CHAPTER 3

BUSINESS FORMATION

Ch 3 -1
3.1 INTRODUCTION

 A business formation deals with the formalization

and actual implementation of business ideas in to
practice.
 In today’s economic development/transformation,
small businesses are creating new jobs even as
large businesses continue eliminating jobs and they
are more flexible than large ones in the products
and services they offer.
 3.2 The Concept of Small Business Development
 Specifying size and standard to define small business is
necessarily arbitrary, because people adopt different
standards for different purposes.
 Based on socio- economic conditions, countries define
small business differently.
 But all may use size and economic criteria as a base to
define small business.
 Size criteria include number of employees and the
startup capital.
 Size does not always reflect the true nature of an
enterprise; in addition, qualitative characteristics are
used to differentiate small business from other business.
 The economic/control definition covers market share,
independence and personalized management. Ch 3 -3
 Micro and small enterprises (MSEs) cover a wider
spectrum of industries and play an important role in
both developed and developing economies.
 Ethiopia is no exception and MSEs occupy a
prominent position in the development of the
Ethiopian economy.
 While the small entrepreneurs can set up a unit even
with less capital, enjoy quick returns and have the
flexibility to handle the vagaries(change) of the
market, they have to face many problems like lack of
finance, poor operations management, lack of
experience, poor financial management, etc,.

Ch 3 -4
 3.3 Forms of Business (A Short Explanation)
 There are three basic legal forms of business formation.
 The three basic legal forms are:-
 Proprietorship:

 form of business with single owner who has unlimited

liability, controls all decisions, and receives all profits
 Partnership:

 two or more individuals having unlimited liability who

have pooled resources to own a business, and
 Corporation:

 separate legal entity that is run by stockholders having

limited liability.
 These three basic legal forms are compared with regard to ownership,
liability, start-up costs, continuity, transferability of interest, capital
requirements, management control, distribution of profits, and
attractiveness for raising capital. Ch 3 -5
 3.4 Definition and Role/Importance of MSEs in
Developing Countries
 Definition of MSEs
 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 entrepreneurial venture often is a growth-oriented
innovative company with product or service offerings
that are new to the market.
 Small businesses could be entrepreneurial ventures.
 Most entrepreneurial ventures start as a small business.
Ch 3 -6
 There are two approaches to define small business.
 They are:
 Size Criteria, and

 Economic/control criteria.

 Size Criteria
 Even the criteria used to measure the size of businesses

vary; size refers to the scale of operation.

 Some criteria are applicable to all industrial areas, while

others are relevant only to certain types of business.

 For instance, some of the criteria used to measure size are:

 number of employees

 volume, and value of sales turnover

 asset size, and volume of deposits

 total capital investment
 volume/value of production, and a combination of the
stated factors. Ch 3 -7
 Even though the number of employees-is the most widely used
yardstick, the best criterion in any given case depends upon
the user’s purpose.
 The following general criteria for defining a small business are
suggested by Small Business Administration (SBA).
 Financing of the business is supplied by one individual or a
small group. Only in a rare case would the business have
more than 15 or 20 owners.
 Except for its marketing function, the firm’s operations are
geographically localized.
 Compared to the biggest firms in the industry, the business is
small.
 The number of employees in the business is usually fewer than
100.
 This size criteria based definition of MSEs varies from country to
country.
 All over the world, number of employees or capital investment
or both has been used as the basis for defining MSEs. Ch 3 -8
 Economic/Control Criteria
 Size does not always reflect the true nature of an
enterprise.
 In addition, qualitative characteristics may be used to
differentiate small business from other business.
 The economic/control definition covers:
 Market Share,

 Independence

 Personalized Management.

 Technology: more labor intensive that capital intensive

 Geographical Area of Operation is more localized.

 Role/Importance of MSEs in Developing Countries

 Micro and Small Enterprises (MSEs) cover a wider

spectrum of industries and play an important role in
both developed and developing economies.
 Some of the contributions are;
 Large Employment Opportunities

 Economical Use of Capital

 Balanced Regional Development/ Removing

Regional Imbalance/
 Equitable Distribution of Wealth and Decentralization

of Economic Power
 Resolve Unregulated Growth of Large-scale industries results in
concentration of economic· power in the hands of a few;
 Dispersal over Wide Areas
Ch 3 -10
 Higher Standard of Living
 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
 Shorter Gestation Period
 Facilitate Development of Large Scale Enterprises
 Individual Tastes, Fashions, and Personalized Services
 More Employment Creation Capacity

Ch 3 -11
 3.5 Classification of Micro and Small Enterprises
 In Case of Manufacturing Enterprise (Manufacturing,
Construction and Mining):
1. A Micro Enterprise is one in which the investment in
plant and machinery (total asset) does not exceed
birr100, 000 (one hundred thousand); and operates
with 5 people including the owner.
2. Small Enterprises is one in which the 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 6-30
persons.
Classification of Micro and Small Enterprises
 In Case of Service Enterprise (Retailing, Transport,
Hotel and Tourism, ICT and Maintenance):

1. A micro enterprise is one with the values of total

asset is not exceeding Birr 50,000(fifty
thousands); and operates with 5 persons
including the owner of the enterprise.
2. Small Enterprises is one in which the total asset
value or a paid up capital of birr100, 000 (one
hundred thousand) and not more than Birr 1.5
million; and operates with 6-30 persons.

Ch 3 -14
 Priority Sectors and Sub-Sectors for MSEs Engagement
In Ethiopia
 Manufacturing Sector
 This is the one which 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.
 Construction Sectors
 This is the one which comprises sub-contracting; building

materials; traditional mining works; cobble stone;

infrastructure sub-contract; and prestigious goods
 Trade Sectors
 This is the one which comprises whole sale of domestic
products; retail sale of domestic products and raw
materials supply.
 Service Sectors-
 This is the one which 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.
 Agriculture Sector (Urban Agriculture)
 This is the one which comprises modern livestock

raring; bee production; poultry; modern forest

development; vegetables and fruits; modern
irrigation; and animal food processing.
 Levels of MSEs in Ethiopia
 Start-up:- It is a level where an enterprise begins
production and service under legal framework or legal
entity.
 Growth Level:- An enterprise is said to be at growth level
when an enterprise become competent in price, quality
and supply and profitable using the support provided.
 Maturity Level:- Maturity level means when 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.
 3.6 Setting up Small Scale Business
 Steps for Setting up the Entrepreneurial Venture
 The entrepreneurial process of launching a new
venture can be divided into three key stages of:
 Discovery;

 Evaluation; and

 Implementation.

 These can be further sub-divided into seven steps as

shown below:

Ch 3 -18
 Discovery:
 The first stage of discovery is to identify opportunities
that may form the basis of an entrepreneurial
venture.
 It requires creative thinking to identify issues that

can benefit from an entrepreneurial vision.

 This stage can be divided into two steps:

 Step 1 Discovering your entrepreneurial potential -

the first step is to know more about your personal
resources and attributes through some self-
evaluation– what will you bring to the venture?
What are your strengths and challenges? These
will affect the type of venture you choose.
 Step 2 Identifying a problem and potential
solution – a new venture has to solve a problem
and meet a genuine need.
 Evaluation:
 By the end of first stage of discovery, you should
have selected an idea worthy of further detailed
investigation. The next stage evaluates if this all adds
up to a feasible business in two further steps:
 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?
 Exploitation:
 The last stage is to make the final preparations and
launch it into the market. It can be developed in
three further steps:
 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.
 3.7 Small Business Failure and Success Factors

 Small Business Failure Factors

 Even though business owners launch their ventures with
the best of intentions and work long, hard hours, some
businesses inevitably fail.
 Causes of Business Failure
 Inadequate Management: Business management is

the efficient and effective use of resources. For small

business owners, management skills are especially
desirable—and often especially difficult to obtain.
 Inadequate Financing: Business failure due to
inadequate financing can be caused by improper
managerial control as well as shortage of capital.
 Other common causes of business failure include
Neglect, Fraud, and Disaster.
 Small Business Success Factors
 success factors are categorized as:-
 Conducive Environment: Political, economic,
technological and socio-cultural factors in the
environment impinge upon the life of the small
enterprises and generate much of the needs required
for their existence.
 Adequate Credit Assistance: Small enterprise
development cannot be ensured without
arrangement for financing.
 Markets and Marketing Support: Market for a small
enterprise in a developing country can be quite a
problem. The small business entrepreneur will be in
competition not only with locally mass-produced
goods but even imports.
THANK YOU!