Starting a New Business
Part II: Starting a New Business
Overview
Part II focuses on the critical functions involved in organizing a new business, ensuring aspiring entrepreneurs understand the foundational elements necessary for success.
Chapter 5 delves into the various forms of business ownership, providing a detailed analysis of their respective advantages and disadvantages to aid in making informed decisions.
Chapter 6 explores how entrepreneurship can be leveraged to create or significantly improve a business, outlining the key components of a robust business plan essential for guiding business operations and strategic growth.
Chapter 5: Selecting a Form of Business Ownership
Learning Goals:
Describe the advantages and disadvantages of a sole proprietorship: Understand the trade-offs between autonomy and liability in this simple business structure.
Describe the advantages and disadvantages of a partnership: Explore the benefits of shared resources against the complexities of shared control and liability.
Describe the advantages and disadvantages of a corporation: Learn how corporations offer liability protection and capital-raising opportunities but also introduce complexities in management and taxation.
Explain how the potential return and risk of a business are affected by its form of ownership: Analyze how different ownership structures can either amplify or mitigate financial risks and returns.
Describe methods of owning existing businesses: Investigate options such as purchasing established businesses or entering franchise agreements to leverage existing operational frameworks and brand recognition.
Key Considerations for Entrepreneurs
Entrepreneurs must carefully consider the form of business ownership as it significantly impacts profitability, the level of risk assumed, and the overall value of the business.
Decisions regarding business ownership affect how earnings are distributed among stakeholders, the extent of personal liability, the degree of control exerted, and potential financial returns versus risks faced.
Sole Proprietorship
Definition: A sole proprietorship is defined as a business owned and operated by a single individual, known as the sole proprietor.
Creditors provide loans without gaining ownership; the proprietor is solely responsible for repayments and retains all profits without sharing them with creditors.
Examples: Common sole proprietorships include local restaurants, construction companies, barber shops, laundry services, and clothing stores, often characterized by direct owner involvement in daily operations.
Statistics: Sole proprietorships account for approximately 70% of all firms in the United States, yet they generate less than 10% of the total business revenue, reflecting their prevalence among small-scale operations.
Earnings from a sole proprietorship are treated as personal income and are therefore subject to personal income taxes, simplifying tax reporting but potentially affecting overall tax liability.
Characteristics of Successful Sole Proprietors:
Willingness to accept full responsibility: Successful sole proprietors readily take accountability for all aspects of the firm’s performance, demonstrating a strong sense of ownership.
Flexibility in work hours: They are prepared to work flexible hours and cover for employees, ensuring business continuity and adaptability to unforeseen circumstances.
Continuous monitoring of operations: They diligently monitor business operations to maintain quality standards and identify areas for improvement.
Strong leadership skills: They exhibit robust leadership abilities, are well-organized, and communicate effectively with employees to foster a productive work environment.
Previous market experience: Prior work experience in the relevant market equips them with valuable insights and enhances their ability to navigate challenges.
Advantages of a Sole Proprietorship:
All Earnings Go to the Sole Proprietor:
The owner retains all profits without needing to share them with partners or shareholders, maximizing individual financial gain.
The owner directly benefits from the firm’s success, creating a strong incentive for business growth and efficiency.
Easy Organization:
Establishing a sole proprietorship is straightforward, with minimal legal requirements compared to more complex business structures.
There is no requirement to create a separate legal entity, streamlining administrative processes and reducing initial setup costs.
Registration is typically a simple process conducted via mail, further simplifying the organizational phase.
Occupational licenses may be necessary, depending on the nature of the business, ensuring compliance with local regulations.
Complete Control:
Decision-making is streamlined as there is only one owner, eliminating potential conflicts and enabling quick responses to market changes.
The owner has complete authority over all aspects of the business, including menu decisions, pricing strategies, and employee compensation.
Lower Taxes:
Earnings are taxed as personal income, which may result in lower overall tax rates compared to the corporate tax structure, benefiting the owner financially.
Disadvantages of a Sole Proprietorship:
The Sole Proprietor Incurs All Losses:
The owner is solely responsible for all financial losses, without the ability to share the burden with partners or shareholders.
This includes investment losses and liability for borrowed funds, potentially placing significant financial strain on the individual.
Unlimited Liability:
The owner has unlimited liability, meaning there is no legal distinction between personal and business assets, exposing personal wealth to business debts and lawsuits.
The sole proprietor is personally liable for any judgment against the firm, potentially leading to the loss of personal assets in case of legal action.
Limited Funds:
The ability to raise funds is limited to the owner’s personal resources and borrowing capacity, restricting potential business growth.
Difficulty engaging in businesses that require substantial initial funding or ongoing capital investments, limiting market opportunities.
There are limited funds available to support expansion efforts or to absorb temporary financial setbacks, increasing financial vulnerability.
Limited Skills:
The sole proprietor may lack expertise in all facets of the business, potentially leading to inefficiencies or missed opportunities.
Partnership
Definition: A partnership is defined as a business co-owned by two or more individuals, known as partners, who agree to share in the profits or losses of the business.
Registration with the state and occupational licenses may be required to ensure compliance with regulatory standards.
Partnerships account for approximately 10% of all firms, reflecting their popularity among businesses seeking shared management and investment.
General Partnership: In a general partnership, all partners have unlimited liability, meaning they are each responsible for the business's debts and obligations.
Limited Partnership: A limited partnership includes general partners with unlimited liability and limited partners whose liability is capped at their investment amount.
Limited partners do not participate in the day-to-day management but share in the profits and losses, providing capital without direct involvement.
General Partners: Manage the business operations, receive salaries for their work, share in the profits or losses, and bear unlimited liability for the firm’s obligations.
Earnings are distributed to each partner according to the partnership agreement, representing personal income subject to individual income taxes.
Advantages of a Partnership:
Additional Funding:
Partners contribute additional capital, enhancing the financial capacity to finance business operations and investments.
Losses Are Shared:
Business losses are distributed across all partners, reducing the financial burden on any single individual.
More Specialization:
Partners can specialize in different areas of the business, leveraging individual skills to enhance overall efficiency and service quality.
The diversity in skills enables the business to serve a broader range of customer needs.
Disadvantages of a Partnership:
Control Is Shared:
Decision-making is shared among partners, potentially leading to disagreements and conflicts in management decisions.
Business and personal relationships may suffer due to conflicting opinions, affecting overall business harmony.
Unlimited Liability:
General partners face unlimited liability, similar to sole proprietors, exposing personal assets to business debts.
Profits Are Shared:
Profits must be divided among all partners, reducing the individual share compared to sole proprietorships.
The more partners involved, the smaller the portion of profits each partner receives, potentially diminishing individual financial incentives.
S-Corporations
Definition: An S-corporation is a firm with no more than 100 owners that meets specific IRS criteria, blending features of partnerships and corporations.
Owners benefit from limited liability, similar to corporation shareholders, but are taxed as if they were partners, avoiding double taxation.
Earnings are distributed to owners and taxed at their individual personal income tax rates, simplifying tax obligations.
Some state governments levy a corporate tax on S-corporations, adding a layer of tax consideration.
Many accounting firms and small businesses opt for the S-corporation structure due to its favorable tax implications and liability protection.
Limited Liability Company (LLC)
Definition: An LLC combines the benefits of a general partnership with the added advantage of limited liability for all partners, safeguarding personal assets.
Typically, an LLC protects a partner’s personal assets from liabilities arising from the negligence of other partners, fostering a secure business environment.
The company’s assets remain unprotected, requiring prudent management and insurance coverage to mitigate risks.
An LLC must be legally formed according to the specific regulations of the state where the business operates, ensuring compliance with local laws.
Corporation
Definition: A corporation is a state-chartered legal entity that is distinct from its owners, pays taxes, and can enter contracts, own property, and conduct business as a separate entity.
Corporations represent approximately 20% of all firms but account for nearly 90% of total business revenue, highlighting their significance in the economy.
Formation: Requires the adoption of a corporate charter, which outlines the firm's structure and purpose, and filing it with the appropriate state government.
Corporate Charter: Specifies key details, such as the corporation’s name, the type and quantity of stock issued, and the scope of business operations.
Bylaws: Establish general guidelines for managing the corporation, detailing operational procedures and governance structures.
Limited Liability: Shareholders have limited liability, meaning their personal assets are protected from corporate debts and lawsuits, limiting their risk to the amount of their investment.
Board of Directors: Elected by stockholders to oversee the corporation’s strategic direction and establish broad policies.
Key Officers: Appointed by the board of directors to manage the day-to-day operations of the business, executing the strategic plans and policies set by the board.
How Stockholders Earn a Return:
Dividends: A distribution of the corporation’s recent earnings to stockholders, providing a direct monetary return on investment.
Stock Value Increase: As the corporation becomes more profitable and its prospects improve, the value of its stock tends to increase, allowing stockholders to profit by selling shares at a higher price.
Private versus Public Corporations:
Private Corporations: Ownership is restricted to a select group of investors, limiting the trading of shares and maintaining confidentiality.
Examples: Include L. L. Bean, Enterprise Rent-A-Car, and Rand McNally & Co., which maintain private ownership to control company direction and financial disclosures.
Public Corporations: Shares are available for purchase by the general public, enabling easy trading on stock exchanges and broad investor participation.
Going Public: Involves the initial offering of stock to the public, allowing a corporation to raise capital and providing liquidity for early investors.
Advantages of a Corporation:
Limited Liability:
Owners enjoy limited liability, shielding their personal assets from business debts and legal judgments, unlike sole proprietors and general partners.
Access to Funds:
Corporations can raise capital by issuing new stock, attracting investors and generating funds for expansion and new ventures.
Transfer of Ownership:
Investors can easily buy or sell their stock in publicly traded corporations, facilitating quick transactions and liquidity.
Owners of sole proprietorships or partnerships may face challenges in selling their ownership shares due to limited liquidity.
Disadvantages of a Corporation:
High Organizational Expense:
Forming a corporation involves substantial costs, including creating a corporate charter and complying with state filing requirements.
Financial Disclosure:
Publicly traded corporations must disclose detailed financial information, which may be strategically disadvantageous.
Privately held firms are not obligated to disclose their financial details to the public, maintaining confidentiality.
Agency Problems:
Conflicts may arise between managers and stockholders, as managers may prioritize personal interests over the company’s financial health, leading to inefficiencies.
High Taxes:
Corporations are subject to double taxation, where profits are taxed at the corporate level and dividends are taxed again as personal income.
Double taxation occurs because corporations pay taxes on their profits, and then shareholders pay taxes on the dividends they receive from those profits.
Earnings\, before\, Tax = $10,000,000
Corporate\, Tax = $3,000,000
Earnings\, after\, Tax = $7,000,000
Dividends\, Received = $7,000,000
Taxes\, Paid \, on\, Dividends = $700,000
Income\, after\, Tax = $6,300,000
Assuming a personal tax rate of 20%, the total tax would be 20 \% \times $10,000,000 = $2,000,000.
Exhibit 5.2: Illustration of Double Taxation
Exhibit 5.3: Comparison of Tax Effects on Corporations and Sole Proprietorships
Capital Gain: The profit earned from selling stock, calculated as the difference between the selling price and the purchase price.
How Business Ownership Can Change
The optimal form of business ownership can evolve as the business matures and its needs change, requiring periodic reassessment.
How Ownership Can Affect Return and Risk
Business owners weigh potential returns against potential risks when evaluating investment in a business, aiming for an optimal balance.
The form of ownership significantly influences both the potential return on investment and the level of risk exposure.
Impact of Ownership on the Return on Investment
Return on investment is derived from the firm’s profitability, reflecting its efficiency in generating earnings from invested capital.
After-tax earnings are critical in determining the financial rewards for business owners.
Assess overall profitability by assessing return on equity (ROE): assessing value of the business for investors as a financial indicator
A high amount of equity is only beneficial if the firm can effectively use it to generate profits, which enhances overall financial performance.
Impact of Ownership on Risk
Risk involves the uncertainty regarding a firm’s future earnings, which affects the stability and predictability of returns for the owners.
Exhibit 5.4: Return on Equity for Zemax Company
Larger businesses, such as partnerships and corporations, tend to be less risky due to diversified resources and management structures.
The greater the number of owners, the larger the pool of funds available for business operations, but each owner shares in the performance outcomes.
Poor performance can often be traced to:
Inefficient resource management
Inadequate marketing strategies
Insufficient financing
Since business decisions are interdependent, a misstep in one area can negatively impact other areas of the business.
Obtaining Ownership of an Existing Business
Common methods for acquiring ownership include:
Assuming control of a family-owned business
Purchasing an existing business outright
Entering into a franchise agreement
Franchising
Definition: Franchising is a business arrangement where a franchisor grants a franchisee the right to use its trademark, trade name, or copyright under specified conditions.
Each franchise operates as an independent business typically owned by a sole proprietor, benefiting from the franchisor’s established brand and operational support.
There are over 500,000 franchises in the United States, generating over $800 billion in annual revenue, demonstrating the widespread adoption of this business model.
Types of Franchises:
Distributorship: A dealer gains the right to sell products manufactured by another company, controlling local distribution and sales.
Example: Car dealerships like Chrysler and Ford.
Chain-Style Business: A franchisee uses the trade name of a company and adheres to standardized guidelines for product pricing and sales.
Examples: Fast-food chains like McDonald’s, CD Warehouse, Holiday Inn, Subway, and Pizza Hut.
Manufacturing Arrangement: A company is authorized to manufacture products using formulas or processes provided by another company, expanding production capabilities.
Advantages of a Franchise:
Proven Management Style: Franchisors provide established operational guidance, reducing the guesswork and risk for new business owners.
Name Recognition: Brand recognition through national advertising increases demand for products, benefiting the franchisee’s bottom line.
Financial Support: Some franchisees receive financial assistance from the franchisor, easing capital constraints during startup.
Disadvantages of a Franchise:
Sharing Profits: Franchisees must share profits with the franchisor through annual fees, often up to 8 percent or more of annual revenue, reducing overall profitability.
Less Control: Franchisees must adhere to strict guidelines regarding product production and pricing, limiting autonomy in business operations.
Business-to-Business (B2B) Franchises
B2B franchises serve other businesses by providing specialized services:
They focus on offering hiring, consulting, and training services to improve business operations.
B2B franchises generally require lower initial capital investments compared to consumer-facing franchises.
Many B2B franchises can be managed remotely from a home office using a computer, optimizing flexibility and cost-effectiveness.
Ownership of Foreign Businesses
Entrepreneurs can expand internationally by purchasing franchises from U.S. firms in foreign markets.
Global franchise examples include fast-food chains like McDonald’s, Pizza Hut, and KFC, which have established a significant international presence.
Key Terms
Sole Proprietorship: A business owned by a single individual who receives all profits and is responsible for all debts.
Partner: An individual who co-owns a business in collaboration with others, sharing responsibilities and profits.
Partnership: A business owned and operated by two or more partners who agree to share profits or losses.
Corporation: A legal entity distinct from its owners, authorized to conduct business, own property, and pay taxes as a separate entity.
Capital Gain: The profit earned from the sale of stock when the selling price exceeds the purchase price.
Equity: The total investment in a firm by its stockholders, reflecting their ownership stake and financial commitment.
Franchise: A business agreement where a franchisor grants a franchisee the right to use its business model, brand, and operational systems under specific terms.
Chapter 6: Entrepreneurship and Business Planning
Learning Goals:
Identify the advantages and disadvantages of being an entrepreneur and creating a business. It helps entrepreneurs see both opportunity and risk.
Identify the market conditions that should be assessed before entering a market. It will help to navigate market dynamics.
Explain how a new business can develop a competitive advantage. It's crucial for standing out in the market.
Explain how to develop a business plan. It's an essential tool for organizing your goals.
Identify the risks to which a business is exposed, and explain how they can be managed. This helps in protecting assets and business continuity.
Creating a New Business
Small businesses are essential to the economy, with over 99% of all firms employing fewer than 500 employees, highlighting their importance in job creation.
Many small businesses are established with minimal initial capital, demonstrating that entrepreneurial success doesn't always require significant investment.
Examples of Successful Small Businesses:
Domino’s Pizza: -Started with minimal funding when Tom Monaghan and his brother acquired a bankrupt pizza parlor in 1960.
Tom borrowed $500 to invest in the firm, illustrating the bootstrapping approach to entrepreneurship.
The company now generates approximately $1 billion in annual sales, showcasing the potential for remarkable growth from humble beginnings.
Jeremy’s MicroBatch Ice Cream: -Applied the microbrewery concept to ice cream manufacturing.
Produces ice cream in small batches and markets it in limited editions, appealing to niche consumer tastes.
Glow Dog, Inc.: -Sells light-reflective apparel for pets.
The company averages annual sales exceeding $1 million, demonstrating the financial viability of specialized pet products.
Pros and Cons of Being an Entrepreneur
Advantages of Being an Entrepreneur:
Potential for large profits and a much higher income than if employed by another business. It offers substantial financial rewards for successful ventures.
Being your own boss and running the business the way you want. It gives you autonomy over business operations and strategic decisions.
Not needing to fear being mistreated by a boss or being fired. It offers job security, provided the business remains successful.
Satisfaction of working in a business that you created, with direct rewards for your work. It provides a sense of accomplishment from building something from scratch.
Disadvantages of Being an Entrepreneur:
Possible incurrence of large losses and even losing your entire investment in the business. There's a high degree of financial risk if the business fails.
Though you may be in control of the business, you have to ensure that the business functions properly. You are responsible for all aspects of the business, which can be stressful.
Though, as the owner of a business, you will not be fired, you could still lose your source of income if the business fails. The business’s success is directly tied to the owner’s income, leading to potential instability.
Entrepreneurial Profile
Important characteristics that distinguish entrepreneurs from other people:
Characteristics:
Risk Tolerance: Entrepreneurs must be willing to accept the risk of losing their business investment. They are comfortable with uncertainty and potential losses.
Creativity: Entrepreneurs recognize ways to increase customer satisfaction. They are skilled at developing innovative solutions to market issues and customer needs.
Initiative: Entrepreneurs must be willing to take the initiative to make their ideas happen. Self-starters who proactively pursue opportunities exemplify them.
Assessing Market Conditions
Conditions in the market that must be assessed before creating a new business:
Demand
Competition
Labor conditions
Regulatory conditions
Demand
The demand for most products is partially influenced by general economic conditions. It indicates that the economic climate impacts consumer spending and business viability.
The demand within a particular market changes over time. Market demand is dynamic and requires continuous monitoring and adjustment.
Competition
Each business has a market share, representing its sales volume as a percentage of the total sales in a specific market. The percentage of total sales reflects how successfully the brand performs against the competitors.
If the competition within a particular market is limited, firms can more easily increase their market share and, therefore, increase their revenue. It has a higher chance of business growth.
Competition within Segments
Each market has segments, or subsets, that reflect a specific type of business and the perceived quality. Segmentation helps in identifying focused areas within the broad market.
Segmenting the market in this way allows a firm to identify its main competitors so that they can be assessed. Understanding who you are competing against, including their strengths and vulnerabilities, is critical to the SWOT analysis model.
Labor Conditions
Some markets have specific labor characteristics. Industries with specialized skills often face higher labor costs.
The cost of labor is higher in industries with specialized skills, such as in healthcare. Specialized labor conditions directly impact operating expenses.
Unions may also affect the cost of labor. Union activities and agreements significantly influence labor costs and operational flexibility.
Understanding the labor environment within an industry can help an entrepreneur estimate labor expenses and decide whether a new business could produce products at lower costs than existing firms. It helps in maintaining financial forecasts.
Regulatory Conditions
The federal government may enforce environmental rules or may prevent a firm from operating in particular locations or from engaging in particular types of business. Regulatory frameworks dictate business operations and strategic planning.
Exhibit 6.1: Identifying Market Segments
Exhibit 6.2: Effects of Market Conditions on a Firm’s Performance
Developing a Competitive Advantage
Entrepreneurs can search for ways to increase or at least maintain their market share. This is a vital element to remain relevant.
Must assess a market segment to determine whether they have a competitive advantage; if something makes your brand better than the other brands.
Key Advantages
Produce products more efficiently (lower costs): cost effectiveness.
Produce a higher quality product or service.
Using the Internet to Create a Competitive Advantage
Many firms rely on the Internet to create a competitive advantage. Internet helps with branding.
Establish a website to advertise their products. An online presence helps enhance brand growth.
Advantages of a Web-Based Business
Can replace a store. It helps lower operating expenses.
Can provide personalized service to customers. Using data, you can connect to the consumers better.
Can reduce expenses when providing services in the form of information. Online data presence lowers the costs of brick and mortar expansion.
Can reach additional customers and increase the revenue that the business generates. Helps expand consumer outreach.
Expenses of a Web-Based Business
Developing a website and installing a shopping cart system on the site to accept orders: ($500 - $20,000). It helps to set up business online.
Credit card payment fees.
Screen credit card payments.
Charge a monthly fee for-firm services.
Web marketing fees. Boosts visibility and drives traffic to consumers.
Pay website firm for hosting sites, etc.
Using SWOT Analysis to Develop a Competitive Advantage
Entrepreneurs can use SWOT analysis to assess a company’s strengths, weaknesses, opportunities, and threats.
Use strengths to capitalize on opportunities while reducing exposure to threats.
Exhibit 6.3: How a Firm’s Earnings Are Measured
Developing the Business Plan
Develop a business plan, which is a detailed description of the proposed business
The business plan forces entrepreneurs to think through the details of how they would run the business as a clear checklist.
Components of a Business Plan:
Assessment of the Business Environment: -Includes economic, industry, and global environments.- Assessment involves industry’s economic impact, industry environment, and global environment to determine competition.
Management Plan: -Includes an operations plan that focuses on the firm’s proposed organizational structure, production, and human resources.
Organizational Structure: -Identifies the roles and responsibilities of the employees hired by the firm.
Production: -Decisions must be made about the production process, such as the site (location) of the production facilities and the design and layout of the facilities.
Human Resources: -Businesses must set up a work environment that will motivate its employees A plan must be developed for monitoring and evaluation of employees.
Marketing plan, focused on: - Target market
Product characteristics
Pricing
Distribution
Promotion
Financial Plan: -Determines the means by which the business is financed and demonstrates the feasibility of the potential business.
Feasibility
A business’s feasibility can be measured by calculating its expected earnings (profits).
Online Resources for Developing a Business Plan
Business plan software can make the process much easier, including:
text generation
forecasting graphs.
Funding by the Small Business Administration (SBA)
It backs the loans by guaranteeing a portion of each loan so the lenders are able to get partial repayment of the loan and encourage entrepreneurship
Exhibit 6.4: Contents of a Typical Business Plan
Exhibit 6.5: Common Sequence of Business Decisions Made in Developing a Business Plan
Key Points of Business Plan:
1. Assessing market conditions involves assessing consumer needs and the business environment which enables a decision for the type of product to produce.
2.Decide organizational structure (Management Decision)
3.Decide production process (Management Decision)
4.Decide how to hire and evaluate employees (Management Decision)
5.Decide how to price products (Marketing Decision)
6.Decide how to distribute products (Marketing Decision)
7.Decide how to promote products (Marketing Decision)
8.Decide how to finance the business (Finance Decision)(As time passes, consider investing in new projects)
Exhibit 6.6: Exposure to Firm-Specific Characteristics
Risk Management by Entrepreneurs
As entrepreneurs plan their new business, they often consider what could happen to affect the company. Risk-sources include:
Heavy reliance from 1 customer
Heavy reliance from 1 supplier
Heavy reliance on one employee
Reducing risk:
Purchasing insurance can be an easy way for firms to guarantee they can withstand an emergency (disaster, fraud, and/or loss of business). Insurance helps provide peace of mind.