In the defence of small enterprises

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In the defence of small enterprises

In a recent article in the Economist "Startup myths and obsessions", Mariana Mazzucato argues that it is a myth that small and medium startups are valuable to the economy, regardless of how we measure it.
"SMEs and the startups that form part of this group are neither under-financed, nor are they particularly valuable to the economy—whether measured by jobs, productivity or innovation."

Mariana Mazzucato

She goes on arguing against SMEs job creation record, saying that they destroy almost as many as the job they create during their first three years of existence.
"In fact, once you take into account the number of SME jobs lost after the first three years of their creation, there is very little net job creation by these firms."

Mariana Mazzucato

An otherwise brilliant researcher, Professor Mazzucato puts forward an argument against small and medium startups innovation and job creation, based on hindsight bias. Her argument about small and medium startups, is that they are "wasting" the government's R&D funding of the innovation ecosystem, while it would be best, as she argues, to direct it towards those few "high growth innovative firms (of any size) within that system". This hindsight bias argument makes erroneous assumptions similar to what is called the historian's fallacy. Her retrospective analysis argument of directing R&D funding to the few successful high growth startups (i.e. gazelles), wouldn't have been available to them prior to the point in time when it would be possible for an analyst to identify a "gazelle" startup, and if startup funding had not been available to them they might have never grown fast enough to become gazelles in the first place.

One would need to be able to see into the future in order to do that. Saying for example that 'our analysis shows that firms that research into Artificial Intelligence show the highest growth, thus the R&D government funding should target these type of startups', because of some trend of our times, will inevitably restrict funding from the next big innovative idea of which we are currently unaware, in the same way that nobody had thought of the airplane changing the game in transportation back in the era of train transport domination, or the of the advent of automobile in the era of horse-based transportation. History is full of failed predictions of the future. Not sure if it is wise to build government policies around fortune telling or trends.

Her other argument, the one against small and medium startups creating any jobs, so no need to waste funding on them, is even more erroneous. I am a big fan of Professor Mazzucato and I really like her work on showing how public-private partnerships (PPP) have created many of the innovations we enjoy today, but she goes on to mention her Sussex University colleague David Storey, who has actually argued that the single most important variable for any startup -success story- is no other than capital. Storey in his well-known gambler's ruin argument finds that the highest impact factor responsible for the survival and future growth of a new venture is capital; either initial capital, capital in the form of cash flow or other types of funding. The new venture that has enough money to survive the first three difficult years will have an exponentially higher probability to survive further and grow.

Returning to the job creation argument, recent research finds that business start-ups of less than a year old (zero years) account for all net job creation, while later in their life many of these start-ups will destroy some jobs or all of them (go out of business). The ones that will survive will continue to create more jobs as they grow, and destroy jobs when business turns bad.
“Firms large and small are continuously and simultaneously destroying and creating jobs”.

Tim Kane

Research at Kauffman finds that all new jobs are in fact created by early stage startups. The net job creation of established businesses is either zero, or negative. Furthermore, their analysis shows that the significant majority of jobs created by new businesses on average maximise at their first year and continuously decreases after that, with the exception of businesses that the literature calls “gazelles”. But as we explained earlier, we can only identify the gazelles after their high growth has been recorded and not before, that is in hindsight. What we can do is to make sure funding is available to all startups and later direct further funding to those startups that show promise, by linking it for example to growth measurements.
“New and young companies and the entrepreneurs that create them are the engines of job creation and eventual economic recovery.”

Dane Stangler, Robert Litan

We know that all net new jobs are being created by business start-ups in their first year (zero years old) and that new businesses retain on average 80 percent of the jobs they created up to their fifth anniversary. Moreover, 70 percent of the start-ups will not survive past the fifth year benchmark, but those that survive compensate for the significant amount of job losses due their own growth. Thus, there is an accumulated effect of job creation by business startups, which is ultimately the individually most significant factor in keeping unemployment at a low level. This effect can be seen as being similar to the effect that economies of scale have in keeping average costs low; an employment of scales effect if you like due to lack of another definition.

Since entrepreneurship is an activity that results in the creation of at least one job (that of the entrepreneur), and most likely of two jobs (one employee), to the defence of small and medium startups then, it is clear that even if not all startups end up being gazelles and no other value is being created by 'small-time' entrepreneurs, there would still be the beneficial effect of job-creation to account for.

SMEs play a significant role in the entrepreneurial activity taking place in an economy, contributing thought a multi-layered functionality; they provide jobs, reduce unemployment, support the social security system and government income through tax contributions, are a source of innovation and contribute to economic and social mobility (Curran, 2000⁠; Van Stel et al., 2005). Moreover, small businesses continue to generate more jobs than larger ones even during economic downturns (Curran, 1996)⁠. Low unemployment is particularly valuable to the economy and SMEs contribute greatly to keeping it low.

References

Curran, J., 2000. What is Small Business Policy in the UK for? Evaluation and Assessing Small Business Policies. International Small Business Journal, 18(3).

Van Stel, A., Carree, M. & Thurik, R., 2005. The Effect of Entrepreneurial Activity on National Economic Growth. Small Business Economics, 24(3).

Kane, T., 2010. The Importance of Startups in Job Creation and Job Destruction. Kauffman Foundation Research Series: Firm Formation and Economic Growth, (July).

Stangler, D. & Litan, R.E., 2010. Why is the Number of New Firms Constant ? Kauffman Foundation Research Series: Firm Formation and Economic Growth Exploring Firm Formation, (January).

Storey, D.J., 2014. Volatility and New Ventures Performance: Comparing Strategic Entrepreneurship with Gambler’s Ruin.

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