Chapter 3

Business Formation
 Introduction

 Business formation deals with the formalization and actual implementation

of business ideas in to practice.
 sometimes referred to as company registration.
 When this happens, the business becomes a distinct legal entity; an individual
‘person’ in the eyes of the law.
 Business formation is a necessary early step when starting a business
 The way in which your business is formed will determine:
 the personal liability of the founders
 how taxes are paid, and
 other important details.
 Description of Legal Forms of Business

 The legal forms are classified based on

 Ownership
 Liability
 Start-up costs
 Continuity
 Transferability of interest
 Capital requirements
 Management control
 Distribution of profits or losses
 Attractiveness for raising capital.
 Forms of Business organizations

 There are three basic legal forms of businesses:

 Sole Proprietorship
 Partnership,
 Limited Liability Company (LLC), and
 Corporation
 Sole Proprietorship

 It is also known as sole tradership, individual entrepreneurship or proprietorship. 

 an unincorporated business that one person owns and manages.
 the business and the owner are not legally separate
 the simplest form of business structure and are easy and cheap to start due to few
government rules.
 Proprietors enjoy full control and profits from the business but incur unlimited legal
liability personally.
 Sole proprietors report their income and expenses on their personal tax returns and pay
income and self-employment taxes on their profits.
 do not have any government protection. This means that all liabilities extend from the
business to the owner.
 can be a good choice for low-risk businesses and owners who want to test their business
idea before forming a more formal business.
 Partnership

 the simplest structure for two or more people to own a business together
 Partnerships can be a good choice for:
 businesses with multiple owners
 professional groups (like attorneys), and
 groups who want to test their business idea before forming a more formal
business.
 Partnership Cont’d

Three options:
1. General
 the default structure for partnerships
 a business entity in which two or more partners agree to share in a company’s
profits, losses, and assets.
 all partners are assumed to have certain management responsibilities for running
the organization.
 partners take on personal responsibility for the business. That means equal
liability for debts or legal action.
 Partners can adjust the split of both profits and liabilities in their partnership
agreement, but an equal split is the default.
 pass-through entities, meaning partners pay income taxes on profits at the
personal level. 
 Partnership Cont’d

2. Limited Partnership
 one partner is designated a general partner with unlimited liability.
 other partners are limited partners, which means their liability is the same as
their investment. 
 These limited partners are typically silent partners—they invest in the business
but don’t involve themselves in day-to-day operations.
 Limited partnerships are pass-through tax entities, so taxes are paid at the
individual level.
 Partnership Cont’d

3. Joint Ventures
 formed by two or more people who are working on a single project.
 As a result, they’re typically more limited in scope and length of time than a
partnership, which may continue indefinitely.
 the necessary elements of a joint venture include:
 an express or implied agreement
 a common purpose that the group intends to carry out
 shared profits and losses; and
 each member’s equal voice in controlling the project.
 joint ventures are treated differently when it comes to taxes.
 Partnerships are pass-through tax entities
 while joint ventures can be taxed as a corporation or a partnership.
 Limited Liability Company (LLC)

 the hybrid of a sole proprietorship and a corporation

 Like a corporation, the owners of LLC have limited liability
 It is also shares the pass-through taxation of a sole proprietorship or partnership
(meaning, if you own an LLC, you are only taxed once for your business).
 There’s no limit to the number of members your LLC can have, but LLCs can’t
issue stock.
 LLCs can be a good choice for:
 medium- or higher-risk businesses
 owners with significant personal assets they want protected, and
 owners who want to pay a lower tax rate than they would with a corporation.
 Corporation

 A corporation, sometimes called a C corp, a legal entity that's separate

from its owners.
 can make a profit, be taxed, and can be held legally liable.
 offer the strongest protection to its owners from personal liability
 the most complex and expensive of your business formation options
 corporations pay income tax on their profits
 corporate profits are taxed twice — first, when the company makes a
profit, and again when dividends are paid to shareholders on their personal
tax returns.
 have a completely independent life separate from its shareholders.
 Corporation

 Corporations have an advantage when it comes to raising capital because

they can raise funds through the sale of stock, which can also be a benefit
in attracting employees.
 Corporations can be a good choice for medium- or higher-risk businesses,
those that need to raise money, and businesses that plan to "go public" or
eventually be sold.
 S corp - is a special type of corporation that's designed to avoid the double
taxation drawback of regular C corps.
 allow profits, and some losses, to be passed through directly to owners' personal
income without ever being subject to corporate tax rates.
 Corporation Cont’d

 Both types of corporations have a lot in common:

 To create one, you file articles of incorporation with government.
 required to have elected directors (typically chosen from among a corporation’s
owners, or shareholders),
 profits (or dividends) are distributed to shareholders according to the number of
shares they each own.
 corporation owners have limited personal liability protection because the
corporation is considered a separate entity from the owners.
 Small Business Development

 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: Include number of employees and startup capital and doesn’t always reflect
the true nature of an enterprise as qualitative characteristics also used to
differentiate small business from other business.
 The economic/control covers market share, independence and personalized
management.
 SMEs in Developing Countries

 Definition of MSEs – different criteria

1. Size Criteria approach – scale of operation
 The most widely used yardsticks are;
 The 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
 Size Criteria Cont’d

 The general criteria are suggested by Small Business Administration (SBA).

 Owned and financed by one individual or a small group/ 15 or 20 owners
in a rare case/.
 The firm’s operations are geographically localized.
 The business is small Compared to the biggest firms in the industry
 The number of employees in the business is usually fewer than 100.
 2. Economic/control criteria approach

 Covers four characteristics :

a) Small market share: it is not large enough and unable to influence the
prices of national quantities of goods sold to any significant extent.
b) Independence: the owner control the business himself/herself.
a) Personalized Management: little delegation/ the owner actively participates
in all aspects of the management of the business
b) Limited geographical area of operation: The operation of a small firm is
often local.
 Role/Importance of MSEs in Developing Countries

 Large Employment Opportunities

 Balanced Regional Development/ Removing Regional Imbalance
 Equitable Distribution of Wealth and Decentralization of Economic Power
 Unregulated Growth of Large-scale industries
 Dispersal over Wide Areas
 Higher Standard of Living
 Mobilization of Locals Resources/Symbols of National Identity
 Innovative and Productive /Simple Technology
 Less Dependence on Foreign Capital/ Export Promotion
 Roles Cont’d

 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
 Setting up Small Scale Business

 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:
 Small Business Failure and Success Factors

 Small Business Failure Factors

1) Actions such as bankruptcy, foreclosure, or voluntary withdrawal from the
business with a financial loss to a creditor or
2) A Court action such as receivership (taken over involuntarily) or reorganization
(receiving protection from creditors).
 Causes of Business Failure

 The most common causes are inadequate management and financing.

1. Inadequate Management:
 89 % of failure of the businesses is internal factors (controllable factors)
 Adequate capital
 Cash flow
 Facilities/equipment
 Inventory control
 Human resources
 Leadership
 Organizational structure
 Accounting systems
 Causes of Failure Cont’d

2. Inadequate Financing:
 Includes improper managerial control as well as shortage of capital.
 Lack of adequate funds to begin with, makes unable to afford the facilities or
personnel needed to start up the business correctly.
 Although adequate capital available, failure to manage resources wisely,
inability to maintain adequate inventory or keep the balance needed to run the
business.
 In General, there are various causes of failure:
 Much credit
 Fail to plan for the future
 Overinvest in fixed assets
 Hire the wrong people.
 Business Termination VS Failure

 A termination occurs when a business no longer exists for reasons of

getting opportunity to sell for a profit, to move on to a new business, to
retire, or lost interest in the business.
 If market for product have changed or become saturated, owner decided it
would be more appealing to work for someone else.
 A business failure occurs when a business closes with a financial loss to a
creditor.
 Mistakes Leading to Business Failure

 The most common mistakes are;

 Neglect to plan for the future
 Lack of commitment and hard work
 No delegation/not hiring additional employees
 Inaccurate estimates of cash flow and capital requirements.
 Small Business Success Factors

 Identifying failure factors can discover ways to tilt the scales towards
success.
 These success factors are categorized as:-
i. Conducive Environment;
ii. Adequate Credit Assistance;
iii. Markets and Marketing Support.

 Conducive Environment
 Political, economic, technological and socio-cultural factors
 Success Factors Cont’d

ii. Adequate Credit Assistance

 Adequate and timely supply of credit
 Special financing programs such as lower interest rates; less collateral
requirements and lower equity ratio;
 Various assistance schemes such as preparing the project study; etc.

iii.Markets and Marketing Support

 Small enterprises can sell their products as one body through closely-knit
associations or organizations.
 The government assist small groups of entrepreneurs in selling their products.
MSEs in Ethiopia

Level of Enterprise Sector Human Power Total Asset

Industry ≤5 Br ≤100,000
Micro Enterprise
Service ≤5 Br ≤50,000

Small Enterprise Industry 6-30 Br ≤1,500,000

Service 6-30 Br ≤500,000

 Priority Sectors and Sub-Sectors for MSEs Engagement In Ethiopia

 Manufacturing Sector
 Construction Sectors
 Trade Sectors
 Service Sectors
 Agriculture Sector (Urban Agriculture)
 Levels of MSEs in Ethiopia

 Start-up
 Growth Level
 Maturity Level
 Growth- Medium Level
 Main Supporting Packages for MSEs Development
in Ethiopia
 In Ethiopia supporting packages for MSEs includes;
 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% of the projects);
 Facilitate working premises; industry extinction services and;
 Bookkeeping and audit services.
 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.
 Lack of adequate finance and credit has always been a major problem of
the Ethiopian small business.
 Small-scale units do not have easy access to the capital because they
mostly organized on proprietary and partnership basis and are of very
small size.
 Problems in Ethiopia Cont’d

 Small scale enterprises find it difficult to get raw materials of good quality
at reasonable prices in the field of production.
 Outdated techniques of production Because of their poor financial position
they are not able to buy new equipment, consequently their productivity
suffers.