By Karen Mills
May 27, 2015
Harvard Business Review
Americans have long believed in the importance of entrepreneurs to the health of our economy. We see ourselves as risk-takers and innovators. Today more than ever, the entrepreneur is celebrated, failure is accepted as a cost of doing business, and starting your own company is seen as a path to achieving the American Dream. Although it’s difficult to measure directly, entrepreneurship is understood to be a way to a middle class life. In an economy where traditional manufacturing jobs have gone offshore, and globalization and technology have put pressure on U.S. wages, small businesses may be an even more critical pathway than ever to mobility and opportunity – not just for the business owner, but also for those who fill the jobs that business creates.
Americans understand this, but do their economic policymakers?
Even in this era of political gridlock there is agreement in Congress that entrepreneurs need support. And mayors and governors are experimenting widely at the state level and in cities and towns. But the economic toolbox that works for big companies isn’t the same one that works for small ones. If policymakers hope to be successful in their efforts to promote entrepreneurs and small businesses, they need to know what works – in short, they need a “Playbook” for small business job creation.
Shift the focus to include small companies
In the past, economic development has prioritized big businesses. That’s why states continue to compete to lure companies to build new offices and plants — like the Tesla gigafactory in Nevada — by offering tax breaks and multi-billion dollar incentive packages. But these economic development strategies focused on big businesses, sometimes known as “elephant hunting,” may overstate the importance of large firms.
Half the people who work in this country either own or are employed by businesses with fewer than 500 employees. And these smaller firms create two out of every three net new jobs. It is sometimes more effective for a region to grow its small businesses than to get caught up in a bidding war for elephants — a process that too often helps only the elephant.
Like big companies, small businesses do love tax breaks, and reductions in red tape. But these things are not enough. An effective policy strategy for small businesses needs to focus on the unique needs these companies have.
Three things small businesses need
Despite the lack of comprehensive national strategy toward entrepreneurs, new programs are gaining traction at the federal, state, and local levels across the country. A Massachusetts economic growth bill passed last fall with over two dozen investments targeted at entrepreneurs and small business owners. Over the last six years the federal government funded more than 50 new regional innovation “clusters,” and across America new accelerators and entrepreneurship boot camps are proliferating.
In fact, we know a lot about what works from observing this recent experimentation. Two important themes have emerged: First, the programs that work well to help entrepreneurs and small business owners tend to involve partnerships between many players. Business, government, research universities and community colleges all need to be involved, as well as the entrepreneurs themselves. There is no one large anchor company with whom to make the deal, so new “institutions for collaboration” such as NorTech in Northern Ohio or Ben Franklin Institute in Pennsylvania have become important intermediaries. And it is interesting to note that how effectively these new partnerships function seems to be critical to the success of the region.
Second, there is no one-size-fits-all package to help small businesses, precisely because each of the different types of small businesses has different needs. The Main Street business owner needs a different kind of capital from the high-tech entrepreneur. For each city or region the right mix of programs depends on what outcomes the leadership of that area is trying to achieve. Hence the development of the Playbook, an array of new approaches that can be tailored to meet the specific situation.
The Playbook is a policy menu, based around three core needs of small businesses: access to capital; people and skills; and innovation ecosystems. By picking appropriate policies from each major area, some mayors, governors, and even the federal government, are creating successful models for shaping policy agendas to drive entrepreneurship and small business growth.
Access to capital
Entrepreneurs and small business owners need to access capital to start and to grow. The type of capital required and its source depends on the type of business, its stage of life, and its strategy for the future. A Main Street small business might require a term loan from a bank to buy a piece of equipment. A supplier might need a working capital loan to finance a big order. A start-up might need an angel investor who believes in the project to provide initial equity.
The types of capital generally split into two areas: Debt and Equity.
For debt, the traditional source is bank debt, though recently there had been a rapid influx of new online lenders (such as the recently public Lending Club and OnDeck Capital) that provide new, though sometimes costly alternative products. There also have been innovative new entrants in accounts receivable lending such as Fundbox and C2FO.
In some areas and sectors, the market provides all the capital needed. But even with the economic momentum we’ve seen recently, gaps in certain areas still persist. That is where government can often play a critical role. For example, the market for bank credit for small businesses has been tight, particularly for loans under $150,000. For the government to help make more debt available, the most powerful policy tool is loan guarantees. Providing a guarantee verses a direct loan has a number of advantages. First, there is someone else in the picture, most often a bank, which also has a stake in having a positive outcome. This second voice, often from the private sector, can be a critical to reduce losses. Second, the actual cost of a guarantee is only the cost of the losses, giving these kinds of programs the ability to deploy large volumes of capital. In the case of the more than $30 billion in loans the Small Business Administration (SBA) guaranteed in years following the recession, the loss rates and cost were projected to be under 5% of the actual capital deployed, and those projections are currently holding true.
The gap in equity capital is even more extensive and exists in most regions of the U.S. In fact over 70% of venture capital funding currently goes to companies in only three states: California, Massachusetts, and New York. To offset this, policymakers can offer tax credits to angel investors, create state-funded venture capital funds, or employ hybrid structures such as the federal Small Business Investment Company (SBIC), where private investors use their funds augmented by government guaranteed funding to increase the level of growth capital invested in promising companies in the region. Accelerators and business plan competitions with funding for the winners have also helped fill the significant gap in early stage funds.
People and skills
Having the right people with the right skills is just as important to small businesses as having access to capital. But here again, the market does not always work perfectly on its own. Recent work by Joe Fuller at Harvard Business School shows a significant gap in “middle skills,” those that require more training than a high school diploma but less than a college degree. This research shows that the market for middle skills operates very poorly. There is little planning and almost no communication between the relevant parties. Businesses expect a “just-in-time” solution to their work force needs — they post a job and expect a worker to show up immediately with exactly the right skills.
In reality, no part of the labor market can work well without accurate information about the current and future need for skills. Businesses have to plan their workforce needs ahead of time; community colleges need to know what training to offer; and young people need to know what career paths will be open to them if they enter different academic programs.
Better incentives are needed to get businesses, community colleges, local workforce boards, and others to collaborate and share information. In Cleveland, the NorTech initiative has had success working with Lorain County Community College to increase skills training needed in the workforce to match up with jobs in the flexible electronics businesses growing in their area. Vermont has done the same with farmers to support their Farm to Plate growth plans.
Policymakers should also work to foster entrepreneurial skills. Research has shown that small business owners have more success if they have some counseling or mentorship. Many business owners have no formal business training and are hungry for the basics so they don’t have to reinvent the wheel themselves. Programs from the Kauffman Foundation’s FastTrac to Goldman Sachs’ 10,000 Small Businesses are working to address this issue while the SBA already counsels over 1 million small businesses a year through its large network of Small Business Development Centers, Women’s and Veterans’ Business Centers and SCORE volunteers.
Ecosystems for innovation and entrepreneurship support
Finally, governments can help create innovation ecosystems that build on a given region’s entrepreneurial strengths. This idea may sound vague, but it is rooted in a long line of research on the economic benefits of geographic clusters. Silicon Valley has shown the benefit of clustering entrepreneurs around innovative companies and research universities. These ecosystems start organically but often benefit from additional support to grow. (It is always better to build on assets that exist, rather than to try to create an innovation center from scratch.)
Clusters have gained credibility as a policy tool in the last decade since work by Mercedes Delgado, Michael Porter, and Scott Stern showed that strong clusters drove better economic performance. In the last six years the federal government funded 56 cluster initiatives in areas from green energy to defense contracting. The best cluster initiatives are well-led organizations with a strategy to help small businesses get the things they need to grow. This might be a national marketing campaign, as in the efforts of the Oregon Wine Cluster, or innovation in composite technology for Maine’s boat builders.
Federally-funded Manufacturing Institutes are also a new model of building ecosystems, where universities and businesses collaborate to develop promising innovations in advanced manufacturing. The first such institute, split between Youngstown, Ohio, and Pittsburgh, focuses on additive manufacturing. The recently passed provisions of the Revitalizing America’s Manufacturing and Innovation Act (RAMI) funded up to 15 more.
A third promising policy area is the emergence of accelerators. These new institutions take entrepreneurs with budding business ideas and give them the time, space, and mentorship to build their businesses. The multi-week programs usually end in “Demo Days” or other opportunities for entrepreneurs to present to potential funders. Shared work spaces and other entrepreneurship communities and incubators, such as “1776” in Washington, D.C., the Capital Factory in Austin, and “1871” in Chicago (named for the year of the Great Chicago Fire), provide another way to create a vibrant locus of startup activity in a region. In June 2014, almost 800 accelerators from across the country competed for $2.5 million of federal grants, which were eventually awarded to 50 winners from 31 states, indicating that very small funding can motivate intense interest in this sector.
Finding a way forward
Not everyone believes in an active policy agenda for entrepreneurs and small business owners. Many think that the right formula is just to leave small business owners alone, and that cutting taxes and reducing regulation will be enough to create a favorable environment. Others are concerned that if government gets involved it will “pick winners and losers,”or “put a thumb on the scale,” giving some small businesses an unfair advantage over others, rather than allowing the market to work.
There are two problems with these arguments. First, the use of competitive processes reduces the likelihood that government funding might be subject to favoritism. Second, market failures are all too common, and so certain segments of the small business community are chronically underserved. For example, women- and minority-owned firms have greater challenges in accessing growth capital, but tend to over-perform when capital is available. Government’s role is to step in when these failures occur and provide access and opportunity so that all of America’s entrepreneurs have a chance to succeed and contribute to economic growth.
Today, the American middle class is being squeezed. The benefits of economic growth are going to a small group at the top. New business creation is down. Globalization will continue to exert pressure on workers. In such an environment, good policies to further entrepreneurs and small businesses are more needed than ever. The interest in such an agenda is there; what’s most often missing is a clear recipe that both works and that can be adapted to local conditions. This Playbook is an attempt to fill that gap.
Entrepreneurship is America’s “secret sauce.” With the right tools, we have the chance – mayors, governors, national leaders and even the business community — to set the playing field for entrepreneurs so they can do what they do best: grow their companies and create jobs.