and personal drive and motivation to expand the franchised business. The franchisee uses the
franchisor’s brand or trademark, proven methods of operation, marketing resources, and
technical advice to enter, develop, and maintain customer demand, and ultimately to succeed
as an entrepreneur within the community. The franchisee is often given an opportunity to be
part of the operation with limited capital and prior experience, while having a very good
chance of success.

This business arrangement or franchise opportunity has three major components: (1) a
trademark and/ or logo, (2) the use of the product or service following a marketing plan, and
(3) a payment of royalty fee. These components constitute the essence of what is generally
referred to as a franchise, whether the arrangement happens to be in auto and truck sales,
convenience food stores, restaurants, cleaning services, gasoline retailing, or a host of other
products and services.

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Types of franchising

These are different forms of franchising opportunities. These different forms of franchising
opportunities can be grouped into different classes on the basis of different dimensions.
Hence, we can classify franchises by using the nature of the franchising agreement or the
parties involved in the agreement.
Types of franchise based on franchising arrangements- On the basis of this
dimension, there can be at least four types of different franchising arrangements.
 Product and trade name franchising- This type exists when a franchisor gives a
franchisee the right to use a widely recognized product or trade name. Product and
trade-name franchising has evolved from suppliers making sales contacts with
dealers to buy or sell certain products or product lines. In this relationship, the
dealer acquires the trade name, trademark, and/or product from the supplier. The
dealer (franchisee) identifies with the supplier (franchisor) through the product
line. Historically, this approach to franchising has consisted of distribution from a
single supplier (or manufacturer) to a large number of dealers either directly or
through regional supply centers. This franchising approach has been used in the
auto and truck, soft drink, tire, and gasoline service industries.
 Business format franchising- This arrangement provides the franchisee an entire
marketing system and an ongoing process of assistance and guidance. Business
format franchising is concerned with the format or operations procedures to be
used by a franchisee in providing the franchisor’s product or service line to the
customer. Fast food outlets and business services are examples of this type of
franchising.
 Piggyback franchising- This form refers to the operation of a retail franchise
within the physical facilities of a host store. Examples would be a cookie
franchise doing business in side a fast food outlet or a car phone franchise with in
an automobile dealership. This type of franchise benefits both parties. The host
store is able to add a new product line, and the franchise is located near to the
customer.

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  Master franchising (sub franchising) - a master franchisor is an individual who
has a continuing contractual relationship with a franchisor to sell its franchises.
This independent business person is a type of a sales agent. Master franchisors are
responsible for finding new franchisees within a specified territory.

Types of franchise based on the parties involved in the agreement: Depending on the
parties involved in a franchising arrangement and the level they occupy in the value chain,
there are three different franchising systems:
 System A franchise- In this system a producer or creator of a product gives
franchising rights to a wholesaler. This system is common in the soft drink
industry. Examples include Coca Cola, Pepsi Cola, and Dr Pepper…etc.
 System B franchise- In this case, the franchisor is a wholesaler instead of a
producer. This system prevails among super markets and general merchandising
stores.
 System C franchise- This is a widely used system, and the franchisor is a
producer/creator while the franchisee is a retailer. Automobile dealerships and
gasoline service stations are prototypes of this system.

ACTIVITY

 Which form of franchising is best in business franchising?

Commentary: There is no one best form of franchising. All forms of franchising are appropriate
under different conditions.

Advantages and Disadvantages of Franchising

Franchising is an alternative business growth and expansion strategy for the franchisor while it
can be an alternative business ownership opportunity for the franchisee. Hence, the advantages

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and disadvantages of franchising can be discussed from two perspectives- the franchisee and
franchisor.

Advantages to the franchisee

The franchisee gains a number of potential advantages from being involved in a franchising
relationship. Some of these have been mentioned briefly before. The following paragraphs
elaborate on these and others.

 Product acceptance or established product or service: The major

advantage to the franchisee, as previously discussed, is that the franchisee
enters a business that has an established, highly marketed product or service
name. Consumers are already aware of the name and reputation of the product
or service the franchisee will be offering. This advantage is assured to the
franchisee by the fact that every year large franchisors spend millions of
advertising dollars to keep the public aware of their products or services. Such
franchisors will generally spend a large portion of their advertising budget on
campaigns through television commercials and full-page advertisement on
popular magazines.

 Technical and managerial Assistance: A second advantage to the franchisee

is the technical and managerial assistance provided by the franchisor. The
franchisee benefits from the accumulated experience and knowledge of the
franchising organization. Franchisors provide the instruction necessary to
operate a franchise unit, including on-the-job training in a pilot store. Once
operating the unit, the franchisee receives assistance in managing day-to-day
operations as well as advice for dealing with crisis situations. Therefore, a
person can enter without prior experience in that particular field because the
franchisor will supply the pilot training needed to develop experience and will
provide follow-up assistance once the franchised unit has begun operations.

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 Most business consultants would warn a potential entrepreneur not to attempt
a business venture in unfamiliar field. Franchising provides the opportunity to
do exactly that and be successful. In fact, some franchisors prefer franchisees
that have no prior experience in their particular business field. The franchisor
can then train the new franchisee in the methods and procedures of the
franchising company, and to be unlearned and no bad habits to break. Some
franchisors are looking not for people who know the industry but for those
who are motivated and willing to follow instructions.

In addition to managerial guidance, the franchisee will receive technical

assistance from the franchisor. Technical assistance often includes location
and site selection, store layout and design, store remodeling, inventory control
and suggested stock purchases, equipment and fixture purchasing, and the
grand opening of the store. It should be noted that although many franchisors
provide these specific services, some provide only selected types of
assistance. The types of technical assistance provided are usually what the
franchisor has found to be absolutely essential for helping the franchisee to be
successful. A franchise should therefore realize that a full range of technical
assistance is not always part of the franchising package.

 Financial assistance-Starting a new venture can be costly in terms of both

time and money. The franchise offers an opportunity to start a new venture
with up-front support that could save the entrepreneur significant time and
possibly capital. Some franchisors conduct location analysis and market
research of the area that might include an assessment of traffic, demographics,
business conditions, and competition. In some cases, the franchisor will also
finance the initial investment to start the franchise operation. The initial
capital required to purchase a franchise generally reflects a fee for the
franchise, construction costs, and the purchase of equipment.

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 The layout of the facility, control of stock and inventory, and the potential
buying power of the entire franchise operation can save the entrepreneur
significant funds. The size of the parent company can be advantageous in the
purchase of health care and business insurance, since the entrepreneur would
be considered a participant of the entire franchise organization. Savings in
start-up are also reflected in the pooling of monies by individual franchisees
for advertising and sales promotion.

 Marketing advantages- Any established franchise business offers the

entrepreneur years of experience in the business and knowledge of the market.
This knowledge is usually reflected in a plan offered to the franchisee that
details the profile of the target customer and the strategies that should be
implemented once the operation has begun. This is particularly important
because of regional and local differences in markets. Competition, media
effectiveness, and tastes can vary widely from one market to another. Given
their experience, franchisors can provide advice and assistance in
accommodating any of these differences. Most franchisors will be constantly
evaluating market condition and determining the most effective strategies to
be communicated to the franchisees. Newsletters and other publications that
reflect new ideas and developments in the overall market are continually sent
to the franchisees.

 Operating and structural controls- two problems that many entrepreneurs

have in starting a new venture are maintaining quality control of products and
services and establishing effective managerial controls. The franchisor,
particularly in the food business, will identify purveyors and suppliers that
meet the quality standards established. In some instances, the suppliers are
actually provided by the franchisor. Standardization in the supplies, products,
and services provided helps ensure that the entrepreneur will maintain quality
standards that are so important. Standardization also supports a consistent
image on which the franchise business depends for expansion.

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 Administrative controls usually involve financial decisions relating to costs,
inventory, and cash flow, and personnel issues such as criteria for
hiring/firing, scheduling, and training to ensure consistent service to the
customer. These controls will usually be outlined in a manual supplied to the
franchisee upon completion of the franchise deal.

 Quality control Standards: The quality control standard imposed by the

franchisor upon the franchisee is another potential advantage. Properly
administered and controlled, such standards help the franchise to achieve
constructive, positive results by ensuring product or service uniformity
throughout the franchise system. By setting and maintaining high standards, a
franchisor does the franchisee genuine service. Often franchisees appreciate
having standard methods of operation and product or service delivery. If the
reason for quality standards being maintained is clearly understood, the
franchisee will learn what operations and performance are necessary to be a
success. Further, standards of quality are vital in presenting consistent
patronage image, ensuring return business, maintaining employee morale and
pride in work, and instilling in employees the value of team work.

Why would a franchisee want to continually have to meet standards imposed

by someone else? As long as the quality standards are assessed and
maintained in a good manner, the standards serve both the franchisor and the
franchisee. For example, in franchised restaurants, if franchisees courteously
and efficiently serve an appealing meal in an attractive and comfortable
setting, they have a better chance to attract and maintain a large, loyal
clientele, which clearly benefits the franchisor as well.

 Less Operating Capital: In many cases an entrepreneur can open a

franchised business with less cash than if an independent business were
started. Often, a franchisee can start with considerably less operating capital

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 because the business may not require as much inventory as a comparable non-
franchised business. The knowledge and experience of the franchisor
concerning how much stock is needed and when to reorder can dramatically
reduce the potential for aging of stock, waste or spoilage of perishables,
unprofitable storage of low-demand items. Also, a new franchisee may be able
to receive some financial assistance from the franchisor or from the
franchisor’s financial sources. Other specifics associated with a new venture,
such as having access to existing architectural drawings for the store and
knowing how best to use the floor space for the product or service, can save
the franchisee countless hours and dollars.

Other facets of this advantage can be realized once the business is in

operation. A franchisee can expect to share in certain collateral benefits, such
as a business insurance and health insurance that, because of the group buying
power of the parent company, are often less expensive than the same coverage
sought independently. A franchisee can also expect to have a higher profit
margin than a comparable independent business owner because of group
franchising power and other benefits of associating with the franchisor. This,
of course, returns cash to the franchisee.

 Opportunities for Growth: The other advantage to the franchise concerns

growth opportunities for operating the territorial franchises. The growth
opportunities may come either from negotiating a territorial franchise or from
the availability of additional single-unit franchises. A territorial franchise
guarantees that there will be no competition from the same franchisor within
the specified geographic boundaries. A territorial franchisee may sub-
franchise or license other persons to operate stores within the allotted area.
Even in the case of single-unit franchisee, sometimes called operating
franchisees, additional units can often be added either within the local
geographical area or in other areas. Existing franchisees decide to retire or

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 more areas and achieve much of their own growth through opening more
units.

Accompanying all these advantages is the devise and assistance available from the franchisor
that the franchisee could not have gained without years of experience in the field. This
opportunity to benefit from another’s experience – to learn from someone else’s mistakes – is a
primarily advantage of entering a franchising relationship. However, these advantages have to
be tempered with a disclaimer since they may not accrue to every franchisee. What might be a
decided advantage to one could be in consequential to another.

Advantages to the franchisor

Just as there are major advantages for the potential franchisee to enter relationship with a
franchisor, there are significant advantages for the franchisor. Even though the franchisor
appears to be the major player of the two, the franchisor simply cannot achieve the amount of
growth alone that can be gained through the franchise relationship. Thus, it is important to
consider the advantages of franchising from the franchisor’s viewpoint.
 Expansion: Perhaps the single greatest reason for an entrepreneur to create a
franchising chain is to allow a business to expand with limited capital, limited
risk, and limited equity investment. A franchisor does not have to spend large
sum of money or incur major debt to expand the business into new location.
Franchisors can authorize and then place franchised operations in selected
areas gradually or they can choose to develop business locations throughout a
region or country. A franchised company requires few managers and therefore
has a lower staff payroll and fewer staff problems. This provides a greater
likelihood of effective monitoring and control of company operations. Also, a
franchisor may find potential investors willing to buy into a franchised
company if the company is seen to promise continuing profitability. Similarly,
persons with little or no experience in the franchisor’s business field may be
willing to buy a franchise as a potentially profitable investment. Thus,
franchising can attract capital through direct investment in the parent company

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 or through the sale of franchises to be used for expansion of the franchise
system.

A related advantage is that the franchising approach provides an opportunity

for the parent company to expand into geographic areas that otherwise might
not be likely locations for expansion. When a franchised company contract
with a franchisee within a particular community, that franchisee may be able
to acquire a commercial site that the parent company would be unable to
acquire. Communities may be more willing to work with local entrepreneurs
than with a remote corporation. Therefore, zoning and other local regulations
may be more easily obtained by franchisees than by large corporation from
another country.

Expanding through franchising also simplifies the management structure and

reporting requirements associated with expansion. Significant growth by a
traditional corporation required the formation of a sizable management
structure to develop, implement, monitor, and control the enhanced level of
operations. The capacity of the firm’s management to control the business
activity may not be sufficient to keep pace with the growth of the business
itself. In contrast, rapid expansion through franchising network enables the
franchisor to devote more time to operational planning, market analysis and
assessment, quality control, and strategies for improving the franchise system
itself.

 Cost advantages- The mere size of a franchised company offers may

advantages to the franchisor. The franchisor can purchase supplies in large
quantities, thus achieving economies of scale that would not have been
possible otherwise. Many franchise businesses produce parts, accessories,
packaging, and raw materials in large quantities, then in return sell these to the

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 franchisees. The franchisee is usually required to purchase these items as part
of the franchise agreement, and they usually benefit from lower prices.

One of the biggest cost advantages of franchising for a business is the ability
to commit larger sums of money to advertising. Each franchisee contributes a
percentage of sales (1to 2%) to an advertising pool. This pooling of resources
allows the franchisor to conduct advertising in major media across a wide
geographic area. If the business had not been franchised, the company would
have had to provide funds for the entire advertising budget.
Franchise revenues - In addition to cost advantage, franchising provides the
franchisor with a lot of revenue in the form of initial franchise fees, royalties
fees, sales of products and supplies, real estate income, fees for services like
bookkeeping, purchasing contracts, legal assistance, marketing research…etc,
and promotional fees.

 Motivation: A major advantage of franchising as opposed to expanding

company owned outlets is that franchisees are generally more highly
motivated than company-employed managers. When a franchised unit is
operated by an owner rather than a company-employed manager, that unit will
usually benefit from the owner’s motivation, self-direction, and personal
interest in the success of that operation. In addition, the franchisee is often a
respected and influential member of the local community, which may result in
greater community support of the venture.

 Shared Advertising: In a typical franchise relationship, the franchisee pays

advertising fee of 1 percent or 2 percent of sales to the franchisor in addition
to the royalty fee. This is then combined with the franchisor’s commitment to
advertising in order to provide a greater financial investment in advertising.
This combined amount is sufficient in most cases to offer all inclusive
advertising. This provides economics of scale since a single ad can typically
be run in all market areas. If the expansion were through company-owned

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 units only, the parent company would have to underwrite all the cost of
advertising for the entire chain. Since more capital would have been spent in
the operation of the units, less would be available for advertising purpose.

Disadvantages to the franchisee

Most franchising agreements work well for both the franchisor and the franchisee. The
franchise agreement is meant to develop a strong relationship between these two mutually
bound profit seekers. The franchising approach helps both to realize profits and develop
healthy and prosperous business life. However, there are some disadvantages to the
franchisee that can be associated with the franchising relationship.

 Cost of franchise-The franchise cost consists of several components. Only

after all of these cost components have been examined can a realistic picture
be drawn. The cost of a franchise begins with the franchise fee. Other costs
include royalty payments, promotion costs, inventory and supplies cost, and
building and equipment costs. When these costs are considered with the
franchise fee, the total investment may look surprisingly large. If
entrepreneurs could earn the same income independently, they would save the
amount of these fees and some of the other costs. However, this is not a valid
objection if the franchisor provides the benefits previously described. In that
case, franchisees are merely paying for the advantages of their relationship
with the franchisor.

 Restriction on growth- A basic way to achieve business growth is to expand

the existing sales territory. However, many franchise contracts restrict the
franchisee to a defined sales territory, thereby eliminating this form of growth.
Usually, the franchisor agrees not to grant another franchise to operate within
the same territory. The potential franchisee, therefore, should weigh territorial
limitation against the advantages cited earlier.

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  Loss of absolute independence- Frequently, individuals leave salaried
employment for entrepreneurship because they dislike working under the
direct supervision and control of others. By entering in to a franchise
relationship, such individuals may simply find that a different pattern of close
control over personal endeavors has taken over. The franchisee does surrender
a considerable amount of independence upon signing a franchise agreement.

Even though the franchisor’s regulation of business operations may be helpful

in assuring success, it may be unpleasant to an entrepreneur who cherishes
independence. In addition, some franchise contracts go to extremes by
covering unimportant details or specifying practices that are more helpful to
others in the chain than to the local operation. Thus, as an operator of a
franchised business, the entrepreneur occupies the position of a semi-
independent businessperson.

Disadvantages to the franchisor

Franchising is by no means a miraculous or problem-free solution to a distribution

problem. The idea of using money belonging to other individuals to finance the major
part of a business expansion is no doubt exciting, but the application of that idea can be
fraught with difficulty. The foremost problem or challenge is how to maintain control of
the expanding franchise system and oversee the general operations of each business. In
addition, a franchisee may in time re-evaluate the franchising relationship and come to
the conclusion that the particular business unit would be better off without the franchisor.
Major disadvantages of franchising to the franchisor are discussed below.

Within the franchisor-franchisee relationship, there are three categories of potential

disadvantages for the franchisor. These are problems of recruitment, communication, and
freedom.
 Recruitment: The recruitment problem concerns the difficulty of finding
promising franchisee. While there are many who seek franchising as a means

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 to enter business, most lack the experience and motivation and many do not
have the proper capital backing they will need to become successful
franchisee. In addition, prospective franchisees may not fully realize the
amount of time, work, and responsibility required to own and operate an
ongoing franchised business.

 Communication: As in any business relationship, communication problem

can arise. The franchise agreement should be well written in clear language in
order to minimize difficulties and misunderstandings. This is particularly true
in regard to royalty and other fee payment formulas. Most franchisees pay fee
to the franchisor on the basis of the franchised unit’s gross income. Some
franchisee may have a difference of opinion as to what constitutes “gross
income,” or may be reluctant to disclose gross income figures to the
franchisor. For this reason it is important that the formula for determining any
fees or royalties be clearly stated in written franchising agreement and
understood by both parties. When such understandings exist, the likelihood of
resentments based on unclear language or personal intent can be minimized.

 Loss of Freedom: The third potential relationship problem concerns the

franchisor’s loss of freedom as a new franchisee becomes part of the franchise
system. Independent businesspersons can easily make decisions and change
policies within their organizations. But once a franchise system is developed,
the franchisor or patent company must get permission from franchisees to
introduce new products, to add or eliminate services, or to change operating
policies. Thus, the franchisor stands to lose a substantial amount of control
once a franchise system increases in size to any great degree. It can become
extremely difficult for the franchisor to modify the product or process in order
to meet the ever changing needs of customers, particularly if the franchise
system is spread across a large geographic area containing varied consumer
markets.

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The franchising process

The quality of franchising as an ownership opportunity highly depends on the image,

reputation, and historical success of the franchisor; and the kind of rights and privileges
granted to the entrepreneur by a franchise contract. Therefore, the entrepreneur, before
entering into a franchise arrangement with anyone, must carefully evaluate his/her options
and follow certain procedures.
 Locating a franchise opportunity- The entrepreneur must first be able to locate
a good franchising opportunity. Sources of information in this regard can be
advertisements in news papers and magazines, existing franchise owners, or other
publications and personal contacts.

 Evaluating the franchise offer- Once a franchise opportunity is found, it must be

carefully evaluated. Doing so requires a lot of information which can be obtained
from the franchisor himself, existing franchisees, governmental and trade sources,
business magazines, and franchise consultants. The entrepreneur, in evaluating
franchise offer, should be aware of franchising frauds. There are some
unscrupulous fast-buck artists who offer a wide variety of fraudulent schemes to
attract the investment of unsuspecting individuals. The franchisor in this case is
merely interested in obtaining the capital investment of the franchisee and not in a
continuing relationship.
There are certain areas that the entrepreneur should focus on when evaluating a
franchise offer. These include the following:
 Business experience of the franchisor
 Business experience of the directors and the chief executives of the
franchisor
 Litigation history of the franchisor
 Bankruptcy history of the franchisor
 Initial funds required to be paid by a franchisee
 Recurring funds required to be paid by a franchisee
 Financing arrangements

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  Restriction on sales
 Termination, cancellation, and renewal of the franchise
 Training programs
 Financial information concerning the franchisor …etc.
In most countries, the franchisor is legally obliged to provide the franchisee with a
disclosure statement that clarifies the above issues.

 Initiating the negotiation Once the entrepreneur has identified and carefully
evaluated a franchise opportunity, the next step will be starting talks with the
franchisor in order to establish franchising relations. Although disclosure
statements provide information necessary to make a sound evaluation of the
business opportunity, they are seldom sufficient for actually deciding to contract
for a franchise. Disclosure information provides a foundation for negotiations. All
the services and types of assistance offered in a franchise contract are subject to
negotiations, and experienced entrepreneurs often prefer to handle most of their
own activities such as accounting, leasing, purchasing, employee training, and
maintenance. Location decisions are usually made jointly by a franchisor site-
selection team and the franchisee, but there may be little latitude for decisions
about facilities or unique designs. Some obligations are not negotiable (or have a
narrow range of options), including franchise fees, royalty schedules, brand
management, inventory, use of proprietary patents, copyrights, and trademarks,
and legal rights of both parties.

 Closing the deal Few franchise contracts are signed by the prospective franchisee
without due diligence and legal assistance. Subsequent to initial meetings with the
franchisor, prospective franchisees will take the negotiated proposal to a
professional accountant or attorney experienced in due-diligence research for
thorough review. This is not an act of mistrust by the franchisee, but only sensible
behavior, and most reputable franchisors will insist on a legal review of the
propos

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 ACTIVITY

 In the franchising agreement, as a franchisee there is a possibility of losing your

absolute independence. Explain.

Commentary: In a franchising arrangement, the franchisee can lose his or her absolute freedom.
This can be explained in terms lack of autonomy in making decision regarding some critical
material inputs used for the production of goods and services, selection of location for future
expansion and product design and development.

3.4 Legal Issues for the Entrepreneur

In establishing a new venture, the entrepreneur should deal with various legal issues.
Understanding the legal issues involved in entrepreneurship and taking appropriate measures
protect the entrepreneur from later legal complications which might hinder the smooth running
of the new business. In this regard, the entrepreneur must seek the assistance of a competent
attorney who is in a better position to understand all possible circumstances and outcomes related
to any legal action. Some of the legal issues the entrepreneur should address in starting a new
business are discussed below.

Intellectual Property This refers to exclusive right given to the entrepreneur to benefit from
his/her innovations and creations; which includes: patents, trademarks, copy rights, and
trademarks. These are very important assets to the entrepreneur and must be understood even
before engaging the services of an attorney. Too often entrepreneurs, because of the lack of
understanding of intellectual property, ignore the important steps to take in order to protect these
assets.
i. Patents: A patent is a contract between the government and an inventor. In this contract,
the inventor agrees to disclose his/her invention in return for grants by the government
exclusivity regarding the invention for a specified period of time. At the end of this time
the government publishes the invention and becomes part of the public domain. The

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regulations concerning patent were issued by the Transitional Government of Ethiopia
under the proclamation No.123 in 1995 GC. The Ethiopian Government grants patents for
machines, compositions of matters such as chemical compounds to be used in an industry,
manufactured items, and industrial processes, provided that they meet a number of legal
conditions. Patents are also available for significant improvements on previously invented
items and for certain types of industrial designs. Currently, the Ethiopian Science and
Technology Institution is the central government office responsible for the determination
of the validity of patents.

Importance of patents Having laws and regulations concerning patent and other
intellectual properties benefits both the country and the individual entrepreneur in a
number of ways:
 It is necessary to create favorable conditions in order to encourage local
inventive and related activities thereby building up national technological
capabilities.
 It has been found essential to encourage the transfer and adaptation of
foreign technology; by creating a good environment to assist the national
development efforts of the country.
 The task of fulfilling the nation’s multidimensional demand for harmonious
scientific and technological progress, to be used for the public benefits, shall
be most effectively served when there exists an appropriate legal frame
work.

Application to get a patent To obtain a patent in Ethiopia, an individual must write an

application to the Ethiopian Science and Technology Institution. The application should
have three parts:
 Introduction This should contain the background and advantages of the
invention and the nature of problems that it overcomes. It should also clearly
state how the invention differs from existing offerings.
 Description of the invention: The application should also contain a brief
description of the drawings that accompany it. Then, this should be followed
by a detailed description of the invention, which may include engineering

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 specifications, materials, components, and so on, that are vital to the actual
making of the invention.
 Claims Claims serve as the criteria by which any infringements will be
determined. They serve to specify what the entrepreneur is trying to patent.
Essential parts of the invention should be described in broad terms so as to
prevent others from getting around the patent. At the same time, the claims
must not be so general that they hide the invention’s uniqueness and
advantages.

Patentable invention To qualify for a patent, an invention must fulfill the following:
 An invention is patentable if it is new, involves an inventive step, and is industrially
applicable.
 An invention shall be considered new if it is not anticipated by prior art. Prior art shall
consist of everything disclosed to the public, anywhere in the world by publication in
tangible form or by oral disclosure, by use or any other way, prior to the application or,
where appropriate, the priority date of the application claiming the invention.
 Notwithstanding the above provision, the disclosure to the public of the invention shall
not be taken in to consideration if it occurred within the 12 months preceding the filing
date or where applicable, the priority date of the application, and if it was by reason or in
consequence of acts committed by the applicant or his predecessor in title partly with
regard the applicant or his predecessor in title.
 An invention shall be deemed as involving an inventive step if, having regard to the prior
art relevant to the application and defined in the second criterion above, it would not have
been obvious to a person having ordinary skill in the art.
 An invention shall be considered industrially applicable when it can be made or used in
handicraft, agriculture, fishery, social services or any other sector
Non patentable invention As per the patent regulations of Ethiopia the following inventions
shall not be granted patent protections:
 Inventions contrary to pubic order or morality.
 Plant or animal varieties or essentially biological processes for the production of plants
and animals.

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 Schemes, rules, or methods for playing games or performing a commercial activity.
 Discoveries of scientific theory and mathematical methods.
 Methods for the treatment of the human or animal body by surgery or therapy, as well as
diagnostic method practiced on a human or animal body

Disputes Occasionally, several people apply for a patent for the same invention.
Under the Ethiopian law, the person who first invented the item receives the
patent. If it is unclear who invented the item first, the ESTI decides who gets the
patent in a proceeding called interference. The losing party can appeal the
decision in the court of appeals. Most other countries grant the patent to whoever
first applied for the patent protection.
Terms If the ESTI finds that the invention fulfills the conditions listed above,
grants the patent. Under the current Ethiopian law, a patent is given for five years
to the individual or individuals who came up with the invention. However, if the
inventor is an employee and did the work as part of his/her job, the grant will be
given to the employer too.
Infringement It refers to the act of making, using, or selling a patented invention
without the consent of the patent holder. Anyone who infringes a patented
invention is susceptible to a legal action by the patentee-the holder of the patent.
The infringer might argue that the patent should not have been given in the first
place and it will be up to the court to decide whether or not the patent is valid.
Another defense that can be used by the infringer is the first sell principle. Under
this principle, once the patentee sells a particular item, the purchaser of that item
may use it or resell it without being considered an infringer.
Options to avoid infringement: to avoid risks that are associated with patent
infringement, the entrepreneur should follow the following procedures:
 Assess whether the item is patented or not
 If not patented, file for patent
 If a patent exists, determine whether the patent is new or nearly
expired
 If it is nearly expired, plan for introduction when the patent expires

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  If it is new, determine if other expired patents exist that accomplish
the same purpose
 If yes, develop the product using other designs
 If no, see if it is possible to introduce some changes in the product
and commercialize it without infringement
 If this is not possible, seek a license from the patentee
 If it is possible, produce using the modified version

ii. Trademarks It may be a word, symbol, design, or some combination of such, or it could be
a slogan or even a particular sound that identifies the source of the sponsorship of certain
goods or services. Unlike the patent, trade mark can last indefinitely, as long as it continues
to perform its indicated function.
Most countries of the world legally protect trademarks. The current Ethiopian law also gives
companies the right to register their trademarks and have them protected. Trademark
registration is carried out by the Ministry of Inland Revenue; and to be eligible for
registration the mark must be used in internal or foreign commerce.
The owner of a trademark may permit others to use it by granting them a license in return for
a royalty’s fee. The owner of the trademark must supervise the licensees to make sure that
they provide a consistent type and quality of goods and services. Failure to supervise can
result in loss of rights to the trade mark.
Sometimes the public may stop thinking of the trademark as a brand name and begins to
think of it merely as a general category of goods. The trademark owner has a responsibility to
make sure that this does not happen. If the trademark owner fails to do so, he/she will lose
his/her legal rights to the trademark because the source of the good or service can no longer
be identified.
The law forbids the use of someone else’s trademark in a way that confuses the public about
the source of the product. And, anyone who does this is considered an infringer and can be
sued by the trademark owner.
iii. Copy right It refers to the right given to prevent others from printing, copying, or publishing
any original work of authorship. The protection in a copy right does not protect the idea
itself, and thus it allows someone else to use the idea or concept in a different manner.

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iv. Trade secrets In certain instances, the entrepreneur may prefer to maintain an idea or
process as confidential and sell or license it as a trade secret. The trade secret will have a life
as long as the idea or process remains a secret. Employee involved in working with an idea or
process may be asked to first sign a confidential information agreement that will protect
against their giving out the trade secret either while an employee or after leaving the
organization. The entrepreneur should hire an attorney to help draw up any such agreement.
The holder of the trade secret has the right to sue any signee who breaches such an
agreement.
What or how much information to give to employees is difficult to judge and is often
determined by the entrepreneur’s judgment. Historically, entrepreneurs tend to protect
sensitive or confidential company information from anyone else by simply not making them
privy to this information. Today, there is a tendency to take the opposite view that the more
information entrusted to employees, the more effective and creative employees can be. The
argument is that the employees cannot be creative unless they have a complete understanding
of what is going on in the business.
v. Contracts The entrepreneur, in starting a new venture will be involved in a number of
negotiations and contracts with vendors, land lords, and clients. A contract is a legally
enforceable agreement between two or more parties as long as certain conditions are met. It
is very important for the entrepreneur to understand the fundamental issues related with
contracts while also recognizing the need for a lawyer in many of these negotiations.
Conditions that must be fulfilled for a contract to be legally enforceable include:
 Capacity The parties in a contractual agreement must have the legal capacity
to participate in contracts. A person is legally capable of singing contracts if
his 18 years of age or older, sane, and not judicially interdicted.
 Consent For a contract to be enforceable; it must be made out of the consent
of the parties involved; and this includes agreement and intention.
 Object It refers to the obligation to perform or pay; that is to deliver the price
of the said thing or object. The object of a contract must be legal and possible.
You cannot enter in to a contract to do the impossible or illegal things.
 Form Contracts can be either written or oral depending on the nature of the
agreement.

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Summary

Each year a number of people go into business for themselves. They do so in one of three ways:
by buying an existing business, by coming a franchising, or by starting an independent business.
Starting a business is a difficult undertaking that requires painstaking analysis and planning. The
idea for the business can originate from a variety of sources and in a variety of ways. Once idea
has been clearly developed, it must be carefully evaluated in terms of the customers the business
will serve and the competition it will face. The question of advantages and disadvantages should
be further examined.

The other alternative means for entrepreneurship or business ownership is acquisition. Buying a
business is not something to be done quickly or easily, however. There is seldom a need to “rush
into the deal.” Each purchase is unique because each business is unique. It may take longer to
complete the negotiation and purchase. Starting a business from scratch and acquisition are not
the only options available to an entrepreneur. The other alternative is franchising. Franchising
provides its viability in advanced economy and has become a key part of small business sector
because it offers many would – be entrepreneurs to opportunity to own and operate a business
with great chance for success. Despite its impressive growth rate to date, the franchising industry
still has a great deal of room for grow.

Self Assessment Questions

1. Describe the forms of franchising.

2. Discuss the right way to buy a franchise
3. Explain the benefits and drawbacks of buying a franchise.
4. What are the evaluation criteria for an existing business offered for sale?

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 CHAPTER FOUR
SMALL BUSINESSES AS VITAL COMPONENT OF THE ECONOMY

Learning objectives

After reading this chapter, you should be familiar with:

 the definition and meaning of small business
 the type of industry in which small businesses operate
 unique contributions of small businesses to the society
 the causes of small business failure

Introduction
It is easy to overestimate the importance of big business because of its high visibility. Hence,
small businesses seem dwarfed by such corporate giants. Yet small businesses, even though less
conspicuous, are a vital component of every economy. In this chapter, we not only examine the
extent of small business activity but also the unique contributions of small businesses that help
preserve our economy’s well-being. Furthermore, we will see the alternative forms of business
out of which an entrepreneur can select one. Finally, we will examine small business failure
factors.

4.1 DEFINITION OF SMALL BUSINESS

Specifically any size standard to define small business is necessary, because people adopt
different standards for different purposes. For example, legislators may exclude small firms from
certain regulations and specify ten employees a cut-off point. Moreover, a business may be
described as “small” when compared to larger firms, but “large” when compared to smaller ones.
For example, most people would classify independently owned gasoline stations, neighborhood
restaurants, and locally owned retail stores as small businesses.

Similarly, most would agree that the major automobile manufacturers are big businesses. And
firms of in between sizes would be classified as large or small on the basis of individual
viewpoints. There are different dimensions or approaches to define small business. All the

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available dimensions, with this material we use the size criterion to provide a detail account on
small businesses.

Definition of Small Business on Size Criterion

Even the criteria used to measure the size of business vary. Some criteria are applicable to all
industrial areas, while, others are relevant only to certain types of business. Examples of criteria
used to measure size are:
 number of employees
 sales volume
 asset size
 insurance in force
 volume of deposits

Although the first criterion listed above – number of employees – is the most widely used
yardstick, the best criterion in any given case depends upon the user’s purpose. To provide a
clear image of a small business discussed in this material, we suggest the following general size
criteria for defining a small business:

1. Financing of the business by one individual or a small group. Only in rare cases would
the business have more than 15 or 20 0wners.
2. Except for its marketing function, the firm’s operations are geographically localized.
3. Compared to the biggest firms in the industry, the business is small.
4. The number of employees in the business is usually fewer than 100.

Obviously, some small firms fail to meet all the above standards. For example, a small executive
search firm – a firm that helps corporate clients, recruits, managers from other organizations –
may operate in many sections and thereby fail to meet the second criterion. Nevertheless, the
discussion of management concepts in this material is aimed primarily at the type of firm that fits
the general pattern just described.

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4.2 THE CONTRIBUTION OF SMALL BUSINESSES TO THE ECONOMY

As part of business community, small firms unquestionably contribute to the nation’s economic
welfare. They produce a substantial portion of the total goods and services. Thus, their general
economic contribution is similar to that of big businesses. Small firms, however, possess some
qualities that make them more than miniature versions of big business corporations. They make
exceptional contributions as they provide new jobs, introduce innovations, stimulate competition,
aid big business, and produce goods and services efficiently. The following section presents
these contributions in some detail.

Provide New Jobs

As the population and the economy grow, small businesses must provide many of the new job
opportunities. It seems clear, indeed, that small businesses must produce the “lion’s share” of the
new job. Data released by the office of Advocacy of the U.S., Small Business Administration,
show clearly the special contribution of small firms in expansion of employment. Small firms are
the leader in adding jobs. Firms with fewer than 20 employees add more jobs than firms of 500
or more employees. In fact, small and medium-size firms, those with fewer than 500 employees,
accounted for almost two-thirds of all jobs added in the economy.

Of course, as newer firms grow in employment size, they become part of the big business sector.
We would also note that not all small firms grow at an even rate.

It is thus incorrect to speak of small enterprises as a uniformity expanding and active group. It
is better to think of them as a large collection of seeds, a few of which sprout and become
large plants. Their job-creating powers flow from the few, not the many.

New jobs, therefore, come from the birth of new firms and their subsequent expansion. Also,
some growth in employment comes from large corporations that expand and create additional
jobs.

Introducing Innovation

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New products that originate in the research laboratories of big business make a valuable
contribution to our standards of living. There is question, however, as to the relative importance
of big business in achieving the truly significant innovations. The record shows that many
scientific breakthroughs originated with independent inventors and small organizations. The
following is a list of some of the twentieth-century examples of new products created by small
firms:
1. Photocopiers 4. Penicillin
2. Insulin 5. Jet engine
3. Vacuum tube 6. Helicopter

It is interesting to note those research departments of big businesses tend to emphasize the
improvement of existing products. In fact, it is quite likely that some ideas generated by
personnel in big businesses are sidetracked because they are not related to existing products or
because of their unusual nature. Unfortunately, preoccupation with an existing product can
sometime blind one to the value of new idea. The jet engine, for example, had difficulty winning
the attention of those who were accustomed to international combustion engines.
Studies of innovation have shown the greater effectiveness of small firms in research and
development, and that small firms are superior innovators in both increasing-employment and
decreasing-employment industries. Others believe that small companies are somewhere between
1.8 and 2.8 times as innovative per employee as large companies. Innovation contributes to
productivity by providing better products and better methods of production. The millions of
small firms that provide the centers of initiative and source of innovation are thus in a position to
help improve productivity.

Stimulating Economic Competition

Many economists, beginning with Adam Smith, have expounded the value inherent in economic
competition. In a competitive business situation, individuals are driven by self-interest to act in a
socially desirable manner. When producers consist of only a few big businesses, however, the
customer is at their mercy. They may set high prices, withhold technological developments,
exclude new competitors, or otherwise abuse their position of power. If competition is to have a
“cutting edge,” there is need for small firms.

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Even socialist economies such as that of China tolerate and encourage the formation of small
businesses as a means of stimulating economic growth. As China’s leaders have in recent years
introduced elements of capitalism, including privately owned businesses, the country has
experienced a dramatic rise in living standards. Not every competitive effort of small firms is
successful, but big businesses may be kept on their toes by small businesses. However, there is
no guarantee of competition in numbers alone. Many tiny firms may be no match for one large
firm or even for several firms that dominate an industry.

Aiding Big Business

The fact that some functions are more expertly performed by small business enables small firms
to contribute to the success of large ones. If small businesses were suddenly removed from the
contemporary scene, big businesses would find themselves saddled with a myriad of activities
that they could perform only inefficiently. Two functions that small businesses can perform more
efficiently than big businesses are the distribution function and the supply function. Few large
manufacturers of inexpensive consumer products find it desirable to own wholesale and retail
outlets. Small businesses act as suppliers and subcontractors for large firms. In addition to
supplying services directly to large corporations, small firms provide services to customers of big
businesses.

Producing goods and Services Efficiently

In considering the contribution of small businesses, we are concerned with an underlying

question of small-business efficiency. Common sense tells us that the efficient size of a business
varies with the industry. We can easily recognize, for example, that a big business is better in
manufacturing automobiles but that small business is better in repairing them. The continued
existence of a small business in a competitive economic system is itself evidence of efficient
small operation. If small firms were hopelessly inefficient and making no useful contribution,
they would be forced out quickly by stronger competitors. Although research has identified some
cost advantages for small firms over big businesses, the economic evidence related firm size and
productivity is limited.

ACTIVITY
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 What are the roles of small businesses in the nation’s socio – economic
development?
4.3 SMALL BUSINESS FAILURE FACTORS

Every year many small business firms cease operations. The most frequent cause is failure to pay
debts, in which case it is common for the owner to declare bankruptcy and to seek to
accommodate the creditors, such paying them 25 cents on Birr. In other instances, businesses go
out of existence because the owners realize that, although currently they are solvent, if they
continue operations they will incur debts they cannot meet. In these instances, business failure
can be defined as a halt of operations.

Some Specific Causes of Failure

Year after year, the major reason that businesses fail is incompetence. The owners simply do not
know how to run the enterprise. They make major mistakes an experienced and well-trained
entrepreneur would see quickly and easily side steps. The second most common reason
businesses fail is unbalanced experience. This means owners do not have well-rounded
experience in the major activities of the business, such as finance, purchasing, selling, and
production. Because the owner lacks experience in one or more of these critical areas, the
enterprise gradually fails. A third common cause of business failure is lack of managerial
experience. The owners simply know how to manage people. A fourth potential reason is lack
of experience in the line; that is, the owner has entered a business field in which he or she has
very little knowledge. Other common causes of business failure include:

 Neglect: Occurs whenever an owner does not pay sufficient attention to the
enterprise. The owner who has someone else manage the business while he or she
goes fishing often finds the business failing because of neglect.
 Fraud: This involves intentional misrepresentation or deception. If one of the people
responsible for keeping the business’s books begins purchasing materials or goods for

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 himself or herself with the company’s money, the business might find itself bankrupt
before too long. Of course the owner can sue the individual for recovery of the
merchandize and have him and her sent to jail, but that all may happen after the firm’
creditors have demanded payment for their merchandize and the owner has had to
close the business.
 Disaster: This refers to some unforeseen happening or “act of God”. If a hurricane
hits the area and destroys material sitting 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.

4.4 FORMS OF BUSINESS ORGANIZATIONS

One of the first decisions an entrepreneur faces when starting a new business, whether or not the
business is small, is selecting the form of ownership for the new venture. Too often,
entrepreneurs give little thought to choosing a form of ownership and simply select the form that
is most popular, even though it may not suit their needs best. Although the decision is not
irreversible, changing from one form of ownership to another once a business is up and running
can be difficult, expensive, and complicated. That is why it is so important for an entrepreneur
to make the right choice at the outset. This seemingly mundane decision can have a significant
impact on almost every aspect of a business and its owner(s) – from the taxes the company pays
and how it raises money to the owner’s liability for the company’s debts and the ability to
transfer the business to the next generation. Each form of ownership has its own unique set of
advantages and disadvantages. The key to choosing the “right” form of ownership is
understanding the characteristics of each one and knowing how they affect an entrepreneur’s
business and personal circumstances. Although there is no best form of ownership, there may be
a form of ownership that is best for each entrepreneur’s circumstances.
The following are a few considerations that every entrepreneur should review prior to making the
final form of ownership choice:

Tax considerations: The graduated tax rate under each form of ownership, the
government’s constant tinkering with the tax code, and the year-to year fluctuations in the

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 company’s income mean that an entrepreneur must calculate the firm’s tax bill under
each ownership opinion every year.
Liability exposure: Certain forms of ownership offer business owners greater protection
from personal liability due to financial problems, faulty products, and a host of other
difficulties. Entrepreneurs must decide the extent to which they are willing to assume
personal responsibility for their companies’ obligations.
Startup capital requirement: Forms of ownership differ in their ability to raise startup
capital. Depending upon how much capital an entrepreneur needs and where he/she plans
to get it, some forms are superior to others.
Control: By choosing certain forms of ownership, an entrepreneur automatically gives
up some control of the company. Entrepreneurs must decide early how much control they
are willing to sacrifice in exchange for help from other people in building a successful
business.
Business goals: How big and how profitable an entrepreneur plans for the business to
become will influence the form of ownership chosen. Businesses often switch forms of
ownership as they grow, but moving from some formats to others can be extremely
complex and expensive.
Management Succession Plans: When choosing a form of ownership, business owners
must look ahead to the day will pass their companies on to the next generation or to a
buyer. Some forms of ownership make this transition much smoother than others.
Cost of Formation: Some forms of ownership are more costly and involved to create.
An entrepreneur must weigh the benefits and the costs of the particular form he or she
chooses.
Entrepreneurs have a wide choice of forms of ownership. In recent years, various hybrid forms
of business ownership have emerged. This part will outline the key features of the most common
forms of ownership, beginning with the sole proprietorship, the partnership, and the corporation.

4.4.1 Sole proprietorship

The sole proprietorship is a form of business organization in which an individual introduces his
capital, use of his own skill and intelligence in the management of its affairs and is solely

91
responsible for the results of its operation. It is a form of business owned and managed by one
individual. This form is known also as individual or single proprietorship, sole ownership or
individual enterprise.

This form of business organization can be cited as the first stage in the evolution of the forms of
business organization and this is the oldest and simplest among them. Establishing this business
is easy and simple because the legal requirement is less. The individual himself provides the
capital either from his personal saving or by borrowing from family or relatives. The individual
may run the business alone or take the help of the members of the family or may obtain the
assistance of employees-like managers, specialist and others, the owner drives the total benefit
and assumes the risk to which the business is exposed.

In the eye of the law, there is no distinction between the business and the individual’s private
affair, meaning that the law recognizes the individual and the business as being one and the
same. Example: Photo studio, bookshop, bakeries, small town restaurants, retail stores, radio and
watch repair shops, and other elementary forms of business where personal service is important.
The proprietorship is the simplest and cheapest way to start operation and is frequently the most
appropriate form of a new business.

4.4.1.1 Advantages of Sole proprietorships

Ease and low cost of formation and dissolution

It is simple to establish because there may not be a need for making it formal. Except in those
cases where a license is required such as for establishing a barbershop, restaurants, opening a
bar, there are no restrictions on either starting or terminating small business operations.

Direct motivation and personal care

In this form of organization, all the profit of the business belongs to one person who faces every
loss and this gives great incentive to the owner to take personal care in the business and manage
it most efficiently. As only one man is dealing with the business, the proprietor can come into

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close contact with the customers, he can, gain good- will by attending the customers’ demands
promptly and satisfactorily.

Freedom and promptness of action

The sole proprietor can take his own decision and there is none to question his authority. He has
full authority to make decisions and ultimately he is responsible for the results of his decisions.
This type of freedom of action promotes initiative and self-reliance. As there is no need to
consult any other person, the sole proprietor can take prompt decisions especially when an
emergency arises.

Business Secrecy
In this type of business, it is easy to maintain the secrecy of business. Since confidential
information is a key to success of a competitive business, it is unlikely that the owner will leak
the information; thus any changes he wants to make regarding business methods or policies can
be done without the knowledge of others.

Social Desirability
From the social point of view, the sole proprietorship is desirable as it ensures that too much
wealth does not concentrate in a few hands. It may be one of the ways in which equitable
distribution of wealth is ensured. Furthermore the limited liability of the proprietor ensures
members of the society involve in these forms business organization for their maximum effort,
which indirectly helps the society to grow and prosper.

Single Tax
The proprietorship does not pay tax as a business; the profits from the business are the personal
income of the owner and are declared on his individual income tax return.

4.4.1.2 Disadvantages of sole proprietorship

Limited resources and size

In this form of organization, the resources that are the capacity and skill are very limited.

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As one person is responsible for the business, the capital is limited to his capacity particularly to
operate a large-scale enterprise. Lending institutions may hesitate to lend large sum of money
and suppliers may be unwilling to make sales in large quantities of items on credits with such a
business because it is neither safe nor dependable which results in making the business to remain
limited in size.
Limited managerial skill
While running a business, many complex and difficult problems may arise requiring wide array
of knowledge in management. This makes the possibility of solving the problems difficult for
one person in such form of business especially where the business organization is very large and
complex that demands different expertise or knowledge.
A sole proprietor may not be expected to perform every function like purchasing, selling,
accounting, hiring and other necessary functions, and lead the business to suffer from being
improperly managed.

Unlimited liability
The sole proprietor will be legally liable for all debts of the business. At time of loss and
bankruptcy if the business asset is not sufficient to satisfy the obligation to settle debts of
creditors, his personal and real property may be required to pay off. This indicates how the
owner is committing his personal assets for the business failure.
This concept of unlimited liability is, on the one hand, a source of courage and real devotion. On
the other hand it makes the owner to limit his activities only in specified areas restricting himself
to involve on every new opportunities.

Uncertain future/death of the owner terminates the business

This kind of business suffers from uncertain future, which means there is instability or lack of
certainty; the business may come to an end if the owner cannot continue to run the business due
to death, insanity, imprisonment or bankruptcy. If at all there are successors, they may not
possess the same degree of self-reliance, drive and ability and this makes the life of the business
to be terminated.

Difficulty in hiring and keeping high achievement employees

A good employee of the business may quit because there is no opportunity to obtain an
ownership interest in it.

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Few fringe benefits
If you are your own boss, you lose many of the fringe benefits that come from working for
others.

ACTIVITY

 Does the concept of limited liability apply to a proprietorship? Why or why not?

Commentary: No, because a sole proprietorship business has no legal body. Therefore, the
owner of the business is liable to the extent of his or her other assets if the capacity of the
business is not sufficient to meet its financial obligations.

4.4.2 Partnership

The association of two or more persons to carry on as co-owners of a business where the
relationship is based on agreement is called partnership. This form of a business requires the
existence of two or more persons entering into a contractual relationship. This contract, which is
an agreement between the parties, is known as a memorandum of association or article of
partners’ deed.

4.4.2.1 Kinds of Partners

The individuals who comprise a partnership are known as partners, or copartners. They may be
classified in several different ways. The most common types of partners are the following:

1. A general partner- assumes unlimited liability and is usually active in managing the business.
Most partners are general partners.
2. A limited or special partner- assumes limited liability, risking only his /her investment in the
business. Limited partners may not be active in management, and their names are not used in the
name of the business.

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3. A secret partner- takes an active role in managing a partnership but whose identities are
unknown to the public. i.e the general public does not know of this person’s partnership status.
4. A silent partner- as opposed to a secret partner, a silent partner, his identities and
involvement, is known to the general public, but is inactive in managing the partnership
business.
5. A dormant or sleeping partner- is nether known to the general public nor is active in
management
6. Nominal partners- are not actually involved in a partnership but lend their names to it for
public relations purposes but invest no money in the firm and play no role in its management.
These are not partners but who claim they are or allow others to think of them as partners. Such
individuals may assume some of the responsibilities of general partners.
7. Senior partners- assume major roles in management because of the long tenure (possession),
amount of investment in the partnership, or age. They normally receive large shares of the
partnership’s profits.
8. Junior partners - are generally younger partners in tenure, have only small investment in the
firm, and are not expected to make major decision. They assume limited role in the partnership’s
management and receive a smaller share of the partnership’s profits.

4.4.2.2 Types of partnership

There are two common types of partnerships: General partnership and Limited partnership

General partnership (Ordinary partnership)

They have the right to participate actively in the management affair of the business. If the assets
available in the business are not sufficient, debt coverage goes to the extent of their personal
assets. The partner faces the risk of implied authority. i.e the partner is liable for the wrongful
acts of a copartner in the operation of the business.

Limited partnership
They cannot take part on the management of the business and their act does not bind the firm
since their liability is limited, their rights are also restricted. The liability of the limited partners
is limited to the extent of their investment in the firm. If the business fails, creditors cannot

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claim their personal property. They do not play an active role in the operations of the business.
Basically limited partners are needed to increase the capital of the business.

4.4.2.3 Advantages of Partnership

Easy to establish
Like the proprietorship, the partnership is easy and inexpensive to establish. The owner must
obtain the necessary business licenses and submit a minimal number of forms. In most cases,
partners must file a certificate for conducting business as partners, if the business is run under a
trade name.

Complimentary skill
In a sole proprietorship, the owner must wear lots of different hats, and not all of them fit well. In
successful partnerships, parties’ skills and abilities usually complement one another,
strengthening the company’s managerial foundations.

Division of profit
There are no restrictions on how partners distribute the company’s profit as long as they are
consistent with the partnership agreement and do not violate the rights of any partner. The
partnership agreement should articulate the nature of each partner’s contribution and
proportional share of the profit. If the partners fail to create an agreement, they share equally in
the partnership’s profits, even if their original capital contributions are unequal.
Larger pool of capital
The partnership form of ownership can significantly broaden the pool of capital available to the
business. Each partner’s asset base improves the business’s ability to borrow needed fund;
together the partners’ personal assets will support a larger borrowing capacity.

Ability to attract limited partners

When partners share in owing, operating, and managing a business, they are general partners.
General partners have unlimited liability and usually take an active role in managing the
business. Limited partners do not participate in the day-to- day management of a company; they
typically are only financial investors in the business. A partnership can have any number of

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limited partners, but there must be at least one general partner. A limited partnership can attract
investors by offering them limited liability and the potential to realize a substantial return on
their investment if the business is successful. Many individuals find it very profitable to invest in
high-potential small business, but only if the disadvantage of unlimited liability while doing so.
Little governmental regulation
Like the proprietorship, the partnership form of operation is not burdened with red tape.
Flexibility
Although not as flexible as sole ownership, the partnership can generally react quickly to
changing market conditions because no giant organization stifles quick and creative responses to
new opportunities.
Taxation
The partnership itself is not subject to federal taxation. It serves as a conduit for the profit or
losses it earns or incurs; its net income or losses are passed along to the partners as personal
income, and the partners pay income tax on their distributive shares. The partnership, like the
proprietorship, avoids the double-taxation disadvantage associated with the corporate form of
ownership.

4.4.2.3 Disadvantages of Partnership

Unlimited liability of at least One partner

At least one member of every partnership must be a general partner. The general partner has
unlimited personal liability, even though he or she is often the partner with the least personal
resources.

Capital accumulation

Although the partnership form of ownership is superior to the proprietorship in its ability to
attract capital, it is generally not as effective as the corporate form of ownership.

Difficulty in disposing of partnership interest without dissolving the partnership

Most partnership agreements restrict how a partner can dispose of his share of the business. It is
common to find that the partner is required to sell his interest to the remaining partners. Even if
the original agreement contains such a requirement and clearly delineates how the value of each
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partner’s ownership will be determined, there is no guarantee that the other partner(s) will have
the financial resources to buy the seller’s interest. When the money is not available to purchase a
partner’s interest, the other partner(s) may be forced to accept a new partner, or to dissolve the
partnership, distribute the remaining assets, and begin again. When a partner withdraws from the
partnership, the partnership ceases to exist unless there are specific provisions in the partnership
agreement for a smooth transition. When a general partner dies, becomes incompetent, or
withdraws from the business, the partnership automatically dissolves, although it may not
terminate. Even when there are numerous partners, if one wishes to disassociate his or her name
from the business, the remaining partners will probably form a new partnership.
Lack of continuity
If one partner dies, complications arise. Partnership interest is often nontransferable through
inheritance because the remaining partner(s) may not want to be in a partnership with the person
who inherits the deceased partner’s interest. Partners can make provisions in the partnership
agreement to avoid dissolution due to death if all parties agree to accept as partners those who
inherit the deceased’s interest.

Potential for personality and authority conflict

Being in a partnership is much like being in a marriage. Making sure partners’ work habits,
goals, ethics, and general business philosophy are compatible is an important step in avoiding a
nasty business divorce. Still, as in a marriage, friction among partners is inevitable. The key is
having a mechanism such as a partnership agreement and open lines of communication for
controlling it. The demise of many partnerships can often be traced to interpersonal conflicts and
the lack of procedure to resolve those conflicts.

4.4.3 Corporation

The corporation is the most complex of the three major forms of business ownership.
Corporation can be defined as an artificial being, invisible, intangible, and existing only in the
contemplation of the law. In other words a corporation is an artificial person authorized and

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recognized by law, with distinctive name, a common seal, comprising of transferable shares of
fixed values, carrying limited liability and having a perpetual or continued
or uninterrupted succession life.

4.4.3.1 Characteristics of Corporation

Separate legal entity: It can sue or be sued. It has the right to manage its own affairs.
Shareholders cannot be liable for the acts of the corporation

Limited liability: Since the corporation has separate legal entity its debts are its own. The assets
and liabilities, rights and obligations incidental to the company’s activities are assets and
liabilities, rights and obligations respectively of the company and not of its members.

Transferability of shares: It is easy to transfer ownership in a corporation. A stockholder may

sell stock to another person and transfer the membership and membership interest freely without
consulting other stockholders.

Perpetual existence: Death, insanity, retirement and withdrawal of shareholders will not affect
the company.

Common seal: A corporation has a common seal with the name of the company engraved on it,
which is used as a substitute for its signature through it acts through its agents.

Separation of ownership from management: All shareholders, large in numbers, do not have
the opportunity of managing the day-to-day activity of the corporation. A company cannot, as an
artificial person, manage itself. It must therefore have managers, or directors. Directors are the
persons to whom management of a company is entrusted. Directors may be appointed and
removed by a simple majority vote of the shareholders. Except in very small corporations, most
stockholders are not directly involved in the management of the company. The company is free
to hire any employee it can afford and is thus able to get the specialized professional skills
needed for sound management.

Supervision: A company is created by the legal process of incorporation. While it exists, it is

subject to detailed regulation; for instance, it must prepare and deliver to the registry annual
accounts and an annual return (a summary of its situation). The Registrar of Companies, the

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Department of Trade and Industry and the courts all may have power of regulation and
investigation over companies.

Written Constitution: On the creation of a company, the promoters must file certain
documents with the Registrar of Companies. These include the Article of Association and the
Memorandum of Association.

4.4.3.2 Advantages of a corporation

Limited liability of stockholders

The corporation allows investors to limit their liability to the total amount of their investment.
This legal protection of personal assets beyond the business is of critical concern to many
potential investors.

This shield of limited liability may not be impenetrable, however. Because startup companies are
so risky, lenders and other creditors require the owners to personally guarantee loans made to the
corporation. By making these guarantees, owners are putting their personal assets at risk despite
choosing the corporate form of ownership.

Ability to attract capital

Based on the protection of limited liability, corporations have proved to be the most effective
form of ownership for accumulating large amount of capital. Limited only by the number of
shares authorized in its charter (which can be amended), the corporation can raise money to
begin business and expand as opportunity dictates by selling shares of its stock to investors. A
corporation can sell its stock to a limited number of private investors (a private placement) or to
the public (a public offering).

Ability to continue indefinitely

Unless limited by its charter, the corporation as a separate legal entity theoretically can continue
indefinitely. The corporation’s existence does not depend on the fate of any single individual.
Unlike a proprietorship or partnership in which the death of a founder ends the business, the

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corporation lives beyond the lives of those who gave it life. This perpetual life gives rise to the
next major advantage – transferable ownership.

Transferable ownership

If stockholders in a corporation are displeased with the business’s progress, they can sell their
shares to someone else. Millions of shares of stock representing ownership in companies are
traded daily on the world’s stock exchanges. Shareholders can also transfer their stock through
inheritance to a new generation of owners. During all of these transfers of ownership, the
corporation continues to conduct business as usual.

Unlike that of large corporations whose shares are traded on organized stock exchanges, the
stock of many small corporations is held by a small number of people, often company founders,
family members, or employees. The small number of people holding the stock means that the
resale market for shares is limited, which could make the transfer of ownership more difficult.

4.4.3.3 Disadvantages of a Corporation

Cost and time involved in the incorporation process

Corporations can be costly and time-consuming to establish. The owners are giving birth to an
artificial legal entity – and the gestation period can be prolonged for the novice. In some states an
attorney must handle incorporation, but in most states entrepreneurs can complete all of the
required forms alone. However, an owner must exercise great caution when incorporating
without the help of an attorney.

Double taxation

Because a corporation is a separate legal entity, it must pay taxes on its net income at the federal
level. Before stockholders receive a penny of its net income as dividends, a corporation must pay
these taxes at a corporate tax rate. Then stockholders must pay taxes on the dividends they
receive from these same profits at the individual tax rate. Thus, a corporation’s profits are taxed
twice. Double taxation is a distinct disadvantage of the corporate form of ownership.

Potential for diminished managerial incentives

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As corporations grow, they often require additional managerial expertise beyond that which the
founder can provide. Because the founder created the company and often has most of his or her
personal wealth tied up in it, the entrepreneur has an intense interest in making it a success and is
willing to make scarifies for it. Professional managers the entrepreneur brings into help run the
business as it grows do not always have the same degree of interest in or loyalty to the company.
As a result, the business may suffer without the founder’s energy, care, and devotion. One way to
minimize this potential problem is to link managers’ compensation to the company’s financial
performance through a profit-sharing or bonus plan. Corporations can also stimulate managers’
incentive on the job by creating an employee stock ownership plan in which managers and
employees become part or whole owners in the company.

Legal requirements and regulatory red tape

Corporations are subject to more legal and financial requirements than other forms of ownership.
Entrepreneurs must resist the temptation to commingle their personal funds with those of the
corporation and must meet more stringent requirements for recording and reporting business
transactions. They must also hold annual meetings and consult the board of directors about major
decisions that are beyond day-to-day operations. Managers may be required to submit some
major decisions to the stockholders for approval.

Potential loss of control by the founder(s)

When entrepreneurs sell shares of ownership in their companies, they relinquish some control.
Especially when they need large capital infusions for startup or growth, entrepreneurs may have
to give up significant amount of control, so much, in fact, that the founder becomes a minority
shareholder. Losing majority ownership – and therefore control – in his or her company leaves
the founder in a precarious position.

ACTIVITY

 How does the death of an owner affect the legal operation of a corporation?

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Commentary: The death of the owner does not affect the operation of a corporate business. This
can be due to the nature of the business itself. Therefore, address the question from the features
of corporation.

Summary

Specifically any size standard to define small business is necessary, because people adopt
different standards for different purposes. A business may be described as “small” when
compared to larger firms, but “large” when compared to smaller ones. There are different
dimensions or approaches to define small business. Of all the available dimensions, with this
material we use the size criterion to provide a detail account on small businesses. Besides this
criterion for defining small business, we use number of employees, sales volume, asset size,
insurance in force, and/or volume of deposits

As part of business community, small firms unquestionably contribute to the nation’s economic
welfare. They produce a substantial portion of the total goods and services. Thus, their general
economic contribution is similar to that of big businesses. Small firms, however, possess some
qualities that make them more than miniature versions of big business corporations. They make
exceptional contributions as they provide new jobs, Introduce innovations, stimulate
competition, aid big business, and produce goods and services efficiently.

Every year many small business firms cease operations. The most frequent cause is failure to pay
debts, in which case it is common for the owner to declare bankruptcy. . In other instances,
businesses go out of existence because the owners realize that, although currently they are
solvent, if they continue operations they will incur debts they cannot meet. In these instances,
business failure can be defined as a halt of operations.

One of the most challenging decisions an entrepreneur faces when starting a new business,
whether or not the business is small, is selecting the form of ownership for the new venture.
Entrepreneurs have a wide choice of forms of ownership. In recent years, various hybrid forms
of business ownership have emerged.

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Self Assessment Questions
1. Suppose you decide to publish a tax advisory newsletter for small business owners. How
would you define your target market in terms of business size? What difference this
decision make?
2. What are the major problems of small business in Ethiopia?
3. Explain the benefits of owning a small business.
4. In which sectors of the economy is small business most important?

CHAPTER FIVE
FINANCING THE NEW VENTURE

Learning objectives

After reading this chapter, you should be familiar with:

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  the need to finance a venture adequately
 the need to analyze carefully the amounts and kinds of financing that are best for a
particular venture
 the nature of equity financing
 the different kinds of debt financing
 the nature and use of venture and venture capital and initial public stock offerings
 considerations in developing a financial package

Introduction

Financing the venture can be one of the most challenging and frustrating tasks facing the
entrepreneur. Virtually all new ventures and most small ventures are undercapitalized. Seldom is
sufficient capital available to launch a venture in the optimal way and most ventures are
continually limited in their strategies by scare capital resources. Yet, surmounting the challenge
of obtaining capital for the venture can be one of the most financially and psychologically
rewarding aspects of entrepreneurship. Making a company grow with new infusions of cash that
fuel necessary expansion is one of the real thrills of being an entrepreneur.

Obtaining capital for a new venture is more difficult than obtaining cash for an existing venture.
It is difficult because the venture has no track record and the entrepreneur may also have only a
modest history of managing the venture. Most lenders tend to be conservative in lending to new
venture, and it is appropriate that they should be. Most businesses failures occur in the first
years of existence. Thus, the lenders and venture capitalist tend to favor those firms that have
survived the start up phase.

This chapter will first consider the need for financing. It will then discuss the various types of
financing for a new venture. Discussion then moves to matching the types of financing to the
specific needs and stages of a venture. The chapter concludes with the requirements for financial
packages.

5.1 THE NEED FOR FINANCE

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New and growing ventures require financing for a variety of needs as they develop over time
(Table 5.1). These needs are a function of the type of venture, the rate of growth, and the stage of
the venture’s development. Low growth firms, for example, require smaller amounts of funding
than do higher-growth firms. Service ventures require less than manufacturing firms. Ventures
poised to enter their rapid growth stage will require more funds than one which has just been
launched.
Pre start-up capital is the investment required long before the venture is launched. If a new
product is involved, prototype development must come before the venture is launched.
Significant research and development and market research may be necessary. Funds for strategic
plan development and initial site acquisition may also be necessary at this time.

Startup expenses are those costs incurred shortly before, during, and immediately after the actual
launch of the venture. Expenditures at the time of start-up include facilities and equipment,
inventory, grand opening advertising, prepaid expenses such as deposits and insurance, licenses,
and professional fees for accountants and attorneys.

Additional funding will be necessary once the venture is begun. Typical operating expenses such
as advertising, additional inventory, salaries, and sales expenses are included here. Of particular
interest is the need to balance seasonal or cyclical cash flow deficits. Virtually all businesses
will have uneven cash flows. The purchase of inventory is an example of this since inventory
must be purchased weeks or months before it can be sold. Thus, inventory financing becomes the
major financing need for most retail businesses as well as for many manufacturing ventures.

Stage of development Financing needs

Pre-start-up prototype development, site acquisition,

business plan preparation, research and
development, market research

Start-up Inventory, plant and equipment, grand

opening advertising, professional fees,
prepaid expenses

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Post-start-up Advertising, sales expenses, wages and
salaries, rent, utilities, additional inventories,
seasonal/cyclical cash flow needs

Growth Facility expansion, additional distribution

methods, geographical expansion,
acquisitions, cost of underwriting more
financing

Table 5.1 Financing needs for various stages of development

Low-growth small businesses typically do not need substantial funding once the initial launch
and stabilization occur. Moderate or high growth ventures on the other hand, will require major
additional inflows of capital to underwrite expansion. Additional plant and equipment may be
required, additions or changes in distribution system may be costly, geographical expansion can
absorb significant funding, acquisition of other firms can be quite expensive, and substantial
funding may be required before going public.

Some of the financing needs will be short term. Other needs can be met only using long-term
financing methods. Short-term capital may be that which is necessary to launch the venture or to
finance development costs before the venture is formally launched. Long-run capital is typically
used to finance fixed equipment and facilities or major research and development effort.

5.2 SOURCES OF FINANCE

There are two basic sources of financing: equity and debt. Equity financing is capital provided
in exchange for ownership. Debt financing is provided to the venture in exchange for interest
payment and does not include the ownership provision. Each of these types of financing will be
discussed in depth before considering their appropriateness for specific situations. The following
section presents a detailed account on the different sources of finance.

5.2.1 DEBT FINANCING

Debt capital is the financing that a small business owner has borrowed and must repay with
interest. Small enterprises have fewer choices than large firms for obtaining debt financing.
They are excluded from financial sources such as money raised through the sale of bonds

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debentures, and commercial papers. Also, many small businesses are limited by size; with small
inventories or markets that provide few assets for collateralizing loans. Very few entrepreneurs
have adequate personal savings to finance the complete start up of a small business; many of
them must rely on some form of debt capital to launch their companies. Lenders of capital are
more numerous than investors, although small business loans can be just as difficult (if not more
difficult) to short-term borrowing (one year or lasses) is often required for working capital and is
repaid out of the proceeds from sales. Long-term debt (term loans of one to five years or long
term loans maturing in more than five years) is used to finance the purchase of property or
equipment, with the purchased asset serving as collateral for the loans. Although borrowed
capital allows entrepreneurs to maintain complete ownership of their business, it must be carried
as a liability on the balance sheet as well as be repaid with interest at some point in the future. In
addition, because lenders consider small businesses to be greater risks than bigger corporate
customers, they require higher interest rates on loans to small companies because of the risk
return trade off_ the higher the risk, the greater the return demanded. Most small firms pay the
prime rate the interest rate banks charge their most credit worthy customers-plus a few
percentage points. Still, the cost of debt financing often is lower than that of equity financing.
Because of the higher risks associated with providing equity capital to small companies,
investors demand greater returns than lenders. Also unlike equity financing, debt financing does
not require an entrepreneur to dilute her/his ownership interest in the company. We now turn to
the various sources of debt capital.

1. Commercial Banks:
Commercial banks are by far the most frequently used source of short-term funds by the
entrepreneur. Banks tend to be conservative in their lending practices and prefer to make loans
to established small businesses rather than to high-risk start-ups. Bankers want to see evidence
of a company’s successful track record before committing to a loan. They are concerned with a
firm’s operating past and will scrutinize its records to project its position in the immediate future.

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They also want proof of the stability of the firm’s sales and about the ability of the product or
service to generate adequate cash flows to ensure repayment of the loan.

Banks will refuse loan requests when, in their opinion, there is not an excellent chance for
repayment of the loan proceeds with interest. Banks view themselves as stewards of the
depositors' money and under law have a fiduciary responsibility to depositors. A banker's
commodity is money, and once it has left the bank, the banker's control is virtually nonexistent.
Banks certainly have methods by which they can legally pursue funds but they are both costly
and counterproductive. Therefore, bankers need to feel extremely confident that repayment will
occur in a timely manner.

Commercial banks provide unsecured and secured loans. An unsecured loan is one in which
collateral is neither requested nor given, i.e., it is a personal or signature loan. This type of loan
is generally short term in nature__ that is, less than one year, and is granted to only the most
credit worthy customers. These loans are generally made for a specific purpose such as the
purchase of inventory for a specific order. An entrepreneur is granted the loan on the strength of
his/her reputation. Unsecured signature loan will have high interest charges.

Secured loans are those with security pledged to the bank as assurance that the loan will be paid.
There are many types of security a bank will consider, such as a guarantor another credit worthy
person or company that agrees to pay the loan in the event the borrower defaults but most
security is in the form of tangible assets pledged as collateral. Hence, if they do make loans to a
start up venture, banks like to see sufficient cash flows to repay the loan, ample collateral to
secure it. Repayment of the principal is over the term established and comes chiefly from cash.

To secure a bank loan, an entrepreneur typically will have to answer a number of questions. Five
of the most common questions, together with descriptive commentaries, follow:
1. What do you plan to do with the money? Do not plan on using funds for a high-risk
venture; banks seek the most secure venture possible.
2. How much do you need? Some entrepreneurs go to their bank with no clear idea of how
much money they need. All they know is that they want money. The more precisely the
entrepreneur can answer this questions the more likely the loan will be granted.

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 3. When do they need it? Never rush to the bank with immediate requests for money with
no plan. Such a strategy shows that the entrepreneur is a poor planner, and most lenders
will not want to set involved
4. How long will you need it? The shorter the period of time the entrepreneur needs the
money, the more likely he or she is to get the loan. The time at which the loan will be
repaid should correspond to some important milestone in the business plan.
5. How will you repay the loan? This is the most important question. What if plans go
awry? Can other incomes be diverted to pay off the loan? does collateral exist? Even if a
lot of fixed assets exists, the bank may be unimpressed because it knows from experience
that assets sold at a liquidation auction bring only a fraction of their value.

Bank Lending Decisions

Due to previous bad loan decisions by banks, banks are far more cautious in lending money since
they cannot afford to incur more bad loans. Commercial loan decisions are made only after the
loan officer and loan committee do a careful review of the borrower and the financial track
record of the business. For this reason the small business owner needs to be aware of the criteria
bankers use in evaluating the credit worthiness of loan applicants. Most bankers refer to these
criteria as the five Cs of credit: Capital, Capacity, Collateral, Character, and conditions.
1. CAPITAL: A small business must have a stable capital base before a bank grants a loan.
Otherwise the bank would be making, in effect, a capital investment in the business.
Most banks refuse to make loans that are capital investments because the potential for
return on the investment is limited strictly to the interest on the loan, and the potential
loss would probably exceed the reward. In fact, the most common reasons that banks
give for rejecting small business loan applications are under capitalization or too much
debt. The bank expects the small business to have an equity base of investment by the
owner(s) that will help support the venture during times of financial strain.
2. CAPACITY: A synonym for capacity is cash flow. The bank must be convinced of the
firm’s ability to meet its regular financial obligations and to repay the bank loan, and that
takes cash. More small businesses fail from lack of cash than from lack of profit. It is
possible for a company to be showing a profit and still has no cash that is, to be
technically bankrupt. Bankers expect the small business loan applicant to pass the test of

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 liquidity, especially for short-term loans. The bank studies closely the small company’s
cash flow position to decide whether or not it meets the capacity required.
3. COLLATERAL: Collateral includes any assets the owner pledges to the bank as
security for repayment of the loan. If the company defaults on the loan, the bank has the
right to sell the collateral and use the proceeds to satisfy the loan. Bankers view the
owner’s willingness to pledge collateral (personal or business assets) as an indication of
dedication to making the venture a success. A sound business plan can improve a
banker’s attitude toward a venture.
4. CHARACTER: Before approving a loan to a small business, the banker must be
satisfied with the owner’s character. The evaluation of character frequently is based on
intangible factors such as honesty, competence, polish, determination, intelligence and
ability. Although the qualities judged are abstract, this evaluation plays a critical role in
the banker’s decision. Loan officers know that most small businesses fail because of
incompetent management, and so they try to avoid extending loans to high-risk managers.
The business plan and a polished presentation by the entrepreneur can go far in
convincing the banker of the owner’s capability.
5. CONDITIONS: The conditions surrounding a loan request also affect the owner’s
chance of receiving funds. Banks consider factors relating to the business operation such
as potential growth in the market, competition, location, form of ownership, and loan
purpose. Again, the owner should provide this relevant information in an organized
format in the business plan. Another important condition influencing the banker’s
decision is the shape of the overall economy including interest rate levels, inflation rate,
and demand for money. Although these factors are beyond an entrepreneur’s control, they
still are important components in a banker's decision.
The higher a small business scores on these five Cs, the greater its chance will be to receive a
loan. The wise entrepreneur keeps this in mind when preparing a business plan and presentation.

2. Non-bank source of debt capital

Banks are not the only source of debt financing. There are some reasons that force entrepreneurs
to look beyond the bank:
 To acquire more money

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  To overcome banks' conservatism
 To accommodate the diversity of the small business sector
 To nourish success
 To forestall failure
 To reduce dependence on leverage
 To support innovation
 To improve networking and community visibility
 To finance substantive growth.
Let us now turn our attention to non-bank sources of debt financing that entrepreneurs can tap to
feed their cash hungry companies.

2.1 Trade credit: It is a credit given by suppliers who sell goods on account. This credit is
reflected on the entrepreneur’s balance sheet as account payable and in most cases it must be
paid in 30 to 90 or more days, interest free. Because of its ready availability, trade credit is an
extremely important source of financing to most entrepreneurs. When banks refuse to lend
money to a start up business because they see it as a bad credit risk, the owner usually is able to
turn to trade credit as a viable source of capital. Getting suppliers to extend credit in the form of
delayed payments usually is much easier for a small business than obtaining bank financing.

2.2 Equipment suppliers: Most equipment vendors encourage business owners to purchase
their equipment by offering to finance the purchase. This method of financing is similar to trade
credit but with slightly different terms. Usually, equipment lenders offer reasonable credit terms
with only a modest down payment with the balance financed over the life of the equipment
(usually several years). In some cases, the vendors will repurchase equipment for salvage value
at the end of its useful life and offer the business owner another credit agreement on new
equipment.

2.3 Accounts receivable financing: It is short term financing that involves either the pledge of
receivables as collateral for a loan or the sale of receivables (factoring).
Account receivable bank loans are made on a discounted value of the receivables pledged. A
bank may make receivable loans on a notification or non-notification plan. Under the
notification plan, purchasers of goods are informed that their accounts have been assigned to the

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bank. They then make payments directly to the bank, which credits them to the borrower’s
account. Under the non-notification plan, borrowers collect their accounts as usual and then pay
off the bank loan.
Factoring is the sale of accounts receivable. Under this arrangement, the receivables are sold, at
a discounted value to a factoring company. Some commercial finance companies also do
factoring. Under a standard arrangement the factor will buy the client’s receivables out right,
without recourse, as soon as the client creates them by its shipment of goods to customers.
Factoring fits some businesses better than others, and it has become almost traditional in
industries such as textiles, furniture manufacturing, clothing manufacturing, toys, shoes, and
plastics.

2.4 Credit unions: Credit unions are non-profit financial cooperatives that promote savings and
provide credit to their members; they are best known for extending loans. But credit unions do
not make loans to just anyone; to qualify for a loan an entrepreneur must be a member. Lending
practices at credit unions are very much like those at banks, but they usually are willing to make
smaller loans.

2.5 Insurance companies: For many small businesses, life insurance companies can be an
important source of business capital. Insurance companies offer two basic types of loans: policy
loans and mortgage loans.

Policy loans are extended on the basis of the amount of money paid through premiums into the
insurance policy. It usually takes about two years for an insurance policy to accumulate enough
cash surrender value to justify a loan against it. Once cash value is accumulated in a policy, an
entrepreneur may borrow up to 95 percent of that value for any length of time. Interest is levied
annually, but repayment may be deferred indefinitely. However, the amount of insurance
coverage is reduced by the amount of the loan. Only insurance policies that build cash value that
is, combine a savings plan with insurance coverage, offer the option of borrowing. This includes
whole life (permanent insurance), variable life, universal life, and many corporate-owned life
insurance policies. Term life insurance, which offers only pure insurance coverage, has no
borrowing capacity.

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Insurance companies make mortgage loans on a long-term basis on real property. They are
based primarily on the value of the real property being purchased. The insurance company will
extend a loan of up to 75 to 80 percent of the real estate’s value, and will allow a lengthy
repayment schedule of over 25 to 30 years so that the payments do not strain the firm’s cash flow
excessively.

2.6 Bonds (also known as debt securities): A bond is a long-term contract in which the issuer,
who is the borrower, agrees to make principal and interest payments on specific dates to the
holder of the bond. Bonds have always been a popular source of debt financing for large
companies. Few small business owners realize that they can also tap this valuable source of
capital. Although, the smallest businesses are not viable candidates for issuing bonds, a growing
number of small companies are finding the funding they need through bonds when banks and
other lenders say no.

Although they can help small companies raise much needed capital, bonds have certain
disadvantages. The issuing company must follow the same regulations that govern business-
selling stock to public investors.

5.2.1.1 Advantages and Disadvantages of Debt Finance

Debt finance is one principal alternative source of finance for a new venture. As the source of
finance it has its own strengths and weaknesses.

The main advantages of debt finance

Because the lender does not have a claim to equity in the business, debt does not dilute the
owner's ownership interest in the company.

 A lender is entitled only to repayment of the agreed-upon principal of the loan plus
interest, and has no direct claim on future profits of the business. If the company is

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 successful, the owners reap a larger portion of the rewards than they would if they
had sold stock in the company to investors in order to finance the growth.
 Except in the case of variable rate loans, principal and interest obligations are
known amounts which can be forecasted and planned for.
 Interest on the debt can be deducted on the company's tax return, lowering the
actual cost of the loan to the company.
 Raising debt capital is less complicated because the company is not required to
comply with state and federal securities laws and regulations.
 The company is not required to send periodic mailings to large numbers of
investors, hold periodic meetings of shareholders, and seek the vote of shareholders
before taking certain actions.

The principal disadvantages of debt finance

 Unlike equity, debt must at some point be repaid.

 Interest is a fixed cost which raises the company's break-even point. High interest
costs during difficult financial periods can increase the risk of insolvency.
Companies that are too highly leveraged (that have large amounts of debt as
compared to equity) often find it difficult to grow because of the high cost of
servicing the debt.
 Cash flow is required for both principal and interest payments and must be
budgeted for. Most loans are not repayable in varying amounts over time based on
the business cycles of the company.
 Debt instruments often contain restrictions on the company's activities, preventing
management from pursuing alternative financing options and non-core business
opportunities.
 The larger a company's debt-equity ratio, the more risky the company is considered
by lenders and investors. Accordingly, a business is limited as to the amount of
debt it can carry.

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  The company is usually required to pledge assets of the company to the lender as
collateral, and owners of the company are in some cases required to personally
guarantee repayment of the loan.

ACTIVITY

 What is capacity as a criterion for bank loan?

Commentary: Capacity as a criterion for bank loan refers to the ability of the business to
repay the principal and the interest rate.

5.2.2 EQUITY FINANCING

Equity financing represents the personal investment of the owner (or owners) in a business, and
it is sometimes called risk capital because these investors assume the primary risk of losing their
funds if the business fails. However, if the venture succeeds, they also share in the benefits,
which can be quite substantial. The use of equity capital thus requires no repayment in the form
of debt. It does, however, require entrepreneurs earnings (if there are any) and usually to have a
voice in the business’s future directions. In short, it requires sharing the ownership and profits
with the funding sources. Since no repayment is required, equity capital can be much safer for
new ventures than debt financing. Yet the entrepreneur must consciously decide to give up part
of the ownership in return for funding. Although 50 percent of something is better than 100
percent of nothing, giving up control of your business can be disconcerting and dangerous. The
following section presents some specific sources of equity financing.

1. Personal Savings
The first place entrepreneurs should take for start up money is in their own pockets. It is the
least expensive source of funds available. The sooner you take outside money, the more
ownership in your company you will have to surrender; entrepreneurs apparently see the benefits
of self-sufficiency; the most common source of equity funds used to start a small business is the
entrepreneur’s pool of personal savings.
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As a general rule, entrepreneurs should expect to provide at least half of the startup funds in the
form of equity capital. If the entrepreneur is not willing to risk his own money, potential
investors are not likely to risk their money in the business either. Furthermore, if an owner
contributes any less than half of the initial capital requirement, he must borrow an excessive
amount of capital to fund the business properly, and the high repayment schedule put intense
pressure on cash flow. In some cases, however, a creative entrepreneur is able to invest as little
as 10 percent of the initial capital requirement. The important point is that an entrepreneur
should not surrender all hopes of going into business just because he is unable to provide half of
the starting funds.

2. Friends and family

Friends and family are common sources of equity capital for new ventures. Friends and family
can be relatively accessible sources of funding for new ventures, and they are sometimes quite
willing to invest. This is because they know the entrepreneur. Thus, that portion of the
uncertainty that must be overcome by impersonal investors is eliminated. Furthermore, they may
have implicit trust in the entrepreneur and not question the efficacy of the venture concept.

Friends and family typically provide relatively small amounts of equity funding for the ventures.
Part of this because many small business ventures need relatively small amount of total funding.
There are exceptions to this of course. Obtaining equity funds from friends and family has both
advantages and disadvantages. The investment of equity funds means financial ownership.
Friends and family who provide equity capital to the venture become part owners with the
entrepreneur. The ownership percentage may be small, but it is still part ownership. Thus, the
investors may feel that they have a say in the operation of the venture. Sometimes, minor owners
suddenly come to the business and demand action from the entrepreneur or attempt to direct
employees or redesign facilities. This can be disastrous to the operations of a small or new
venture. On the other hand, friends and family are often patient, and do not mind waiting for any
return that might be realized from the operation of the firm.

3. Angels

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After dipping into their own pockets and convincing friends and relatives to invest in their
business ventures, many entrepreneurs still find themselves short of the seed capital they need.
Frequently, the next step on the road to business financing is private investors. These private
investors (or angles) are wealthy individuals, often entrepreneurs themselves, who invest in
business start ups in exchange for equity stakes in the companies.

Angels are a primary source of start-up capital for companies in the embryonic stage through the
growth stage and their role in financing small business is significant. Due to the inherent risks in
start-up companies, many venture capitalists have shifted their investment portfolios away from
start-ups toward more established firms. That is why angel financing is so important. Angles
will often finance the deals that no venture capitalists will consider. Most angels have substantial
business and financial experience and prefer to invest in companies at the start up or infant
growth stage. Angels also look for businesses they know something about and most expect to
invest their knowledge, experience and energy as well as their money in a company. Angels tend
to invest in clusters as well with the right approach and an entrepreneur can attract an angel who
might share the deal with some of his/her close friends or companions.

Angels are an excellent source of “patient money” often willing to wait seven years or longer to
cash out their investments. They earn their returns through the increased value of the business,
not through dividends and interests. For example, more than 1,000 early investors in Microsoft
Inc. (now a giant in computer software industry) are now millionaires. Angles return on
investment targets tend to be lower than those of professional venture capitalists. While venture
capitalists shoot for 60 percent to 75 percent returns annually, private investors usually settle for
35 percent (depending on the level of risk involved in the venture). Private investors typically
take less than 50 percent ownership, leaving the majority ownership to the company founder(s).

4. Partners

An entrepreneur can choose to take on a partner to expand the capital foundation of the proposed
business. Before entering into any partnership arrangement, however, the owner must consider
the impact of giving up some personal control over operations and of sharing profits with one or
more partners. Whenever an entrepreneur gives up equity in his/her business (through whatever

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mechanisms), he/she runs the risk of losing control over it. As the founder’s ownership in a
company becomes increasingly diluted, the probability of losing control of its future direction
and the entire decision-making process increases.

5. Venture Capital Companies

Venture capital companies are private, for profit organizations that purchase equity positions in
young businesses they believe have high growth and high profit potential. They provide start up
(seed-money) capital to new ventures, development funds to businesses in their early growth
stage, and expansion funds to rapidly growing ventures that have the potential to “go public” or
that need capital for acquisitions.

Small business owners must realize that it is very difficult for any small business, especially
fledgling or struggling firms, to pass the intense screening process of a venture capital company
and quality for an investment. Two factors make a deal attractive to venture capitalists: high
returns and a convenient (and profitable) exit strategy.

Venture capitalists are extremely well informed about the industries in which they invest, and
most have experienced market research departments that provide information vital to the
enterprise. As stockholders, venture capitalists are anxious to help business succeed, and they
provide consultation to assist entrepreneurs in every way possible. Most venture capitalist
maintain frequent contact with their entrepreneurs, and through their contacts, they provide
access to prospective customers, suppliers, and professional services.

In many instances, they also become “mentors.”/advisors. Venture capitalists are involved, but
they do not try to take over the business. They are primarily investors and are not interested in
managing the business in which they invest. To do so would mean that venture capitalists would
have to personally assume management responsibilities for a dozen or more new business every
year. Consequently, entrepreneurs are not likely to lose control of their businesses. To the
contrary, venture capitalists invest because they are reasonably convinced that entrepreneurs are
capable.

6. Public Stock Sale (“going public”)

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In some cases, entrepreneurs can “go public” by selling shares of stock in their corporation to
outside investors. This is an effective method of raising large amounts of capital, but it can be an
expensive and time consuming process filled with regulatory nightmares.
Going public is not for every business. In fact, most small companies do not meet the criteria for
making a successful public stock offering. It is almost impossible for a start-up company with
no track record of success to raise money with a public offering.
Here are some of the advantages to this approach.
 Size of capital amount: Selling securities is one of the fastest ways to raise large sum of
capital in a short period of time.
 Liquidity- The public market provides liquidity for owners since they can readily sell
their stock.
 Value: The market place puts a value on the company’s stock, which in turn allows
value to be placed on the corporation.
 Image: The image of a publicly traded corporation often is stronger in the eyes of
suppliers, financers, and customers.

ACTIVITY

 Put the sources of equity financing as per their order of importance.

Commentary: There are a number of sources for equity financing. When you arrange there
several sources of equity finance as per their order of importance you should consider the extent
to which the sources help the owners to avoid conflict in the decision making process.

5.2.2.1 Advantages and disadvantages of equity finance

Equity finance can sometimes be more appropriate than other sources of finance, eg bank loans,
but it can place different demands on you and your business.

The main advantages of equity finance

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The funding is committed to your business and your intended projects. Investors only realize
their investment if the business is doing well, eg through stock market flotation or a sale to new
investors.

 The right business angels and venture capitalists can bring valuable skills, contacts and
experience to your business. They can also assist with strategy and key decision making.
 In common with you, investors have a vested interest in the business' success, ie its
growth, profitability and increase in value.
 Investors are often prepared to provide follow-up funding as the business grows.

The principal disadvantages of equity finance

 Raising equity finance is demanding, costly and time consuming. Your business may
suffer as you devote time to the deal. Potential investors will seek background information
on you and your business - they will closely scrutinize past results and forecasts and will
probe the management team. However, many businesses find this discipline useful
regardless of whether or not they actually receive any funding.
 Depending on the investor, you will lose a certain amount of your power to make
management decisions.
 You will have to invest management time to provide regular information for the investor
to monitor.
 At first you will have a smaller share in the business - both as a percentage and in
absolute monetary terms. However, your reduced share may become worth a lot more in
absolute monetary terms if the investment leads to your business becoming more
successful.
 There can be legal and regulatory issues to comply with when raising finance, eg when
promoting investments.

5.3 MATCHING FINANCING TO VENTURE DEVELOPMENT

This chapter presented a number of different funding sources for new and existing ventures.
However, the capital sources are not all relevant for all ventures in all stages of development. For

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example, low-growth ventures will never use venture capital because they do not need it and
because venture capitalists do not have an interest in intentionally small ventures. Conversely,
rapid-growth ventures will not normally use friends and family because they need far more
capital than typical friends and family can provide.

The type of funding required is a function of the type or nature of the venture itself, which
includes the industry in which it competes and the product or service produced. It is also a
function of two major variables: the stage of the venture’s development and the amount of
growth required.

5.3.1 Stage of Development

The type of financing used is dependent to a large extent on the stage of development of the
venture. As discussed earlier, ventures go through at least three stages. The first is the pre-launch
stage. In this stage, the entrepreneur or entrepreneurial team plans the venture and determines
what the venture concept will be, the level of growth desired, the amount of funding required,
and a general idea of the strategies it will use. In some cases, such as a new product
development, the team members must do a substantial amount of work to develop and/or test the
product and its acceptance before the venture can be begun. Hence, significant funding may be
required before the venture can even be lunched. Other ventures, particularly low-growth
ventures, do not require significant pre-launch funding.

Start-up funding refers to the capital needed to get the venture into operation. This includes final
product development, manufacturing facilities, marketing expenses associated with the launch,
setting up distribution networks, and hiring personnel. Although the amount of funding for the
launch stage varies greatly with growth orientations and types of ventures, this stage requires a
large one-time infusion of capital.

Later stage financing is sometimes considered to be single stage and sometimes considered to be
two or more. In either case, this funding is a major infusion of capital to take the venture from
initial launch and stabilization along a path toward rapid growth. This will likely require multiple
sources of financing and may include venture capital or public stock offering.

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5.3.2 Growth Rate

Low-growth ventures and their entrepreneurs are typically restricted to use their own funds in a
pre-start-up situation. Their ventures do not have the potential to attract outside funding. If
partners are involved, each partner may invest in the concept and family and friends may be
enticed to loan limited sums. This capital is quite limited. As the venture is launched, additional
funding will be necessary. Again, this usually comes from the entrepreneur’s personal fund plus
whatever can be raised from family and friends. If the venture concept is sound, bank will
usually loan funds. This will depend heavily on whether it is the first venture for the entrepreneur
or not, whether the entrepreneur has a track record in a similar business, and whether sufficient
collateral exists. In later stage funding, banks will be more willing to be involved since the
entrepreneur will have shown at least some degree of stability and/or growth.

Initial funding for moderate-growth firms will come largely from personal sources and banks.
These firms will often be corporation, but the number of stockholders will often be small or the
stock will be family held. Banks will typically be willing to lend to these entrepreneurs because
they have either an established venture or at least a venture plan that clearly appears to be sound.
Depending up on the growth rate desired, personal, bank and internally generated funding may
be sufficient. If higher rate of growth are desired than these sources can underwrite, then selling
additional stock to acquaintances or to informal investors may be useful.

The high-growth or rapid-growth venture uses different combinations of funding. The

entrepreneurial team will often have substantial funds to invest in the venture although their
personal funds may still be a small part of the total package. Most entrepreneurs do not have that
flexibility, although many rapid-growth entrepreneurs do have substantial personal funds from
earlier successful ventures. Large banks, venture capitalists, and informal investors may enter the
picture early in the fast growing venture. If the venture goes as planned, however, the need for
major infusion of funds will come within few years.

5.4 Developing the Financial Package

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In cases where small amount of capital are needed, developing a financial package is relatively
simple. It involves putting together a loan request to a bank, asking friends to contribute either
debt or equity capital, or perhaps applying for a small business administration loan. The
documentation required may be only a brief business plan and whatever papers the lending
institution requires. Most of this can be done by the entrepreneur, perhaps an accountant, and the
lending institution staff.

Summary

Capital is the lifeblood of any business venture. Few ventures, and virtually no new ventures,
have enough capital to begin life and grow without an infusion from external sources. This
chapter has discussed the various needs for capital, the source of equity and debt capital, and the
relationship between growth rate of ventures, stages in venture development, and the type of
capital that are most appropriate.

Equity capital provides ownership to the investors. Some amount of equity capital will be
required regardless of the type or level of the venture. Equity capital includes personal funds of
the entrepreneurs, partners, private stockholders, informal investors, venture capitalists, or public
stockholders. Debt capital does not provide ownership, but provides a return to the investor in
the form of interest on capital supplied. In addition to traditional debt and equity capital,
entrepreneurs can also obtain the use of capital from suppliers, customers, and efficient use of
their own internal policies.

Some forms of financing are more viable for some types and levels of venture than others. Small
business ventures are, by their nature, restricted to their own personal funds for pre-launching
financing. They may use banks for later stage financing. Moderate-growth ventures will make
extensive use of bank financing; some of these may go public after several years of sustained
growth. Venture capital and initial public offerings are more applicable for rapid-growth
ventures, and they will more likely be used for later stage financing than for start-ups and pre-
launch financing.

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Regardless of the types of financing used, substantial planning must be done to ensure that
funding can be generated. A business plan is necessary for virtually all types of funding, and
carefully written plan is a must for anything other than the simplest financing sources.

Review and Discussion Questions

1. Why is it important for an entrepreneur to generate capital on equity as much as possible

rather than to depend entirely on debt financing?
2. In order to retain as much control as possible in your company, what sources of capital
would you first investigate?
3. Which sources of financing would you prefer, equity or debt, from the point of view of
risk? Why?

CHAPTER SIX
PREPARING A BUSINESS PLAN

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Introduction

An early, important step in the launching of any business is preparation of a business plan.
Obviously, a plan of some type exists in the mind of any person who is thinking about a new
business venture. However, this is a weak substitute for a written business plan. The concern of
this chapter is to discuss how to transform those vague ideas that exist in the entrepreneur’s mind
into a written document that lays the ground work for the proposed venture.

6.1 DEFINITION OF BUSINESS PLAN

A business plan can be defined as a written document prepared by the entrepreneur that describes
all relevant external and internal elements involved in starting a new venture. In other words, a
business plan is a document that helps the entrepreneur analyze the market and plan the business
strategy. It is often an integration of functional plans such as marketing, finance,
manufacturing/operations, and human resources. It addresses both short term and long term
decision making for the first three years of operation. A business plan is often prepared by an
existing company to ensure that future growth is properly managed. If the plan is prepared for a
start up, it helps the entrepreneur avoid costly mistakes. Thus the business plan – or as it is
sometimes referred to, the game plan, the venture plan, a loan proposal, an investment
prospectus, or the deal- answers the questions: Where am I now? Where am I going? How will I
get there?

6.2 WHY A BUSINESS PLAN?

Although not mandatory, preparing a formal written business plan is very important for a number
of reasons:

 The entire business planning process forces the entrepreneur to analyze all aspects
of the venture and to prepare an effective strategy to deal with the uncertainties
that arise. Thus, a business plan may help an entrepreneur avoid a project doomed
to failure.

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  The time, effort, and research needed to put together a formal business plan force
the entrepreneur to view the venture critically and objectively.
 The competitive, economic, and financial analyses included in the business plan
subject the entrepreneur to close scrutiny of his assumptions about the venture’s
success.
 Since all aspect of the business venture must be addressed in the business plan,
the entrepreneur develops and examines operating strategies and expected results
for outside evaluators.
 The business plan quantifies objectives, providing measurable benchmarks for
comparing forecasts with actual results.
 The completed business plan provides the entrepreneur with a communication
tool for outside financial sources as well as an operational tool for guiding the
venture towards success.

6.3 WHO SHOULD PREPARE THE BUSINESS PLAN

The business plan should be prepared by the entrepreneur; however, he/she may consult with
many other sources in its preparation. Lawyers, accountants, marketing consultants, and
engineers are useful in the preparation of the plan. If and when external help is sought in
preparing the business plan, the entrepreneur must remain the driving force behind the plan.
Seeking the advice and assistance of outside professionals is always wise, but entrepreneurs need
to understand every aspect of the business plan, since it is they who come under the scrutiny of
financial sources. Thus, the business plan stands as the entrepreneur’s description and prediction
for his or her venture, and it must be defended by the entrepreneur- simply put, it is the
entrepreneur’s responsibility.

6.4 WHO READS THE BUSINESS PLAN?

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The business plan may be read by employees, bankers, venture capitalists, suppliers, customers,
advisors, and consultants. Whoever is expected to read the business plan, can often affect its
actual content and focus. Since each of these groups reads the business plan for different
purposes, the entrepreneur must be prepared to address all their issues and concerns. However,
there are probably three perspectives that should be considered when preparing the plan:

The perspective of the entrepreneur: The entrepreneur understands better than

anyone else the creativity and technology involved in the new venture. The
entrepreneur must be able to clearly articulate what the venture is all about.

The marketing perspective: Too often the entrepreneur would consider only the
product or the technology and not whether or not someone would buy it. But more
important than high technology or creative flair is the marketability of a new
venture. Referred to as ‘market-driven,’ this type of enterprise convincingly
demonstrates the benefits to users-the particular group of customers it is aiming
for- and the existence of a substantial market.

The investor’s perspective: This is concentrated with the financial forecast.

Sound financial projections are necessary if investors are to evaluate the worth of
their investment. This is not to say that the entrepreneur should fill the business
plan with spreadsheets of figures. In fact, many venture-capital firms employ a
‘projection discount factor,’ which merely represents the belief of venture
capitalists that successful new ventures usually reach approximately 50% of their
projected financial goals. However, a three to five-year financial projection is
essential for investors to use in making their judgment of the venture’s future
success.

6.5 GUIDELINES IN PREPARING A BUSINESS PLAN

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Below is a list of recommendations about how to prepare a successful business plan given by
experts in venture capital and new venture development. Entrepreneurs need to adhere to these
guide lines in order to make the business plan successful in satisfying the needs of various people
who read the business plan:
i. Keep the plan respectably short: Readers of business plans are important people
who refuse to waste their time. Therefore, entrepreneurs must be able to explain the
venture not only carefully and clearly but also concisely.

ii. Organize and package the plan appropriately: A table of contents, an executive
summary, an appendix, exhibits, graphs, proper grammar, a logical arrangement of
segments, and overall neatness are critical elements to the effective presentation of
the business plan.

iii. Orient the plan towards the future: Entrepreneurs should create an air of
excitement in the plan by developing trends and forecasts that describe what the
venture intends to do and what the opportunities are for the product or service.

iv. Avoid exaggeration: Sales potentials, revenue estimates, and the venture’s
potential growth should not be inflated. Many times, a best-case, worst-case, and
probable-case scenario should be developed for the plan. Documentation and
research are vital for the credibility of the plan.

v. Highlight critical risks: The critical risks segment of the business plan is important
in that it demonstrates the entrepreneur’s ability to identify potential problems and
develop alternative course of action.

vi. Give an evidence of an effective entrepreneurial team: The management

segment of the business plan should clearly identify the skills of each key person as
well as demonstrate how all such persons can effectively work together as a team in
managing the venture.

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 vii. Do not over diversify: Focus the attention of the plan on one main opportunity for
the venture. A new business should not attempt to create multiple markets nor
pursue multiple ventures until it has successfully developed one main strength.

viii. Identify the target market: Substantiate the marketability of the venture’s product
or service by identifying the particular customer niche being sought. This segment
of the business plan is pivotal to the success of the other parts. Market research has
to be included to demonstrate how this market segment has been identified.

ix. Keep the plan written in the third person: Rather than continually stating “I,”
“we,” or “us,” the entrepreneur should phrase everything as “he,” “they,” or
“them.” In other words, avoid personalizing the plan, and keep the plan objective.

x. Capture the reader’s interest: Because of the numerous business plan submitted
to investors and the small percentage of plans funded, entrepreneurs need to capture
the reader’s interest right away by starting with the uniqueness of the venture. Use
the title page and the executive summary as key tools for capturing the reader’s
attention and creating a desire to read more.

ACTIVITY

 Why is a business plan so important to the entrepreneur?

Commentary: The business plan is important for the entrepreneur in that the document serves as
a communication tool, roadmap and standard to measure actual performance.

6.6 CONTENTS AND STRUCTURE OF A BUSINESS PLAN

A detailed business plan usually has ten sections. The ideal length of a plan is 50 pages, although
depending on the need for detail, the overall plan can range from 40 to more than 100 pages
(including the appendix). Below is the detail discussion of the ten elements of a business plan.

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1. Introductory page: This is the title or cover page that provides a brief summary of the
business plan’s contents. The introductory page should contain the following:
 The name and address of the company
 The name of the entrepreneur(s), telephone number, fax number, e-mail
address and website address if available
 A paragraph describing the company and the nature of the business
 The amount of financing needed. The entrepreneur may offer a package,
that is, stock, debt, and so on. However, many venture capitalists prefer
to structure this package in their own way.
 A statement of the confidentiality of the report. This is for security
purposes and is important for entrepreneur.

2. Executive summary: This section of the business plan is prepared after the total plan is
written. About 2-3 pages in length, the executive summary should stimulate the interest of the
potential investor. This is a very important section of the business plan and should not be
taken lightly by the entrepreneur since the investor uses the summary to determine if the entire
business plan is worth reading. Thus, it would highlight in a concise and convincing manner
the key points in the business plan. Although determining what is important in any executive
summary would be difficult since every business plan is different, there are a number of
significant issues that should be addressed:

 The entrepreneur should briefly describe the business concept.

 Any data that support the opportunity for this venture should be briefly
stated.
 After establishing the reality of the opportunity the executive summary
should then state how this opportunity will be pursued.
 Next the executive summary should highlight some of the key financial
results that can be achieved from the implemented marketing strategy.
 Important experience of entrepreneur(s), any important contracts or
other legal documents that are in place, and any other information that is
felt can assist in selling the business venture to a potential investor
should also be mentioned

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3. Environmental and industry analysis: It is important to put the new venture in proper
context by first conducting environmental analysis to identify trends and changes occurring
on a national and international level that may impact the new venture. Examples of these
environmental factors include:
Economy: The entrepreneur should consider trends in the GNP, unemployment,
disposable income, and so on.

Culture: An evaluation of cultural changes may consider shifts in the population

by demographics, shifts in attitudes, or trends in safety, health, and nutrition as
well as concern for the environment.

Technology: Advances in technology are difficult to predict. However, the

entrepreneur should consider potential technological developments determined
from resources committed by major industries or the government. Being in a
market that is rapidly changing due to technological developments will require the
entrepreneur to make careful short-term marketing decisions as well as to be
prepared contingency plans given any new technologic developments that may
affect his/her product or service.

Legal concerns: There are many important legal issues in starting a new
business. The entrepreneur must pay attention to any future legislation that might
affect the product or service, channel of distribution, price or promotion strategy.
The deregulation of prices, restriction on advertising, and safety regulations
affecting the product or packaging are examples of legal restriction that can affect
any marketing program.

All the above external factors are generally uncontrollable. However, an awareness and
assessment of these factors using various sources can provide strong support for the opportunity
and can be invaluable in developing the appropriate marketing strategy.

Once environmental scanning has been completed, the entrepreneur should conduct an industry
analysis that will focus on specific industry trends. And this includes:

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 Industry demand: Knowledge of whether the market is growing or declining, the
number of new competitors and possible changes in consumer needs are important issues
in trying to ascertain the potential business that might be achieved by the new venture.

Competition: The entrepreneur should be aware of who the major competitors are and
what their strengths and weaknesses are so that an effective marketing strategy can be
implemented.

4. Description of the venture: In this section, the entrepreneur must ascertain the size and scope
of the business. It should begin with the mission statement. This statement basically describes
the nature of the business and what the entrepreneur hopes to accomplish with the business.
Other issues that must be discussed in this section include:
 The product or service
 The location and size of the business
 The personnel and office equipment that will be needed
 The back ground of the entrepreneur(s) and the history of the venture

5. Marketing Plan: this section of the business plan describes how the product(s) or service(s)
will be distributed, priced, and promoted. Marketing research evidence to support any of the
critical marketing decision strategies as well as to forecast sales should be described in this
section. The specific forecasts for product(s) or service(s) are indicated in order to project
profitability of the venture.

What is included in the marketing Section?

The executive summary that you have developed briefly describes the products or services that
the company will offer. The marketing section of the business plan provides a detailed
description of how the company will compete in the market place as it sells those products and
services. The marketing section includes:

 A more detailed description of the products and services

 An analysis of the competition
 An examination of the pricing structure

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  An explanation of the company’s credit policy
 An explanation of the competitive advantage
 A profile of the target market
 A promotional plan

What is Your Product or Service?

A detailed description of the company’s products and services is important for two reasons. First,
it helps you thoroughly developed the concept, requiring you to move from the idea stage to
something more tangible. Second, it helps the reader of your business plan to better understand
your business. If you plan to sell a product, the description should include the size weight, shape,
packaging, quality and so forth. If you to sell a service describe all of the services you will offer
and explain the typical procedures that you will follow.

Who are Your Competitors?

Almost every small business faces competition from both large and small companies. It is
important to know the competition thoroughly in order to develop your competitive strategy. An
analysis of the competition can be completed by determining their strengths and weaknesses and
examining specific aspects of their operation. Do they have large product line? Do they have
poor service? Are they strong or weak financially? Do they have a stable workforce or is there a
high turnover?

It is important to consider both direct and indirect competition since many entrepreneurs
underestimate their competition. For example, if an entrepreneur plans to start a Chinese
restaurant, he or she often only considers the number of Chinese restaurant in the area.
However, other full-service restaurants are direct competitors, even if they sell Italian food or
Ethiopian food. Indirect competitors include any business which sells prepared food including
fast food restaurants and grocery stores with take-out menus.

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What is Your Pricing Objectives?

It is important to determine what you want to accomplish with your pricing structure. The goals
to be achieved with your pricing structure are known as your pricing objectives. Typical pricing
objectives may be:
 to achieve a specific dollar amount of profit.
 to achieve a profit level as a percentage of sales.
 to capture a specific share of the market.
 to reach a certain level of sales volume.
Pricing objective should be specific and quantifiable so that at the end of the year, it can be
determined if the goals were met.

What are Your Pricing Policies?

Once pricing objectives have been established, you should then determine your pricing policies.
Pricing policies are general pricing guidelines that you will follow to achieve your goals. Typical
pricing policies might include the following:
 Will you run sales to take advantages of the different seasons or to eliminate seasonal
merchandises?
 Will you try to match competitors’ prices?
 Will you give employees discounts on merchandise they purchase?
 Will you use coupons to attract customers?

How Will You Determine Your Prices?

Entrepreneurs often use a very simplified approach to pricing without realizing that pricing is a
very important part of the marketing strategy. There are many factors that must be considered
before prices are established. Some of the considerations are as follows:
 Cost: The pricing structure must cover all costs and provide an acceptable profit margin.
If you are selling a product, you must consider your costs to purchase the product from
your suppliers. If you provide a service, you must determine the labor costs. The costs to
purchase the product and the cost of wages to perform a service are known as direct
costs. All other costs incurred in running the business such as rent, utilities, other wages,
supplies and so forth must be considered. These are known as your indirect costs. The

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 pricing structure must be designed to cover the direct and indirect costs and provide
profit.
 Competitors’ Price: The competitors’ price cannot be ignored, since customers will
consider prices when making their purchase decision. In the previous section of the
marketing plan, we provided a method to analyze the competitors. When setting prices,
this analysis must be considered. If you competition has poor service, a smaller product
selection, and so on, you will be justified in charging a higher price than the competitor.
Conversely, If the competition has many advantages compared to your business, you may
have to offer a low price in order to compete effectively.
 Effect on Demand: The demand for a product is often affected by the price. If consumers
demand less as the price increases and demand more as the price decreases, this is known
as an elastic demand. For some products and services, however, the demand does not
change mush if the prices change. This is known as an inelastic demand. So when setting
price policies it is a must to consider the price elasticity of demand.
 Image: For many products, a higher price actually results in higher sales, since customers
often equate quality and price. If you want customers to perceive your product or service
as a high quality item, a higher price is best. One self-employed photographer found that
demand for his services increased after he raised his prices. When his prices were too
low, consumers assumed that the quality of his work was equally poor.

What Type of Promotion Will You Use?

Promotion may take many forms including the following:

 Direct marketing: Direct marketing includes direct mail, mail-order catalogs, direct
selling, telemarketing, direct-response ads through mail, broadcast, and print media.
 Advertising: Advertising consists of non-personal messages directed at a large number of
people. Advertising is carried out through media such as radio, television, newspapers,
and so forth.
 Sales promotion: sales promotion consists of marketing activities that provide extra value
or incentives to the sales force, distributors, or the ultimate consumer. Sales promotions
are developed to increase sales.

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  Publicity and public relations: Publicity is company information released as news on
radio, television, or in newspapers. Publicity is designed to create an awareness of the
company and its products. Public relation consists of community activities of a company
designed to create a favorable impression with the public.

6. Production Plan or Operational Plan If the new venture is a manufacturing operation, a

production plan is necessary. This plan should describe the complete manufacturing process.
If some or all of the manufacturing process is to be subcontracted, the plan should describe the
subcontractor(s), including location, reason for selection, costs, and any contracts that have
been completed. If the manufacturing is to be carried out in whole or in part by the
entrepreneur, he or she will need to describe the physical plant layout; the machinery and
equipment needed to perform the manufacturing operations; raw materials and suppliers’
names, addresses, and terms; costs of manufacturing; and any future capital equipment needs.
If the venture is not a manufacturing operation but retail store, service, or some other type of
non-manufacturing business, this section would be titled operational plan and the entrepreneur
would then need to describe the chronological steps in completing a business transaction.

7. Organizational plan The organization plan is part of the plan that describes the venture’s
form of ownership-that is, proprietorship, partnership, or corporation. If the venture is a
partnership, the terms of the partnership should be included. If the venture is a corporation, it
is important to detail the shares of stock authorized, share options, as well as the names,
addresses, and resumes of the directors and officers of the organization. It is also useful to
provide an organization chart indicating the line of authority and the responsibilities of the
members of the organization.
8. Assessment of Risk Every new venture will be faced with some potential hazards, given the
particular industry and competitive environment. It is important that the entrepreneur makes
an assessment of risk in the following manner:
 The entrepreneur should indicate the potential risks to the new venture.
 Then, the entrepreneur should discuss what might happen if these risks
become reality- meaning, the impact of each risk on the new venture if it
materializes.

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  Finally, the entrepreneur should talk about the strategy that will be
employed to prevent, minimize, or respond to the risks should they
occur.
Major risks for a new venture could result from a competitor’s reaction; weaknesses in the
marketing, production, or management team; and new advances in technology that might render
the new product obsolete. Even if these factors present no risks to the new venture the
entrepreneur should discuss why that is the case.

9. Financial Plan The financial plan determines the potential investment commitment needed
for the new venture and indicates whether or not the business is financially feasible.
Generally, three financial areas are discussed in this section of the plan:
 The start-up costs
 How the business will be financed
 The second major area of information needed is cash flow figures for
three years, with the first year’s projection provided monthly. Since bills
have to be paid at different times of the year, it is important to determine
the demand on cash in a monthly basis, especially for the first year.
Remember that sales may be irregular; receipts from customers may also
be spread out, thus necessitating the borrowing of short-term capital to
meet fixed expenses such as salaries and utilities.
 The entrepreneur should summarize the forecasted sales and the
appropriate expenses at least for the first three years, with the first year’s
projections provided monthly.
 The last financial item needed in this section of the business plan is the
projected balance sheet. This shows the financial conditions of the
business at a specific time. It summarizes the assets of the business, its
liabilities (what is owed), the investment of the entrepreneur and any
partners, and retained earnings (or cumulative losses).

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Start-up Costs

Start-up costs are costs that are necessary to open the business. Most of these costs will be
incurred prior to the time the company opens for business. Start-up costs for business vary by
industry, but the following categories are common for most businesses.
 Inventory: Inventory consists of any item you will buy and resell to customers. Estimates
of inventory costs can be obtained from companies that will be your suppliers.
 Furniture and Fixtures: Furniture and fixtures include office desks and chairs, shelving,
counters, display cases, and so forth. Estimates of costs can be obtained from retailers of
these items.
 Machinery and equipment: This category includes computers, cash registers, copiers, fax
machines, as well as a special industry items such as manufacturing equipment,
construction equipment, and the forth. Entrepreneurs should identify the companies from
which they would purchase the machinery and equipment and obtain the costs for each
item.
 Prepaid Expenses: It is often necessary to pay for services before the company is open for
business. These prepaid expenses may include legal fees, insurance for the first six
months of operation, grand opening advertising and so forth. Determine what expenses
must be paid before the company opens and obtain an estimate for each.
 Training costs for employees: When the door opens for business, the employees must
know how to perform their jobs efficiently. For this reason, it is usually necessary to hire
and train employees before the first day of operation. If they are hired a week or two
before opening, they may receive a paycheck before any sale is generated
 Deposits: Many entrepreneurs forget to include deposits in their start-up costs only to
find that this amounts thousands of Birr.
 Renovations and/or building purchase: Unless the business operates at home, there will
be costs associated with the site. If a location is leased renovations may be required.
Renovations to leased property are called leasehold improvements. If the facility is
purchased, the sales price is start-up cost and renovation may be added.
 Working Capital: For most businesses, it takes at least several months to develop a good
customer base. During this time, the sales volume is not usually sufficient to pay all of
the bills. Working capital is a cash reserve to cover monthly expenses until the cash

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 coming into the company every month is equal to or greater than the amount of bills that
need to be paid. In general, the working capital amount should cover at least six months’
expenses.

How Will The Business Be Financed?

The financing section of the business plan should identify the type of financing that will be used
because this may have a financial impact on you and your company. For example, If a large
amount of money is borrowed, the company will have substantial loan payments every month
which could be burden for a new company. If you use personal assets as collateral for a loan, you
could lose them if the business does not succeed. Money that is borrowed, known as debt
financing, must be repaid with interest, this is at the same time a burden for a new business. On
the other hand, if you plan to obtain private investors, or if friends and relatives will provide
funds, you must consider how they will compensate for their investment. Some investors and
partners only want financial return, whereas others want to take an active role in making
company decisions. So, before you make decisions on how to finance a new venture you need to
consider all the alternatives.

The business plan must also state how debt financing will be repaid and what will be given in
exchange for equity funds. For loans, the plan should state the number of years over which the
loan will be repaid and the interest rate. For equity, the percentage ownership must be stated
along with other payments. It is common to reward investors with dividends, which are periodic
payments based on the net profit the company. The business plan should therefore state both
percentage of ownership for investors and dividends that will be paid.

Projected Financial Statement

The projected financial statements that are included in the business plan are the projected balance
sheet statement, the projected income statements, and the projected cash flow statements. The
following section discusses these statements.

i. Projected Balance Sheet Statement

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The balance sheet compares the possessions of a company and the debts that it owes on a
specific day. Therefore, while the income statement records profit or loss over a period of time,
the balance sheet only shows the financial situation on a certain day.
Asset: A company’s possessions, called asset, may be tangible items such as machinery
and equipment, or they may be intangible assets such as patent or goodwill. On the
balance sheet, assets are divided into several categories- current, fixed and other.
Current Asset: are those that are easily converted into cash and include the following:
 Cash: All cash on hand in the business and in the business checking and savings
accounts is recorded.
 Account Receivable: If a company extends credit and consumers owe for
purchases, this is a company asset because it is money that will be received in the
future.
 Inventory: All items available for resale are current assets. In a manufacturing
firm, the inventory may be separated into two categories- raw materials and
finished goods.
 Supplies: All supplies such as shop supplies, office supplies, bags and boxes for
customers’ packages, and so forth would be included.
 Prepaid expenses: The prepaid expenses listed in start-up costs are considered as a
current asset.
Fixed assets are items that are more permanent in nature and are used in business. These
include:
 Machinery, equipment, furniture, fixtures: All items listed in your start-up costs in
these categories would be fixed assets.
 Land and building: If you purchase land and a building or if you construct a
building, this would be shown in the amount of the price paid or the construction
costs.
 Renovations: If you spend money for renovations to leased property, this is
considered a business asset even though you do not own the property.
 Vehicles: This includes all company cars, trucks, and so on.
A company may have assets that do not fall in the above categories. For example, if you are
required to pay deposits for lease or utilities, the money is often held for several years before it is

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returned. For this reason, it is not considered a current asset and is therefore placed in a category
called “other assets.” Similarly, a company may have intangible assets such as goodwill or
patents; these are included in “other assets.”
Liabilities: The liabilities section of the balance sheet includes all debts that the company
owes. As with the assets, the liabilities are categorized as current and long term liabilities.
Current liabilities are those liabilities that must be paid within 12 months and include the
following:
 Account payable: All bills due for inventory and supplies are included in this
category.
 Accrued expenses: Bills due for utilities and other miscellaneous expenses are
considered accrued expenses. Also, if employees are paid every two weeks and
wages are owed to them when the balance sheet is prepared, these would be
included.
 Notes payable: Any short term loans that are due within 12 months from the date
of the balance sheet are considered as current liability. Loan payments include
both principal (loan repayment) and interest. Only the principal is recorded o the
balance sheet.
 Current portion of long-term debt: Even if loan is to be repaid over several years,
a portion of the loan is due within the next year. That principal portion due within
the next 12 months is considered the current portion of long-term debt. For
example, if a loan principal of Birr 10,000 is due over a five year period, and Birr
3,000 of that amount is due within the next year, the Birr 3,000 is considered the
current portion of the long-term debt.
Long-term liabilities are those debts or portions of debts that are due more than 12
months from the date of the balance sheet.

Equity: Another category in the balance sheet is called equity, net worth, or capital
account. This account represents the difference between the assets and liabilities. Total
asset minus total liabilities must equal net worth or equity. The equity includes all the
money the entrepreneur has invested from personal funds as well as retained earnings.
Retained earnings is an accumulation of all profits and losses of the company from the

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 day it began until the day the balance sheet is prepared. If the company makes profit,
retained earnings increases; if the company loses money, retained earning decrease.
Although the total equity figure does not necessarily represent the market value of the
company, it is an important figure because financial institutions often compare the total
liabilities to the total equity if the company applies for loan.

ii. Projected Income statement

The income statement is completed on a periodic basis and records sales, cost of goods sold,
expenses and profit or loss.
 Sale: On the income statement, the sales of a company may be listed as “sales,”
“income,” or “revenue,” depending on the type of a company. If the statements are
completed on an accrual basis, this represents the sales that have been generated, not
necessarily those for which payment has been received.
 Cost of Goods Sold: cost of goods sold includes any costs for products, material, or labor
that are directly related to sale. In a retail firm, cost of goods sold is the costs paid to
suppliers for inventory. In service firms such as housecleaning or maid service
businesses, the product cost is very small but labor is the major part of the cost of goods
sold.
 Gross Margin: is the difference between sales and costs of goods sold. It shows the
markup on the sales or activity of the company.
 Operating Expenses: Include ongoing expenditures that occur in the process of selling
and managing the company. As a company grows, the operating expenses may have
subcategories such as “selling expenses,” general and administrative expenses,” and so
forth.
 Net Profit: Net profit is equal to gross margin minus operating expenses. The full amount
is not available to the entrepreneur, however, since income taxes and other cash outlays
must deducted from this sum.

iii. Projected Cash Flow Statement

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In new – venture creation, the cash flow statement may be the most important document since it
sets forth the amount and timing of expected cash inflows and outflows. This section of the
business plan should be carefully constructed.

10. Appendix: The appendix of the business plan contains any backup material that is not
necessary in the text of the document. Reference to any of the documents in the appendix
should be made in the plan itself. Information that should be given in the appendix might
include:
 Letters from customers, distributor, or subcontractors
 Any documentation of information- that is, secondary data or primary
research data used to support the decisions made in the plan
 Leases, contracts or any other types of agreements that have been initiated
 Price list from suppliers and competitors … etc.

ACTIVITY

 Describe each of the three financial statements that are mandatory for the financial
segment of a business plan.

Commentary: There are three major financial statements which should be included in the
business plan. These are forecasted income statement, balance sheet statement and cash flow
statement. With your explanation you need consider the components of each financial statement.

Summary

This chapter has established the scope and value of the business plan and outlined the steps in its
preparation. The business plan may be read by employees, investors, lenders, suppliers,
customers, and consultants. The scope of the plan will depend on who reads it, the size of the
venture, and the specific industry for which the venture is intended. The business plan is
essential in launching a new business. The result of many hours of preparation will represent a

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comprehensive, well-written, and well organized document that will serve as a guide and an
instrument to the entrepreneur raise the necessary capital.

Before beginning to write the business plan, the entrepreneur will need information on the
market, manufacturing operations, and financial estimations. The internet represents a low-cost
service that can provide valuable information on the market, customers and their needs, and
competitors. This information should be evaluated based on the goals and the objectives of the
new venture. These goals and objectives also provide a framework for setting up controls for the
business plan. Other important sources of information include micro and small industry agencies,
chambers of commerce, bureau of trade and industry, libraries, universities and training centers,
banks, trade journals, trade associations and regional governments.

The chapter provides a comprehensive discussion of a typical business plan. Each key element in
the plan is discussed and examples are provided. Control decisions are presented to ensure the
effective implementation of the business plan. In addition, some insights as to why business
plans fail are discussed.

Self Assessment Questions

1. What kind of information should be provided in the industry analysis of the business
plan? Where can the entrepreneur get information on any specific industry?
2. What is the purpose of the financial plan to the potential investor? To a potential lender?
What kinds of financial information will be needed for each? Why?
3. What are some examples of potential hazards that should be evaluated in the risk
assessment section of the business plan? How would they differ for service,
manufacturer, or retailer?
4. Why is it necessary to update the business plan? What specific factors can enhance the
need to update it?

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 Answer Key for Self Assessment Questions

Chapter One

1. First identify two Ethiopian entrepreneurs Like Mr. X and Miss Z. Further explain their
contribution to and roles in the economy in terms of :
 Creation of job opportunity
 Better production methods and products
 Identification of business opportunities and markets
 Conservation of natural resources
 Abolish of monopoly and enhancement of competition
 Development of complementary goods producers
 Increase the per capita output and income
 Generation of foreign currency
 Better utilization of resources
 Positive externalities
 Business opportunities of suppliers
2. Consider Individuals who created their own business in your surrounding and evaluate
them whether or not they have the quality of entrepreneurs. When you try to evaluate
their quality consider the following:
 Risk taking
 Initiative taking
 Organizing and reorganizing of resources
 Clear vision and mission
 Wealth creation is involved.
 Decision making
 Using available resources in novel ways
 The ability to see business opportunities
 The ability to gather resources to take advantage of them and the ability to take
action; and
 The ability to search for change, responds to it, and exploits it.

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 3. There are several sources of innovation. The major sources are:
 Unexpected occurrences
 Incongruities
 Process need
 Industry and market changes
 Demographic changes
 Perceptual changes

4. The creative process has five commonly agreed-on phases or steps. Most experts agree on
the general nature and relationship among these phases, although they refer to them by a
variety of names. These are:
 Idea germination
 Preparation
 Incubation
 Illumination
 Verification

Chapter Two

1. Yes, it is true that most entrepreneurs have failed at some point in their business career.
There are a number of factors that attribute for the failure of entrepreneurial businesses.
Though there are several factors for entrepreneurial business failure the following are the
most important:
 Management deficiency: The new entrants, in many cases did not have any prior
training or back ground in management of their enterprises and were adverse to
innovations and changes.
 Limited access to finance: Financial inadequacy is one of the most inhibiting
factors in the growth of entrepreneurship. The following are some of the limiting
factors in accessing business finances: New is too risk, No preferential interest
rates, Longer loan processing time, and Lack of collateral demanded by lenders.
 Limited access to market: Entrepreneurs face over all limitations on penetrating
and servicing their markets. The cost of penetrating the existed or the new market
is relatively high for the newly developed business of an entrepreneur.

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2. Given the sizable risks, time and energy requirements of entrepreneurship, why do so
many individual take the entrepreneurial plunge every year? Entrepreneurs are motivated
to launch business for a number of reasons. While the motivations for venturing out alone
vary greatly, they can be grouped in to two broad categories: pull factors and push
factors.
Pull Factors: Some individuals are attracted towards small business ownership by
positive motive such as a specific idea which they are convinced to work. Pull factors are
those which encourage individuals to become entrepreneurs by virtue of the
attractiveness of the entrepreneurial option. Some important pull factors are the
following:
 Independence: "Being my own boss
 The need for power or control
 Need for Achievement
 Profit
 Role Models

Push Factors: Push factors on the other hand are those which encourage
entrepreneurship by making the conventional option less attractive. Many people are
pushed (forced) in to founding a new business by variety of factors. Some of the push
factors include:
 An Alternative to a Dissatisfying Job
 Job Insecurity
 Personal and Professional Growth
 Unemployment

3. Some people feel that entrepreneurs are less educated than the average non- entrepreneur.
However, research proves otherwise. In fact, most entrepreneurs were found to have at
least a college degree. Furthermore you must look into the importance of education
behind the success of entrepreneurs.

Chapter Three

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1. These are different forms of franchising opportunities. These different forms of
franchising opportunities can be grouped into different classes on the basis of different
dimensions. Hence, on the basis of franchising arrangements, there can be at least four
types of different franchising arrangements.

 Product and trade name franchising- it exists when a franchisor gives a

franchisee the right to use a widely recognized product or trade name.
 Business format franchising- this arrangement provides the franchisee an entire
marketing system and an ongoing process of assistance and guidance.
 Piggyback franchising- refers to the operation of a retail franchise within the
physical facilities of a host store
 Master franchising (sub franchising) - a master franchisor is an individual who
has a continuing contractual relationship with a franchisor to sell its franchises.

2. The right way to buy a franchise requires an entrepreneur to go through the franchising
process. Therefore, the entrepreneur, before entering into a franchise arrangement with
anyone, must carefully evaluate his/her options and follow certain procedures.

 Locating a franchise opportunity- the entrepreneur must first be able to find a

good franchising opportunity.
 Evaluating the franchise offer- once a franchise opportunity is found, it must be
carefully evaluated. There are certain areas that the entrepreneur should focus on
when evaluating a franchise offer. These include the following:
 Business experience of the franchisor
 Business experience of the directors and the chief executives of the
franchisor
 Litigation history of the franchisor
 Bankruptcy history of the franchisor
 Initial funds required to be paid by a franchisee
 Recurring funds required to be paid by a franchisee
 Financing arrangements
 Restriction on sales

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  Termination, cancellation, and renewal of the franchise
 Training programs
 Financial information concerning the franchisor …etc.
 Initiating the negotiation- once the entrepreneur has identified a franchise
opportunity and carefully evaluated, the next step will be starting talks with the
franchisor in order to establish franchising relations. All the services and types of
assistance offered in a franchise contract are subject to negotiations.
 Closing the deal- few franchise contracts are signed by the prospective franchisee
without due diligence and legal assistance.

3. Franchising is an alternative business growth and expansion strategy for the franchisor
while it can be an alternative business ownership opportunity for the franchisee. Hence,
the advantages and disadvantages of franchising can be discussed from two perspectives-
the franchisee and franchisor.

Advantages to the franchisee

The franchisee gains a number of potential advantages from being involved in a
franchising relationship. Some of these are:
 Product acceptance or established product or service
 Technical and managerial Assistance:
 Financial assistance
 Marketing advantages
 Operating and structural controls
 Quality control Standards:
 Less Operating Capital:
 Opportunities for Growth:

Advantages to the franchisor

Just as there are major advantages for the potential franchisee to enter relationship with
a franchisor, there are significant advantages for the franchisor. These are:
 Low cost of expansion

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  Cost advantages
 Motivation
 Shared Advertising
Disadvantages to the franchisee
Most franchising agreements work well for both the franchisor and the franchisee.
However, there are some disadvantages to the franchisee that can be associated with the
franchising relationship.
 Cost of franchise
 Restriction on growth
 Loss of absolute independence

Disadvantages to the franchisor

Within the franchisor-franchisee relationship, there are three categories of potential
disadvantages for the franchisor. These are problems of recruitment, communication,
and freedom.

Chapter Four
1. The benefits of owning a small business are :

 Opportunity to gain control over your own destiny

 Opportunity to make a difference
 Reach your full potential
 Reap unlimited profits

Chapter Five

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 1. It is advisable for entrepreneurs first to exhaustively equity finance rather than. This is
because of:
 Size of capital amount: selling securities is one of the fastest ways to raise
large sum of capital in a short period of time.
 Liquidity- The public market provides liquidity for owners since they can
readily sell their stock.
 Value: the market place puts a value on the company’s stock, which in turn
allows value to be placed on the corporation.
 Image: the image of a publicly traded corporation often is stronger in the eyes
of suppliers, financers, and customers.

2. In order to retain as much control as possible in your company priority should be given
for debt financing. As to the reasons please consider the weaknesses of equity financing.
3. From the point of view of risk debt financing is better than equity financing. Discuss the
reasons from the perspective of:

 Hard working
 Commitment
 High sense of responsibility
 Personal interest on assets of the business
 Controlling and monitoring measures taken by the lenders

Chapter Six

1. The entrepreneur should conduct an industry analysis that will focus on specific industry
trends. And this includes:
Industry demand: knowledge of whether the market is growing or declining, the
number of new competitors and possible changes in consumer needs are
important issues in trying to ascertain the potential business that might be
achieved by the new venture.
Competition: the entrepreneur should be aware of who the major competitors are
and what their strengths and weaknesses are so that an effective marketing
strategy can be implemented.

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2. Potential investors and lenders are principal users of the business plan developed by the
entrepreneur. This document is useful for both stakeholders in that it is only through this
instrument that they can check the viability, feasibility and profitability of the proposed
business. For this end they require the business plan to include information like
description of the new venture, environmental and industry analysis, marketing plan,
production or operations plan, and much more than these it should incorporate forecasted
financial statements such as forecasted income statement, balance sheet statement and
cash flow statement.

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References
Billard, Bolton and John Thompson, Entrepreneurs: Talent, temperament, Technique, Boston,
Butterworth-Heinemann, 2000.

Bierke, Bjorn and Claes M. Hultman, Entrepreneurial Marketing: The Growth of Small Firms in
the New Economic Era, Northampton, Edward Elgar, 2002.

Chaston, Ian, Entrepreneurial Marketing: Competing by Challenging Conventions, Macmillan

Business, 2000.

Desai, Vasant, Dynamics of Entrepreneurial Development and Management, 3rd rev ed.,
Mumbai, Himalia Publishing House, 1997.

Drucker, Peter F, Innovation and Entrepreneurship: Practice and Principles, New York, Harper
and Row, 1985.

Hisrich, Robert and Michael P. Peter, Entrepreneurship, 4th ed., Boston, Irwin McGraw-Hill,
2000.

Holt, David, Entrepreneurship: New Venture Creation, New Delhi, Prentice-Hall, 1992.

Kuratko, Donald and Hodgetts Richard, Entrepreneurship: A Contemporary Approach, 5th ed.,
South-Western, 2001.

Lambing, Peggy and Kuehl Charles, Entrepreneurship, 2nd ed., New Jersey, Prentice-Hall, Inc.,
2000.

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