ENTREPRENEURSHIP AND COMMUNICATION

LEGAL ISSUES FOR ENTREPRENEURSHIP

LEGAL FORMS OF BUSINESS

There are three basic legal forms of business formation and one new form that is gaining
acceptance. The three basic legal forms are:
1. Proprietorship,
2. Partnership, and
3. Corporation, with variations particularly in partnerships and corporations.

SOLE PROPRIETORSHIP

In a sole proprietorship, one person owns the entire business, provides all the capital and
assumes all responsibility.

This is the simplest form of a business organisation. A sole trader or a sole proprietor owns the
business alone. He provides all the necessary capital and other resources alone. He engages in
business on his own account. The business has no existence apart from the owner. It is,
therefore, not incorporated into a legal entity but a trading license is required. The law does not
recognise a sole trader as a separate entity from his business. Many businesses in Kenya are of
this type and include kiosks, general shops and restaurants.

A sole trader is entitled to all the profit and is also responsible for all the losses. This means that
the liabilities of the business are the personal liabilities of the sole proprietor as long as he is the
owner of the business. This also implies that should the business suffer losses to an extent that
the business assets are not enough to pay the debts, the sole trader will be required to pay the
debts from his private sources.

ADVANTAGES AND DISADVANTAGES OF A SOLE PROPRIETORSHIP

Advantages
(i) start--up costs: It is easy to start a one-person business because there are few legal
Low start
intricacies. Compared to other forms of business organizations, sole proprietorships are
easier and simpler to start and to wind up.
(ii) Greatest freedom from government intervention
(iii) Direct control and decision-
decision-making by the owner: The sole trader takes all decisions alone.
This means that decisions are made timely and quickly. Implementation of decisions is
also fast because very few people are involved.
(iv) All profits go to the owner. The sole trader enjoys all the profit from his business and this
may encourage him to work harder. He will also be more careful to avoid any losses
because he knows that he will suffer the losses alone – even from his private sources.
(v) Flexibility
(vi) Networking: Sole traders are in a better position to establish direct contacts both with
their customers and employees. Such contacts are more likely to lead to better
understanding of employee and customer needs and result in provision of better services.
Better services will mean greater success for the business.
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(vii) Secrecy: The sole trader is in a better position to keep his business secrets than any other
form of business ownership.

Disadvantages

(i) Unlimited liability for the owner. The sole trader is personally liable for all the debts of
the business. If the assets of the business are not enough to pay the: liabilities, personal
property can be. attached by the creditors.
(ii) Difficulties in raising capital for startup or future expansion. Sole traders are often unable
to raise sufficient capital funds.. They have to rely on their own ability to raise money to
finance their own businesses. This is not always easy. The business will, therefore, be
restricted by lack of capital.
(iii) Relatively limited experience by the owner. Sole traders suffer from lack of training and/or
specialization.
(iv) Unstable business life. A sole trader may be unable to attract and/ or keep highly qualified
persons who seek opportunities to manage, operate, and share in the profit of the
business. He may also not be able to retain good employees because of inability to provide
them with attractive terms and conditions of service.
(v) Long working hours: They also have to work for long hours and all these may adversely
affect performance including net incomes.
(vi) Lack of continuity: Sole proprietorships suffer from lack of continuity because the life of
the business is usually limited to the life-span 'bf the owner. This means that the business
is likely to close down if the owner becomes bankrupt, dies, is unable to run the business
or is imprisoned. However, some businesses may continue if the next of kin are also
business minded.

PARTNERSHIPS

If two or more individuals decide to share the responsibilities and profits of operating a business,
they have formed a partnership.

Each partner contributes money, property and labour and in turn the partners share in the profit
and losses of the business. A partnership can be forged by agreement between the partners when
they want to use their personal names to constitute the name of the firm. If the partners want to
use a name different from their own, the firm’s name must be registered with the Registrar
General’s office.

A partnership can be permanent or temporary. A Permanent partnership is intended to continue

indefinitely. This means that the date of termination is not known at the time of formation. A
temporary partnership is formed for either a specific purpose or period. Upon the expiry of such a
purpose or period the partnership is automatically dissolved.

There are two categories – general and limited partnerships.

In a general partnership, each partner is personally responsible for all the debts and liabilities of
the firm. This amount could very easily exceed the sum he or she has invested in the business
and could lead to personal bankruptcy. Each partner may be held responsible for the acts of the
other partners if he or she represents the business at the time of action.

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On the positive side, sharing the ownership of the business is one way to obtain sufficient
financing for the enterprise. You may lack technical or management skills that are basic to the
business. Finding a partner with these skills could be the best way to cover this deficiency. The
selection of a partner could be one of the most important decisions you will make; base the
decision on logic, not on emotion. In a good general partnership, each member contributes an
element of expertise that the others do not have and each can see how his or her work is
important to the business.

A limited partnership is made up of one or more general partners and one or more limited
partners. The general partners are responsible for all debts and liabilities of the business, while
the limited partners are responsible only for the amount of their investment. This option can
attract investors who do not wish to be part of the day-to-day operation of the business.

Writing a partnership agreement is strongly recommended for any partnership. It can specify the
duties of each partner, indicate how profits/losses will be shared and cover the ‘what if’ situations
that may be encountered when more than one person runs a business. A written agreement
prepared with the help of an attorney can prevent misunderstandings among partners in later
years; verbal agreements may be subject to different interpretations, especially after a few years
have passed.

The partnership terms are governed by the Kenya’s Partnership Act, 1963 or a Deed of
Agreement. Where the Deed exists, it operates instead of the terms of the Act. The agreement
defines the following terms and conditions under which the partnership will operate:

(i) Name and purpose of business.

(ii) Location of business and commencing date.
(iii) Name, address and occupation of each partner.
(iv) Duration of the agreement (annual, when a partner leaves, etc)
(v) Status or type of each partner, e.g. limited, general, active, dormant, minor or quasi.
(vi) Capital to be contributed by each partner and in what ratios.
(vii) Interest rates to be paid on capital (if any).
(viii) Remuneration of partners.
(ix) How profits and losses will be shared.
(x) Drawings allowable each year.
(xi) Duties and rights of each partner.
(xii) Admission, withdrawal and expulsion of partners
(xiii) Arbitration of disputes
(xiv) Death or disability of a partner
(xv) Sales of partnership interests

Types of Partners

The major types of partners include:

• General partner. The. General partner has unlimited liability for the firm’s debts.
• Limited partner. A limited partner has limited liability in the partnership.
• Active partner. One in normal partnership practice, as a partner sharing in every way the
capital contribution, management and shares in the profit and liabilities of the business. He
may be given a fixed area of responsibility e.g. sales. He is disclosed to the public as being a
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 partner.
• Silent partner. Refers to a limited partner who does not participate actively in the
management of the organisation. He is. Disclosed to the public as being a partner.
• Secret partner. Is a limited partner who actively participates in management of the firm and
is not disclosed to the public as being a partner?
• Nominal partner. Is not one of the owners or actual partners of the firm but allows his name
to be identified with the business. He does not contribute any capital nor take any part in the
management of the firm. He, however, becomes liable for the firm’s obligations in an
unlimited basis. The nominal partner lends his name to be used by the business for a fee. The
business benefits because it uses the partner’s name for promotional purposes. Such a part-
ner must, therefore, be a well known person who can enhance the firm’s prestige and
reputation.
• Quasi Partner. One who is presented to the public as a partner although he contributes no
capital and does not participate in the management of the firm. He may share the profit and
liabilities of the firm.
• Minor partner. This is a person serving as a partner while he is under the statutory majority
age of eighteen years. Since he is a minor, his liability is limited to his capital. However, on
attaining the statutory majority age; he will rank as an active partner with unlimited
liability.

ADVANTAGES AND DISADVANTAGES OF A PARTNERSHIP

Advantages

(i) Ease of formation: Formation of partnership is easy because all that is essentially needed
in a partnership is an agreement between the partners. The partnership agreement is
usually prepared in writing although an oral control is also acceptable. In other words for-
mation of a partnership is free from complicated legal requirements.
(ii) start--up costs
Low start
(iii) May provide additional sources of capital: Partners can sometimes raise more capital than
a sole trader since ownership vests in a group of two or more (maximum twenty), each of
whom can contribute capital. A partnership is also likely to be more creditworthy than a
sole trader
(iv) managementt base: Each partner may have expertise in different functions of the
Broader managemen
firm such as finance and sales. The partners can, therefore, be called upon to be
responsible for those functions in which they are specialized. This may lead to increased
performance and profitability. Decision making and consultations are shared for mutual
benefit.
(v) Direct profit rewards
(vi) Relative freedom from government control and special taxation
(vii) Ease of expansion: Expansion can be done very easily by increasing the size of the
partnership, including addition of specialist’s skills.
(viii) Sharing of losses and liabilities: Liabilities are better spread to a number of persons thus
reducing the burden on anyone person. This spreading of risk to many encourages more
people to join partnerships because the risks are less than in sole proprietorship.
(ix) Duration: Partnerships have longer durations than sole proprietorships because death or
retirement of one partner cannot interrupt the partnership where the partnership has
more than two partners and also where provisions have been made to perpetuate the part-
nership.
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Disadvantages

(i) Lack of continuity: A partnership has a limited and uncertain life. A partnership can be
terminated very easily especially if the partners disagree or if one partner dies or is
incapacitated.
(ii) Divided authority: Since a partnership consists of two or more owners, authority is divided
and decisions may be difficult to reach. Delays may also occur when reaching decisions
because all the partners have to be consulted. Delayed decisions may not be fully effective
and may result in the firm losing many opportunities. Sometimes the partners cannot
compromise and the only recourse may be to dissolve the partnership.
(iii) Unlimited personal liability of at least one partner: The liability of general partners is
unlimited. This means that if the assets of the partnership are not sufficient to pay its
debts, the partners are obliged to pay the debts from their personal resources.
(iv) Hard to raise large sums of capital: Partnerships have difficulties in obtaining large sums
of capital especially long term financing. This is a serious problem especially if the firm
intends to finance major development projects.
(v) Hard to find suitable partners
(vi) Difficult to dispose of a partnership interest: If a partner is no longer committed or
interested in the partnership, it is often difficult to withdraw his investment. The buying
out of a partner may be difficult unless specifically arranged for in the written agreement.
Partners who may wish to withdraw find it impossible to do so and this leads to
dissatisfaction and lack of commitment to the firm.
(vii) profits: Since partners have to share in the profits of the firm, this leads to
Sharing of profits
minimization in direct benefits accruing from personal efforts of individual partners. This
is more so where some partners may be contributing more than others to the well-being of
the firm. Also, the fact that profit is shared reduces the amount receivable by each
partner.

CORPORATION

A corporation is a separate legal entity. Members of the corporation are not personally liable for
its debts or for legal judgments held against it. The owners’ liability is limited to the amount
each individual pays for stock shares. The life of the corporation is not affected by death or the
transfer of shares of stock by any or all owners. However, corporate profits are taxed twice, first
as a business tax and then as a personal income tax when they are distributed.

A corporate body it is created under the law and has an entity of its own, quite separate from
members who own it. Therefore, under the law, a corporation is a fictitious but a legal person
that can enter into contracts, own property, incur liabilities, sue others, and be sued by others. It
can only do what it has been formed to do. This means that if a company has been formed to
carry out production and marketing activities of particular goods and/or services it can carry out
only this type of business unlike an individual who can engage in any type of business at any
time.

Types of Companies

Companies can be grouped into two categories: registered and statutory companies. Registered
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companies are those that are formed, registered and operate under the Companies Act, 1962,
Cap. 486, Laws of Kenya. These constitute the most common type of companies.

Statutory companies are created by an Act of Parliament. The powers and functions of these
companies are defined by the Acts that create them. Most companies owned by the Kenya
Government (commonly referred to as parastatal organizations) fall in this category. Examples
are the Agricultural Finance Corporation (AFC)' the Industrial arid Commercial Development
Corporation (ICDC) and the Kenya National Trading Corporation Ltd. (KNTC).

Registered companies may further be classified into public, private, limited or unlimited
companies.

Public Companies

These companies must have a minimum membership of seven but there is no maximum number.
Their shares are freely transferable usually through the Nairobi Stock Exchange. Shares and
debentures are open for public subscription. Certificates of trading and annual audit of accounts
are compulsory. The minimum number of directors is two. They may have limited or unlimited
liability.

Private Companies

They can be described as an advanced form of partnership. The minimum membership is two
and the maximum is fifty excluding past and present employees. Their shares are not freely
transferrable. They cannot offer shares or debentures to the public for subscription. They must
have at least one director. They commence business on receipt of Certificate of Incorporation
from the Registrar of Companies. Presentation of prospectus and audited accounts is not
compulsory for private companies.

Limited and Unlimited Companies

Companies

In a limited company, the liability of members is limited to a stated amount, usually to the face
value of shares a member holds in the company. The liability of unlimited companies is
unlimited like those of sole traders and general partners. There are, however, no unlimited
companies in Kenya.

THE LIMITED LIABILITY COMPANY

This form of organization has some elements of a partnership and some of a corporation.
Income taxes are paid only on money distributed to members as ordinary income like a
partnership. Members’ liability for the actions of the company or other members is limited like in
a corporation. However, like a partnership, members can be held liable for their own actions or
misconduct.

This form of organization can be cumbersome and expensive. Memberships can be sold only
when all members agree to the transaction. Financial statements must be prepared at the
request of any member. The LLC status has enhanced its choice by entrepreneurs. The LLC has
the following characteristics:

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• Whereas the corporation has shareholders and partnerships have partners, the LLC has
members.
• No shares of stock are issued, and each member owns an interest in the business as
designated by the articles of organization, which is similar to the articles of incorporation or
certificates of partnership.
• Liability does not extend beyond the member’s capital contribution to the business. Thus,
there is no unlimited liability, which can be detrimental in a proprietorship or general
partnership.
• Members may transfer their interest only with the unanimous written consent of the
remaining members.

Companies Limited by Guarantee

Some companies may have no share capital in which case the liability of its members may be
limited to a sum guaranteed by them. The associations of trade and professional people such as
the Kenya Association of Manufacturers (KAM) and the Kenya National Chamber of Commerce
and Industry (KNCCI) are usually registered as companies without share capital and therefore
limited by guarantee. This means that if such a company is wound up and its assets are not
found sufficient to meet its debts, the members would be required to contribute up to the
maximum of the amount guaranteed by them at the time of taking membership.

FORMATION OF A COMPANY

Persons intending to form a joint stock company are required to furnish the Registrar of
Companies with the following documents:

(i) Memorandum of Association.

(ii) Article of Association (or adoption of model Articles, termed Table A in the Act).
(iii) List of directors, with details of names, addresses, occupations, shares subscribed and
statement of agreement to serve as directors.
(iv) A statement signed by directors stating that they agree to act as such.
(v) A declaration that the. Necessary requirements of registration have been duly complied,
with. This declaration, can be signed by the company Secretary or by one of the directors or
promoters of the company.

If these documents are found to be in order by the Registrar of Companies, he may ask the
promoters of the company to pay the necessary registration fees. After payment of the fees, a
Certificate of Incorporation, giving legal entity to the company is issued.

The Memorandum of Association

This is the most important document to be prepared when forming a company. It lies down and
defines the powers and limitations of the company. The document governs the relationship of the
company with outsiders and any person dealing with the company needs to know its contents.

It contains the following six clauses:

(i) Name clause: This clause states the name of the company ending in “Limited.” The name
of the company should not be confused with a name of another existing company. The
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 name should also not give a false idea of the nature of business. Names with political
connotations are normally not acceptable.
(ii) Situation clause: This clause states the domicile of the company, that is, where the
registered office is situated. It is enough to mention the name of the country only. All
official communications would be channeled to the stated place.
(iii) Objects clause: This is the most important clause. It sets out specifically all the aims,
objectives and purposes of the proposed company. Once incorporated, the company can
operate only within the objects stated in the Memorandum of Association. Any dealings
made by the company which are not within the objects laid down in the Memorandum of
Association are void by law.
(iv) Capital clause: This clause sets out the share capital the company wishes to have. The
total value of all the shares is called the nominal share capital. After the registration is
completed, the company can raise this amount by selling shares. It is then referred to as
authorized or registered share capital. The following inf9rmation must also be given in
this clause:
(a) total amount
(b) Types of shares and the units (shares) into which the share capital is divided. The
number of units to be shown by each type and
(c) The value of each share in each separate group.
(v) Liability clause: This clause states that the liability of the shareholders shall be limited
(vi) Declaration clause: This clause states the willingness of the promoters to form themselves
into a limited company. This declaration must be signed by at least seven persons (the
promoters) in the case of public limited companies and two persons in the case of private
limited companies. These persons must agree to take at least one share each. The names,
addresses and number of shares taken up by each promoter must also be included.

Articles of Association

This document lays down the rules and regulations of the internal organization of the company
as follows:

(i) The different types of shares and the rights and powers of each separate class or type.
(ii) Transfer of shares procedure.
(iii) Classes of loan capital issued and their rights and powers as well as the transfer
procedures.
(iv) Kinds of meetings and the methods of calling and conducting meetings.
(v) Details concerning directors as to numbers, election or appointment, qualifications and
disqualifications, powers, duties and liabilities in the management of the company.
(vi) Appointment of the secretary to the company under the Act, remuneration, powers, duties
and responsibilities.
(vii) Details of the procedures for keeping records of share and loan registers, meetings of all
types, accounting and audit.
(viii) Arrangements for the declaration and distribution of dividends on share capital and
interest on loan capital.
(ix) Rules governing the appointment of auditors.

Articles of Association can be altered by a meeting of shareholders. The resolution -seeking

alteration must be passed by the majority vote and it must be forwarded to the Registrar of
Companies. .
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It is important to note that a company can choose not to prepare its own Articles of Association
and instead adopt the standard article of association in "Table A" of the Companies Act, 1962,
Cap. 486.

ADVANTAGES AND DISADVANTAGES OF A CORPORATION

Advantages

(i) Liability limited to the investment in stock: This means that even if the company is unable to
pay its debts, the shareholders cannot in accordance with the law lose more than the value of
their investment in the company. This is a great protection against financial risk. It is an
advantage that companies have over partnerships and sole proprietorships.
(ii) Ownership is easily transferable: Ownership in a company can be transferred very easily.
Shareholders in public limited companies can sell their shares to other people whenever they
wish.
(iii)Stability and relative permanence of existence: The legal existence of any company is not
affected by the death of any shareholder unlike the sole proprietorship and partnership. If a
shareholder dies, his shares revert to his lawful heirs.
(iv) Easier to secure large amounts of capital through stock sales: Companies can raise capital
with greater ease than sole proprietorships and partnerships. This is possible because com-
panies can invite the public to buy shares. Most members of the public can afford to buy the
shares because they are divided into small units of say Kshs. 5; Kshs. 10; Kshs. 20.
Companies can also borrow large sums of money at low interest rates because of their legal
status and also because they have securities.
(v) Centralized control in board of directors: The companies are managed by boards of directors.
A board of directors may be formed in such a way that experts in various fields are included.
Decisions of these experts are normally better than a one person’s decision. Boards of direc-
tors are also known for discussing policy issues thoroughly and hence risks of hasty decisions
can be avoided.
(vi) Specialized management possible: Because of its size and scope of operations, a company can
afford to hire well qualified employees who can manage the company efficiently.
(vii) Economies of scale: Large sums of capital enable large-scale operations which result in
reduced costs per unit produced and consequently higher profit. Large scale operations also
facilitate specialization which leads to efficiency in operations.

Disadvantages

(i) Most closely regulated form of business

(ii) Most expensive to organize and form: Forming a company is more costly, complicated and
time-consuming. It is more costly because of the legal fees paid to the lawyer who prepares
the memorandum and articles of association. There is also the cost of registration. The
process is complicated because adherence to certain rules is a necessity. These rules in-
clude those regarding the minimum number of shareholders and the minimum amount of
capital.
(iii) Double taxation: The company is a taxable entity for income tax purposes. It pays taxes
separately from the owners. A corporation tax is levied on the net profit of the company.
Earnings distributed to shareholders in the form of dividends are also taxed. This
amounts to double taxation because the same profit which belongs to the shareholders is
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 taxed twice.
(iv) Extensive record keeping necessary:
(v) Less incentive if manager does not share in profits:
(vi) Charter and legal restrictions: A company can only operate in accordance with its
memorandum and articles of association. This may sometimes be too limiting especially if
a company wishes to engage in more profitable activities which are not covered by the
above documents and there is not enough time to alter the document.
secrecy: Unlike the sole proprietorship and partnership, the
(vii) Impersonality and lack of secrecy
dispersed ownership of the company leads to impersonality and consequent avoidance of
personal interest and responsibility. The owners (shareholders) do not have a direct con-
trol over the running of the business. They feel alienated from the company and left to be
interested ,only in dividends and value of shares. The required publication of financial
reports allows others to obtain useful competitive information. This means that it may not
be possible to maintain confidentiality in some aspects. In a competitive environment
certain confidentiality is certainly very important but unfortunately public companies may
not be able to keep confidentiality.
decision--making
(viii) Slow, and. expensive decision making: This is so because of the nature of the decision
making process in companies. In companies, all important decisions are normally taken by
the directors and the more important decisions by the shareholders. This process is slow
and often expensive.
(ix) Direct control by owners is not possible: The owners (shareholders) do not control the
company directly. Their control is of a very indirect .character because direct control is
vested in the board of directors. The shareholders' ability to influence the company policy
is usually minimal, restricted usually to their voice and vote during the annual
shareholders’ meeting. Practically, the shareholders endorse almost all the board's
recommendations during the annual general meeting. This may lead to a dangerous
situation if the board's decisions are not viable.

Figure 1: Differentiating between the three

three forms of business

Factors Sole Partnership Corporation

Proprietorship
Ownership Individual No limitation on No limitation on
number of partners number of
stockholders
Liability of Individual liable In general, Amount of capital
owners for business partnership, contribution is
liabilities individuals all liable limit of
for business liabilities. shareholder
In limited partnership, liability
partners are liable for
amount of capital
contribution
Costs of None other than Partnership Created only by
starting filing fees for agreement, legal costs, statute. Articles of
business trade name and minor filing fees incorporation,
for trade name. filing fees, taxes,
Limited partnership and fees for
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 requires more registration to do
comprehensive business
agreement, hence
higher costs
Continuity of Death dissolves Death or withdrawal of Greatest form of
business the business one partner terminates continuity. Death
partnership unless or withdrawal of
partnership agreement owner(s) will not
stipulates otherwise. affect legal
In limited partnership, existence of
death or withdrawal of business.
one of limited partners
has no effect on
continuity.
Transferability Complete freedom General partner can Most flexible.
of interest to sell or transfer transfer his/her Stockholders can
any part of interest only with sell or busy stock
business. consent of all other at will. Some
general partners. stock transfers
Limited partner can may be restricted
sell interest without by agreement.
consent of general
partners.
Capital Capital raised Loans or new New capital
requirements only by loan or contributions by raised by sale of
increased partners require a stock or bonds or
contribution by change in partnership by borrowing
proprietor. agreement. (debt) in name of
corporation.
Management Proprietor makes All partners have equal Majority
control all decisions and control and majority stockholder(s)
can act rules. In limited have most control
immediately. partnership, only the from legal point of
general partners have view. Day-to-day
control of the business. control in hands
of management
who may or may
not be major
stockholders.
Distribution of Proprietor Depends on Shareholders can
profits and responsible and partnership agreement share in profits by
losses receives all profits and investment by receipt of
and losses. partners. dividends.
Attractiveness Depends on Depends on capability With limited
for raising capability of of partners and success liability of owners,
capital proprietor and of business more attractive as
success of an investment
business opportunity

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It is very important that the entrepreneur carefully evaluate the pros and cons of the various
legal forms of organizing the new venture. This decision must be made before the submission of a
business plan and request for venture capital.

In addition to these factors, it is also necessary to consider some intangibles. Various types of
organizational structures reflect an image to suppliers, existing clients, and prospective
customers. For example, suppliers may prefer to deal with profit-making organizations rather
than nonprofit companies. This attitude may be reflected in the perceived impressions that
nonprofit firms are slow in paying their bills. Customers may sometimes prefer to do business
with a corporation. Because of their continuity and ownership advantages, they are sometimes
viewed as a more stable type of business. As a customer, it may be desirable to have assurance
that the firm will be in business for a long time.

1. Ownership

In the proprietorship, the owner is the individual who starts the business. He or she has full
responsibility for the operations. In a partnership, there may be some general partnership
owners and some limited partnership owners. In the corporation, ownership is reflected by
ownership of shares of stock. There is no limit as to the number of shareholders who may own
stock.

2. Liability of Owners

Liability is one of the most critical reasons for establishing a corporation rather than any other
form of business. The proprietor and general partners are liable for all aspects of the business.
Since the corporation is an entity or legal “person,” which is taxable and absorbs liability, the
owners are liable only for the amount of their investment. In the case of a proprietorship or
regular partnership, no distinction is made between the business entity and the owner(s). Then,
to satisfy any outstanding debts of the business, creditors may seize any assets the owners have
outside the business.

In a partnership, the general partners usually share the amount of personal liability equally,
regardless of their capital contributions, unless there is a specific agreement to the contrary. The
only protection for the partners is insurance against liability suits and each partner putting his
or her assets in someone else's name. The government may disallow the latter action if it feels
this was done to defraud creditors.

In a limited partnership, the limited partners are liable only for the amount of their capital
contributions. This amount, by law, must be registered at a local courthouse, thus making this
information public.

3. Costs of Starting a Business

The more complex the organization, the more expensive it is to start. The least expensive is the
proprietorship, where the only costs incurred may be for filing for a business or trade name. In a
partnership, in addition to filing a trade name, a partnership agreement is needed. This
agreement requires legal advice and should explicitly convey all the responsibilities, rights, and
12
duties of the parties involved. A limited partnership may be somewhat more complex than a
general partnership because it must comply strictly with statutory requirements.

The corporation can be created only by statute. This generally means that before the corporation
may be legally formed, the owners are required to:
(i) Register the name and articles of incorporation and
(ii) Meet the statutory requirements (Companies Act requirements). In complying with these
requirements, the corporation will likely incur filing fees and an organization tax. Legal
advice is necessary to meet all the statutory requirements.

4. Continuity of Business

One of the main concerns of a new venture is what happens if one of the entrepreneurs (or the
only entrepreneur) dies or withdraws from the business. Continuity differs significantly for each
of the forms of business. In a sole proprietorship, the death of the owner results in the
termination of the business. Sole proprietorships are thus not perpetual, and there is no time
limit on how long they may exist.

The partnership varies, depending on whether it is a limited or a general partnership and on the
partnership agreement. In a limited partnership, the death or withdrawal of a limited partner
(who can withdraw capital six months after giving notice to other partners) has no effect on the
existence of the partnership. A limited partner may be replaced, depending on the partnership
agreement. If a general partner in a limited partnership dies or withdraws, the limited
partnership is terminated unless the partnership agreement specifies otherwise or all partners
agree to continue.

In a partnership, the death or withdrawal of one of the partners results in termination of the
partnership. However, this rule can be overcome by the partnership agreement. Usually the
partnership will buy out the deceased or withdrawn partner’s share at a predetermined price
based on some appraised value. Another option is that a member of the deceased’s family may
take over as a partner and share in profits accordingly. Life insurance owned by the partnership
is a good solution for protecting the interests of the partnership, along with carefully outlining
contingencies in the partnership agreement.

The corporation has the most continuity of all the forms of business. Death or withdrawal has no
impact on the continuation of the business. Only in a closely held corporation, where all the
shares are held by a few people, may there be some problems trying to find a market for the
shares. Usually, the corporate charter requires that the corporation or the remaining share-
holders purchase the shares. In a public corporation this, of course, would not be an issue.

5. Transferability of Interest

There can be mixed feelings as to whether the transfer of interest in a business is desirable. In
some cases the entrepreneur(s) may prefer to evaluate and assess any new owners before giving
them a share of the business. On the other hand, it is also desirable to be able to sell one’s
interest whenever one wishes. Each of the forms of business offers different advantages as to the
transferability of interest.

In the sole proprietorship, the entrepreneur has the right to sell or transfer any assets in the
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business. The limited partnership provides for more flexibility than the partnership regarding
transfer of interest. In the limited partnership, the limited partners can sell their interests at
any time without consent of the general partners. The person to whom the limited partner sells,
however, can have only the same rights as the previous owner. A general partner in either a
limited partnership or a partnership cannot sell any interest in the business unless there is some
provision for doing so in the partnership agreement. Usually the remaining partners will have
the right of refusal of any new partner, even if the partnership agreement allows for transfer of
interest.

The corporation has the most freedom in terms of selling one’s interest in the business.
Shareholders may transfer their shares at any time without consent from the other shareholders.
The disadvantage of the right is that it can affect the ownership control of a corporation through
election of a board of directors. Shareholders’ agreements may provide some limitations on the
ease of transferring interest, usually by giving the existing shareholders or corporation the
option of purchasing the stock at a specific price or at the agreed-on price. Thus, they sometimes
can have the right of first refusal.

6. Capital Requirements

The need for capital during the early months of the new venture can become one of the most
critical factors in keeping a new venture alive. The opportunities and ability of the new venture
to raise capital will vary, depending on the form of business.

For a proprietorship, any new capital can come only from loans by any number of sources or by
additional personal contributions by the entrepreneur. In borrowing money from a bank, the
entrepreneur in this form of business may need collateral to support the loan. Often, an
entrepreneur will take a second mortgage on his or her home as a source of capital. Any
borrowing from an outside investor may require giving up some of the equity in the
proprietorship. Whatever the source, the responsibility for payment is in the hands of the
entrepreneur, and failure to make payments can result in foreclosure and liquidation of the
business. However, even with these risks the proprietorship is not likely to need large sums of
money, as might be the case for a partnership or corporation.

In the partnership, loans may be obtained from banks but will likely require a change in the
partnership agreement. Additional funds contributed by each of the partners will also require a
new partnership agreement. As in the proprietorship, the entrepreneurs are liable for payment
of any new bank loans.

In the corporation, new capital can be raised in a number of ways. The alternatives are greater
than in any of the other legal forms of business. Stock may be sold as either voting or nonvoting.
Nonvoting stock will of course protect the power of the existing major stockholders. Bonds may
also be sold by the corporation. This alternative would be more difficult for the new venture since
a high bond rating will likely occur only after the business has been successful over time. Money
may also be borrowed in the name of the corporation. This protects the personal liability of the
entrepreneurs.

7. Management Control

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In any new venture, the entrepreneur(s) will want to retain as much control as possible over the
business. Each of the forms of business offers different opportunities and problems as to control
and responsibility for making business decisions.

In the proprietorship, the entrepreneur has the most control and flexibility in making business
decisions. Since the entrepreneur is the single owner of the venture, he or she will be responsible
for and have sole authority over all business decisions.

The partnership can present problems over control of business decisions if the partnership
agreement is not concise regarding this issue. Usually in a partnership, the majority rules unless
the partnership agreement states otherwise. It is quite important that the partners be friendly
toward one another and that delicate or sensitive decision areas of the business spelled out in the
partnership agreement.

The limited partnership offers a compromise between the partnership and the corporation. In
this type of organization, we can see some of the separation of ownership and control. The
limited partners in the venture have no control over business decisions. As soon as the limited
partner is given some control over business decisions, he or she then assumes personal liability
and can no longer be considered a limited partner.

Control of day-to-day business in a corporation is in the hands of management, who may or may
not be major stockholders. Control over major long-term decisions, however, may require a vote
of the major stockholders. Thus, control is separated based on the types of business decisions. In
a new venture, there is a strong likelihood that the entrepreneurs who are major stockholders
will be managing the day-to-day activities of the business. As the corporation increases in size,
the separation of management and control becomes more probable.

Stockholders in the corporation can indirectly affect the operation of the business by electing
someone to the board of directors who reflects their personal business philosophies. These board
members, through appointment of top management, then affect the operation and control of the
day-to-day management of the business.

8. Distribution of profits and Losses

Proprietors receive all distributions of profits from the business. As discussed earlier, they are
also personally responsible for all losses. Some of the profits may be used to pay back the
entrepreneur for any personal capital contributions that are made to keep the business
operating.

In the partnership, the distribution of profits and losses depends on the partnership agreement.
It is likely that the sharing of profits and losses will be a function of the partners' investments.
However, this can vary depending on the agreement. As in the proprietorship, the partners may
assume liability. The limited partnership provides an alternative that protects against personal
liability but may reduce shares of any profits.

Corporations distribute profits through dividends to stockholders. These distributions are not
likely to absorb all the profits that may be retained by the corporation for future investment or
capital needs of the business. Losses by the corporation will often result in no dividends. These
losses will then be covered by retained earnings or through other financial means discussed
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earlier.

9. Attractiveness for Raising Capital

In both the proprietorship and the partnership, the ability of the entrepreneurs to raise capital
depends on the success of the business and the personal capability of the entrepreneur. These
two forms are the least attractive for raising capital, primarily because of the problem of
personal liability. Any large amounts of capital needed in these forms of business should be given
serious consideration.

The corporation, because of its advantages regarding personal liability, is the most attractive
form of business for raising capital. Shares of stock, bonds, and/or debt are all opportunities for
raising capital with limited liability. The more attractive the corporation, the easier it will be to
raise capital.

FUNDING THE BUSINESS

The Need for Financing

Money is needed both to start a business and to keep it going. Sales revenue does not generally
flow evenly. Both income and expenses may vary from month to month or from year to year. It is
important therefore to understand not only the various sources of capital but also the
expectations and requirements of these sources.

SOURCES OF FUNDS

The four primary sources of funding are:

1. Sales revenue,

2. Equity capital,

3. Debt capital, and

4. Proceeds from the sale of assets.

We begin with an examination of the differences between debt and equity financing

Debt Financing
The use of debt to finance a new venture involves a payback of funds plus a fee (interest) for the
use of the money. Debt places a burden of repayment and interest on the entrepreneur.

Equity Financing
Equity Financing involves the sale of some of the ownership in the venture. It is money invested
in the venture with no obligation for entrepreneurs to repay the principal amount or interest on
it. It does however; require sharing the ownership and profits with the funding source. Thus
equity financing forces the entrepreneur to relinquish some degree of control.
In the extreme, the choice for the entrepreneur is:
i. to take on debt without giving up ownership in the venture or
ii. To relinquish a percentage of ownership in order to avoid having to borrow.
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Advantages of Debt Financing
i. No relinquishment of ownership is required.

ii. More borrowing allows for greater return on equity.

iii. During periods of low interest, the opportunity cost of borrowing is low

Disadvantages
i. Regular (monthly) interest payments are required.

ii. Continual cash flow problems can be intensified because of payback responsibility.

iii. Heavy use of debt can inhibit the growth and development.

iv. Depending on the duration, the sources of finance can be grouped into short-term, medium
term or long-term financing.

Short-
Short-Term Financing Needs

Short-term financing is money that will be used for one year or less and then repaid.Certain
necessary business practices may affect a firm’s cash flow and create a need for short-term
financing. Cash flow is the movement of money into and out of an organization.

Long-
Long-Term Financing Needs
Long-term financing is money that will be used for longer than one year.

short--term financing
Sources of short
Short-term financing is usually easier to obtain than long-term debt financing for the following
reasons.
i. The shorter repayment period means there is less risk of nonpayment.

ii. The amount of short-term loans are usually smaller than those for long-term loans.

iii. A close working relationship normally exists between the short-term borrower and the
lender.

iv. Most lenders do not require collateral for short-term financing. When they do, it is usually
because they are concerned about the size of a particular loan, the borrowing firm’s poor
credit rating, or the general prospects of repayment.

Sources of Unsecured Short-

Short-Term Financing

Unsecured financing is financing that is not backed by collateral. A company seeking unsecured
short-term capital has several options.

Trade Credit
Trade credit is a type of short-term financing extended by a seller who does not require
immediate payment after delivery of merchandise. Between 80 and 90 percent of all transactions
between businesses involve some trade credit. This credit is reflected on the entrepreneur’s
balance sheet as accounts payable. In most cases it must be paid within 30 to 90 days.
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Promissory Notes Issued to Suppliers
A promissory note is a written pledge by a borrower to pay a certain sum of money to a creditor
at a specified future date. Unlike trade credit, promissory notes usually require the borrower to
pay interest. The customer buying on credit—called the maker—is the party that issues the note.
Most promissory notes are negotiable instruments that can be sold when the money is needed
immediately.

Unsecured Bank Loans

Banks and other financial institutions offer unsecured short-term loans to businesses at interest
rates that vary with each borrower’s credit rating. The prime interest rate (or reference rate) is
the lowest rate charged by a bank for a short-term loan. Banks generally offer unsecured short-
term loans through promissory notes, a line of credit.

It is important for the entrepreneur to remember that the bank-lending decisions are made
according to five Cs of lending namely:

Character, capacity, capital, collateral and conditions.

Past financial statements (balance sheet and income statements) are reviewed in terms of key
profitability and credit ratios, inventory turnover, the entrepreneurs’ capital invested and the
commitment to the business. Future projections on the market size, sales, and profitability are
also evaluated to determine the ability to repay the loan.

Capacity and character: This part of the loan decision is the most difficult part to assess.
The entrepreneur must present his or her capabilities and prospects for the company in a way
that elicits positive response from the lender.

This intuitive part of the loan decision becomes even more important when there is little or no
track record, limited experience in financial management, nonproprietary product or service (i.e.
one that is not protected by a patent), or few assets available.
The entrepreneur will typically have to answer a number of questions.

Five of the most common are:

1. What do you plan to do with the money? Do not plan to use the money for a high risk
venture. Banks normally seek the most secure venture possible.
2. How much money do you need? The more precisely an entrepreneur can answer this
question; the more likely the loan will be granted.
3. When do you need the money? Do not rush to the bank with immediate request for money
with no plan. It shows the entrepreneur is a poor planner and most lenders will not want
to get involved.
4. How long will you need the money? The shorter the period the entrepreneur needs the
money, the more likely he or she will get it. The time at which the loan will be paid should
correspond to some important milestone in the business plan.
5. How long will you repay the loan? What if the plans go awry? Can other sources be
diverted to pay off the loan? Does the collateral exist?
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Commercial Paper
Commercial paper is a short-term promissory note issued by large corporations. Commercial
paper is secured only by the reputation of the issuing firm; no collateral is involved.

Sources of Secured Short-

Short-Term Financing
If a business cannot obtain enough capital through unsecured short-term financing, it must put
up collateral to obtain additional financing it needs. Almost any asset can serve as collateral, but
inventories and accounts receivable are the assets most commonly used for short-term financing.

Loans Secured by Inventory. Finished goods, work in process, or raw materials can be pledged as
collateral for short-term loans.

Loans Secured by Receivables. Accounts receivable are amounts owed to a firm by its customers.

They are created when trade credit is given to customers and are usually due in less than 60
days. A firm can pledge its accounts receivable as collateral to obtain short-term financing.

Factoring Accounts
Accounts Receivable

Accounts receivable can be sold to a factoring company, or factor. This called factoring. A factor is
a firm that specializes in buying other firms’ accounts receivable. The factor buys the accounts
receivable for less than their face value (discounted value), but it collects the full dollar amount
when each account is due. The factor’s profit is thus the difference between the face value of the
accounts receivable and the amount the factor has paid for them. Even though the selling firm
gets less than face value for its accounts receivable, it does receive needed cash immediately.
Moreover, it has shifted both the task of collecting and the risk of nonpayment to the factor,
which now owns the receivables. A form of factoring called forfeiting is an increasingly popular
method of financing international transactions.

Sources of equity financing

Sources of long-term financing vary with the size and type of business. Equity capital can be
raised through two major sources: public stock offerings and private placing.

A sole proprietorship or partnership acquires equity capital (sometimes referred to as owner’s

equity) when the owner or owners invest money in the business.
Family and friends

Family and friends are a common of equity capital for new venture. They are most likely to
invest due to their relationship with the entrepreneur. This helps overcome one portion of
uncertainty felt by impersonal investor-knowledge of the entrepreneur. Although the amount of
money provided may be small, if it is in form of equity financing, the family members or friends
then have an ownership position in the venture and all rights and privileges of that position.
This may make them feel they have a direct input into the operations of the business, which may
have negative effect on employees, facilities, or sales and profits.
Otherwise, where the family members or friends expect to be paid back this will be part of short
term financing.

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For corporations, equity-financing options include the sale of stock and the use of profits not
distributed to owners.

• Selling Stock. Some equity capital is used to start every business—sole proprietorship,
partnership, or corporation.

• Equity financing is attractive to large corporations for at least two reasons.

The corporation doesn’t have to repay money obtained from the sale of stock.

The corporation is under no legal obligation to pay dividends to stockholders.

Public Offerings: Going public is the term used to refer to a corporation’s raising capital through
the sale of securities on the public markets for example the sale of Safaricom shares in 2008 in
the Nairobi stock exchange.

Advantages of Public Offerings

1. Size of capital.
capital Selling securities is one of the fastest ways to raise large sums of capital in
the shortest time possible.
2. Liquidity.
Liquidity The public market provides liquidity for owners since they can readily sell their
stock.
3. Value.
Value The marketplace puts a value on the company’s stock, which in turn allows value to
be placed on the corporation.
4. Image.
Image The image of a publicly traded corporation is often stronger in the eyes of
suppliers, financiers and customers.

Ordinary (Common Stock). A share of common stock represents the most basic form of
ownership. By law, every corporation must hold an annual meeting at which the holders of
common stock may vote for directors and approve (or disapprove) major corporate actions.
Among such actions are:

Amendments to the corporate charter or by-laws

Sale of certain assets

Mergers and acquisitions.

Preferred Stock
Stock
The owners of preferred stock usually do not have voting rights, but their claims on dividends
and assets precede those of ordinary (common) stock owners.If the board of directors approves
dividend payments, holders of preferred stock must receive their dividends before holders of
common stock receive theirs. Preferred stockholders also have first claim (after creditors) on
corporate assets if the firm is dissolved or declares bankruptcy. Even so, preferred stock (like
common stock) does not represent a debt that must be legally repaid. A corporation usually
issues one type of common stock, but it may issue many types of preferred stock with varying
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dividends or dividend rates. A corporation may decide to call in or buy back an issue of preferred
stock when management believes it can issue new preferred stock at a lower dividend rate—or
possibly common stock with no specified dividend.

Retained Earnings

Most large corporations distribute only a portion of their after-tax earnings to shareholders. The
portion of a corporation’s profits that is not distributed to stockholders is called retained
earnings. Because retained earnings are undistributed profits, they are considered a form of
equity financing. More mature corporations may distribute 40 to 60 percent of their after-tax
profits as dividends. Most small and growing corporations pay no cash dividend—or a very small
dividend—to their shareholders.

Venture Capital
While corporations can sell stock to finance a business start-up and retain a portion of their
profits to finance expansion, many entrepreneurs have fewer options. To establish a new
business or expand an existing one, an entrepreneur may try to obtain venture capital. Venture
capitalists are valuable and powerful source of equity funding for new ventures. These are
experienced professionals who provide a full range of financial services for new or growing
ventures including the following:

Capital for start ups and expansion.

Market research and strategy for businesses that do not have their own marketing
departments.

Contacts with prospective customers, suppliers and other important business people.

Assistance in negotiating technical agreements.

Helps in controlling management and accounting controls.

Helps in employee recruitment and development of employee agreements e.t.c.

Most venture capital firms do not invest in the typical small business—but in firms which have
the potential for rapid increases in sales and profits. Generally, a venture capital firm consists of
a pool of investors, a traditional partnership established by a wealthy family, or an insurance
company.
Venture capital firms vary in size and scope of interest. Some offer financing for start-up
businesses, while others finance only established businesses. Whether the firm requesting the
money is a start-up or an established business, a business plan is essential. Most requests for
venture capital are dropped on the basis of lack a business plan. Only two percent are finally
accepted. As partial owners of the companies they invest in, venture capitalists are most
concerned with return on investment. As a result they put a great deal of time weighing the risk
of a venture against potential returns.

long--term debt financing

Sources of long
Many people think that for a business, borrowing money is a sign of weakness. Although it can
be a sign of financial weakness, businesses borrow money on a short-term basis for many valid
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reasons besides desperation. There are also valid reasons for long-term borrowing. In fact,
successful businesses often use financial leverage created by borrowing money to improve their
financial performance.
Financial leverage is the use of borrowed funds to increase the return on owner’s equity. The
principle of financial leverage works as long as a firm’s earnings are larger than the interest
charged for the borrowed money. However, if the firm’s earnings should drop below the interest
cost of borrowed money, the return on owner’s equity will decrease. For a small business, long-
term debt financing is generally limited to loans. Large corporations have the additional option
of issuing corporate bonds.

Long-
Long-Term Loans
Many businesses finance their long-term activities with loans from commercial banks, insurance
companies, pension funds, and other financial institutions. Banks normally give a large number
of medium term loans with maturities of one to five years. Banks may also offer few loans with
maturities with maturities greater than five years.
For medium and long term loans the banks normally require collateral consisting of stocks,
machinery, equipment and real estate. Manufacturers and suppliers of heavy equipment and
machinery may also provide long-term financing by granting extended credit terms to their
customers. When the loan repayment period is longer than one year, the borrower must sign a
term-loan agreement.
A term-loan agreement is a promissory note that requires a borrower to repay a loan in monthly,
quarterly, semiannual, or annual installments. Long-term business loans are normally repaid in
three to seven years.
The interest rate and other specific terms are often based on such factors as the reasons for
borrowing, the borrowing firm’s credit rating, and the value of collateral. A company that cannot
obtain a long-term loan to acquire property, buildings, and equipment may be able to lease these
assets.
A lease is an agreement by which the right to use real estate, equipment, or other assets is
temporarily transferred from the owner to the user.

Bonds
A bond is a long term contract in which the bond holders lend money to a company. In return the
company (usually) promises to pay the bond owners a series of interest payment until the bond
matures. At maturity the bond holder receives a specified principal called the par (face or
nominal) value of the bond. Bonds may be regarded as merely IOUs (I owe you) with pages of
legal clauses expressing the promises made.
• A corporate bond is a corporation’s written pledge to repay a specified amount of money
with interest.

• The maturity date is the date on which the corporation is to repay the borrowed money.

• An individual or firm generally buys a corporate bond through a securities broker. After
the purchase, the corporation pays interest to the bond owner—usually every six months—
at the stated rate.

Types of Bonds. Today, most corporate bonds are registered bonds.

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 A registered bond is a bond registered in the owner’s name by the issuing company while
with a bearer bond, the holder or the bearer is the owner, so the issuer keeps no record of
ownership.
A debenture bond is a bond backed only by the promise of the issuer to pay interest and
principal on a timely basis. They can be secured or unsecured.

Unsecured debentures are secured by the general credit and reputation of the issuing
corporation.

Secured bonds are backed by a legal claim on some specified property of the issuer in the
case of default.

For example a mortgage bond is a corporate bond secured by various assets e.g. real estate
assets; equipment e.t.c of the issuing firm.
A convertible bond can be exchanged, at the owner’s option, for a specified number of shares of
the corporation’s common stock.
Repayment Provisions for Corporate Bonds
Maturity dates for bonds generally range from 15 to 30 years after the date of issue. If the
interest is not paid or the firm becomes insolvent, bond owners’ claims on the assets of the
corporation take precedence over both common and preferred stockholders.

Features affecting Bond’s Maturity

Entrepreneurs should be aware of the three alternative call option features that affect the
maturity of a bond. A freely callable provision allows the issuer to retire the bond at any time
with a typical notification of 30 to 60 days.
The other extreme is a non callable provision where the issuer cannot retire the bond before its
maturity. Intermediate between these is the deferred call provision, which means that the issue
cannot be called for a certain period of time after the date of issue (e.g. 5 to 10 years). At the end
of the deferred call period the issue becomes freely callable.
Callable bonds have a call premium. Usually the corporation pays the bond owner a call
premium which is the amount above maturity value that the issuer must pay to the bondholder
for prematurely retiring the bond.
Financing through a bond issue differs considerably from equity financing.

Bond interest must be paid periodically (and is fixed)—usually every six months.

In the eyes of the Internal Revenue Service, interest is a tax-deductible business expense.

It can issue the bonds as serial bonds—bonds of a single issue that mature on different
dates.

A corporation that issues bonds must also appoint a trustee—an independent firm or
individual that acts as the bond owners’ representative.

The uses of funds

Uses range from the payment of recurring expenses to the payment of one-time costs. In general,
a business uses funds to pay for the resources it needs to produce and market its products. The
effective use of finances is an important function of financial management. To some extent,
financial management can be viewed as a two-sided problem. On one side, the uses of funds often

23
dictate the type or types of financing needed by a business. On the other side, the activities a
business can undertake are determined by the types of financing available.

Financial managers must ensure that funds are available when needed, that they are obtained
at the lowest possible cost, and that they are used as efficiently as possible. Financial managers
must ensure that funds are available for the repayment of debts in accordance with lenders’
financing terms.

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