Business Organization

BBA 102: Business Organization

 

UNIT I

 

Business
We may define the term business in the following words :

"As an institution organized by person or group of persons to produce or distribute goods or services within incentive of earning profit through the satisfaction of human wants. The element of risk is also involved in it."
Following are the main characteristics of a business :

1.      Every business deals in goods and services.

2.      The profit motive in the business is essential.

3.      Element of risk is also involved in business.

4.      In a business there should be a series of deal.

5.      People should do the business for money. Free consumption of goods is not included in business.

 

Business Organization

A business organization is an institutional arrangement to form any business activity.

An entity formed for the purpose of carrying on commercial enterprise, predicated on systems of law governing contract and exchange, property rights, and incorporation.

The term business organization describes how businesses are structured and how their structure helps them meet their goals. In general, businesses are designed to focus on either generating profit or improving society. When a business focuses on generating profits, it is known as a for-profit organization. When an organization focuses on improving the social good through the arts, education, health care, or some other area, it is known as a nonprofit (or not-for-profit) organization and is not typically referred to as a business.

Business organization affects how a business is treated under the law. State and federal governments provide incentives and rules for every type of business organization. Profitability in industry helps a country’s economy grow, so governments generally support corporations by passing laws that protect investors from liability for the debts of the business.

 

Business objectives are something which a business organisation wants to achieve or accomplish over a specified period of time. These may be to earn profit for its growth and development, to provide quality goods to its customers, to protect the environment, etc.

Classification of Objectives of Business:

It is generally believed that a business has a single objective. That is, to make profit. But it cannot be the only objective of business. While pursuing the objective of earning profit, business units do keep the interest of their owners in view. However, any business unit cannot ignore the interests of its employees, customers, the community, as well as the interests of society as a whole.

For instance, no business can prosper in the long run unless fair wages are paid to the employees and customer satisfaction is given due importance. Again a business unit can prosper only if it enjoys the support and goodwill of people in general. Business objectives also need to be aimed at contributing to national goals and aspirations as well as towards international well-being. Thus, the objectives of business may be classified as;

A. Economic Objectives

B. Social Objectives

C. Human Objectives

D. National Objectives

E. Global Objectives

Now, we shall discuss all these objectives in detail.

A. Economic Objectives:

Economic objectives of business refer to the objective of earning profit and also other objectives that are necessary to be pursued to achieve the profit objective, which include, creation of customers, regular innovations and best possible use of available resources.

(i) Profit Earning:

Profit is the lifeblood of business, without which no business can survive in a competitive market. In fact profit making is the primary objective for which a business unit is brought into existence. Profits must be earned to ensure the survival of business, its growth and expansion over time.

Profits help businessmen not only to earn their living but also to expand their business activities by reinvesting a part of the profits. In order to achieve this primary objective, certain other objectives are also necessary to be pursued by business, which are as follows:

(a) Creation of customers:

A business unit cannot survive unless there are customers to buy the products and services. Again a businessman can earn profits only when he/she provides quality goods and services at a reasonable price. For this it needs to attract more customers for its existing as well as new products. This is achieved with the help of various marketing activities.

(b) Regular innovations:

Innovation means changes, which bring about improvement in products, process of production and distribution of goods. Business units, through innovation, are able to reduce cost by adopting better methods of production and also increase their sales by attracting more customers because of improved products.

Reduction in cost and increase in sales gives more profit to the businessmen. Use of power looms in place of handlooms, use of tractors in place of hand implements in farms etc. are all the results of innovation.

(c) Best possible use of resources:

As we all know, to run any business we must have sufficient capital or funds. The amount of capital may be used to buy machinery, raw materials, employ men and have cash to meet day-to-day expenses. Thus, business activities require various resources like men, materials, money and machines.

The availability of these resources is usually limited. Thus, every business should try to make the best possible use of these resources. Employing efficient workers. Making full use of machines and minimizing wastage of raw materials, can achieve this objective.

B. Social Objectives:

Social objective are those objectives of business, which are desired to be achieved for the benefit of the society. Since business operates in a society by utilizing its scarce resources, the society expects something in return for its welfare. No activity of the business should be aimed at giving any kind of trouble to the society.

If business activities lead to socially harmful effects, there is bound to be public reaction against the business sooner or later. Social objectives of business include production and supply of quality goods and services, adoption of fair trade practices and contribution to the general welfare of society and provision of welfare amenities.

(i) Production and Supply of Quality Goods and Services:

Since the business utilizes the various resources of the society, the society expects to get quality goods and services from the business he objective of business should be to produce better quality goods and supply them at the right time and at a right price It is not desirable on the part of the businessman to supply adulterated or inferior goods which cause injuries to the customers.

They should charge the price according to the quality of e goods and services provided to the society. Again, the customers also expect timely supply of all their requirements. So it is important for every business to supply those goods and services on a regular basis.

(ii) Adoption of Fair Trade Practices:

In every society, activities such as hoarding, black- marketing and over-charging are considered undesirable. Besides, misleading advertisements often give a false impression about the quality of products. Such advertisements deceive the customers and the businessmen use them for the sake of making large profits.

This is an unfair trade practice. The business unit must not create artificial scarcity of essential goods or raise prices for the sake of earning more profits. All these activities earn a bad name and sometimes make the businessmen liable for penalty and even imprisonment under the law. Therefore, the objective of business should be to adopt fair trade practices for the welfare of the consumers as well as the society.

(iii) Contribution to the General Welfare of the Society:

Business units should work for the general welfare and upliftment of the society. This is possible through running of schools and colleges better education opening of vocational training centres to train the people to earn their livelihood, establishing hospitals for medical facilities and providing recreational facilities for the general public like parks, sports complexes etc.

С. Human Objectives:

Human objectives refer to the objectives aimed at the well-being as well as fulfillment of expectations of employees as also of people who are disabled, handicapped and deprived of proper education and training. The human objectives of business may thus include economic well-being of the employees, social and psychological satisfaction of employees and development of human resources.

(i) Economic Well-being of the Employees:

In business employees must be provided with tan remuneration and incentive for performance benefits of provident fund, pension and other amenities like medical facilities, housing facilities etc. By this they feel more satisfied at work and contribute more for the business.

(ii) Social and Psychological Satisfaction of Employees:

It is the duty of business units to provide social and psychological satisfaction to their employees. This is possible by making the job interesting and challenging, putting the right person in the right job and reducing the monotony of work Opportunities for promotion and advancement in career should also be provided to the employees.

Further, grievances of employees should be given prompt attention and their suggestions should be considered seriously when decisions are made. If employees are happy and satisfied they can put then best efforts in work.

(iii) Development of Human Resources:

Employees as human beings always want to grow. Their growth requires proper training as well as development. Business can prosper if the people employed can improve their skills and develop their abilities and competencies in course of time. Thus, it is important that business should arrange training and development programmes for its employees.

(iv) Well-being of Socially and Economically Backward People:

Business units being inseparable parts of society should help backward classes and also people those are physically and mentally challenged. This can be done in many ways. For instance, vocational training programme may be arranged to improve the earning capacity of backward people in the community. While recruiting its staff, business should give preference to physically and mentally challenged persons. Business units can also help and encourage meritorious students by awarding scholarships for higher studies.

D. National Objectives:

Being an important part of the country, every business must have the objective of fulfilling national goals and aspirations. The goal of the country may be to provide employment opportunity to its citizen, earn revenue for its exchequer, become self-sufficient in production of goods and services, promote social justice, etc. Business activities should be conducted keeping these goals of the country in mind, which may be called national objectives of business.

The following are the national objectives of business.

(i)Creation of Employment:

One of the important national objectives of business is to create opportunities for gainful employment of people. This can be achieved by establishing new business units, expanding markets, widening distribution channels, etc.

(ii) Promotion of Social Justice:

As a responsible citizen, a businessman is expected to provide equal opportunities to all persons with whom he/she deals. He/ She is also expected to provide equal opportunities to all the employees to work and progress. Towards this objectives special attention must be paid to weaker and backward sections of the society.

(iii) Production According to National Priority:

Business units should produce and supply goods in accordance with the priorities laid down in the plans and policies of the government. One of the national objectives of business in our country should be to increase the production and supply of essential goods at reasonable prices.

(iv) Contribute to the Revenue of the Country:

The business owners should pay their taxes and dues honestly and regularly. This will increase the revenue of the government, which can be used for the development of the nation.

(v) Self-sufficiency and Export Promotion:

To help the country to become self-reliant, business units have the added responsibility of restricting import of goods. Besides, every business units should aim at increasing exports and adding to the foreign exchange reserves of the country.

E. Global Objectives:

Previously India had very restricted business relationship with other nations. There was a very rigid policy for import and export of goods and services. But, now-a-days due to liberal economic and export-import policy, restrictions on foreign investments have been largely abolished and duties on imported goods have been substantially reduced.

This change has brought about increase in competition in the market. Today because of globalisation the entire world has become a big market. Goods produced in one country are readily available in other countries. So, to face the competition in the global market every business has certain objectives in mind, which may be called the global objectives. Let us learn about them.

(i) Raise General Standard of Living:

Growth of business activities across national borders makes quality goods available at reasonable prices all over the world. The people of one country get to use similar types of goods that people in other countries are using. This improves the standard of living of people.

(ii) Reduce Disparities among Nations:

Business should help to reduce disparities among the rich and poor nations of the world by expanding its operation. By way of capital investment in developing as well as underdeveloped countries it can foster their industrial and economic growth.

(iii) Make Available Globally Competitive Goods and Services:

Business should produce goods and services which are globally competitive and have huge demand in foreign markets. This will improve the image of the exporting country and also earn more foreign exchange for the country.

 

Scope of Business Organization

Business is a vast and interesting subject. If one goes deeper into it, he faces more absorbing and uphill tasks. It encounters with the use of latest scientific and technical know-how, challenges and difficulties it faces from production to the smooth supply of the products to the target audience, problems confronting in raising money and by which method to raise money and the most challenging job of bringing employee together and to spur their motivation level up to a point so that they strive pleasantly to achieve the organizational goals.

A business also encounters the most amazing and challenging job of grappling with so many laws and regulations lay down by the government. The consumers, employees and various other interests groups also influence the business.

In keeping with its above mentioned factors it is always difficult to limit the discussion on the subject like scope of business.

But with the below factors an endeavour has been made to discuss the nature and scope of business:

1. Vastness:

Earlier there used to be the business in form of sole proprietorship or in partnership forms and that too was within the boundaries of a particular district or state. Then slowly and gradually the bigger form of business organization evolved in the form of Joint Stock Company. Because the earlier forms could not cope up with the ever growing demand of the society and were unable to meet the challenges of mass production.

The formation of bigger size companies have gradually started replacing manual labour in manufacturing process and with the advent of automatic machines, production in bulk has become possible. The production philosophy has been replaced by the marketing philosophy where the production is being done by knowing the need of the consumers first and then demand is created.

Traditional channels of distribution have been replaced by the new distribution channels, super bazaars, discount houses, trade fairs, different promotional scheme and reshaped world of advertising has become the order of the day in business to meet the present-day challenges. The bigger production level fetches economies of scale and ultimately the benefits pass on to the final buyers.

The trend toward growing business into bigger size is quite evident. The companies like IOC, ONGC, SAIL, etc., have shown their presence in the Fortune 500 lists. This scenario has given a kind of dynamism to the business.

2. Globalization:

There used to be a time when business operations were limited up to a particular area. Now the trade barriers are crumbling day by day because the word is shrinking rapidly. Networks of transportation, communication, music, and economics have tied the people of the world together as never before. Political boundaries are no barriers to the business.

The fast moving phenomenon of globalization is becoming imperative due to the certain technological explosion, intensity of market competition, and changing lifestyles of the people which has led to the demand for new products. This scenario has occurred due to the multi fold exposure of the people to the ever-growing field of information technology which has opened up new vistas for the business.

This has added up a new dimension that people have stranded learning to be a global manager to meet the challenge of the diversity of the culture to sustain a strong position in the international market.

3. Challenges to the Service Providers:

There was a time when only production and exchange of goods used to come under the scope of business. Service was being considered as the alien part of businesses. But now it is entirely a separate industry which is growing at a very fast pace. These are rapidly growing and increasingly important part of today’s global economy.

Because services are customer-driven, pleasing the customer is more important than ever because service-quality strategists emphasis that it is no longer enough simply to satisfy the customer. The strategic service challenge today is to anticipate and exceed the customer’s expectations which were a rare phenomenon in yester years’ businesses.

Because customers are more intimately involved in the service-delivery process than in the manufacturing process, the business needs to go directly to the customer for service-quality criteria. So, the horizons of business have expanded immensely.

4. An Interdisciplinary Field:

A principle cause of the expansion of the business is due to the information explosion which has been contributed by the various disciplines. Scholars from various fields including psychology, sociology, cultural anthropology, mathematics, philosophy, statistics, political science, economics, logistics, computer science and various fields of engineering have, at one time or another, been interested in business field and its various management theories.

In addition, administrators in business, government, church, health care and education all have drawn from and contributed to the study of business which have given immense knowledge of the field to the practitioners. With each new perspective, new questions and assumptions, new research techniques, different technical jargon, and new conceptual frameworks have come up. This has altogether revolutionized the field of businesses.

5. Information Overload:

Since the time immoral, entire civilization have come and gone. In one form or another, business management was practiced in each. Sadly, during those thousands of years of experience, one modern element was missing- a systematically recorded body of knowledge. In early cultures management was something one learned by word of mouth and on trial and error basis not to record about in textbooks, theorized about or experience with in written form.

Thanks to the modern print and electronic media, the collective genius of thousands of management theorists and practitioners has been compressed into a veritable mountain of textbooks, journals, research monographs, audio and video tapes and computer disks, etc. Use of Internet has also made it more explosive in nature. Never before have present business had so much relevant information at their fingertips, often as close as the nearest library.

6. Diversification:

Today’s business is also characterized by diversification. Earlier people used to stick to the one or two business only. The product portfolio of today’s business is expanding like anything. One can understand the concept of diversification by having an overview of Tata’s business in India which ranges from salt to steel. Diversification means introducing different lines of products which are not related to each other.

Proliferation is another name of the game today. It represents introducing different brands in the same product line. For example, FMCG’s giant HLL (Hindustan Lever Ltd.) in India has so many soaps in one time but with different brand names. Nowadays, these measures are used by the companies in the form of certain weapons to face severe competition to sustain in the market as we have never seen before this sort of scenario.

The merger and acquisition waves are also sweeping the world. To prevail in the market, we are able to witness some of the biggest mergers in the world which is another feature of today’s business. With the repeal of the some of the provisions relating to Monopolies and Restrictive Trade Practices Act, 1969 (MRTP Act), many companies in our country stretched too far in the name of diversification.

7. Foreign Capital and Technology:

There was a time when hardly any country was in the practice of using foreign capital and technology. Because the world is witnessing so many changes and with the implementation of WTO regulations, almost every country has gone international. To pay the international debts, country requires huge amount of foreign capital reservoirs. Most of the countries have been making use of foreign capital and technology to accelerate the pace of their economic growth.

There is hardly any country which is not assisted by foreign capital and technology. Foreign capital and technology play a vital role in the shaping of an economy in a big way. India being a developed economy, the importance of foreign capital and technology needs no emphasis as we have to payback lots of international debts as a new and developing economy.

Broadly a country can access these types of foreign investment, namely, foreign direct investment (FDI) and portfolio investment (FIIs). While FDIs refers to the direct investment in a foreign country whereas the portfolio investors has only a short-term property interest in investing in equities, banks and other securities.

8. Emphasis on Diversity:

Labour forces and consumers are becoming more diverse in terms of national origin, race, religion, gender, and different age categories and personnel preferences around the globe. In today’s business, managers are challenged to manage diversity effectively to tap the full potential of every individual’s unique combination of abilities and traits.

Successful business are the ones which hire the kind of managers who can anticipate and adjust to changing circumstances rather than being passively swept along or caught unprepared. Employers today are hiring managers who can take unfamiliar situations in stride. They are calling for the multilingual and multicultural managers who can manage diversity.

Those who are aware of that how to motivate a diverse workforce. Managing across cultures, emphasis on learning foreign languages are other features of today’s business. Moving from tolerance to appreciation and managing women and their powers are the other different challenges before the business today. This scenario has led the business to different dimensions.

9. Environmentalism:

Environmental issues such as deforestation, global warming, and depletion of the ozone layer, pollution of land, air and water are no longer strictly the issues related to books and conferences. The leading politicians and managers around the world have picked up the environmental banner. The green marketing movement has been gaining momentum around the world.

The businesses are challenged today to develop creative ways to make profits without unduly harming the existing environment. Considering the variety of these sources of change in the environment, global managers are challenged to keep themselves abreast and adjust as necessary. Some companies like Daewoo, Hyundai, Maruti, Tata and Hero Honda in India, with their pollution prevention programmes are leading the way. Indeed, cleaning up the environment promises to generate whole new classes of jobs in the future.

10. Competition:

Gone are the days when business was heavily protected and subsidized, licences, quotas and restrictions were the order of the day. Now competition is the name of modern business. Businessmen always stand on the brink of a fear to eliminate from the market. They stand on their feet to cut down costs, to eliminate deficiencies and incessant improvement in the quality is order of the day.

But by the competition, consumer is obviously benefitted by the diverse openings of different competitors. According to Michael Porter “aggressive home based suppliers and demanding local suppliers competing domestic rivals will keep each other honest in obtaining government support”. Nowadays, competition is not only from rival firms but also from the ever improving technology.

For example, typewriters have been completely wiped out from the market by the computers. Traditional postage telegrams are at the verge of elimination by the increasing use of Internet services. So, today’s business is witnessing the manifolds competition which was not prevalent in the past.

11. The Rise of the Rural Market:

The rapid growth of the rural market for a number of products is another important development. The developed economies in the world enjoyed the fruit of sustained growth over a longer period of time but now their markets have been saturated due to the limited population. In the search of growth the Multinational Corporations (MNCs) has started looking for the newer avenues.

In the beginning they targeted the underdeveloped and developing nations in their urban areas. In India particularly with the liberalization policy of 1991 of the government of India, so many products were flooded in the Indian markets of genuine prices. This scenario could be witnessed up to 1995-96 but then urban markets of India have also started saturating and the different companies started looking for the newer kinds of market and that was rural market.

Earlier rural market due to certain traditional is cultural barriers was not considered by the marketers but now these markets have become the order of the day where around 70 per cent of the population reside in these areas and contributes hefty percentage in the GDP. So, we can say that business have gone to the every nook and corner of the world.

So, from the above discussion, we can conclude that as far as scope of the business is concerned, it is vast and fascinating. It encompasses the use of latest technology and scientific know-how, it has changed its dimension from just producing and exchange of goods as service industry has given a different direction to it. Literature on this subject is ever-growing.

Numerous books, journals, monographs and research articles are being written and fulfillment on each functional area of the business which have never seen before. Special courses are being conducted by the various universities and institutions on business as it has taken a thoroughly professional shape over a period of time. It has crossed its boundaries across the borders so the managers have to learn how to cope up with the diversities of race, casts, languages, religion and sex, etc.

They have to acquaint different cultures and traditions to be successful in the global market. Therefore, we can say that today’s business is entirely different than that of earlier ones and it poses numerous opportunities as well as challenges to the entrepreneurs.

 

Characteristics of a Business Organization

From the above discussion, we can draw certain characteristics of today’s business which are as follows:

(i) It is a Human Activity:

Business is a human activity which makes available goods and services to the society. It is not only dependent on making available the goods and services or the mere production of these but also depends on the exchange of value which is provided in return because if you are engaged in giving gifts to somebody then it will not be treated as business.

(ii) Continuous Economic Activity:

In business an economic activity must be repeated again and again because if an entrepreneur does not do that it will not be treated as business. For example, if a person sells his own house, this activity does not come under the framework of business.

(iii) Profit Motive:

Any economic activity which leads to generation of profit is considered as business. Therefore, intension should be to earn profit otherwise if a person is engaged in social service or preaching about the religion cannot be treated as business.

(iv) Entrepreneurship:

One cannot run any sort of business without the element of entrepreneurship irrespective of the size of the business. Business can only be run by a daring person who has the ability to face risk of loss, because no business is there where the element of risk is missing. Involvement of element of risk of loss makes the business world more challenging and to face financial challenge is not everybody’s cup of tea.

(v) Creation of Utility:

A man does not produce anything in a way, he only converts the form of resources which are provided by the nature. The business changes the form, place and possession utility of goods and makes them available in usable form. The business creates the utility of the things so that these can be consumed.

 

Structure of a Business Organization

An organizational structure identifies the roles and responsibilities of the employees hired by the firm. The organizational structure of a new factory is more complicated than that of a pizza delivery shop. If the owner plans to manage most of the operations, the organizational structure is simple. Some businesses begin with the owner assuming most responsibilities, but growth requires the hiring of managers.

Even if the owners initially run the business, they should develop plans for the future organizational structure. A job description for each employee should be included, along with the estimated salary to be paid to each employee.

 

Classification of a Business Organization

Business organization is the single-most important choice you’ll make regarding your company. What form your business adopts will affect a multitude of factors, many of which will decide your company’s future. Aligning your goals to your business organization type is an important step, so understanding the pros and cons of each type is crucial.

Your company’s form will affect:

• How you are taxed
• Your legal liability
• Costs of formation
• Operational costs

There are 4 main types of business organization: sole proprietorship, partnership, corporation, and Limited Liability Company, or LLC. Below, we give an explanation of each of these and how they are used in the scope of business law.

Sole Proprietorship

The simplest and most common form of business ownership, sole proprietorship is a business owned and run by someone for their own benefit. The business’ existence is entirely dependent on the owner’s decisions, so when the owner dies, so does the business.

Advantages of sole proprietorship:

• All profits are subject to the owner
• There is very little regulation for proprietorships
• Owners have total flexibility when running the business
• Very few requirements for starting—often only a business license

Disadvantages:

• Owner is 100% liable for business debts
• Equity is limited to the owner’s personal resources
• Ownership of proprietorship is difficult to transfer
• No distinction between personal and business income

Partnership

These come in two types: general and limited. In general partnerships, both owners invest their money, property, labor, etc. to the business and are both 100% liable for business debts. In other words, even if you invest a little into a general partnership, you are still potentially responsible for all its debt. General partnerships do not require a formal agreement—partnerships can be verbal or even implied between the two business owners.

Limited partnerships require a formal agreement between the partners. They must also file a certificate of partnership with the state. Limited partnerships allow partners to limit their own liability for business debts according to their portion of ownership or investment.

Advantages of partnerships:

• Shared resources provides more capital for the business
• Each partner shares the total profits of the company
• Similar flexibility and simple design of a proprietorship
• Inexpensive to establish a business partnership, formal or informal

Disadvantages:

• Each partner is 100% responsible for debts and losses
• Selling the business is difficult—requires finding new partner
• Partnership ends when any partner decides to end it

Corporation

Corporations are, for tax purposes, separate entities and are considered a legal person. This means, among other things, that the profits generated by a corporation are taxed as the “personal income” of the company. Then, any income distributed to the shareholders as dividends or profits are taxed again as the personal income of the owners.

Advantages of a corporation:

• Limits liability of the owner to debts or losses
• Profits and losses belong to the corporation
• Can be transferred to new owners fairly easily
• Personal assets cannot be seized to pay for business debts

Disadvantages:

• Corporate operations are costly
• Establishing a corporation is costly
• Start a corporate business requires complex paperwork
• With some exceptions, corporate income is taxed twice

Limited Liability Company (LLC)

Similar to a limited partnership, an LLC provides owners with limited liability while providing some of the income advantages of a partnership. Essentially, the advantages of partnerships and corporations are combined in an LLC, mitigating some of the disadvantages of each.

Advantages of an LLC:

• Limits liability to the company owners for debts or losses
• The profits of the LLC are shared by the owners without double-taxation

Disadvantages:

• Ownership is limited by certain state laws
• Agreements must be comprehensive and complex
• Beginning an LLC has high costs due to legal and filing fees

 

Establishment of a new Business Unit

Establishing a new business unit is the last process in the series of process for promotions of an entrepreneurial venture, which is like giving birth to a baby, the reason is that just as a mother has to bear various types of pains and problems, before and after the birth of the child, similarly an entrepreneur has also to perform various entrepreneurial functions for establishing of a new business unit.

1. The Emergence of the Idea to Establish an Institution or Enterprise

These ideas may be of several types, like, invention or investigation of any new commodity, the idea of any new natural source and its business use, idea to increase the utility, attractiveness or availability of any commodity, idea of preparing substitute commodities for any particular commodity and the idea of taking advantages of the low competition in any market area.

The entrepreneur should practically and constructively think over establishing any institution/enterprise only on the basis of sound grounds.

2. Selection of Business

The success of the entrepreneur depends upon the selection of the appropriate business.

For that, the entrepreneur should make sufficient use of his experience, knowledge, skills, and foresightedness.

 

Top 10 Key Functions for Establishing A New Business Unit

Establishing a new business unit is the last process in the series of process for promotions of an entrepreneurial venture, which is like giving birth to a baby, the reason is that just as a mother has to bear various types of pains and problems, before and after the birth of the child, similarly an entrepreneur has also to perform various entrepreneurial functions for establishing of a new business unit.

What are the Key Points to Start a Business?

The following are the major Functions for Establishing a New Business Unit:

1. The Emergence of the Idea to Establish an Institution or Enterprise

These ideas may be of several types, like, invention or investigation of any new commodity, the idea of any new natural source and its business use, idea to increase the utility, attractiveness or availability of any commodity, idea of preparing substitute commodities for any particular commodity and the idea of taking advantages of the low competition in any market area.

The entrepreneur should practically and constructively think over establishing any institution/enterprise only on the basis of sound grounds.

2. Selection of Business

The success of the entrepreneur depends upon the selection of the appropriate business.

For that, the entrepreneur should make sufficient use of his experience, knowledge, skills, and foresightedness.

Besides, while taking advice from the experts, he should keep various points in view like – initial investigation, gaining information related to the emerged idea, like product analysis, market analysis, government policy, profitability, availability of resources, technical Knowhow, managerial capabilities, possibilities of the future of the business and business policy, etc.

3. Determination of the Form of Business Ownership

While determining it, elements, like – size, working area, production process, financial requirements, technical requirements, market area, the scale of production, and risks of the business or enterprise are to be considered properly.

4. Determination of Objectives and Working Area of the Business

All functions of the organization are operated only on the basis of these objectives.

Hence, it is essential that these may be very clear and specific.

Besides, the working area of the enterprise should also be well determined.

The working area of the enterprise may be of local, provincial, national, or international levels.

But, for determining it, sources and size of the enterprise should be kept in view.

5. Determination of Optimum Size of the Business

After the selection of form and determination of objectives and area of the enterprise, by an entrepreneur/manager/promoter, he is should also determine the optimum size of the Enterprise.

6. Initial Contracts

Before establishing a business/enterprise, some initial contacts are required, like

1. Contract with the owner of the existing business, if he wants to purchase it.
2. The initial contract with the concerned parties for land, and building, copyright, patent rights, etc. if he wants to do his own new business.
3. Initial Contracts with office employees, experts, and legal advisors, etc.
4. In case of purchase of the ongoing business, decisions regarding payment for the purchase, determination of reputation, and assessment of assets should be done after thoughtfully considering various issues.

7. Determination of the location of the Business

For it, the entrepreneur should keep various points into consideration, like – proximity to the market, availability of raw materials, means of transportation and communications and sources of energy, etc. 

8. Financial Planning

Finance is the lifeblood of the business. It is not possible to operate any business without finance or capital.

For financial planning, capital requirements of the enterprise are to be identified, sources of capital are to be studied and appropriate decisions are taken for capitalization, so that the problems of Undercapitalization and overcapitalization may not arise.

9. Sound Organisational Structure

The success of a business enterprise depends upon the sound organizational structure also.

It includes determination of functions, departmentalization, delegation of powers, determination of responsibilities, determination of levels of management, employee relations, and determination of system of supervision of the subordinates.

While determining and distributing work, the powers, duties, and responsibilities of the employees should be made very clear, and organizational structure should be framed in accordance with the goals, policies, objectives, and budget of the enterprise.

Besides it, proper arrangements for required furniture, stationery, time and Labour saving recruitments and computer, etc. should be suitably considered.

10. Completion of Formalities

For the establishment of a new enterprise unit, various legal formalities are to be completed.

These formalities depend upon the nature, size, volume of capital, and type of ownership of the business.

Normally, the legal formalities may be:

• Getting registration of the firm in case of the parties partnership business, registration of shop and office, under shop, and Establishment Act.
• To present various documents before the registrar, to obtain the certificate, in case of the company.
• Getting registration from the Commercial Taxes Department and requirement and selection of the employees and.
• To start the Enterprise.

 

Business vs. Profession

Many people do not have a clear understanding of business and profession. They use to think that both terms are the same. However, they are not.

The difference between Business and Profession is that business doesn’t require a person to have a specific qualification. On the other hand, the profession requires you to be skilled in your niche and have a certification in that. Business is generally concerned with the buying and then selling of articles. In a profession, you are required to provide services through your skills.

The main objective of a business is to earn a profit. Every person has their own tactics in order to make a considerable amount of profit in the industry.

In the profession, one aims to provide top-notch services to the company. They have to be experts in that particular field in order to do so.

As business is concerned with buying and selling, it doesn’t require any certificate or a degree from a person. What all matters is that if you can increase the profits, the business is making. However, the profession requires you to be qualified in your field as you will be providing services on the basis of your qualifications.

Comparison Table Between Business and Profession

Parameter of Comparison	Business	Profession
Definition	It is a type of economic activity in which a person produces and sells articles with the only purpose of making profits.	A profession is concerned with providing services that require a person to have a certain qualification in a particular niche in order to successfully do that.
Purpose	The main goal here is to make money.	In profession, the purpose is to provide services.
Qualification	No qualification is required. You are just required to produce, buy, and sell items in order to earn.	Qualification is required. It is mandatory that you have expertise in the area you are providing your services in.
Involvement of risk	The risk factor is quite high here.	There is almost no risk factor.
Advertisement	Businesses use advertisements to boost their sales.	Advertisement isn’t allowed because of the professional code of conduct.

 

 

UNIT III

 

Business Combinations

The term business combination refers to the combination of several business units or different companies into a single, larger organization. Business combination is used to improve operational efficiency by reducing redundant personnel and processes. Business combination can result in long-term cost savings and a concentration of market share, but in the short-term can be expensive and complex.

• Business combination is a combination of several business units or companies into a single, larger organization.
• The reasons behind combination include operational efficiency, eliminating competition, and getting access to new markets.
• Combination can lead to a concentration of market share and a bigger customer base.
• Some of the disadvantages of combination include dealing with cultural differences between firms and potential issues with personnel.

Consolidation happens when two or more companies merge to become one. Also known as amalgamation, business consolidation is most often associated with mergers and acquisitions (M&A). This often happens when several similar, smaller businesses combine to form a new, larger legal entity. In most cases, the smaller entities that are acquired cease to exist. Other kinds of consolidation are explained further on.

Combining multiple companies or business units into a brand new company is the most drastic option. This can be an expensive proposition if one of the merging companies is liquidated, and can carry additional costs associated with creating a new brand. But businesses that want to consolidate their operations have other options at their disposal. Another option for business consolidation involves moving smaller operations into an existing company that does not intend to be dismantled.

The reasons behind consolidation vary, and there are many. They include but aren't limited to:

• Operational efficiency
• Eliminating the competition for customers and/or resources
• Access to and expansion into new markets
• Innovation and new products
• Cheaper financing options for bigger businesses
• Shared operations

Regardless of the rationale, businesses can't—and shouldn't—take the decision to consolidate lightly. Not only are the costs to consolidate hefty, but there are also other things to consider. For instance, executives and other key personnel have to satisfy shareholders' concerns, they must consider what happens with redundancies in the workforce, whether to sell assets, and how to market and brand the new company once the whole process is complete.

 

The decision to consolidate shouldn't be taken lightly especially since the related costs are very hefty

Types of Business Combination

Just like company types, there are many different kinds of business combination. It all depends on the strategy, the desired outcome, and the nature of the businesses involved. They fall into a few categories that are listed below.

Statutory Combination

When businesses are combined into a new entity, the original companies cease to exist. By combining these businesses together, they create a new, larger corporation. This is called statutory combination, which is normally done through a merger transaction.

Statutory Merger

This kind of business combination takes place when an acquiring company liquidates the assets of a company it buys. After doing so, the acquirer incorporates or dismantling the target company's operations. So, unlike a statutory combination, the acquiring company keeps its operations going, while the acquired entity no longer exists.

Stock Acquisition

This is a combination of businesses in which an acquiring company buys a majority share or a controllin interest of another company. In order for it to be a majority share, the acquirer must take out more than 50% in the target. In the end, both companies survive.

Variable Interest Entity

When an acquiring entity owns a controlling interest in a company that is not based on a majority of voting rights, it is referred to as a variable interest entity. These entities are normally established as special purpose vehicles (SPVs).

Advantages and Disadvantages of Business Combination

Pros

There are many advantages to combining two or more business entities together. Consolidated business can obtain cheaper financing if the newly formed entity is more stable, more profitable, or has more assets to use as collateral. The new company may also be able to use its larger size to extract better terms from suppliers because it will be able to buy more units. In addition, business combinations can result in a concentration of market share, a more expansive product lineup, a greater geographical reach, and therefore a bigger customer base.

Cons

With the positives, there also comes a lot of negatives. Companies that combine operations must deal with cultural differences between firms. For example, merging an older, established technology company with a small startup company may achieve a beneficial transfer of knowledge, experience, and skills, but also may cause personnel to clash. In such an example, management in the older firm may feel more comfortable with operating under strict administrative hierarchies, while the startup company may have preferred less administrative authority over operations.

 

Mergers and acquisitions (M&A)

Mergers and acquisitions (M&A) is a general term used to describe the consolidation of companies or assets through various types of financial transactions, including mergers, acquisitions, consolidations, tender offers, purchase of assets, and management acquisitions.

The term M&A also refers to the desks at financial institutions that deal in such activity.

• The term mergers and acquisitions (M&A) refer broadly to the process of one company combining with one another.
• In an acquisition, one company purchases the other outright. The acquired firm does not change its legal name or structure but is now owned by the parent company.
• A merger is the combination of two firms, which subsequently form a new legal entity under the banner of one corporate name.
• M&A deals generate sizable profits for the investment banking industry, but not all mergers or acquisition deals close.
• Post-merger, some companies find great success and growth, while others fail spectacularly.

 

The terms "mergers" and "acquisitions" are often used interchangeably, although in actuality, they hold slightly different meanings. When one company takes over another entity, and establishes itself as the new owner, the purchase is called an acquisition. From a legal point of view, the target company ceases to exist, the buyer absorbs the business, and the buyer's stock continues to be traded, while the target company’s stock ceases to trade.

On the other hand, a merger describes two firms of approximately the same size, who join forces to move forward as a single new entity, rather than remain separately owned and operated. This action is known as a "merger of equals." Both companies' stocks are surrendered and new company stock is issued in its place. Case in point: both Daimler-Benz and Chrysler ceased to exist when the two firms merged, and a new company, Daimler Chrysler, was created. A purchase deal will also be called a merger when both CEOs agree that joining together is in the best interest of both of their companies.

Unfriendly ("hostile takeover") deals, where target companies do not wish to be purchased, are always regarded as acquisitions. A deal is can thus be classified as a merger or an acquisition, based on whether the acquisition is friendly or hostile and how it is announced. In other words, the difference lies in how the deal is communicated to the target company's board of directors, employees and shareholders.

Types of Mergers & Acquisitions

Here is a brief overview of some common transactions that fall under the M&A umbrella:

Mergers

In a merger, the boards of directors for two companies approve the combination and seek shareholders' approval. Post merger, the acquired company ceases to exist and becomes part of the acquiring company. For example, in 1998 a merger deal occurred between Digital Computers and Compaq, whereby Compaq absorbed Digital Computers. Compaq later merged with Hewlett-Packard in 2002. Compaq's pre-merger ticker symbol was CPQ. This was combined with Hewlett-Packard's ticker symbol (HWP) to create the current ticker symbol (HPQ).

Acquisitions

In a simple acquisition, the acquiring company obtains the majority stake in the acquired firm, which does not change its name or alter its legal structure, and often preserve the existing stock symbol. An example of this transaction is Manulife Financial Corporation's 2004 acquisition of John Hancock Financial Services, where both companies preserved their names and organizational structures. Acquisitions may be done by exchanging one company's stock for the others or using cash to purchase the target company's shares.

Consolidations

Consolidation creates a new company through combining core businesses and abandoning the old corporate structures. Stockholders of both companies must approve the consolidation, and subsequent to the approval, receive common equity shares in the new firm. For example, in 1998, Citicorp and Traveler's Insurance Group announced a consolidation, which resulted in Citigroup.

Tender Offers

In a tender offer, one company offers to purchase the outstanding stock of the other firm, at a specific price rather than market price. The acquiring company communicates the offer directly to the other company's shareholders, bypassing the management and board of directors. For example, in 2008, Johnson & Johnson made a tender offer to acquire Omrix Biopharmaceuticals for $438 million. While the acquiring company may continue to exist — especially if there are certain dissenting shareholders — most tender offers result in mergers.

Acquisition of Assets

In an acquisition of assets, one company directly acquires the assets of another company. The company whose assets are being acquired must obtain approval from its shareholders. The purchase of assets is typical during bankruptcy proceedings, where other companies bid for various assets of the bankrupt company, which is liquidated upon the final transfer of assets to the acquiring firms.

Management Acquisitions

In a management acquisition, also known as a management-led buyout (MBO), a company's executives purchase a controlling stake in another company, taking it private. These former executives often partner with a financier or former corporate officers, in an effort to help fund a transaction. Such M&A transactions are typically financed disproportionately with debt, and the majority of shareholders must approve it. For example, in 2013, Dell Corporation announced that it was acquired by its chief executive manager, Michael Dell.

The Structure of Mergers

Mergers may be structured in multiple different ways, based on the relationship between the two companies involved in the deal.

• Horizontal merger: Two companies that are in direct competition and share the same product lines and markets.
• Vertical merger: A customer and company or a supplier and company. Think of a cone supplier merging with an ice cream maker.
• Congeneric mergers: Two businesses that serve the same consumer base in different ways, such as a TV manufacturer and a cable company.
• Market-extension merger: Two companies that sell the same products in different markets.
• Product-extension merger: Two companies selling different but related products in the same market.
• Conglomeration: Two companies that have no common business areas.

Mergers may also be distinguished by following two financing methods--each with its own ramifications for investors.

• Purchase Mergers: As the name suggests, this kind of merger occurs when one company purchases another company. The purchase is made with cash or through the issue of some kind of debt instrument. The sale is taxable, which attracts the acquiring companies, who enjoy the tax benefits. Acquired assets can be written-up to the actual purchase price, and the difference between the book value and the purchase price of the assets can depreciate annually, reducing taxes payable by the acquiring company.
• Consolidation Mergers: With this merger, a brand new company is formed, and both companies are bought and combined under the new entity. The tax terms are the same as those of a purchase merger.

Special Considerations

A company may buy another company with cash, stock, assumption of debt, or a combination thereof. In smaller deals, it is also common for one company to acquire all of another company's assets. Company X buys all of Company Y's assets for cash, which means that Company Y will have only cash (and debt, if any). Of course, Company Y becomes merely a shell and will eventually liquidate or enter other areas of business.

Another acquisition deal known as a "reverse merger" enables a private company to become publicly-listed in a relatively short time period. Reverse mergers occur when a private company that has strong prospects and is eager to acquire financing buys a publicly-listed shell company, with no legitimate business operations and limited assets. The private company reverses merges into the public company, and together they become an entirely new public corporation with tradeable shares.

 

What Is a Takeover?

A takeover occurs when one company makes a successful bid to assume control of or acquire another. Takeovers can be done by purchasing a majority stake in the target firm. Takeovers are also commonly done through the merger and acquisition process. In a takeover, the company making the bid is the acquirer and the company it wishes to take control of is called the target.

Takeovers are typically initiated by a larger company seeking to take over a smaller one. They can be voluntary, meaning they are the result of a mutual decision between the two companies. In other cases, they may be unwelcome, in which case the acquirer goes after the target without its knowledge or some times without its full agreement.

In corporate finance, there can be a variety of ways for structuring a takeover. An acquirer may choose to take over controlling interest of the company’s outstanding shares, buy the entire company outright, merge an acquired company to create new synergies, or acquire the company as a subsidiary.

• A takeover occurs when an acquiring company successfully closes on a bid to assume control of or acquire a target company.
• Takeovers are typically initiated by a larger company seeking to take over a smaller one.
• Takeovers can be welcome and friendly, or they may be unwelcome and hostile.
• Companies may initiate takeovers because they find value in a target company, they want to initiate change, or they may want to eliminate the competition.

Understanding Takeovers

Takeovers are fairly common in the business world. However, they may be structured in a multitude of ways. Whether both parties are in agreement or not, will often influence the structuring of a takeover. 

Keep in mind, if a company owns more than 50% of the shares of a company, it is considered controlling interest. Controlling interest requires a company to account for the owned company as a subsidiary in its financial reporting, and this requires consolidated financial statements.¹ A 20% to 50% ownership stake is accounted for more simply through the equity method. If a full-on merger or acquisition occurs, shares will often be combined under one symbol. 

Types of Takeovers

Takeovers can take many different forms. A welcome or friendly takeover will usually be structured as a merger or acquisition. These generally go smoothly because the boards of directors for both companies usually consider it a positive situation. Voting must still take place in a friendly takeover. However, when the board of directors and key shareholders are in favor of the takeover, takeover voting can more easily be achieved. 

Usually, in these cases of mergers or acquisitions, shares will be combined under one symbol. This can be done by exchanging shares from the target’s shareholders to shares of the combined entity.

An unwelcome or hostile takeover can be quite aggressive as one party is not a willing participant. The acquiring firm can use unfavorable tactics such as a dawn raid, where it buys a substantial stake in the target company as soon as the markets open, causing the target to lose control before it realizes what is happening.

The target firm’s management and board of directors may strongly resist takeover attempts by implementing tactics such as a poison pill, which allows the target’s shareholders to purchase more shares at a discount to dilute the potential acquirer’s holdings and voting rights.

A reverse takeover happens when a private company takes over a public one. The acquiring company must have enough capital to fund the takeover. Reverse takeovers provide a way for a private company to go public without having to take on the risk or added expense of going through an initial public offering (IPO).

A creeping takeover occurs when one company slowly increases its share ownership in another. Once the share ownership gets to 50% or more, the acquiring company is required to account for the target’s business through consolidated financial statement reporting.¹ The 50% level can thus be a significant threshold, particularly since some companies may not want the responsibilities of controlling ownership. After the 50% threshold has been breached, the target company should be considered a subsidiary.

Creeping takeovers may also involve activists who increasingly buy shares of a company with the intent of creating value through management changes. An activist takeover would likely happen gradually over time.

 

Reasons for a Takeover

There are many reasons why companies may initiate a takeover. An acquiring company may pursue an opportunistic takeover, where it believes the target is well priced. By buying the target, the acquirer may feel there is long-term value. With these takeovers, the acquiring company usually increases its market share, achieves economies of scale, reduces costs, and increases profits through synergies.

Some companies may opt for a strategic takeover. This allows the acquirer to enter a new market without taking on any extra time, money, or risk. The acquirer may also be able to eliminate competition by going through a strategic takeover.

There can also be activist takeovers. With these takeovers, a shareholder seeks controlling interest ownership to initiate change or acquire controlling voting rights.

Companies that make attractive takeover targets include:

• Those with a unique niche in a particular product or service
• Small companies with viable products or services but insufficient financing
• Similar companies in close geographic proximity where combining forces could improve efficiency
• Otherwise viable companies that pay too much for debt that could be refinanced at a lower cost if a larger company with better credit took over
• Companies with good potential value but management challenges

Funding Takeovers

Financing takeovers can come in many different forms. When the target is a publicly-traded company, the acquiring company can buy shares of the business in the secondary market. In a friendly merger or acquisition, the acquirer makes an offer for all of the target’s outstanding shares. A friendly merger or acquisition will usually be funded through cash, debt, or new stock issuance of the combined entity. 

When a company uses debt, it's known as a leveraged buyout. Debt capital for the acquirer may come from new funding lines or the issuance of new corporate bonds.

Example of a Takeover

ConAgra initially attempted a friendly acquisition of Ralcorp in 2011. When initial advances were rebuffed, ConAgra intended to work a hostile takeover. Ralcorp responded by using the poison pill strategy. ConAgra responded by offering $94 per share, which was significantly higher than the $65 per share Ralcorp was trading at when the takeover attempt began. Ralcorp denied the attempt, though both companies returned to the bargaining table the following year.³

The deal was ultimately made as part of a friendly takeover with a per-share price of $90. By this time, Ralcorp had completed the spinoff of its Post cereal division, resulting in approximately the same offering price by ConAgra for a slightly smaller total business.

 

UNIT IV

 

Business Financing

Unless your business has the balance sheet of Apple, eventually you will probably need access to capital through business financing. In fact, even many large-cap companies routinely seek capital infusions to meet short-term obligations. For small businesses, finding the right funding model is vitally important. Take money from the wrong source and you may lose part of your company or find yourself locked into repayment terms that impair your growth for many years into the future.

• There are a number of ways to find financing for a small business.
• Debt financing is usually offered by a financial institution and is similar to taking out a mortgage or an automobile loan, requiring regular monthly payments until the debt is paid off.
• In equity financing either a firm or an individual makes an investment in your business, meaning you don’t have to pay the money back, but the investor now owns a percentage of your business, perhaps even a controlling one.
• Mezzanine capital combines elements of debt and equity financing, with the lender usually having an option to convert unpaid debt into ownership in the company.

 

Debt Financing

Debt financing for your business is something you likely understand better than you think. Do you have a mortgage or an automobile loan? Both of these are forms of debt financing. It works the same way for your business. Debt financing comes from a bank or some other lending institution. Although it is possible for private investors to offer it to you, this is not the norm.

Here is how it works. When you decide you need a loan, you head to the bank and complete an application. If your business is in the earliest stages of development, the bank will check your personal credit.

For businesses that have a more complicated corporate structure or have been in existence for an extended period time, banks will check other sources. One of the most important is the Dun & Bradstreet (D&B) file. D&B is the best-known company for compiling a credit history on businesses. Along with your business credit history, the bank will want to examine your books and likely complete other due diligence.

Before applying, make sure all business records are complete and organized. If the bank approves your loan request, it will set up payment terms, including interest. If the process sounds a lot like the process you have gone through numerous times to receive a bank loan, you are right.

Advantages of Debt Financing

There are several advantages to financing your business through debt.

• The lending institution has no control over how you run your company, and it has no ownership.
• Once you pay back the loan, your relationship with the lender ends. That is especially important as your business becomes more valuable.
• The interest you pay on debt financing is tax deductible as a business expense.
• The monthly payment, as well as the breakdown of the payments, is a known expense that can be accurately included in your forecasting models.

Disadvantages of Debt Financing

However, debt financing for your business does come with some downsides.

• Adding a debt payment to your monthly expenses assumes that you will always have the capital inflow to meet all business expenses, including the debt payment. For small or early-stage companies that is often far from certain.
• Small business lending can be slowed substantially during recessions. In tougher times for the economy, it can be difficult to receive debt financing unless you are overwhelmingly qualified.

 

Equity Financing

If you have ever watched ABC’s hit series “Shark Tank,” you may have a general idea of how equity financing works. It comes from investors, often called “venture capitalists” or “angel investors.”

A venture capitalist is usually a firm rather than an individual. The firm has partners, teams of lawyers, accountants, and investment advisors who perform due diligence on any potential investment. Venture capital firms often deal in large investments ($3 million or more), and so the process is slow and the deal is often complex.

Angel investors, by contrast, are normally wealthy individuals who want to invest a smaller amount of money into a single product instead of building a business. They are perfect for somebody such as the software developer who needs a capital infusion to fund the development of their product. Angel investors move fast and want simple terms.

Equity financing uses an investor, not a lender; if you end up in bankruptcy, you do not owe anything to the investor, who, as a part owner of the business, simply loses their investment.

Advantages of Equity Financing

Funding your business through investors has several advantages, including the following:

• The biggest advantage is that you do not have to pay back the money. If your business enters bankruptcy, your investor or investors are not creditors. They are partial owners in your company and, because of that, their money is lost along with your company.
• You do not have to make monthly payments, so there is often more liquid cash on hand for operating expenses.
• Investors understand that it takes time to build a business. You will get the money you need without the pressure of having to see your product or business thriving within a short amount of time.

Disadvantages of Equity Financing

Similarly, there are a number of disadvantages that come with equity financing, including the following:

• How do you feel about having a new partner? When you raise equity financing, it involves giving up ownership of a portion of your company. The larger and riskier the investment, the more of a stake the investor will want. You might have to give up 50% or more of your company. Unless you later construct a deal to buy the investor’s stake, that partner will take 50% of your profits indefinitely.
• You will also have to consult with your investors before making decisions. Your company is no longer solely yours, and if an investor has more than 50% of your company, you have a boss to whom you have to answer.

 

Mezzanine Capital

Put yourself in the position of the lender for a moment. The lender is looking for the best value for its money relative to the least amount of risk. The problem with debt financing is that the lender does not get to share in the success of the business. All it gets is its money back with interest while taking on the risk of default. That interest rate is not going to provide an impressive return by investment standards. It will probably offer single-digit returns.

Mezzanine capital often combines the best features of equity and debt financing. Although there is no set structure for this type of business financing, debt capital often gives the lending institution the right to convert the loan to an equity interest in the company if you do not repay the loan on time or in full.

Advantages of Mezzanine Capital

Choosing to use mezzanine capital comes with several advantages, including the following:

• This type of loan is appropriate for a new company that is already showing growth. Banks are reluctant to lend to a company that does not have financial data. According to Dr. Ajay Tyagi’s 2017 book Capital Investment and Financing for Beginners, Forbes has reported that bank lenders are often looking for at least three years of financial data.¹ However, a newer business may not have that much data to supply. By adding an option to take an ownership stake in the company, the bank has more of a safety net, making it easier to get the loan.
• Mezzanine capital is treated as equity on the company’s balance sheet. Showing equity rather than a debt obligation makes the company look more attractive to future lenders.
• Mezzanine capital is often provided very quickly with little due diligence.

Disadvantages of Mezzanine Capital

Mezzanine capital does have its share of disadvantages, including the following:

• The coupon or interest is often higher, as the lender views the company as high risk. Mezzanine capital provided to a business that already has debt or equity obligations is often subordinate to those obligations, increasing the risk that the lender will not be repaid. Because of the high risk, the lender may want to see a 20% to 30% return.
• Much like equity capital, the risk of losing a significant portion of the company is very real.

Please note that mezzanine capital is not as standard as debt or equity financing. The deal, as well as the risk/reward profile, will be specific to each party.

 

Off-balance balance financing is good for one-time large purposes, allowing a business to create a special purpose vehicle (SPV) that carries the expense on its balance sheet, making the business seem less in debt.

 

Off-Balance Sheet Financing

Think about your personal finances for a minute. What if you were applying for a new home mortgage and discovered a way to create a legal entity that takes your student loan, credit card, and automobile debt off your credit report? Businesses can do that.

Off-balance sheet financing is not a loan. It is primarily a way to keep large purchases (debts) off a company’s balance sheet, making it look stronger and less debt-laden. For example, if the company needed an expensive piece of equipment, it could lease it instead of buying it or create a special purpose vehicle (SPV)—one of those “alternate families” that would hold the purchase on its balance sheet. The sponsoring company often overcapitalizes the SPV in order to make it look attractive should the SPV need a loan to service the debt.

Off-balance sheet financing is strictly regulated and generally accepted accounting principles (GAAP) govern its use. This type of financing is not appropriate for most businesses, but it may become an option for small businesses that grow into much larger corporate structures.

 

Funding From Family and Friends

If your funding needs are relatively small, you may want to first pursue less formal means of financing. Family and friends who believe in your business can offer simple and advantageous repayment terms in exchange for setting up a lending model similar to some of the more formal models. For example, you could offer them stock in your company or pay them back just as you would a debt financing deal, in which you make regular payments with interest.

 

When you can avoid financing from a formal source, it will usually be more advantageous for your business. If you do not have family or friends with the means to help, debt financing is likely the easiest source of funds for small businesses. As your business grows or reaches later stages of product development, equity financing or mezzanine capital may become options. When it comes to financing and how it will affect your business, less is more.

 

Debenture

A debenture is a type of bond or other debt instrument that is unsecured by collateral. Since debentures have no collateral backing, they must rely on the creditworthiness and reputation of the issuer for support. Both corporations and governments frequently issue debentures to raise capital or funds.

• A debenture is a type of debt instrument that is not backed by any collateral and usually has a term greater than 10 years.
• Debentures are backed only by the creditworthiness and reputation of the issuer.
• Both corporations and governments frequently issue debentures to raise capital or funds.
• Some debentures can convert to equity shares while others cannot.

 

Convertible vs. Nonconvertible

Convertible debentures are bonds that can convert into equity shares of the issuing corporation after a specific period. Convertible debentures are hybrid financial products with the benefits of both debt and equity. Companies use debentures as fixed-rate loans and pay fixed interest payments. However, the holders of the debenture have the option of holding the loan until maturity and receive the interest payments or convert the loan into equity shares.

Convertible debentures are attractive to investors that want to convert to equity if they believe the company's stock will rise in the long term. However, the ability to convert to equity comes at a price since convertible debentures pay a lower interest rate compared to other fixed-rate investments.

Nonconvertible debentures are traditional debentures that cannot be converted into equity of the issuing corporation. To compensate for the lack of convertibility investors are rewarded with a higher interest rate when compared to convertible debentures.

 Just as there are convertible debentures, there are also non-convertible debentures whereby the debt cannot be converted into equity. As a result, non-convertible debentures will offer higher interest rates than their convertible counterparts since investors do not have the option to convert to stock.

Partly-convertible debentures are also a version of this type of debt. These loans have a predetermined portion that can be converted to stock. The conversion ratio is determined at the onset of the debt issuance.

Fully-convertible debentures have the option to convert all of the debt into equity shares based on the terms outlined at the debt issuance. It's important that investors research the type of debenture they're considering for investment including if or when there is a conversion option, the conversion ratio, and the time frame for when a conversion to equity can occur.

 

Stock Exchanges

A stock exchange does not own shares. Instead, it acts as a market where stock buyers connect with stock sellers. Stocks can be traded on several exchanges such as the National Stock Exchange (NSE) or the Bombay Stock Exchange (BSE).  Although most stocks are traded through a broker, it is important to understand the relationship between exchanges and the companies that trade. Also, there are various requirements for different exchanges designed to protect investors.

• A stock exchange is a centralized location that brings corporations and governments so that investors can buy and sell equities.
• Electronic exchanges take place on electronic platforms, so they don't require a centralized physical location for trades.
• Electronic communication networks connect buyers and sellers directly by bypassing market makers.

A stock exchange is where different financial instruments are traded, including equities, commodities, and bonds. Exchanges bring corporations and governments, together with investors. Exchanges help provide liquidity in the market, meaning there are enough buyers and sellers so that trades can be processed efficiently without delays. Exchanges also ensure that trading occurs in an orderly and fair manner so important financial information can be transmitted to investors and financial professionals.

Stocks first become available on an exchange after a company conducts its initial public offering (IPO). A company sells shares to an initial set of public shareholders in an IPO known as the primary market. After the IPO floats shares into the hands of public shareholders, these shares can be sold and purchased on an exchange or the secondary market.

The exchange tracks the flow of orders for each stock, and it's the flow of supply and demand that establishes a stock's price. Depending on the type of brokerage account, you may be able to view this flow of price action.

 

The BSE and NSE

Most of the trading in the Indian stock market takes place on its two stock exchanges: the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). The BSE has been in existence since 1875. The NSE, on the other hand, was founded in 1992 and started trading in 1994. However, both exchanges follow the same trading mechanism, trading hours, and settlement process.

As of February 2020, the BSE had 5,518 listed firms, whereas the rival NSE had about 1,799 as of Dec. 31, 2019. Out of all the listed firms on the BSE, only about 500 firms constitute more than 90% of its market capitalization; the rest of the crowd consists of highly illiquid shares.

Almost all the significant firms of India are listed on both the exchanges. The BSE is the older stock market but the NSE is the largest stock market, in terms of volume. As such, the NSE is a more liquid market. In terms of market cap, they're both comparable at about $2.3 trillion. Both exchanges compete for the order flow that leads to reduced costs, market efficiency, and innovation. The presence of arbitrageurs keeps the prices on the two stock exchanges within a very tight range.

The two prominent Indian market indexes are Sensex and Nifty. Sensex is the oldest market index for equities; it includes shares of 30 firms listed on the BSE, which represent about 47% of the index's free-float market capitalization.⁶ It was created in 1986 and provides time series data from April 1979, onward.

Another index is the Standard and Poor's CNX Nifty; it includes 50 shares listed on the NSE, which represent about 46.9% of its free-float market capitalization.⁶ It was created in 1996 and provides time series data from July 1990, onward.

The overall responsibility of development, regulation, and supervision of the stock market rests with the Securities and Exchange Board of India (SEBI), which was formed in 1992 as an independent authority. Since then, SEBI has consistently tried to lay down market rules in line with the best market practices. It enjoys vast powers of imposing penalties on market participants, in case of a breach.

 

Financial Markets

Financial markets refer broadly to any marketplace where the trading of securities occurs, including the stock market, bond market, forex market, and derivatives market, among others. Financial markets are vital to the smooth operation of capitalist economies.

KEY TAKEAWAYS

• Financial markets refer broadly to any marketplace where the trading of securities occurs.
• There are many kinds of financial markets, including (but not limited to) forex, money, stock, and bond markets.
• These markets may include assets or securities that are either listed on regulated exchanges or else trade over-the-counter (OTC).
• Financial markets trade in all types of securities and are critical to the smooth operation of a capitalist society.
• When financial markets fail, economic disruption including recession and unemployment can result.

 

Financial markets play a vital role in facilitating the smooth operation of capitalist economies by allocating resources and creating liquidity for businesses and entrepreneurs. The markets make it easy for buyers and sellers to trade their financial holdings. Financial markets create securities products that provide a return for those who have excess funds (Investors/lenders) and make these funds available to those who need additional money (borrowers). 

The stock market is just one type of financial market. Financial markets are made by buying and selling numerous types of financial instruments including equities, bonds, currencies, and derivatives. Financial markets rely heavily on informational transparency to ensure that the markets set prices that are efficient and appropriate. The market prices of securities may not be indicative of their intrinsic value because of macroeconomic forces like taxes.

Some financial markets are small with little activity, and others, like the New York Stock Exchange (NYSE), trade trillions of dollars of securities daily. The equities (stock) market is a financial market that enables investors to buy and sell shares of publicly traded companies. The primary stock market is where new issues of stocks, called initial public offerings (IPOs), are sold. Any subsequent trading of stocks occurs in the secondary market, where investors buy and sell securities that they already own.

 

Prices of securities traded in the financial markets may not necessarily reflect their true intrinsic value.

 

Types of Financial Markets

Stock Markets

Perhaps the most ubiquitous of financial markets are stock markets. These are venues where companies list their shares and they are bought and sold by traders and investors. Stock markets, or equities markets, are used by companies to raise capital via an initial public offering (IPO), with shares subsequently traded among various buyers and sellers in what is known as a secondary market. Stocks may be traded on listed exchanges, such as the NSE or BSE, or else over-the-counter (OTC). Most trading in stocks is done via regulated exchanges, and these play an important role in the economy as both a gauge of the overall health in the economy as well as providing capital gains and dividend income to investors, including those with retirement accounts such as IRAs and 401(k) plans.

Typical participants in a stock market include (both retail and institutional) investors and traders, as well as market makers (MMs) and specialists who maintain liquidity and provide two-sided markets. Brokers are third parties that facilitate trades between buyers and sellers but who do not take an actual position in a stock.

Over-the-Counter Markets

An over-the-counter (OTC) market is a decentralized market—meaning it does not have physical locations, and trading is conducted electronically—in which market participants trade securities directly between two parties without a broker. While OTC markets may handle trading in certain stocks (e.g., smaller or riskier companies that do not meet the listing criteria of exchanges), most stock trading is done via exchanges. Certain derivatives markets, however, are exclusively OTC, and so make up an important segment of the financial markets. Broadly speaking, OTC markets and the transactions that occur on them are far less regulated, less liquid, and more opaque.

Bond Markets

A bond is a security in which an investor loans money for a defined period at a pre-established interest rate. You may think of a bond as an agreement between the lender and borrower that contains the details of the loan and its payments. Bonds are issued by corporations as well as by municipalities, states, and sovereign governments to finance projects and operations. The bond market sells securities such as notes and bills issued by the United States Treasury, for example. The bond market also is called the debt, credit, or fixed-income market.

Money Markets

Typically the money markets trade in products with highly liquid short-term maturities (of less than one year) and are characterized by a high degree of safety and a relatively low return in interest. At the wholesale level, the money markets involve large-volume trades between institutions and traders. At the retail level, they include money market mutual funds bought by individual investors and money market accounts opened by bank customers. Individuals may also invest in the money markets by buying short-term certificates of deposit (CDs), municipal notes, or Treasury bills, among other examples.

Derivatives Markets

A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset (like a security) or set of assets (like an index). Derivatives are secondary securities whose value is solely derived from the value of the primary security that they are linked to. In and of itself a derivative is worthless. Rather than trading stocks directly, a derivatives market trades in futures and options contracts, and other advanced financial products, that derive their value from underlying instruments like bonds, commodities, currencies, interest rates, market indexes, and stocks. 

Futures markets are where futures contracts are listed and traded. Unlike forwards, which trade OTC, futures markets utilize standardized contract specifications, are well-regulated, and utilize clearinghouses to settle and confirm trades. Options markets similarly list and regulate options contracts. Both futures and options exchanges may list contracts on various asset classes, such as equities, fixed-income securities, commodities, and so on.

Forex Market

The forex (foreign exchange) market is the market in which participants can buy, sell, hedge, and speculate on the exchange rates between currency pairs. The forex market is the most liquid market in the world, as cash is the most liquid of assets. The currency market handles more than $5 trillion in daily transactions, which is more than the futures and equity markets combined. As with the OTC markets, the forex market is also decentralized and consists of a global network of computers and brokers from around the world. The forex market is made up of banks, commercial companies, central banks, investment management firms, hedge funds, and retail forex brokers and investors. 

Commodities Markets

Commodities markets are venues where producers and consumers meet to exchange physical commodities such as agricultural products (e.g., corn, livestock, soybeans), energy products (oil, gas, carbon credits), precious metals (gold, silver, platinum), or "soft" commodities (such as cotton, coffee, and sugar). These are known as spot commodity markets, where physical goods are exchanged for money. The bulk of trading in these commodities, however, takes place instead on derivatives markets that utilize spot commodities as the underlying assets.

Cryptocurrency Markets

The past several years have seen the introduction and rise of cryptocurrencies such as Bitcoin and Ethereum, decentralized digital assets that are based on blockchain technology. Today, hundreds of cryptocurrency tokens are available and trade globally across a patchwork of independent online crypto exchanges. These exchanges host digital wallets for traders to swap one cryptocurrency for another, or for fiat monies such as dollars or euros. Because the majority of crypto exchanges are centralized platforms, users are susceptible to hacks or fraud. Decentralized exchanges are also available that operate without any central authority. These exchanges allow direct peer-to-peer (P2P) trading of digital currencies without the need for an actual exchange authority to facilitate the transactions. Futures and options trading are also available on major cryptocurrencies.

Examples of Financial Markets

The above sections make clear that the "financial markets" are broad in scope and scale. Two give two more concrete examples, we will consider the role of stock markets in bringing a company to IPO, and the OTC derivatives market in contributing to the 2008-09 financial crisis.

Stock Markets and IPOs

When a company establishes itself, it will need access capital from investors. As the company grows it often finds itself in need of access to much larger amounts of capital than it can get from ongoing operations or a traditional bank loan. Firms can raise this size of capital by selling shares to the public through an initial public offering (IPO). This changes the status of the company from a "private" firm whose shares are held by a few shareholders to a publicly traded company whose shares will be subsequently held by numerous members of the general public. The IPO also offers early investors in the company an opportunity to cash out part of their stake, often reaping very handsome rewards in the process. Initially, the price of the IPO is usually set by the underwriters through their pre-marketing process.

Once the company's shares are listed on a stock exchange and trading in it commences, the price of these shares will fluctuate as investors and traders assess and reassess their intrinsic value and the supply and demand for those shares at any moment in time.

OTC Derivatives and the 2008 Financial Crisis: MBS and CDOs

While the 2008-09 financial crisis was caused and made worse by several factors, one factor that has been widely identified is the market for mortgage-backed securities (MBS). These are a type of OTC derivatives where cash flows from individual mortgages are bundled, sliced up, and sold to investors. The crisis was the result of a sequence of events, each with its own trigger and culminating in the near collapse of the banking system. It has been argued that the seeds of the crisis were sown as far back as the 1970s with the Community Development Act, which required banks to loosen their credit requirements for lower-income consumers, creating a market for subprime mortgages.

 

Securities and Exchange Board of India (SEBI)

The Securities and Exchange Board of India (SEBI) is the most important regulator of securities markets in India. Its stated objective is “to protect the interests of investors in securities and to promote the development of and to regulate the securities market and for matters connected therewith or incidental thereto.”

• The Securities and Exchange Board of India (SEBI) is the leading regulator securities markets in India, analogous to the Securities and Exchange Commission in the U.S.
• SEBI has wide-ranging regulatory, investigative, and enforcement powers, including the ability to impose fines on violators.
• Some criticize SEBI for that they say is a lack of transparency and direct accountability to the public for an institution with such enormous powers.

Creation of the SEBI

The Securities and Exchange Board of India was established in its current incarnation in April 1992, following the passage of the Securities and Exchange Board of India Act by the nation's parliament. It was first established with more limited powers in 1988. It supplanted the Controller of Capital Issues, which had regulated the securities markets under the Capital Issues (Control) Act of 1947, passed just months before India gained independence from the British.

The SEBI headquarters is located in the business district at the Bandra-Kurla Complex in Mumbai. It also has regional offices in the cities of New Delhi, Kolkata, Chennai, and Ahmedabad, and more than a dozen local offices in cities including Bangalore, Jaipur, Guwahati, Patna, Kochi, and Chandigarh.

SEBI's Charter

According to its charter, SEBI is expected to be responsible for three main groups:

• The issuers of securities
• Investors
• Market intermediaries

The body drafts regulations and statutes in a regulatory capacity, passes rulings and orders in a judicial capacity, and conducts investigations and imposes penalties in an enforcement capacity.

SEBI is run by a board of directors, including a chairman who is elected by the parliament, two officers from the Ministry of Finance, one member from the Reserve Bank of India, and five members who are also elected by the parliament.

Criticism of SEBI

Critics say SEBI lacks transparency and is insulated from direct public accountability. The only mechanisms to check its power are a Securities Appellate Tribunal, which consists of a panel of three judges, and the Supreme Court of India. Both bodies have occasionally censured SEBI.

Still, SEBI has been aggressive at times in doling out punishment and in issuing strong reforms. The regulator received praise for its actions following the Satyam fraud scandal when it hit PwC with a two-year ban. It also established the Financial Stability Board in 2009, in response to the global financial crisis, giving the board a broader mandate than its predecessor to promote financial stability.