Chapter-Six

Organizing and Financing the New Venture

Chapter objectives
At the end of this chapter, students are expected;
 To differentiate the different legal form of business, their advantages and
disadvantages
 To know different types of financial sources

Entrepreneurial Team and Business formation

The success of an enterprise is more often determined by the individuals who lead it
forward than by its products or services. The entrepreneurial team transforms creative
ideas into commercial realities through their handwork and determination.
Entrepreneurs must provide inspiration and direction, and they must be able to create
organization to sustain growth.

For the independent small business, the owner must wear several hats at once leading,
managing, and administering the new enterprise. For the corporate venture, a company
must assemble a team of like-minded people capable of breathing life into an
innovation.
As just important, a business venture must be legally structured in such a way to reflect
a logical organization consistent with the firm’s purpose.

Which Legal Form Is Best for Your Business?

When you start a business, you must decide on a legal structure for it. Usually you'll
choose a sole proprietorship, a partnership, or a corporation. There's no right or wrong
choice that fits everyone. The job is to understand how each legal structure works and
then pick the one that best meets your needs.

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For many small businesses, the best initial choice is either a sole proprietorship or, if
more than one owner is involved, a partnership. Either of these structures makes good
sense in a business where personal liability isn't a big worry -- for example, a small
service business in which you are unlikely to be sued and for which you won't be
borrowing much money. Sole proprietorships and partnerships are relatively simple and
inexpensive to establish and maintain.

Forming and operating a corporation is more complicated and costly, but it's worth it for
some.

Legal form of a business

Sole Proprietorship

The vast majority of small business starts out as sole proprietorships. These firms are
owned by one person, usually the individual who has day-to-day responsibility for
running the business. Sole proprietors own all the assets of the business and the profits
generated by it. They also assume complete responsibility for any of its liabilities or
debts. In the eyes of the law and the public, you are one in the same with the business.

Advantage Disadvantage
 Easiest and least expensive form  Sole proprietors have unlimited
of ownership to organize liability and are legally responsible
 Sole proprietors are in complete for all debts against the business.
control, and within the Their business and personal assets
parameters of the law, may make are at risk.
decisions as they see fit.  May be at a disadvantage in
 Sole proprietors receive all income raising funds and are often limited
generated by the business to keep to using funds from personal
or reinvest. savings or consumer loans.
 Profits from the business flow-  May have a hard time attracting
through directly to the owner's high-caliber employees, or those

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 personal tax return. that are motivated by the
 The business is easy to dissolve, if opportunity to own a part of the
desired. business.
 Freedom to direct or make  Some employee benefits such as
decision(Autonomy & self owner's medical insurance
direction) premiums are not directly
deductible from business income
(only partially deductible as an
adjustment to income).
 Ends with owner’s death

Partnerships

In a Partnership, two or more people share ownership of a single business. Like

proprietorships, the law does not distinguish between the business and its owners. The
Partners should have a legal agreement that sets forth how decisions will be made,
profits will be shared, disputes will be resolved, how future partners will be admitted to
the partnership, how partners can be bought out, or what steps will be taken to dissolve
the partnership when needed;. Yes, it’s hard to think about a "break-up" when the
business is just getting started, but many partnerships split up at crisis times and unless
there is a defined process, there will be even greater problems. They also must decide up
front how much time and capital each will contribute, etc.

Advantage Disadvantage
 Partnerships are relatively easy to  Partners are jointly and
establish; however time should be individually liable for the actions
invested in developing the of the other partners(unlimited

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 partnership agreement. legal and financial liability)
 With more than one owner, the  Profits must be shared with
ability to raise funds may be others.
increased.  Since decisions are shared,
 The profits from the business flow disagreements can occur.
directly through to the partners'  Some employee benefits are not
personal tax returns. deductible from business income
 Prospective employees may be on tax returns.
attracted to the business if given  The partnership may have a
the incentive to become a partner. limited life; it may end upon the
 The business usually will benefit withdrawal or death of a partner.
from partners who have
complementary skills.

Corporations
A corporation, chartered by the state in which it is headquartered, is considered by law
to be a unique entity, separate and apart from those who own it. A corporation can be
taxed; it can be sued; it can enter into contractual agreements. The owners of a
corporation are its shareholders. The shareholders elect a board of directors to oversee
the major policies and decisions. The corporation has a life of its own and does not
dissolve when ownership changes.

Advantage Disadvantage
 Shareholders have limited liability  The process of incorporation
for the corporation's debts or requires more time and money
judgments against the than other forms of organization.
corporations.  Corporations are monitored by
 Generally, shareholders can only federal, state and some local
be held accountable for their agencies, and as a result may have

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 investment in stock of the more paperwork to comply with
company. (Note however, that regulations.
officers can be held personally
 Incorporating may result in higher
liable for their actions, such as the
overall taxes. Dividends paid to
failure to withhold and pay
shareholders(double taxation)
employment taxes.)
 Corporations can raise additional
funds through the sale of stock.
 A corporation may deduct the cost
of benefits it provides to officers
and employees.
 Can elects corporation status if
certain requirements are met. This
election enables company to be
taxed similar to a partnership

Financial resources for New Venture

Financial resources are essential for business, but particular requirements change as an
enterprise grows. Obtaining those resources in the amount needed and at the time
when they are needed can be difficult for entrepreneurial ventures because they are
generally considered more than merely obtaining money; it is very much a process of
managing assets wisely to use capital efficiently. The critical issue is to assure sufficient
cash flow for operations, as well as to plan financing that coincides with changes in the
enterprise. Businesses generally obtain money through two general sources, equity or
debt, and both can be obtained from literally hundreds of different sources.

Asset Management

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Managing asset effectively is crucial because underwriting assets creates liabilities that,
if uncontrolled, can devastate the business. Cash is the most important assets to
manage, and to generate cash, business must generate sales. In order to generate sales,
most businesses must have inventory and facilities, service enterprise need offices and
staff, and manufacturers face extensive requirements, including plant and equipment.

Asset management for the start-up entrepreneur is a matter of determining what is

needed to support sales, and then gaining access to those assets at the optimum cost.
The term” gaining access” is used because there are alternatives other than a cash
purchase of assets. Equipment can be leased, for example, and office furniture can be
rented; even pictures and plants can be obtained through office rental centers.
Manufactured products initially can be subcontracted rather than made, thereby
avoiding the expense of procuring materials, equipment, and plant facilities.
Entrepreneurs therefore, have choices about what assets to obtain, when they must
obtained, and how to gain access to them.

Inventory Decision

Most retailers and wholesalers must have inventory in their possession before they can
generate sales, and for start-up enterprises, suppliers normally require cash on delivery
(COD) until entrepreneurs establish themselves as reliable customers. Once a business
has been established, inventory can become collateral for operating loans.

Account Receivable Decision

An account receivable is a consumer’s promise to pay later, and it is an asset owned by

the entrepreneur that can be sold or used as collateral. The value of receivable,
however, is not greater than its probability of being paid. New ventures without track
records for collecting their receivables subsequently find it difficult to sell or borrow
against these assets; therefore, careful asset management practices are important.

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In most instances, managing receivables affect cash flow. Receivables and inventories
also affect one another. Poor purchasing will affect sales and reduce the value of
receivables in two ways: sales can suffer because of weak merchandise, or the
entrepreneur may resort to lax credit terms to induce sales, thereby generating doubtful
accounts.

Managing receivables involves marketing decisions, and although these decisions seem
to have little to do with financing, they influence financing requirements. A decision to
emphasize cash sales, for example, reduces account receivable and provides immediate
cash flow for purchasing. This policy may reduce finance required for merchandise, but
it will restrict sales and subsequently reduces the net worth of the business. Excessive
credit selling also defeats financing of receivables and puts greater cash flow pressure
on the entrepreneur to replace inventory.

Equipment decision

Equipment is important to business because it can help earn profit, not because it has
residual asset value. A computer system, for example, is a depreciating asset, and its
residual value declines every day whether it is being used or not. Vehicles, office
machines, furniture, production machineries, handling equipments and tools
depreciating systematically. They also become obsolete, often quite rapidly. Therefore,
an equipment standing idle is simply an unjustified expense, not an investment.

Entrepreneurs, therefore, must make sound decisions about how to equip and furnish
their enterprise, but they must also understand the cost associated with purchasing
asset. The cost of buying equipment includes the purchase price as well as delivery,
installation, and financing costs. It also includes operating costs such as maintenance
and repairs, and the cost associated with depreciating values. As an alternative, some
equipment can be leased. However, a leasable asset must have certain characteristics. It
must be tangible, have numerous other possible users, be easily transferred between
users, have independent value apart from the business, and require little effort to

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repossess. Vehicles, data processing equipment, common production machinery,
construction equipment, office machines and furniture meet these requirements and
can be leased. Proprietary equipment, special purpose machines, unique furniture and
modified vehicles are rarely leased.

By leasing an entrepreneur can gain access to equipment thereby satisfying the primary
requirement of good asset management. Whether leasing is a cost-effective option
depends on the equipment, its utilization, and lease terms. If costs of buying and leasing
are comparable, and if equipment is in danger of becoming obsolete, then leasing
maybe the better choice.

Facilities Decision

Gaining access to physical facilities involves decisions about real estate and property
management. Options available to entrepreneurs are numerous, but most decisions
depend on location requirements.

Equity financing

Equity is capital invested in a business by its owners.

Sources of Equity

Personal Sources-entrepreneurs must look first to individual resources for start-up

capital. These include cash and personal assets that can be converted to cash. Foe
example, a personal car may provide cash through refinancing, life insurance policies
may also have accumulated equity. Family members and close friends also may become
involved as informal investors, but having them invest can lead to controversy if their
participation is not clear to every one.

Informal risk capital- beyond family and friends, there are many wealthy individuals who
enjoy investing in new ventures. Wealthy investors invest in risky ventures to broaden

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their portfolio. This equity pool is called informal risk capital because investors find
entrepreneurs through personal contacts, and they often invest on hunches or
recommendations; they seldom engage in complex investment analyses

Venture Capital: is an alternative form of equity financing for small businesses, and a
venture capitalist is similar to a mutual fund manager who finds equity investments for a
pool of investors. Unlike mutual fund managers and most other security specialists,
venture capitalists focus on high risk entrepreneurial businesses. They provide start-up
(seed money) capital to new venture, development funds to businesses in their early
growth stages, and expansion funds to rapidly growing ventures that have the potential
to go public or that need capital for acquisition. There are some important criteria to fun
the ventures. The single most important criterion is the capability of the entrepreneur
to sustain an intense effort to make the business work. The second most important
criterion is the entrepreneur’s demonstrated knowledge of his/her markets. On top of
these two criteria, venture capitalist evaluate how well entrepreneur manage risks, the
entrepreneur’s leadership characteristics, and how effectively the entrepreneur
articulates his/her proposal.

Debt

Debt is money borrowed, that must be repaid within a period of time and generates
income for the moneylender (in the form of interest) over that time period)

Dept Financing: The process of borrowing money from the money lender at a
predetermined period interest, which has to be paid within the predetermined time, is
called debt financing.

Debt Sources

Commercial bank- most commercial loans are made to small businesses. Commercial
banks provide unsecured and secured loans. An unsecured loan is a personal or
signature loan that requires no collateral; the entrepreneur is granted to loan on the

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strength of his/her reputation. Unsecured loans are usually small loans for several
thousands dollars, but they can be quite useful for meeting emergency cash flow
requirements such as paying wages or bills. Unsecured signature loans usually must be
paid back within a year, and they will have high interest charges. Most new ventures in
the start-up phase lack performance records or assets to secure substantial loans and
lenders will require general liens against all tangible assets before writing a loan. In
addition, they tend to write short-term loans with payment periods of less than one
year. The length of time depends, of course, on why the money is being borrowed and
the collateral being offered. Long term loans are those that can be repaid in more than
one year, but the upper limit varies according to the type of asset being collateralized.

Finance Companies-there are three types of finance companies. These are sales finance
companies, consumer finance companies and commercial finance companies.

Sales finance companies: focus on loans for specific purchases like automobiles and farm
machineries.

Consumer finance companies: focus on short term loans secured by personal assets, and
most consumer loans are for small amounts at high rates of interest. These loans are
typically negotiated directly between finance companies and consumers for purchases
such as furniture, vacation trip, and home repairs.

Commercial finance companies: are focused on predominantly on small business and

agricultural lending.

Governmental programs- direct loans, grants, subside and loan guarantees to small
business.

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