Are Small Businesses Really An Innovative Economic Engine?

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Mark Zuckerberg isn't a small business owner, and in a way, he never really was. StateImpact explains why not, after the jump.

Small businesses have often been touted as the engine driving the American economy.  They’re tiny firms, sure, but they’re headed by strident entrepreneurs whose purpose in life is to innovate and grow their companies into world-changing enterprises.

Think Mark Zuckerberg and Facebook.

Bill Gates and Microsoft.

Think all the way back to Henry Ford and the Model-T.

And think again.

A couple of economists at the University of Chicago–Erik Hurst and Benjamin Wild Pugsley–have recently been crunching numbers and reviewing small business surveys spanning the late ’90’s to 2007, and in some cases, ’08.  And recession or no recession, they’ve stumbled onto something that contradicts conventional wisdom: Small businesses and entrepreneurs usually aren’t the same animal.

Think sealions vs. seals.  (You know…”All sealions are seals, but not all seals are sealions?”)

In their new paper, “What Do Small Businesses Do?” Hurst and Pugsley found that most of these firms, which they generally define as having 1-19 employees, are concentrated in 40 federally-defined industries.  And most of these businesses are offering goods and services that other businesses already offer.

“[They] primarily include skilled craftsmen (e.g., plumbers, electricians, contractors, painters), skilled professionals (e.g., lawyers, accountants, and architects), insurance and real estate agents, doctors, dentists, mechanics, beauticians, restauranteurs, and small shop keepers (eg.g., gas station owners and grocery store owners).”

In other words, if you’re looking for innovation, you should probably look elsewhere.

Among other interesting findings, the researchers found most firms stay small over their lifetimes, and have no real ambition to grow.  Surprisingly, Hurst and Wild Pugsley also found making money (“pecuniary benefits”) really isn’t that much of a motivator,

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Researchers at the University of Chicago found small business owners are less likely to be interested in creating the next Facebook than in starting their own plumbing business.

“We find that over 50 percent of new businesses reported that non pecuniary benefits were the primary reason as to why they started their business.  Non pecuniary benefits included answers such as ‘wanting flexibility over schedule’ or ‘to be one’s own boss’.  By comparison, only 34 percent of respondents reported that they were starting the business to generate income and only 40 percent indicated that they were starting a business because they wanted to create a new product or because they had a good business idea.”

So for more than half of small business owners, being an economic engine is less important than being able to take long lunches, clock out early on Fridays, or just not having to worry about a boss’ expectations looming over them.  And if you stay small, guess what?  You don’t have to worry about doing a bunch of employee evaluations, creating convoluted office handbooks, or keeping pace with the next hot business idea.  You come into work when you need to, you have a handful of employees to worry about, you do your job, you go home, and you’re only hostage to your bills and your own business expectations.

Slate’s Annie Lowrey does a good job of what, exactly, all of this means, in terms of public policy,

“Programs aimed at helping small businesses are not generally going to reach growing businesses, or innovating businesses, or new businesses. And with Washington spending billions to help small businesses and desperately seeking job creation, that matters…

…Companies that seek venture capital funding, for instance, tend to innovate and create jobs.

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One way the government could differentiate between standard small businesses and those with a more innovative bent is to give special subsidies to firms with venture capital funding.

Thus, a tax break for a company in receipt of VC funding might get more bang for its buck than a tax break for all firms with fewer than 20 employees.

Even easier, Washington could ensure that it subsidizes growing firms, not just small firms. ‘Often subsidies targeted at increasing innovative risk taking and overcoming financing constraints are focused on small businesses,’ the academics write. ‘We believe that these targets are better reached through lowering the costs of expansion, so they are taken up by the much smaller share of small businesses aspiring to grow and innovate.’ The (admittedly obvious) takeaway? Give tax breaks or other incentives to firms hiring new employees if you want to juice employment at small companies.”

For a big small business state, like New Hampshire, this research is even more interesting.  According to the state’s department of Employment Security, more than three out of four private sector companies have had “nine or fewer employees” in 2009.  All told, the state hosts more than 32,000 small businesses.  There’s a continued drive to create new businesses–and the failure rate is correspondingly high.  According to a recent report released by analysts at Dun&Bradstreet, New Hampshire is among the top states for small business failure.  Of course, as economists noted on NHPR’s The Exchange, these numbers could be a result of the state’s high “churn” rate–so many more people give small business a try, many more will consequently fail.

But this report raises the possibility that perhaps the markets are simply saturated with non-innovative businesses–even following recession-related competition thinning.


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