Restarting the job growth engine

January 14, 2013

In Restarting the US small business growth engine, John Horn and Darren Pleasance of McKinsey&Company make the same distinction we’ve often made here about the different types of small firms and the misconception about the source of job growth in the economy.

Last February we wrote:

We believe this argument is based on a category error: the misconception that lumps together “lifestyle” companies and high-growth start-ups. Job growth comes mostly from new businesses which grow rapidly, not the more common short-hand of “small businesses.” The jobs created by high-growth companies, busy inventing products and services (and sometimes industries), dwarf those lost in the ongoing employment churn experienced by small businesses.

The net result is remarkably stable cumulative job creation from start-ups despite their high failure rate. The aforementioned study by Scott Shane may be correct that small businesses “destroy” jobs in years two through five as they fail – but by that fifth year the surviving firms still employ 78% of the jobs created, and the additional start-ups created in those intervening years more than make up for the lost 22%…

Yes, start-ups lack the economies of scale and R&D budgets of larger firms; but that’s the support venture capital provides. Those start-ups that do gain traction are able to raise capital, and, with hard work and a little luck, become large companies. With early-stage activity at its lowest level since 1977, it’d be a good time to help restore a favorable and predictable environment for new business formation – for entrepreneurs and their sources of capital.

In the most recent McKinsey Quarterly, Horn and Pleasance agree that new businesses, not small businesses, have been responsible for all job growth since 1980 and go on to ”dispel” four myths about the “vast universe” of entrepreneurial activity:

There’s mom. There’s apple pie. And there’s small business. As the US economy struggles to go on climbing out of the downturn and create jobs, no hero stands taller in the nation’s political and business psyche than the small-business owner. With good reason. Small businesses, defined as companies with fewer than 500 employees, account for almost two-thirds of all net new job creation. They also contribute disproportionately to innovation, generating 13 times as many patents, per employee, as large companies do.

Sadly, small-business optimism is at its lowest levels in almost 20 years. After crashing in the recession, confidence remains below any level recorded since the early 1990s, because the recovery has been so anemic. Had small business come out of the recession maintaining just the rate of start-ups generated in 2007, the US economy would today have almost 2.5 million more jobs than it does…

While the small-business universe is vast, its real economic impact comes disproportionately from a much smaller subset of high-growth firms. These firms, our research shows, can more or less double their revenues and employment every four years. And they are everywhere, in every industry sector (exhibit) and in far more geographies than is commonly thought…

Myth #1. All small businesses want to grow.
Not all owners of small businesses want them to grow; many “mom and pop” enterprises are happy to stay small. It is really a subset of young businesses—those less than five years old—that do want to grow and that create the majority of jobs: 40 million over the last 25 years. This represents 20 percent of total gross job creation and total net new job creation in the United States over this time period.

Myth #2. All small businesses are equally valuable to job creation in the economy.
Small businesses in general are valuable for the US economy and provide flexibility and valuable services. But a subset of small businesses—high-growth ones—creates the vast majority of new jobs. Seventy-six percent of these high-growth firms are less than five years old. The 1 percent of all firms that are growing most quickly (fewer than 60,000 in all) account for 40 percent of economy-wide net new job creation. To provide a sense of magnitude, high-growth firms add an average of 88 employees a year, while the average non-high-growth company only adds 2 to 3.

Myth #3. High-growth firms come from high-tech locales.
Conventional wisdom suggests looking for high-growth firms in areas like Silicon Valley or the Route 128 corridor outside Boston, where many well-known ones have emerged. However, our look at a broad spectrum of companies shows that all industries have high-growth firms. While sectors do vary somewhat, in no industry do high-growth firms account for even 5 percent of the total number of firms in the industry, and there are very few industries where less than 1 percent of firms are growing quickly. In the United States, high-growth firms are found in every metropolitan statistical area, and no region has a disproportionate number of them. Conversely, Silicon Valley has many firms that struggle to grow and never become breakout stars, as well as many smaller companies that have no desire to grow quickly.

Myth #4. Taxes and regulation are small business’s primary constraint.
Many business leaders will tell you that taxes and regulation are the biggest barriers to starting up and enlarging small businesses. It’s true that some regulations and laws have inhibited the growth of small businesses; the Sarbanes–Oxley Act, for instance, had the unexpected consequence of discouraging some companies from making initial public offerings, a step typically followed by a burst of hiring. But taxes and government oversight are not the primary barriers to stimulating the growth of small businesses. In the latest recession, their owners pointed to a lack of market demand as the primary problem, as well as an inability to obtain financing.

Myths #1 and #2 we’ve covered, here and elsewhere.

Myth #3 could be considered the raison d’etre of this blog.

Myth #4‘s reliance on the adjective “primary” could be considered a bit pedantic, chosen to specifically de-emphasize a political point. Our own experience is that the unavailability of capital and deep uncertainty about the tax and regulatory environment are related and a powerful one-two combination keeping entrepreneurs and their financial backers in check. Also, to state that lack of demand impedes growth sounds more like a tautology than a cause or constraint on economic activity.

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