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Restarting the US small-business growth engine

Reinvigorating small business starts with identifying the high-growth firms that disproportionately drive economic activity and jobs. In an accompanying video, AOL cofounder Steve Case explains how big businesses can benefit too.

November 2012 | byJohn Horn and Darren Pleasance

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.1

Sadly, small-business optimism is at its lowest levels in almost 20 years.2 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.

What’s particularly disturbing is that the greatest decline in entrepreneurial activity occurred in the 18–24-year-old cohort. While older entrepreneurs bring more experience and a higher likelihood of success to their business building, the shortage of young business founders means that the US economy is currently not producing enough of its next generation of serial entrepreneurs.

The recent US presidential campaign made much of the need to restart the US small-business engine, which won’t be easy. But one place to begin, our research suggests, is to focus more sharply than usual in today’s economic debate on two things: precisely how small business contributes to growth and job creation, and the ways the private sector—not just government—can support that job creation dynamic. (For more, view this video interview with Steve Case, chairman and CEO of Revolution and cofounder of America Online, or download a PDF of the edited transcript.)

Video

On entrepreneurship: A conversation with Steve Case

The chairman and CEO of Revolution and cofounder of AOL explains why small, high-growth companies are the secret to economic vitality and job creation and how large companies could benefit from them.

A vast universe

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.

Exhibit

High-growth businesses may be found in virtually all industries.

Of course, many entrepreneurial firms fail, and that too is part of the DNA of small business, so it is routinely impossible to predict which will succeed. That’s why understanding how this high-performing cohort works is important to restoring the confidence and job creation potential of small business.

Of course, government too plays an important role in the way it fosters entrepreneurs and applies regulation. But government assistance is not the only answer. We believe that large businesses can do more—much more—to support small business, both within and outside of their own organizations. In the process, they can make themselves more flexible and add new strategic options.3 To understand why, let’s first dispel some myths about US small business to better understand the contours of a sector that includes more than 99 percent of all employer businesses.

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.4 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.5

Meet the high-growth leaders

What are these high-growth entrepreneurial firms? Many are storied names from Silicon Valley: Google, Hewlett-Packard, Intel, and others. But many high-growth firms are neither in high tech nor based in Silicon Valley. Consider Under Armour, which has grown to take on adidas and Nike in the global sports apparel industry. In the 1990s, founder Kevin Plank, a former football player from the University of Maryland, set out to find a shirt that would keep athletes cooler. After developing one, he would drive up and down the East Coast with the shirts in his trunk and sell them to high-school and college players. Eventually, word of mouth generated a company with revenues of almost $1.5 billion.

Or consider Scentsy, an Idaho company that sells wickless and flameless scented candles. Through multiple outlets (online, home parties, catalog sales), Scentsy has raised its revenue from about $75 million in 2008 to $382 million in 2010, right through the depths of the recession. Or HubSpot, a Cambridge, Massachusetts, firm that provides marketing software to other small and midsize businesses, thus growing by helping other entrepreneurial companies to grow.

Nurturing high-growth businesses

The sectoral and geographic diversity of high-growth enterprises naturally lends itself to discussions of support by federal, state, and local governments. Such steps can effectively cut regulatory red tape, refine tax laws, address immigration laws, and streamline patent procedures. For example, the recently passed JOBS6 Act should encourage firms to launch IPOs, by streamlining red tape, raising limits on soliciting private investors, and providing new funding sources.

Public-sector leaders should examine the policies that limit the growth of entrepreneurial small companies, as well as those that could spur it. But the private sector—and larger businesses, in particular—have a bigger role to play than is generally acknowledged. In fact, we believe that larger businesses should think more broadly and creatively about supporting and mentoring entrepreneurs, spurring demand for the products and services their businesses supply, and providing creative financing to tap mutually beneficial growth opportunities.

Changing mind-sets

Perhaps the most important starting point for large businesses is to change their mind-set regarding small-business entrepreneurs. Too many larger businesses rigidly view them as direct competitors, intent on dethroning large companies from leadership positions. Granted, this is sometimes true. However, in our experience many more vibrant entrepreneurs operate in complementary industries and are often overlooked as suppliers. By supporting burgeoning entrepreneurs, leaders of large businesses can help this critical segment of the economy while providing additional flexibility and options for their own organizations.

Consider, for example, a large health care provider that helps support high-tech software service providers in its area, to make such potential suppliers more effective and efficient. This approach could help build an emerging cluster, which would encourage the development of a larger and better labor pool, as well as more competition for the products and services sold by the suppliers. It would probably also help make large companies in the cluster more efficient and thus better able to stay ahead of their competitors, including the entrepreneurs.

Yet in one roundtable discussion with a group of entrepreneurs, we heard several of them mention that they find it particularly challenging to locate the right representatives at larger companies. One related a story about trying to take a software solution to a larger company after learning publicly that it was seeking just such an offering. When the entrepreneur called to discuss his idea, however, he was first directed to the business-development group, which focused on mergers and acquisitions. A second attempt landed him in the purchasing department, which required him to go through procurement channels before getting a contract. All this took place before he could even determine whether his idea really was the answer to the larger company’s problem.

One way around this issue would be for larger companies to staff a small department that interacts with prospective entrepreneurs to develop better intelligence about their activities. Typically, a large company’s purchasing group has specific product-buying guidelines; there is no reason a similar (but different) group couldn’t be assigned to assess external solutions to challenges that the large company identifies on an ongoing basis.

In fact, some companies do look for innovations outside their walls—for instance, Cisco and P&G, though they focus mostly on acquisitions. InnoCentive, by contrast, is an entrepreneurial firm that helps companies connect with external problem solvers. Whether large companies execute such strategies internally or outsource them, these companies could all be more flexible and adaptable if they increased their connections with smaller businesses that could fill missing capabilities through arm’s-length contracts, joint ventures, or acquisitions.

More mentoring

Another approach leaders of large companies could use more often would be to improve their mentoring of entrepreneurs. Mentoring is one area of support that entrepreneurs find most helpful, yet most difficult to obtain. In particular, a large company could set up a program to mentor current employees planning to start their own businesses—for example, suppose an internal team wants to pursue an offering that wouldn’t meet the company’s hurdle rate but could be profitably developed by a start-up and would benefit the company itself. Such a program could stimulate creative thinking within the company, create new ideas that stayed within it, and help budding entrepreneurs know if their ideas were ready for implementation. For the large companies, it would be more likely to provide new suppliers than direct competitors. Effective mentoring can also build a stronger, more experienced labor pool.

Naturally, people who have lived the experience of starting up and maintaining a firm provide the best mentorship to budding business leaders. It can take the form of assistance with writing business plans, sharing a large company’s experience, and supporting more tactical needs, such as how to get legal advice, as well as accounting and administrative tasks. Large businesses also have a role to play here. American Express OPEN’s small-business support program, Victory in Procurement, has been running a group-mentoring and training program for the past few years as part of an initiative to help entrepreneurs respond to government procurement requests. As part of the program, some participants receive 12 hours of interaction with government contracting experts. And Cisco’s Entrepreneur Institute provides knowledge and business solutions to entrepreneurs. Its Web site details several success stories.

Spurring demand

More than in previous downturns, small entrepreneurs cite a lack of demand—final consumer demand or demand from other businesses—as their primary obstacle: they believe they have good products or services but just can’t find enough customers. Since the supply chains of large companies include many small, entrepreneurial businesses, the large companies could specifically look for them when seeking new business partners. Of course, not all supply chain decisions should be made this way, but if a large business does find a local partner that is more economical, shortens the supply chain, and provides quicker turnarounds, the choice should be a no-brainer.

Studies of clusters lend credibility to the idea of supporting small suppliers in complementary industries. These clusters, such as Silicon Valley in high tech or Research Triangle Park in biotech, have long been regarded as one of the keys to strong economic development. Clusters are desirable because they are self-sustaining innovation machines. The companies in a cluster continually try to out-innovate each other to stay ahead. Their proximity promotes the exchange of ideas that spark new innovations, and they are a natural magnet for talent. But while many countries (and locations across the United States) have tried to replicate the Silicon Valley model, few have succeeded.

When Michael Porter and colleagues studied the impact of clusters on job growth, they found that those comprising more than one sector (for instance, health care and high tech) experienced the fastest growth rates. The United States currently has a broad variety of clusters, and many are interdisciplinary in nature.

More and better financing

Venture capital funding has been shifting to later-stage investments over the past decade, partly because the market for IPOs has declined. Meanwhile, it’s tougher for smaller businesses, as well as many larger ones, to get even the traditional financing they need. Supplier financing is an area where large businesses can help entrepreneurs. By paying some contracts earlier than existing terms require, a large business can cut a small supplier’s working-capital costs. This should be regarded as a short-term support program, not necessarily as an across-the-board, long-term commitment. It isn’t essential to change the terms for every company, but selectively targeting those that need some short-term financing support could be an easy form of aid, especially if it doesn’t materially change the large company’s working capital.

Although the recent downturn hit the US small-business and entrepreneurial segment hard, the trend can be reversed. The public sector has a role, but the private sector must lead where it can develop new and creative solutions, as well. It is often in the interest of larger organizations to foster and encourage smaller ones, especially where everyone can benefit. Not all of the steps a large business can take will produce tomorrow’s Apple or Under Armour—but they’ll improve the chances.

About the authors

John Horn is a senior expert in McKinsey’s Washington, DC, office, and Darren Pleasance is an alumnus of the Silicon Valley office.

About this content

The material on this page draws on the research and experience of McKinsey consultants and other sources. To learn more about our expertise, please visit the Strategy Practice.