Most Small Businesses Shouldn't Be

In “The Illusions of Entrepreneurship,” author and professor Scott A. Shane shows the reality of American entrepreneurship as being decidedly different from the myths that have come to surround it.

An A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University, Shane equates "entrepreneurship" with small business start-ups. He compared data from the past 30 years done by university researchers on business startups and found, first of all, that the United States isn’t very entrepreneurial.

In 2002, the top 10 countries in percent of population that owned new and young businesses were Thailand (27.2%), China, New Zealand, Greece, Brazil, Switzerland, Australia, Jamaica, Venezuela, and Finland (16).

America was at 9.9%. And America hasn’t gotten more entrepreneurial over time. In fact, Shane cites that a higher proportion of people started businesses in 1910 than they do today in the U.S (7).

Shane points out that the more entrepreneurial countries are generally poorer than less entrepreneurial countries. One explanation: capitalism, as equipment increases production, more people quit working for themselves (traditionally, farming) and go work for other people who own the equipment.

Also, as countries get richer, “they change where economic value is created; first from agriculture to manufacturing, then then from manufacturing to services,” which also accounts for a shift from people working for themselves to people working for others (19).

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Farmers and Postmen

In the U.S. from 1983 to 2002, all 100% of horticultural specialty farmers were self-employed, and 98.59% of all farmers were self-employed. Health practitioners, podiatrists, dentists, auctioneers, fishers, and authors all scored as over 70% self-employed, as well (49). 

The lowest percentage of self-employed workers during that same time were Federal mail carriers (0.02%) and elementary school teachers (0.03%). Police, high school teachers, bank tellers, miners, technicians, administrative support and assemblers all scored less than 2% self-employed.

• 7.2% of engineers were self-employed; 
• 12% of car and boat salesmen;
• 26% of actors and directors;
• 29% of carpenters;
• 39% of lawyers;
• 45% of musicians and dressmakers;
• 50% of hunters and trappers;
• 54% of veterinarians;
• 71% of writers.

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Wyoming and California

San Francisco has a far lower proportion of small businessmen than the U.S. city with the highest: Laramie, WY. Per capita, there are two and a half "new-business entrepreneurs" in Laramie for every one entrepreneur in San Francisco, which is ranked 121st behind places like Bozeman, MT; Farmington, NM; Rock Springs, WY; Rapid City, SD; Pikesville, KY; Laredo, TX; Brunswick, GA; Newark, NJ; Anchorage, AK; and Enid, Oklahoma (23).

Most of Americans think only of venture-capital backed, high-growth technology businesses as "entrepreneurial," but those firms—Microsoft, Apple, Google, etc.—make up only a tiny fraction of new businesses. Businesses of opportunity rather than necessity, venture-capital backed tech and medical companies generate virtually all value and jobs from start-up businesses.

“Since 1970, venture capitalists have funded an average of 820 new companies per year. These 820 start-ups—out of the more than 2 million efforts to start a business in this country every year—have enormous economic impact. In 2003, companies that were backed by venture capitalists employed 10 million people, or 9.4% of the private sector labor force in the United States, and generated ... 9.6% of business sales in this country” (162).

That means venture capitalists only fund 0.03% of all new businesses every year, making the odds of getting venture capital for a new business 1 in 4000. The odds of fatally slipping in the bath or shower? 1 in 2232 (91).

So what do most small businesses in the U.S. look like?

Shane says, “The typical entrepreneur [is] a married white man in his forties who started his business because he didn’t want to work for someone else and who is just trying to make a living, not build a high-growth company.

“The characteristics that make people more likely to start businesses aren’t all the desirable ones that our myths associate with entrepreneurship. The data show that the likelihood that a person starts a business increases if he:

• is unemployed
• works part-time
• has changed jobs often
• makes less money

“Finally ... the experiences often associated with being an entrepreneur—immigrating, dropping out of school, and networking—don’t actually increase the odds that people will start businesses. 

“Instead, going to college, getting a professional degree, and having some experience managing others in a business setting are the experiences that actually increase a person’s odds of starting a company” (63).

According to Shane's research, the typical start-up is home-based, employs one person, and has no intention or prospects of growing. It was started using $25,000 or less of the founder’s savings in a run-of-the-mill industry where there are many firms and profits are slim. The business's lifespan is five years or less, during which time the founder makes less money and has fewer job benefits while working more hours than if he worked for someone else (160 - 161).

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Don't Forget the Death and Taxes

In his NOLO series book "Deduct It! Lower Your Small Business Taxes," accountant Steven Fishman reports that these kinds of sole proprietor start-ups are much more likely to get audited than other business entities—especially middle-income sole proprietors (462).

In 2010, the IRS audited:

• 0.4% of partnerships
• 0.4% of S corporations
• 0.7% of regular C corporations with assets worth less than $250,000

However, in that same year, the IRS audited:

• 2.5% of sole proprietors earning between $25,000 and $100,000
• 4.7% of sole proprietors between $100,000 and $200,000, and
• 3.3% of sole proprietors above $200,000

Fishman advises that incorporating or forming an LLC greatly reduces your audit risk, but comes with added complexity, fees, and, in some states, additional taxes (467).

Don't Believe the Job-Creation Hype

Contrary to popular political arguements, Shane says “start-ups don’t generate as many jobs as most people think, and the jobs they create aren’t as good as jobs in existing companies” (161).

“New companies—those that are one to two years old—employ only 1% of people in this country,” Shane says, “Newly formed firms account for only 6 to 7% of gross or net new jobs created every year. ... For ‘new’ firms to create 50% of net new jobs, we would have to expand the definition of ‘new’ to include all firms that are nine years old and younger” (158). 

Add to this, “most businesses are started by people who have a significant amount of experience working in the industry in which they are launching their new companies.” (69).

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Small Business Is Usually Necessity

So why do Americans start small businesses that aren’t innovative, have no intentions to grow, lack a competitive advantage, and generally involve providing the same skill or service provided at the founder’s last place of employment? Because they are forced to.

Should we create policies that make it easier and more attractive for more people to start these small businesses? We should not. America isn’t getting more entrepreneurial. More than anything, we are repackaging entrepreneurship out of surplus unemployment.

Shane says we need to reduce loans, subsidies, regulatory exemptions, and tax benefits for small businesses. “Because the average existing new firm is more productive than the average new firm, we would be better off economically if we eliminated policies that encourage people to start businesses instead of taking jobs working for others”—assuming that jobs working for others exist (163).

Shane dismisses the claim that we don’t know which start-ups will become high-growth businesses. “This view may be politically appealing, but it is naive. It assumes that we can’t identify the things that make new businesses more likely to survive, generate profits, increase sales, and hire people. 

“Unless the beliefs of venture capitalists and sophisticated business angels are completely wrong, and the research discussed in this book is completely incorrect, we know what criteria to focus on” (63).

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What If You Can't Resist the Myth?

For those who feel they must start a business, Shane’s advice is fairly straightforward: 

• Recognize that 90% of the fastest growing private companies in this country sell to businesses (118)
• Start marketing sooner rather than not at all (119)
• Don’t compete on price, but rather on quality or service (119)
• “Improve your chances of success as an entrepreneur by starting a company in an industry that is better for start-ups” (116)

D'uh. From 1982 to 2000, the best industry for start-ups was pulp milling. If you started a paper pulp mill during the 1980s or 90s, you had an 18% chance of becoming a big, rich, job creating, Inc. 500 firm. Six mills made it in 18 years! 

Computer firms were second with 4.2% of 2,359 firms becoming Inc. 500 firms; Guided missiles and space vehicles were third with 3.3% of 60 (115).

Other notable industries and proportions:

• Measuring and controlling devices, 2.0% of 2,482;
• Communications equipment, 1.9% of 1,543;
• Drugs, 1.8% of 1,092;
• Legal services, 0.008% of 129,207;
• Eating and drinking places, 0.007% of 494,731;
• Used merchandise store, 0.004% of 24,442;
• Automotive repair shops, 0.004% of 124,725;
• Beauty shops, 0.004% of 79,081;
• Residential care, 0.004% of 27,710;
• Videotape rental, 0.004%, or 1 of 27,793. 

Even with the terrible odds, we cannot help but admire the riverboat gambler mentality of those who give small business a whirl. After all, somebody wins the lottery: an attitude of hopeless optimism perfectly in line with America's Winner Take All economy.

What If It's Not About The Money?

The only other explanation Shane gives for why people would start a small business involves the human perception of satisfaction. “It makes people happier,” he says, as 62.5% of people who work for themselves report being satisfied or very satisfied with their jobs, compared to only 45.9% of others. 

Women cite the flexibility to work while caring for small children. Men and women both cite the importance of working in a small organization where they can interact directly with everyone and have more autonomy, flexibility and control over their lives.

“Studies show that to be as satisfied when he is working for others as he is when he is working for himself, the average person needs to earn 2.5 times as much money” (109).

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Is "Satisfaction" Enough?

At the core, it depends on how much an individual enjoys working hard for less money while enjoying the perception of more freedom. Those feelings of satisfaction are probably not worth the opportunity cost of more gainful employment at established businesses, except for those who are truly satisfied working alone against the odds.

Perhaps this fatalism, mixed with a handful of strike-it-rich stories, is what we really mean by “the American entrepreneur" in our cultural myth.

However, to feed the myth by artificially forcing the rates of entrepreneurship up is bad economic policy. As Shane concludes, “Increasing the number of people founding construction firms and hair salons and taxi services that don’t do anything innovative isn’t going to do us much good. In fact, it might hinder our economic growth because new businesses are, on average, less productive than existing ones” (162).

Any political argument that exalts small business probably plays on voters' minds in the same way that Las Vegas casinos do: by turning losing odds into big gains for the few who get the many to put some skin in the game.

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As Paul Krugman stated in an op-ed piece "America Isn't a Corporation," we should not mistake governing a macro-system as conceptually the same as doing what’s best for an individual firm.

Shane’s book suggests that perhaps we should govern in a way that’s actually worse for the majority of individual small businesses and strive to create conditions that supplant their having to start in the first place.

Kill Mom-and-Pop businesses? Pay Mom and Pop better in the job market than the satisfaction they feel "working for themselves"? Our myths suggest we will not make that happen: myths about working hard, myths about creating jobs, myths about freedom.

The odds of most small business owners getting a 250% pay raise are worse than slipping in the shower, which is unfortunate, because chances are 50/50 that small business owners and their employees don't have health insurance, either, a situation created by a different set of myths than ones discussed here.

Source:
“The Illusions of Entrepreneurship: The Costly Myths That Entrepreneurs, Investors, and Policy Makers Live By,” Scott A. Shane, Yale University Press, 2008.