Lesson 3: Establishing a business

This lesson will require approximately TEN notional hours. Figure 3.1 represents an overview of lesson
Figure 3.1: Visual overview of lesson 3. (Source: Author's design)
Lesson 3: Establishing a business
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3.1 Introduction

It has become a globally documented phenomenon that the advancement of Small, Medium and Micro-Enterprises (SMMEs) can
greatly contribute to the Gross Domestic Product (GDP), reduce unemployment and stimulate social welfare (Ladzani & Van, 2002;
Oni, Agbobli & Iwu, 2019). However, current studies in South Africa reveal that SMMEs are only creating 28% of total employment
– even though 98.5% of the country's economy is made up of SMMEs. The goal of the National Development Plan (NDP) for small
businesses – to create 90% of the jobs by 2030 – will not be achieved unless this important sector of the economy is accurately
understood. Starting a small business or operating one requires hard work, talent, perseverance, willpower and a lot of research
and planning.

Lesson 3: Establishing a business

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Learning outcomes

When you have worked through lesson 3, you should be able to do the following:

• Define the terms "small business" and "business idea".

• Identify the factors that influence the location of a business.
• Describe the advantages associated with a small business.
• Explain the types of small business failures and the reasons why small businesses fail.
• Distinguish the different forms of ownership that are found in South Africa.
• Discuss the purpose, objectives, components and the development process of a business plan.
• Distinguish the different funding options for a small busine
• Lesson 3: Establishing a business
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• 3.2 Definition of a small business
• Defining a small business is problematic because aspects such as labour, turnover and capital intensities need to be
considered (Langa, & Govender, 2019; Masocha, 2019; Muriithi, 2017). The National Small Business Act 29 of 2004 defines
a small business as a separate and different business entity, such as co-operative enterprises and non-governmental
organisations. Furthermore, the entity is managed by one owner or more, including its branches or subsidiaries, if any, and is
predominantly carried on in any sector or sub-sector of the economy. Small business in South Africa can be classified as a
micro, small or medium enterprise (SMME) (The Presidency, Republic of South Africa, 2004).
• Now that you have learned about the definition of a small business, you need to understand what constitutes a business
idea.
•
LESSON

• Lesson 3: Establishing a business

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• 3.3 Business idea
• The most important factor a person needs before starting a business is a business idea. For some people, coming up with a
great business idea is a rewarding exercise. However, others regard this task as overwhelming. Essentially, one needs to
establish what customers want and try to satisfy a need not fulfilled by others. The key question to ask is what customers
want – instead of focusing on what the business does. A business idea should be innovative and creative. Possible sources
of business ideas include previous work experience, personal interests, industry-related exposure, educational courses, and
suggestions from customers, family and friends. A business idea can be implemented by starting a new business, buying an
existing one or obtaining a franchise.
 • Activity 3.1
• This activity will take approximately 10 minutes to complete.
• Identify a business idea that you could implement in your community and succeed in it.

Feedback

A business idea can come from novelty innovation or doing something people have
been doing for a very long time – selling bread, vegetables, or clothes, for instance.
We advise you to watch the following video by opening the link below for examples of
different business ideas:

https://youtu.be/AH1FN_y8IP8
•
• From the business idea, we move on to look at the importance of geographical location.

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3.4 The importance of geographical location

3.4.1 Geographical location

The choice of geographical location for specific premises is important to all kinds of businesses, although it may be more important
for some than for others. For example, the success of most retail organisations depends on the location of the business. Depending
on the nature of the proposed product or service to be offered, the entrepreneur should, for example, decide whether the business
needs to be located either near its market or near its sources of raw materials, near competitors, in the city centre, in the suburbs,
in a rural area, in existing industrial areas, or according to personal preference. Woolworths, for example, selects the premises of
its stores according to the following criteria (https://www.woolworths.co.za/):

• The premises should be located near other national retailers, banking and other facilities.
• The site should provide adequate security.
• There should be convenient parking facilities.
• The building must comply with Woolworths' specifications regarding size, quality of finish, and so forth.
• It is important to know that no two businesses are alike and that different factors might influence the choice of location,
depending on the nature of the business.

3.4.2 Location factors

Location factors can be described as those aspects you need to consider when selecting the geographical location of a new
business. These factors include:

• sources of raw material

• availability of labour
• the proximity of and access to the market
• availability and cost of transport facilities
• availability and costs of power and water
• availability and costs of a site and buildings
• availability of capital, attitude, regulations and tariffs of local authorities
• the existing business environment, the social environment, climate, central government policy and personal preferences

Activity 3.2
This activity will take approximately 15 minutes to complete.

From the list provided, identify the five most important factors that you would consider in selecting a geographical location for a
business that you would like to establish.

Feedback

Depending on the business idea that you have identified, some of the most important factors
that you would consider in selecting a geographical location for your business would include:

• sources of raw material

• availability of labour
• the proximity of and access to the market
• availability and cost of transport facilities
• availability and costs of power and water
• availability and costs of a site and buildings
• availability of capital, attitude, regulations and tariffs of local authorities
• the existing business environment, the social environment, climate, central government
policy and personal preferences

Now that you understand the importance of geographic location for any organisation, you will learn about the advantages of a small
business.

3.5 Advantages of a small business

LESSON
Lesson 3: Establishing a business
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3.5 Advantages of a small business

A small business is more innovative due to the following factors:

• Passion. A small business owner is concerned with the success of the business and is more receptive to new ideas and
concepts.
• Customer relations. A small business understands its customers' needs better, and is thus in a good position to meet those
needs.
• Agility. A small business is more likely to adapt quickly to a changing environment than big organisations are.
• Risk-taking. An owner of a small business is more willing to take risks.
• The ability to operate with minimal resources. A small business is aware of its few resources and consequently, becomes
proficient at doing more with less.
• Information sharing. A small business is more likely to have a closer social network for sharing ideas due to its small size.

As much as starting or owning a small business comes with advantages, the failure rate of these businesses is alarming. In the
next section, you will learn about the types of small business failures and the reasons why these businesses fail.

3.6 Failure of a small business

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3.6 Failure of a small business

Small businesses are at the heart of encouraging growth in Africa (Muriithi, 2017). Like many other countries, South Africa has
identified developing small businesses as one of the solutions to developmental challenges. However, the 75% failure rate of small
businesses in the country is shocking and is, in fact, one of the highest in the world (Langa & Govender, 2019). It is estimated that
40% of all new businesses in the country fail in their first year of establishment, 60% in the second year and 90% within the first 10
years since the start of the business (Bushe, 2019). The Global Entrepreneurship Monitor report also emphasised that the survival
rate for South African start-up businesses since 2012 is poor compared to other countries (Bushe, 2019).

3.6.1 Types of small business failures

The term failure can have diverse meanings for different people. However, the failure of small businesses is usually measured by
the termination of the operation of the business in the following manners:

• The owner dies and the business ceases to operate.

• The opportunity cost becomes high. This occurs when the owner realises that the business is generating less profit
compared to other options elsewhere to encourage him/her for the effort that is being put into it.
• A business loses money, resulting in it being terminated to avoid losses to its creditors.
• The business becomes bankrupt.

3.6.2 Reasons why small businesses fail

Most small businesses fail to the extent that they are unable to service their commitments and as a result, become insolvent. Table
3.1 summarises the reasons why small businesses fail.

Table 3.1: Reasons why small businesses fail

Managerial inadequacy Financial inadequacy External factors

• Failure in planning (initial start- • Cash-flow problems • Economic
up plan and subsequent • Insufficient first recession
plans) capitalisation • Increasing
• Inexperience with managing • Inadequate financial unemployment
business operation records • Higher interest
• Ineffective staffing rates
• Poor communication skills
 • Failure to seek or respond to • Overlooking the • Lack of desirability
criticism insights of qualified for the product or
• Failure to learn from past accountants service
mistakes • Inadequate capital • Inability to compete
• Overlooking the needs of acquisition with imports
customers strategies • Fraud in the
• Overlooking competition • Overlooking business
• Failure to diversify customer financial issues • Natural disasters
base resulting from
• Failure to innovate growth
• Ineffective marketing
strategies

Source: Adapted from Cadden & Lueder (2012)

Small businesses fail because of obstacles faced in the country. Figure 3.2 depicts the World Economic Forum's statistics about
obstacles that businesses in South Africa face.
Figure 3.2: Most problematic factors for doing business in South Africa
(Source: Schwab, 2017:46)

Tax rates, corruption, access to financing, tax regulations, inefficient government bureaucracy and an inadequately educated
workforce were found to be the most problematic factors when it comes to doing business in South Africa. Corruption was indicated
as the second highest reason; this can be avoided if organisations were to adhere to the principles set out by the United Nations
Global Compact, especially principle 10. Principle 10 encourages businesses to work against corruption in all its forms, including
extortion and bribery. Most of the reasons that result in business failure can be eliminated through a proper business plan based on
research and empirical evidence. In the next section, you will learn about different forms of ownership.

3.7 The legal forms of ownership in South Africa

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3.7 The legal forms of ownership in South Africa
The purpose and objectives of a business idea will inform the type of ownership. Forms of ownership differ regarding the extent to
which the owners want to be liable for financial and legal risks, how the business will be financed and who will have a controlling
interest in the business. The nature of the proposed business activities, the size of the business, the financing needs, the
accountability of participants, and tax and legal implications, the management structure and the participation style need to be
carefully assessed before selecting any form of ownership (Erasmus, Rudansky-Kloppers & Strydom, 2019).

3.7.1 Choosing a form of ownership

One of the concepts that some students find difficult is the question of legal personality. When a business has a legal or juristic
personality of its own (i.e. an organisation or a close corporation), it means that the business is just like a person in his or her own
right. A justice person enjoys limited liability. An example is when creditors sue a sole proprietorship; the claim will be against the
owner of the sole proprietorship in his or her capacity. This is because a sole proprietorship does not have a legal personality.
However, if creditors sue a company, the claim is against the company and not against the shareholders or the directors personally.
This is because the company is a legal personality on its own. A juristic person is also not affected by changes in its membership
and as a result, provides the business with continuity.

Choosing the right type of ownership is not an easy task. In the subsequent section, you will learn about different types of
ownership, their advantages and disadvantages.

3.7.2 Types of ownership

3.7.2.1 Sole proprietorship

Sole proprietorship refers to a business that is established, operated, owned and frequently funded by one person (Gitman et al.,
2018). In a sole proprietorship, the owner makes all the important decisions and is generally responsible for all day-to-day activities.
A sole proprietorship is not a separate legal person, meaning that there is no legal separation of the personal and business assets
of the owner (Erasmus et al., 2019). Therefore, the owner risks losing all his/her possessions if the business does not fulfil its
financial obligations. Table 3.2 summarises the advantages and disadvantages of a sole proprietorship.

Table 3.2: Advantages and disadvantages of a sole proprietorship

 Advantages of a sole proprietorship Disadvantages of a sole
proprietorship
The owner has direct control of the The owner needs to supply all the
business expertise necessary to make the
business a success.
The owner gets all the income earned by The business dissolves when the owner
the business dies.
It is the easiest and less expensive to set The business depends on the owner's
up resources for financing.
Freedom from government regulation The owner endures unlimited liability for
any losses sustained by the business.
Easy to dissolve Involves personal sacrifices and a huge
time commitment.
3.7.2.2 Partnership

A partnership is a business jointly owned by two or more people to generate a profit. Setting up a partnership is more difficult than
starting a sole proprietorship, but it is still comparatively easy and inexpensive. Partners may be individuals or other businesses
operating as a juristic person. A partnership is characterised by each partner contributing something to the business and each
partner expecting a share of the profit. A partnership does not have a juristic personality, meaning that the personal assets of
partners are exposed to the risks of the business (Erasmus et al., 2019). Table 3.3 summarises the advantages and disadvantages
of a partnership.

Table 3.3: Advantages and disadvantages of a partnership

Advantages of a partnership Disadvantages of a partnership

Partnerships are easy to form. The Partners are subject to unlimited liability.
partners agree to do business together
and draw up a partnership agreement.
Brings together a diverse group of Sharing of decision making might bring
talented individuals who share discomfort to other partners.
responsibility for running the business.
The business can draw on the financial Sharing the profit can be complex.
resources of many individuals.
Partners are actively involved in running Difficulty in exiting or dissolving a
the business and can respond quickly to partnership – the value of the partners'
changes in the business environment. share must be calculated when one
partner intends to leave.
Continuity is not a problem since There is potential for conflict between
partners can agree legally to allow the partners.
partnership to survive if one or more
partners die.
3.7.2.3 Close corporation

A close corporation is a legal entity owned and controlled by one or more members, but not more than ten. A close corporation is a
juristic person with its own rights, assets and liabilities. Therefore, it can enter binding contracts, buy and sell property, sue and be
sued, be held responsible for its actions and be taxed. The interest of a member is expressed as a percentage and the total interest
of members must be 100 per cent. A member's interest can be transferred to another individual who will then become a member of
the close corporation (Erasmus et al., 2019). A close corporation may not make any payments to members unless it has been
determined that after payment, the corporation's assets are still more than its liabilities. The name of a close corporation is
precedent by the abbreviation "CC" (Erasmus et al., 2019). After the implementation of the Companies Act 71 of 2008, no close
corporation can be registered and no conversions from companies to close corporations will be permitted. However, existing close
corporations can be continued or be converted to companies. Table 3.4 summarises the advantages and disadvantages of a close
corporation.
Table 3.4: Advantages and disadvantages of a close corporation

Advantages of a close corporation Disadvantages of a close corporation

Limited liability for members
Better access to financial resources
Close corporations can attract highly
skilled and talented employees due to
their size and their ability to pay high
sales commissions and benefits.
There is continuity. A close corporation
has a legal life separate from the lives of
its members and can exist forever.
3.7.2.4 Company
There is a possibility for the agency
problem, which is the conflict of interest
resulting from a relationship in which one
party (employed managers) is supposed
to act in the best interest of the other
(members).
Close corporations are more costly to set
up.
Close corporations are subject to levels
of regulation and government oversight
that can place a burden on small
businesses.
Membership is limited to ten persons.

A company refers to an entity that conducts business to generate profit as a fictitious person with its own rights and duties. A
company does not rely on the life of a natural person or persons for its continuity. Companies enjoy all the benefits of a juristic
person associated with limited liability to the shareholders. The ownership and control are separated as companies are owned by
shareholders but managed by the board of directors and appointed executives. The types of companies include profit and non-profit
companies.

a) Profit company
The most common types of company that operate mainly for profit include personal liability companies, private companies, public
companies and state-owned companies. A personal liability company, usually ending with the word "Inc". or "Incorporated" is
another type of formation found in certain industries, whereby members are allowed to form a business besides operating as a
partnership. Personal liability companies must adhere to the conditions relevant to private companies. Only one individual is
needed to establish a personal liability company with at least one director.

A private company has a minimum of one shareholder and a maximum of 50 shareholders. A private company must have at least
one director. The company must also meet the requirements to appoint an audit committee or a social and ethics committee, where
applicable. Private companies must have a memorandum of incorporation stipulating certain restrictions regarding the
transferability of their securities. This means that the public, in general, cannot buy shares from a private company. A memorandum
of incorporation must be drafted, stipulating that creditors may hold directors equally and individually liable for contractual debts and
liabilities of the company.

A public company requires at least seven persons and can raise capital from the general public. The securities of a public company
are freely transferable and shares are sold to the public to raise capital. The name of a private company ends with the words "(Pty)
Ltd", while the name of a public company ends with "Ltd". A public company must have a minimum of three directors and is strictly
controlled through legal regulations compared to private companies.

State-owned companies have the state as the main shareholder. These companies are registered in terms of the Companies Act
71 of 2008 and listed as a public entity in terms of the Public Finance Management Act 29 of 1999 or owned by a municipality
(Erasmus et al., 2019). Company secretaries and audit committees must be appointed to the state-owned companies and their
names must include the expression "SOC Ltd".

b) Non-profit company

Non-profit companies use the income generated to promote the specific purpose for which the company was established and do
not distribute any profit to its members. These companies are usually established for a philanthropic or public purpose; for example,
the advancement of a specific culture, sport or charity. Non-profit companies do not need to have any members, but they must
have at least three directors. Directors can only expect reasonable remuneration for their services and may not gain any other
benefits. Table 3.5 summarises the advantages and disadvantages of companies.

Table 3.5: Advantages and disadvantages of companies

 Advantages of companies
Legal and natural persona may be
shareholders or members of companies.
There is a separation of control and
ownership.
Shares are easily transferable.
The business can continue indefinitely.
Disadvantages of companies
A high degree of legal regulation
High operational costs
Conflict of interest resulting from a
relationship in which one party
(directors) is supposed to act in the best
interest of the other (shareholders)
Financial affairs are available to the
public.

There is limited liability for members and Directors may be held personally liable
shareholders. for the company's debts if they fail to
meet their legal obligations.
Companies can raise huge capital. Profits distributed to shareholders are
taxable.
3.7.2.5 Business trust

A business trust is formed through a trust deed in terms of which the initiator of the trust places assets under the control of a trustee
to benefit the beneficiaries (Erasmus et al., 2019). There is no limit to the number of beneficiaries and they can be natural or juristic
persons. A trust is not owned by anyone and it is registered like companies. The termination of a trust can be done through an
agreement or if it is sequestrated due to its failure to service its debts. Trustees are liable only to the trust assets, not personal
assets. Table 3.6 summarises the advantages and disadvantages of a business trust.

Table 3.6: Advantages and disadvantages of a business trust

 Advantages of a business trust
Natural and juristic persons may be
parties to trust as founder, trustee or
beneficiary.
It offers extreme flexibility.
It is easy to establish.
There are fewer legal regulations.
There is limited liability.
There is continuity.
3.7.2.6 Co-operative society
Disadvantages of a business trust
There is potential for conflict between
parties.
There is limited access to capital.
There is a loss of direct control of assets.
There are administration costs involved
in the form of trustee fees.
There might be costs involved when
transferring assets into a trust.

A co-operative society is a juristic business, jointly owned and normally structured by farmers or consumers, mainly in the
agricultural sector; however, it can be used for different kinds of businesses. The co-operative society is formed and operated for
the benefit of its owners. Members of a co-operative have limited liability for the debts of the co-operative. The co-operative
society's name must always specify the main business of the co-operative and must include the words "co-operative" or "co-op"
and "limited" or "Ltd", unless the liability for members is not limited. A co-operative society should not restrict its membership based
on racial, social, political, gender or religious discrimination, provided that all interested parties are willing to use their services and
accept the responsibilities of membership (Erasmus et al., 2019). A board of directors is appointed to manage the operations of a
co-operative, which should remain subordinate to the members in general meetings. Table 3.7 summarises the advantages and
disadvantages of a co-operative society.

Table 3.7: Advantages and disadvantages of a co-operative society

Advantages of a co-operative society Disadvantages of a co-operative

society
They can use economies of scale. They do not lead to strong business
ventures.
Equity is generated (co-operative There is a lack of resources and support.
societies play an important role in land
reform schemes).
There are increased incentives for There is potential for conflict between
workers. parties.
The public good is encouraged at a They usually lack managerial skills.
higher level because the co-operative
creates employment opportunities with a
ripple effect of positive spin-offs for small
towns.
The is limited liability. There is incongruence of interests.
There is continuity.
There are no restrictions on the number
of members.
Less strict legal requirements apply.

Activity 3.3

This activity will take approximately 15 minutes to complete.

 Complete the table below regarding the main differences between the forms of ownership. Some of the information required has
not been discussed in this lesson, therefore, you need to do a bit of desktop research to be able to complete this activity.

Number of owners, Legal Liability of Capital Name of the Continuity of

members or personality owners, members acquisition organisation the
shareholders or shareholders potential rules organisation
Sole
proprietorship
Partnership
Close corporation
Profit company
Private company
Non-profit
company
Business trust
Co-operative

Feedback

The forms of ownership can be differentiated as follows:

Number of Legal Liability of Capital Name of the Continuity of

owners, personality owners, acquisition organisation the
members, rules organisation
 shareholders or members or
directors shareholders
Sole One owner Is not a separate Unlimited liability Depends on No particular Lack of
proprietorship juristic person the owner’s arrangement continuity
financial
strength and
credibility

Partnership At least two Is not a separate Unlimited liability Each partner No particular Depends on
partners juristic person makes a arrangement the continued
contribution involvement of
partners

Close One to ten Is a juristic Limited liability; a Member The name Not affected by
corporation members person close corporation contribution ends with the the entry or
has its own rights, expressed in abbreviation withdrawal of
assets and percentage “CC”. members
liabilities

Public company At least three Is a juristic Limited liability May raise The name Exists
directors person capital by ends with the independently
issuing shares abbreviation from its
to the public “Ltd”. members or
shareholders
and has the
 potential for
long-lasting
existence.
Private company At least one Is a juristic Creditors may Capital raised The name Exists
director person hold directors by directors ends with the independently
jointly liable. as the abbreviation from its
company “(Pty) Ltd”. members and
cannot list has the
shares on the potential for
stock perpetual
exchange. existence.
Non-profit At least three Is a juristic Limited liability Donations No particular Can be
company directors person arrangement dissolved when
it has fulfilled
its mandate.

Business trust The owner Is a juristic Limited liability Founder No particular It does not
appoints a trustee person places assets arrangement terminate
to administer the under the unless by
trust for the control of a agreement.
benefit of trustee.
beneficiaries. No
limit on
beneficiaries.
Co-operative A minimum of five Is a juristic Limited liability Funded by The name Membership
natural persons person members and includes the withdrawal
open to all main activities does not affect
persons able of the co- the continued
 to use their operative, as existence of
services well as the the co-
words “co- operative.
operative” or
“co-op”
followed by
“limited” or
“Ltd”.
Once you have decided on the appropriate form of legal ownership that your business would take, you need to develop a business
plan. This brings us to the next section – developing a business plan.