Fintech, Small Business & the American Dream

by Karen G Mills

  Part I

  The Problem

  © The Author(s) 2018

  Karen G. MillsFintech, Small Business & the American Dreamhttps://doi.org/10.1007/978-3-030-03620-1_2

  2. Small Businesses Are Important to the Economy

  Karen G. Mills1

  (1)Harvard Business School, Harvard University, Boston, MA, USA

  Karen G. Mills

  Email: kmills@hbs.edu

  In 2017, late night star John Oliver began a segment by noting something interesting about politicians and small business. First, he showed former Democratic presidential candidate Hillary Clinton saying, “Small business is the backbone of the American economy.” Cut to former Republican vice-presidential candidate Sarah Palin making almost the same statement. Then a split screen of former presidents Barack Obama and George W. Bush intoning the same small business mantra in tandem. More screen mitosis followed until, in total, 34 politicians from across the political spectrum appeared, each touting the importance of small business in almost exactly the same words (Figure 2.1). In an increasingly partisan political arena, support for small business is a rare point of bipartisan agreement.

  Figure 2.1 “Small Business is the Backbone of the Economy” from John Oliver’s Last Week Tonight

  Source: “Corporate Consolidation: Last Week Tonight with John Oliver (HBO),” September 24, 2017.2

  It’s not just politicians who express support for small business—it’s also the public. According to a 2018 Gallup survey, 67 percent of Americans have a “great deal” or “quite a lot” of confidence in small business—twice the average rate for all major institutions surveyed. Only 6 percent said they had “very little” confidence. Small business has consistently ranked near the top in public trust, second only to the military, and well ahead of media, government, religious and criminal justice institutions, and large businesses.1

  Americans have great affection for small businesses and believe in their importance. But what exactly does it mean to say that “small business is the backbone of the American economy?” Are we referring to the importance of innovators and entrepreneurs who develop new ideas and start companies that grow rapidly to become the next tech giant? Or are we describing the Main Street shops and other small businesses that make up the fabric of our communities? How do we measure the impact of small businesses on economic growth and on the quality and quantity of employment? Since half of U.S. employment is in small businesses, we know they are important, but exactly how relevant are they, and why?

  To understand how small businesses fit into both the economic growth and employment picture, we must clarify a point that often leads to confusion among policymakers and the public: not all small businesses are the same. High-growth tech businesses play a different role in the economy than the dry cleaner or restaurant on Main Street, yet each has an important place in helping America prosper. Supporting each type requires a different policy perspective, as each one has different needs, including for capital.

  In this chapter, we draw up a new way to categorize small businesses and quantify the different types of firms that make up the small business sector. This construction helps us better understand the significance and role of America’s small businesses, and sets the stage for exploring the markets where they access capital and evaluating how technology is changing those markets.

  Is Small Business Important to the American Economy?

  Surprisingly, economists have no analytical framework to understand the contribution of small businesses to the economy. Macroeconomists tend to focus on broad indicators, such as GDP, average wages, and the unemployment rate. In Keynesian models, consumption, investment, and government spending drive the economy. Since so much spending power lies with consumers and larger businesses, small businesses receive little attention from these economists. Monetary economists pay attention to inflation and what the Federal Reserve (Fed) does. In their assessments, small businesses are not relevant, as small business policy does not drive monetary flows or outcomes. That is the province of global markets, where small companies seldom participate.

  When macroeconomists think about the contribution of entrepreneurs, it is often through the lens of innovation or productivity. As one economist observed, “No amount of savings and investment, no policy of macroeconomic fine-tuning, no set of tax and spending incentives can generate sustained economic growth unless it is accompanied by the countless large and small discoveries that are required to create more value from a fixed set of natural resources.”3 In this framing, the contribution of entrepreneurs who invest in and market new products and services should be captured as inputs to innovation and reflected as improvements to productivity.4 But this contribution is difficult to measure. For example, it is hard to know how the advances that allow us to Google information instead of going to the library—or use Amazon instead of shopping at a brick-and-mortar store—translate into productivity measures. Arguably, surfing the Internet and binging Netflix have reduced productivity for many of us. Nonetheless, we know that entrepreneurs and the innovations they produce are important because they contribute to the “creative destruction” of the status quo that economist Joseph Schumpeter once argued was the price for a nation to keep or attain leadership in the global economy.5

  Even with accurate productivity measures, this analysis of small businesses’ contribution to the economy would be incomplete. There are only a relatively small number of high-growth small businesses, the ones we often think of as the influential innovators in the U.S. economy. Some economists have argued that these are the only ones that truly matter and should therefore constitute the majority, or even be the sole focus, of government policy. For example, Pugsley and Hurst write that policies that encourage risk-taking and support access to capital for all small businesses might be better aimed at a smaller set of businesses that expect to grow and innovate.6 Others go one step further, arguing that “the focus of entrepreneurship policy should be squarely on spurring more technology-based start-ups.”7

  It is true that these high-growth innovative businesses contribute much to the economy. But try this thought experiment: imagine a world in which we fully subscribed to the belief that the other kinds of small businesses didn’t matter much. If policymakers could identify the high-growth firms early on, they might reasonably decide not to waste time providing licenses to any other small businesses or support their efforts to start and grow. The economic argument would be that small businesses like the shops on Main Street were not worth government or market attention, as they fail at a high rate, are replaced by other businesses, and don’t appear to add much to the economy.

  In this imaginary world, small businesses and the loans and other services that support them would not exist. Without a small business lending market, there would be no private financing for small businesses, other than a few venture capital firms that focused on innovative, high-tech industries. The economy would be driven by large businesses. Every Main Street shop would be a chain restaurant or store. Except for a few high-growth entrepreneurs, sole proprietorships would not exist. The Uber driver would be an employee of Uber and the small-town lawyer would be an employee of a large law firm. The path of starting your own business and building generational wealth would be replaced by an entry-level job at a large company. A world without small businesses would dramatically alter the fabric of our communities. It would certainly change the way we lived and worked, and would affect the image and culture of America—and the American Dream.

  When faced with the prospect of even an imaginary world without small businesses, the average American becomes upset. People inherently know the value of small business. A national survey found that 94 percent of consumers said “doing business with small businesses in their communities is important.”8 And despite the fact that many consumers shop at Starbucks and Walmart, the same survey found that increasing numbers of respondents expressed a willingness to go out of their way, and perhaps even pay more, to support
their local small businesses.

  When politicians say that “small businesses are the backbone of the economy,” or when former NBA superstar Shaquille O’Neal stars in an ad for Small Business Saturday, they aren’t focused on the high-growth firms.9 They are talking about the corner grocery store or the mom and pop coffee shop. But, given their lack of importance in macroeconomic models, is the economic value of these small business just a myth?

  Contributions of Small Business to the Economy

  A deeper look shows us that the sentiment many attach to small businesses is reflected in economic reality. Small businesses do, in fact, matter to the economy. In contrast to macroeconomists, microeconomists see many ways that small businesses contribute to the larger economic picture. Their reasons fall into three major arguments: small businesses provide jobs, drive innovation, and act as a path to achieving the American Dream.

  The most basic argument has to do with the size of the sector and how critical it is to employment and job creation. As Nobel Prize winning economist Robert Solow points out, jobs are the main way our economy has chosen to distribute wealth and other benefits.10 Small businesses employ about half of all working Americans. As of 2017, 58 million jobs were accounted for by people who worked for themselves or for a company with fewer than 500 people.11 In addition, small businesses created 66 percent of net new jobs from 2000 through 2017.12

  The sheer number of employees in the small business sector warrants close attention from a U.S. policy perspective. If small businesses are under pressure and begin to cut jobs, the impact on national employment and wellbeing can be significant. This was the case during the Great Recession. From the first quarter of 2008 through the fourth quarter of 2009, small businesses shed 5.7 million jobs, 61 percent of the jobs lost during that time.13 This sent leaders in Washington scrambling to figure out how to stem the damage. In the United Kingdom, the financial crisis elevated small business policy, particularly with respect to access to capital, to a central place in the government’s agenda—an action that continues to have a positive impact on the United Kingdom’s small business and fintech economies.

  Some economists and political theorists argue that small businesses are important because they provide stability to the economy. This theory has traction in other nations that build their small and medium enterprise (SME) policies around promoting a robust small business segment that can grow and support a thriving and stable middle class.14,15 Saudi Arabia, for example, began an SME fund in 2017 in an attempt to stabilize its economy and provide jobs to its growing middle class in the face of falling oil prices.16

  Even among skeptics, there is widespread agreement that some small businesses play an important role in innovation. A subset of high-growth small businesses are led by innovative entrepreneurs who create competition for established firms and markets by developing new ideas that keep the economy from becoming stagnant.17,18 These small businesses produce nearly 16 times as many patents per employee as larger firms.19 In a review of related economic literature, Mirjam Van Praag and Peter Versloot concluded that entrepreneurs account for significant “employment creation, productivity growth and produce and commercialize high-quality innovations.”20 Entrepreneurship and the experimentation it engenders are important underpinnings of economic growth and success.21

  Small businesses and entrepreneurship also provide a path for upward mobility. Research suggests that self-employment increases intergenerational mobility.22 At the level of the local economy, studies found a positive link between small business lending through the U.S. Small Business Administration (SBA) and future per capita income growth in a local economy.23

  Small business has long been a critical part of the American Dream for new Americans, who often start businesses soon after they arrive. Immigrants inject a greater share of economic dynamism than their numbers would suggest. According to recent research, immigrants make up just 17 percent of the U.S. college-educated workforce, but constitute around a quarter of its entrepreneurs, and account for a similar share of inventions.24 A Kauffman Foundation index shows that, going back to 1996, immigrants have consistently punched above their weight when it comes to entrepreneurship.25 From 1995 to 2005, immigrants founded a staggering 52 percent of new companies in Silicon Valley.26

  Despite these attempts to quantify the impact of small businesses in the local and national economy, there is no clear framework that captures the contribution of all small businesses. This can lead to economic policy largely focused on taxes, research and development, and trade promotion, and geared primarily toward larger companies, leaving small businesses with the policy crumbs. Creating smart and powerful policy geared toward small businesses is a worthy objective, as it can have a positive impact on a large segment of our economy.

  What Is a Small Business?

  One key to economic insights when thinking about small businesses is to eliminate the confusion about the kind of small business being discussed. When we do, it becomes clear that each type of small business has a role, and each needs to be considered separately in terms of product needs and policy approaches. In response, we have segmented small businesses into four categories, quantifying the size and activity of each group. As the old saying goes, “What gets measured, gets done.” But a corollary ought to be, “What gets categorized, gets measured accurately.” The following categorization can help us measure, create policy, and assess the capital markets for the different types of America’s small businesses.

  The Four Types of Small Business

  There is no generally agreed upon way of defining a small business. Most of us have a rough notion of what a small business looks like based on our own experiences. Economists, governments, bankers, and others each categorize small businesses by different measures: their number of employees, their annual revenues, or even the size of loans they take out. “What are you calling small?” is a frequent question.

  Throughout this book, unless otherwise noted, we will rely on the definition used by the SBA, the U.S. Census Bureau, the U.S. Bureau of Labor Statistics, and the Federal Reserve, which all classify a small business as one with fewer than 500 employees. By that definition, there are 30 million small businesses in the United States, constituting more than 99 percent of all American companies.27

  To illustrate the different types of small businesses, let’s take a walk through a typical American town—Brunswick, Maine. Located near the coast, Brunswick’s primary employers are the shipbuilder, Bath Iron Works (owned by General Dynamics), and Bowdoin College. New businesses have been opening in the industrial park, located at the former Brunswick Naval Air Station. One manufactures composite aircraft parts, and another makes health care equipment. These businesses supply goods and services to larger customers. Their employees are happy to get their lunch from the Big Top Deli, where Tony makes the best sandwiches at his shop on Maine Street (spelled with an “e” in Brunswick). Tony had the chance to open another shop in nearby Portland, but decided against expanding. Next door, however, the entrepreneur owners of Gelato Fiasco had bigger plans. With growth capital from investors and a local bank, they opened a wholesale plant and began selling Italian ice cream as far away as San Diego.

  The aircraft parts supplier, Big Top Deli, and Gelato Fiasco are all small businesses, as are the fast-growing tech start-ups moving in down the coast in Portland. Although they are all small, they are different in many ways including the ways they require and access capital. Some need money to invest in equipment and buildings. Others like Tony are content with where they are, but may need a credit line to smooth out operating expenses. Each is an important component of the U.S. economy, but none alone paints the full picture of the small business ecosystem in America.

  The 30 million U.S. small businesses fall into four main categories: non-employer sole proprietorships, Main Street firms, suppliers that primarily serve other businesses and organizations, and high-growth companies (Figure 2.2).

  Figure 2.2 The Four Types of S
mall Businesses

  Small Businesses by Number of Firms in the United States (Millions)

  Source: Author’s calculations using Economic Census data. This analysis is based on the work of Mercedes Delgado and Karen G. Mills, “A New Categorization of the U.S. Economy: The Role of Supply Chain Industries in Innovation and Economic Performance,” MIT Sloan Research Paper, no. 5241-16, December 11, 2018.29

  Non-Employer Firms

  Most small businesses, around 24 million of the 30 million, are sole proprietorships without paid employees. These “non-employer” businesses include consultants and a range of independent contractors and freelancers, from ride-share drivers and painters to real estate agents and hair stylists. Around half of these businesses are full-time jobs for their owners, while others are side businesses.28 Some people start such firms intending to eventually hire employees and expand, but many start them to accomplish other goals, such as having more flexibility over the hours they work. For many Americans looking to supplement their incomes, these businesses provide an attractive opportunity in addition to their traditional work.

  Non-employer firms make up a growing share of U.S. businesses. Between 2007 and 2015, the number of non-employer businesses increased by more than 13 percent (Figure 2.3). Meanwhile, the percentage of American workers in similar types of non-traditional jobs went from 11 percent in 2005 to almost 16 percent by 2015.30 Innovations, such as instantaneous global communication, have made it easier for people to work outside of a central office. Innovation has also promoted growth in the “gig economy,” where people increasingly use online platforms to find independent contractor work as drivers at Uber or Lyft, as freelancers at Upwork or Handy, or even as dog walkers at Wag! or Rover.31