CHAPTER THREE

BUSINESS FORMATION

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 Learning Objectives

Upon the completion of this unit you can:-

 Explain the Concept of Business Development
 Identify the Forms of Business Ownership
 Analyze the Importance/Role of SMEs
 Set Up Small Scale Business
 Distinguish the Failure and Success Factors of SMEs
 Identify the Problems of SSB in Ethiopia and
 Develop Organizational Culture.
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 3.1 The Concept of Small Business Development
• Small businesses are playing an important role in
the industrial economy of the world. These are
particularly important in the developing
economies.
• Small business is predominant even in developed
countries such as USA, Japan etc.
• An organization is said to be “small ’’when
compared to large firms but large when compared
to smaller once
• Basically, there is no accepted standard definition
of small businesses.
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 ….continued
• Because the parameter (criteria) used to classify
the smallness and largeness of Business
organizations differ from country to country.
• Those enterprises are firms that are independently
owned, operated and are too small to be dominant
in its field.
• There are two common approaches to define those
institutions. Namely:-
1. By some measure of size(quantitative)
2. Using control/economic/(qualitative

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 1. Size Criteria
• Even the criteria used to measure the size of
business vary, some criterion are applicable to all
industrial areas,
• While others are relevant only to certain types of
business. Those are:-
 Number of employees
 Sales volume/production
 Asset size/capital investment/
 Insurance in force
 Volume of deposit
 Combination of all those
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 2. Economic /Control/ Criteria
• All the following criteria’s must be satisfied.
1. Market Share
Market share of a SB are not large enough
 Unable to influence the prices of national quantities
to any significant extent
2. Independency
• The owner has control of the business himself/herself.
• Many ways fairly autonomous, refer major decision
(e.g. on capital investment)
• Have a higher level of authority.
  Monday, January 2, 2023 2-6
 … continued
3. Personalized Management
• Is the most characteristic factor of all.
• Implies that the owner actively
participates in all aspects of the
management of the business, and in all
major decision making process.
• But, there is little devolution or delegation
of authority.
• One person is involved when any thing
material is concerned
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 Other General Criteria (by SBA)
Financing of the business is supplied by one
individual or a small group(15 or 20 owners)
Except for its marketing function, the firm’s
operations are geographically localized.
Compared to the biggest firms in the
industry, the business is small.
The number of employees in the business is
usually fewer than 100.

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 Illustrated example

Country Business Criteria

Australia Manufacturing <100 employees
services <20 employees
Germany SME <500 employees
France SME 10 -499 employees
China SME Usually 100 employees: investment
ceiling US $8 million.
Indonesia SME <100 employees
Malaysia SME <175 full time workers &
investment US $1 million
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 3.2 Forms of Business
• There are three basic legal forms of business formation.
1. Sole proprietorship
• Sole proprietorship or individual entrepreneurship
is a business concern owned and operated by one
person.
• The sole proprietor is a person who carries on
business exclusively by and for himself.
• Features of a sole proprietorship
• Single ownership and One man control
• Undivided risk and Undivided profit
• Unlimited liability and No separate entity of the business
• Less government regulation
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… continued
Advantages Disadvantage
• Simplicity Limited funds
• Quick decision Limited skills
• High secrecy Unlimited liability:
• Direct motivation Uncertain life
• Personal touch less synergy
• Flexibility

Monday, January 2, 2023 1-11

 … continued

2. Partnership
• It is an agreement among two or more persons to carry on
jointly to lawful business and to share the profits arising
there from. Persons are partners.
Characteristics:
• Association of two or more persons
• Contractual relationship
• Existence of lawful business
• Sharing of profit and loss
• Mutual agency among partners
• No separate legal entity of the firm
• Unlimited liability Utmost good faith
• Restriction on transfer of interest
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 … continued

3. Corporations
• It is a form of business organization which is
established by stockholders.
Characteristics:
– Has a separate and legal personality distinct from
owners
– Continuity, unaffected by debt or transfer of stock
shares
– Income tax on corporate profit and dividend
– Professional managers as distinct from the
shareholders mostly manage a corporation.
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 3.3 Role of MSEs in Developing Countries
• Large Employment Opportunities:
• Economical Use of Capital:
• Balanced Regional Development/ Removing
Regional Imbalance/:
• Equitable Distribution of Wealth and
Decentralization of Economic Power:
• Unregulated Growth of Large-scale industries
results in concentration of economic
• Dispersal over Wide Areas-
• Higher Standard of Living:
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 ….continued

• Mobilization of Locals Resources/Symbols of

National Identity:
• Innovative and Productive /Simple
Technology:
• Less Dependence on Foreign Capital/ Export
Promotion:
• Promotion of Self Employment:
• Protection of Environment:
• Facilitate Development of Large Scale
Enterprises:
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 3.4 Setting up Small Scale Business
• The process of launching a new venture
can be divided into three key stages as:
Discovery;
Evaluation; and
Implementation.
• These can be further sub-divided into
seven steps as shown below:
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DISCOVERY
• Step 1. Discovering your entrepreneurial potential
 to know more about your personal resources
 attributes through some self-evaluation.
 what will you bring to the venture?
 What are your strengths and challenges?
• Step 2. Identifying a problem and potential
solution
 a new venture has to solve a problem and meet a
genuine need.
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EVALUATION
 Evaluate if the idea in the first stage is worthy
• Step 3. Evaluating the idea as a business opportunity
 find out information about the market need.
 Is the solution to this problem really wanted by enough
customers?
 Investigate the feasibility of the proposed solution
(technically, economically, socially, and legally).
• Step 4. Investigating and gathering the resources
 How will the product/service get to market?
 How will it make money?
 What resources are required?
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Implementation (making it more useful)
• Step 5. Forming the enterprise to create value
 set up a business entity and protect any intellectual
property.
 Get ready to launch the venture in a way that
minimizes risk and maximizes returns
• Step 6. Implementing the entrepreneurial strategy
 activate the marketing, operating, and financial
plans.
• Step 7. Planning the future – look ahead and
visualize where you want to go
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 Illustration example

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 Environmental Analysis
• Entrepreneurship does not exist in a vacuum.
• It is affected by and affects the environment.

• Figure 3.1 Entrepreneurship vs Environment

• Macro Environment Analysis-PESTL
• Sectorial/industrial Analysis-SWOT analysis

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 … continued

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3.5 Small Business Failure and Success Factors
3.5.1 Small Business Failure Factors
• What Is Business Failure?
• 1. bankruptcy, foreclosure, or voluntary withdrawal
from the business with a financial loss to a creditor;
• 2. a court action such as receivership (taken over
involuntarily)or reorganization (receiving protection
from creditors).
Causes of Business Failure
• Poor operations management
– The manager lacks the ability to operate a small
business.
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 ….continued
• Lack of experience
– Many owners start businesses in industries in which
they have no experience
• Poor financial management
– Many owners start with too little money and with
little or no understanding of financial spreadsheet
applications. Illegal loan too!
-- Over-investing in fixed assets
– Owners who over-invest in fixed assets may find
themselves with no access to funds for working capital.
- Poor credit practices
– Owners often sell on credit to meet (or beat) the competition
 and find that they lack the additional working capital
required
Monday, January 2,or
2023the ability to collect receivables. 2-24
 ….continued
• Failure to plan
– The lack of a strategic plan to guide the
business in the long run
– executive fixed asset
– over expansion
• Unplanned and uncontrolled growth
– Growth is natural and healthy, but
unplanned growth can be fatal to a business.
• Economic Factors
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 ….continued
• Neglect-(conflict , family problem, lack of
commitment , poor work habit); occurs whenever
an owner does not pay a due attention to the
enterprise.
• Disaster; refers to some unforeseen happening
• Fraud:- involves intentional misrepresentation or
deception
• Inappropriate location
 Too often, owners seek “cheap” sites and locate
themselves straight into failure.
Monday, January 2, 2023 2-26
 ….continued
• This can be summarized as follows;
o Inadequate management
o Inadequate financing
o Natural disasters
Business Termination versus Failure
• Termination: occurs when a business no
longer exists for any reason.
• Failure: occurs when a business closes with a
financial loss to a creditor.
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 3.5.2 Small Business Success Factors
• Knowledge of customers and markets
• Product and geographical specialization
• Flexibility in management
• Energy, initiative, organization, appearance
• Technical competencies, administrative
ability
• Good judgment, restrain and patience
• Ability to communicate well, leadership
qualities
• Pre-ownership experience
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 ….continued

• These success factors are

summarized as:-
Conducive Environment
Adequate Credit Assistance
Markets and Marketing Support

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 3.6 Classification of Enterprises in Ethiopian
Context
For Manufacturing (Manufacturing, Construction &
Mining):
a) A Micro Enterprise:-investment in plant and machinery
(total asset) does not exceed birr100, 000 (one hundred
thousand); and operates with 5 people including the owner.
b) Small Enterprises:- investment in plant and machinery (a
paid up capital of total asset) of birr100, 000 (one hundred
thousand) and not more than Birr 1.5 million; and operates
with 6-30persons.
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 For Service Enterprise (Retailing, Transport, Hotel & Tourism, ICT and
Maintenance):

a)A micro enterprise:- total asset is not exceeding

Birr 50,000(fifty thousands); and operates with 5
persons including the owner of the enterprise.
b)Small Enterprises:-total asset value or a paid up
capital of birr 100, 000 (one hundred thousand) and
not more than Birr 1.5 million; and operates with 6-
30persons.
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….continued

Tips: When ambiguity is encountered between manpower and total

assets as explained above, total asset is taken as primary
Monday, January 2, 2023 yardstick. 32
 Priority Sectors and Sub-Sectors for MSEs
Engagement In Ethiopia
1.Manufacturing Sector- comprises textile and
garment; leather and leather products; food processing
and beverage; metal works and engineering wood
works including furniture and ornaments service; and
agro-processing.
2.Construction Sectors- comprises sub-contracting;
building materials; traditional mining works; cobble
stone; infrastructure sub-contract; etc
3.Trade Sectors- comprises whole sale of domestic
products; retail sale of domestic products and raw
materials supply.
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 ….continued

4. Service Sectors- comprises small and rural

transport service, café and restaurants, store service,
tourism service, canning/packing service,
management service, municipality service, project
engineering service, product design & development
service, maintenance service, beauty salon and
electronics software development, decoration and
internet café.
5. Agriculture Sector (Urban Agriculture)-
comprises modern livestock raring; bee production;
poultry; modern forest development; vegetables and
fruits; modern irrigation; and animal food processing.
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 Levels of MSEs in Ethiopia
•Start-up:- refers to enterprises that incorporate
people who are interested to establish MSE and those
who completed the required profession/skill from
various institutions and innovated by legally either in
the form of association or private. It is a level where
an enterprise begins production and service under
legal framework or legal entity.
•Growth Level: - An enterprise become competent in
price, quality and supply and profitable using the
support provided. At this level, the enterprise man
power and total asset is larger than at startup level;
and use book keeping system.
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 ….continued
• Maturity Level: - an enterprise able to be
profitable and invest further by fulfilling the
definition given to the sector and using the
support provided.

•Growth- Medium Level:- An enterprise is

said to be transformed from small to medium
level of growth is when it enabled to be
competent in price, quality and supply using the
support given to the level.
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 3.7 Main Supporting Packages for MSEs Development in
Ethiopia
•Awareness creation about the sector
•Provision of legal services, to form legal business
enterprises
•Providing technical and business management
training;
•Financial support based on personal saving, 20/80
(the beneficiaries are save 20% and the MFIs provide
Loan 80%);
•Facilitate working premises;
•Industry extension services and
•BDS provision; bookkeeping and audit services.
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 3.8 Problems of Small Scale Business in Ethiopia
•have not been able to contribute substantially to the
economic development,
•particularly because of financial, production, and
marketing problems.
•because they mostly organized on proprietary and
partnership basis and are of very small size.
•partly because of the fact that their surpluses which
can be utilized to repay loans are relatively small,
limited profit,
•find it difficult to get raw materials of good quality
at reasonable prices in the field of production.
Furthermore, the techniques of production are usually
outdated.
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 Management Of Common
Pitfalls/drawbacks
•by knowing the business in depth;
•By developing a solid business plan;
•By managing financial resources;
•By understanding financial statements;
and
•By learning to manage people effectively.

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 3.9 Organizational Structure and Entrepreneurial Team Formation

3.9.1 Designing the Organization

•The design of the organization will be the entrepreneur’s

formal and explicit indication to the members of the
organization as to what is expected of them. Typically, these
expectations can be grouped into the following five areas:-
• Organization structure-This defines members’ jobs and the
communication and relationship these jobs have with each
other which depicted in an organization chart.
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 ….continued
 Planning, measurement and evaluation schemes-
All organization activities should reflect the goals
and objectives that underlie the venture’s
existence.
 Rewards- Members require rewards in the form of
promotions, bonuses, praise, and so on.
 Selection criteria- determine a set of guidelines for
selecting individuals for each position.
Monday, January 2, 2023 41
 ….continued

 Training- Training on or off the job, must be specified (form

of formal education or learning skills).

 Organization’s design can be very simple (usually

indicative of a start-up) or more complex (when
other employees are hired to perform specific tasks).
 As the organization becomes larger and more
complex, the preceding areas of expectation become
more relevant and necessary.
Monday, January 2, 2023 42
 3.9.2 Entrepreneurial Team & Successful Organization Culture

•Assemble the right mix of people to assume the

responsibilities outlined in the organization structure
and establishing a positive and successful organization
culture.
•There are some important issues the team must be
able to accomplish three functions:-
 Execute the business plan;
 Identify fundamental changes in the business as they
occur; and
 Make adjustments to the plan based on changes in
the environment and market that will maintain
profitability.
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