Tutorial 7 (Week 11) Solutions

Ch08
 Exercises
#: 1, 3, 7, 15
1. What are the main ways of entering a small enterprise and what are their advantages and
disadvantages?

The main ways of entering a small enterprise are by starting a new enterprise, purchasing an existing
enterprise, entering a family enterprise, or by franchising. The advantage of starting a new enterprise is
that it is often cheaper to do this than to buy a business since it is not necessary to buy the "goodwill"
involved in an existing business. However, on the other side starting a new business involves more
uncertainty than buying an existing business. Entering a family business may be an option for some people
and it has the advantages of usually being at low or no cost and of entering a business that is already
established. The problems with a family business can be that it involves working with other family
members that in turn can lead to conflict. Franchising is a popular form of entering a small business and,
as with buying an existing business, the main advantage is that of having a ready-made product or service
for which there is known to be demand. Against this has to be set the restrictions that franchisors impose
on franchisees.

1. Discuss the financial implications of the various legal structures available to small enterprise.

Sole proprietorship – because of the lack of distinction between the owner and the business, the
owner’s personal assets are at risk in the event of the failure of the business. Sources of finance available
to the sole proprietor are usually limited to family members, trade creditors and (short-term borrowings
from) banks.
Partnership – the financial implications associated with partnerships are similar to those of sole
proprietorships, where all partners have unlimited liability should the business fail. Finance is also limited
to family members, creditors and banks. However, due to the fact that there are more people involved
(than in a sole proprietorship) personal resources are likely to be greater in total.
Incorporation – private companies have fewer sources of finance available to them than listed
public companies, since they cannot access the stock market for equity or issue their own debt. Their ability
to raise finance is, therefore, likely to depend on size, assets available as collateral, the quality of
management, the nature of the industry and their track record.
Public companies have greater access to funds than do the other legal structures of small
enterprise because of access to the stock market. However, they face costs of increasing disclosure
requirements and stock market flotation.

6. Why might a potential small enterprise owner-manager consider franchising as an option for entering
small enterprise? Also discuss the 3 main types of franchise options.

A potential small enterprise owner-manager might consider franchising as an option for entering small
entering small enterprise for the following reasons:
(i) It provides a ready-made business with tried operating methods and well-developed training and
support facilities.
(ii) It also provides a trademark and a national image that facilitate national advertising.
(iii) Since most franchisees are chosen after a screening process, failure rates for franchises are often
lower than for other small enterprises.
(iv) An association with a well-known franchise may help in raising finance.

Product franchise: franchisee acts as a dealership &/or outlet. E.g. Petrol industry, car dealership agents.

System franchise: franchisor develops a unique system of doing business under a common trademark or
name. E.g. McDonalds.

Process franchise: licensing arrangement, involves a franchisor providing essential ingredients to a

processor or manufacturer. E.g. Coca Cola.

14. What are the main ways of leaving small enterprise and what are their financial implications?

For owner-managers the best way to leave their small enterprise is likely to be by means of a stock market
flotation. While flotation has costs and problems, one of the main ones, loss of control, may not be so
important to owner-managers who want to leave the business anyway. The big advantage of flotation is
that it enables owners to “harvest” their investment, usually with a big capital gain, and diversify their
portfolio. In the case of a family business it is usual for those leaving to pass their shares on to their heirs.
It may be possible to sell shares but this is problematic if the business is not listed. Other ways of selling an
interest in a small enterprise are by arranging a sale to a competitor (trade sale) or arranging for a
management or employee buyout. The arrangements for leaving a franchised business are likely to be set
out in the contract and may simply involve the expiration of an agreed period of time with no possibility of
on-selling the business since it reverts to the franchisor.

15. Discuss the relative importance of agency theory and financial considerations in determining
ownership structure.

Financial and agency theory considerations are interrelated with agency theory being increasingly invoked
in recent years to explain ownership structures. Agency theory helps to explain differences in ownership
structure in terms of “residual claims” on profit. In a small enterprise residual claims belong to the owner
who is likely to also be the manager. This reduces “pure” agency costs and maximises incentive but at the
cost of inefficiencies in the form of under-investment and lack of diversification. Under-investment is due
to the moral hazard involved in lending to or investing in closely held companies. Shareholders in large
corporations are less likely to be managers but are more able to diversify their portfolios. Larger
corporations are less prone to under-invest because of their access to the stock market that requires that
they take steps to reduce moral hazard such as disclose more information and spread their shares more
widely. Consequently, both forms have advantages and disadvantages and co-exist in the market.