The End of Small Business?

A recent story from MarketWatch echoes what we’ve been hearing over the last two years: While the Main Street small and medium firms are struggling to stay afloat, big multi-nationals continue to do well. Very well, in fact. It’s worth sorting this out a bit to understand why.

Steve Jobs and Steve Wozniak working on the 1st Apple Computer

First, let’s make sure we mean the same thing when we say small business. In most people’s minds these are the small businesses that they visit, like the hairdressers or the corner grocer. These are in fact small businesses, and they are as valuable as any other business in our economy. But when we say that small businesses provide 70% of new jobs, we need to understand that the vast majority of those new jobs come from a different kind of small business. They are really small enterprises. Of course they start with a few employees – Ford Motor Corp started with one employee and 11 investors, or Apple Computer started with the two Steves – but soon they hit stride and hiring happens in bunches. Viewed from this angle, it’s not really the size of the hiring business that matters as much as its age. While Apple continues to grow employment, it does so slowly now that it is a mature corporation. Ford Motor, now past mature, continues to shed jobs. 

So while size matters somewhat when we talk about job creation, it’s not the whole enchilada. The age of the hiring firm is also important. When a new technology company starts to ramp up, it can easily move from small to big in a relatively short period, think Google as a recent example, and continue to hire significant numbers of workers. The bottom line is there is a certain type of small business to which we owe a great deal of our jobs creation: Small businesses that are capitalized by third parties. 

The third parties can be angel investors, venture capitalists, a parent company that spins out a new division or any number of other sources. These are the enterprises that create good, long term job growth. So if we are not seeing job growth – our current circumstance – then it makes sense to ask what has happened to the funding of new enterprises? 

Funding from professional investors is different than funding from more traditional sources, like banks and grandparents. Pros take riskier bets, and as a result expect higher rates of return. These returns are called “the liquidity event.” A young firm’s value becomes liquid when other third parties purchase it, via a stock market initial public offering, IPO, or through the firm’s sale to a larger company.

The first point is that Sarbanes-Oxley, the great over reaction to the Enron fiasco, has made taking a company to the public stock markets so difficult – the average compliance cost of SarbOx is over 6 million a year  - that fewer venture capitalists are injecting money into brash young firms because they know that it is increasingly difficult to get it out. It’s a shame that a company, whose business plan was to sell dog food online, got listed on the NASDAQ; but while markets can be irrationally exuberant from time to time, overall they do find the value creators in an economy and reward them accordingly. The deadening SarbOx effect has taken a while to work its way into the economy, but there can be no doubt that the landscape of young enterprises is much less liquid today than it has been in the past. 

The other option is for large mature firms to spin off small upstarts. But large firms, while very liquid with lots of cash reserves, are reticent. The political winds out of Washington D.C. are favorable to attorneys, tax accountants, green shysters of all types and community organizers. Less so to entrepreneurs and their investors. While the Obama administration has been threatening to raise taxes on the investor class since the 2008 campaign, it has definitely brought hundreds of new regulations, and a giant health care bill which is essentially one enormous regulation of one sixth of the economy, to reality. 

The upshot is that large companies continue selling, here and abroad, and amassing large cash reserves that sit idly, waiting for a more opportune economic environment. It is the supply of new capital investment in the economy that will eventually lift demand; but for that to happen we need a new regulatory and tax attitude in the capital, followed by real reform. Litigation and regulatory compliance are easier for large companies to navigate and fund, but eventually even they become demoralized by the burden. New young firms will eventually supply America with a great onslaught of new jobs, but we must first enable the supply of capital to meet demand.