Private Sector Brief

May 2012

Micro-enterprise growth: evidence-based policy implications

Introduction Support for start-ups and micro-businesses is often seen as the first policy option for creating jobs in the economy. Regrettably, development interventions focusing on these types of businesses have produced fewer results than expected. This is because they build on theories that can mischaracterize the reality of most micro-enterprises. A careful consideration of why this is so should lead us to revise how we think about micro-enterprise growth and support. What theory says about micro-enterprise growth First developed more than 60 years ago, enterprise growth theory still offers little guidance for development practitioners. Levie1 analysed 104 stages of growth models that were widely used between 1962 and 2006, and found that there is neither a consensus on basic constructs nor any empirical confirmations of stages theory. As Nichter et al. said, "the truth is that we know very little about micro and small enterprise growth."2 Almost all models of business creation and growth are built on the flawed assumption that owner-managers seek to maximize profits.3 How micro-enterprises behave: the reality Growth is the essence of entrepreneurship is frequently claimed by scholars and practitioners alike.4 There is, however, much empirical evidence that the vast majority of micro and small enterprises does not grow. Micro-enterprises start small, live small, and die small:5 About 75 percent of micro enterprises never add workers after start-up, or they reduce employment. Less than 3 percent grow by four or more employees and only 1 percent of micro-enterprises graduate to become small enterprises,6 which typically employ 10 or more workers.7 The sometimes staggering aggregate micro- and small-enterprise growth figures are mostly based on a small group of high performers. These results are by no means specific to developing countries. In Europe, 50 percent of net job creation by SMEs is created by just 4 percent of the total. Enterprises are more likely to graduate from the 10-49 employee class to the next level (between 50 and 250 employees) than from the 1-9
Private Sector Briefs will be issued intermittently by UNDPs Private Sector Community of Practice through UNDPs Bratislava Regional Centre. Aimed at practitioners in the country offices, it provides concepttual insights, analysis of crosscountry comparisons and ideas deemed relevant to private sector development and engagement.

Issue I, May 2012

Stephan SchmittDegenhardt, with contributions by Balazs Horvath and Nick Maddock Editing: Peter Serenyi UNDP, 2012

2 employee class to the 10-49 employee class.8 Surveys often focus on growth within a given business (vertical growth). But there is much evidence that, for various reasons, micro-entrepreneurs, especially women-owned businesses, seem to prefer horizontal growth (i.e., creating new micro-enterprises instead of expanding existing one). This leads to more businesses, but with low competitiveness.9 What are the obstacles to growth? Why dont micro enterprises grow? Several explanations can be put forth that fall under the categories external obstacles and internal obstacles.10 Expressed differently, internal factors can be seen mostly as resulting from choices made by entrepreneurs, while external factors lie outside their influence. External factors: External factors that significantly influence enterprises are the legal and the financial environment, as well as corruption. Beck et al (2002)11 found in a size-stratified sample of over 4,000 firms in 54 countries that consistently the smallest firms [] are most adversely affected by all constraints. In the legal environment, specifically, the affordability and consistency of the court system, enforcement capacity and the confidence in the legal system strongly affect business growth. The forms of corruption which are particularly constraining to growth are the amount of bribes paid, the percentage of senior managements time spent with regulators, and the corruption of bank officials. In the financial environment, bank bureaucracies, collateral requirements, high interest rates and access to, e.g., financing for leasing equipment are significantly constraining.12 The importance of credit (per se) for micro-enterprise growth is however more and more disputed.13 Also the effect of non-financial business development services (BDS) is contradictory: some studies found an increase in sales (of 8 percent to 81 percent)14, while others found no significant relationship.15 Internal factors: Characteristics such as the sex, age, education and history of the owner-manager, and the age of the business, make up some common internal factors affecting micro-enterprise growth. Women entrepreneurs in many developing countries make up the majority of entrepreneurs, but their businesses grow more slowly. They usually manage home-based businesses whose growth is usually limited by the businesses (typically) local outreach, as well as by the owners low tolerance for risk16 and their burden of managing both the household and business. Interestingly, neither the owner's age,17 nor family background, experience or even educational level have consistently been identified as influencing business growth.18 It is only confirmed that younger MSEs grow much faster than older ones.19 Enterprise growth is similarly low for necessity entrepreneurs those who are forced to start a business because they have no other choice. They want to survive and maintain a certain level of income. They typically make up a major segment of micro-entrepreneurs (the global average among efficiency driven economies is 31 percent, but Macedonia tops the eight surveyed countries of Eastern Europe with 59 percent).20 They rarely accumulate capital nor reinvest.21 They are ready to abandon their business for a decent employment opportunity.22 An important feature of necessity entrepreneurship is that, consistently, necessity entrepreneurship is much higher among women than among men.23

3 'Life-style firms', by contrast, are businesses that are created to support a certain lifestyle. It is estimated that 'life-style firms' make up about 90 percent of all start-ups in the United States,24 and they might also play an important - though much smaller - role in developing and transition economies. An enterprise can also fail to grow because it is in a state of 'arrested development', if the ownermanager perceives the risk associated with growth, or the changes required to achieve it, as too high (often termed 'growing pains'25 or the 'growth dilemma'26). Growth is not seen as a way to generate higher profits,27 and many expect growth to negatively affect employee well-being.28 People tend to overestimate the potential of failure, and are risk averse when gains are at stake.29 For many businesses there also appears to be an optimal size where further growth even (temporarily) reduces the rate of return.30 Often, the owner-manager chooses not to grow (or to grow by creating other enterprises) or to stay informal, to stay under the radar of rent-seeking officials, or to circumvent taxation and government regulations.31 Finally, owner-managers might also choose not to grow because they do not want to share decisionmaking or delegate power. Beyond 7 to 12 employees, businesses require the establishment of a middle-management structure, as a person can only effectively supervise up to 7 (+/- 2) functions.32 Should they nevertheless choose to continue growing (in terms of employees) their business often collapse. And even if the owner-manager were willing to delegate, or to create an adequate middle management, it might not be possible to find adequate middle-managers on the market.33 In reality, peoples motivations are different from those commonly found in textbooks and assumed by researchers. The diversity of their motivations is the dominant force behind most of these internal factors. About 96 percent of start-up entrepreneurs do not view themselves as truly growthoriented entrepreneurs.34 Income security and not income maximization is the prime goal of most micro-enterprise owners, resulting in horizontal growth, diversification of income sources,35 and low growth expectations.36 But the owner-managers' achievement motivation has repeatedly been found to be the single most important engine of enterprise growth.37 Finally, the typical micro-enterprise is locally oriented; that is, it offers products or services which have by nature only a local reach. Restaurants, retailers, bakeries and many services are examples of this. Growing beyond these boundaries implies substantial changes to the businesss organization and strategy, and to the owners' objectives. A locally oriented business thus reaches an optimal size, which is usually small.38 How should we approach micro-enterprise engagement now? Based on the above analysis, should all micro-enterprise development projects be stopped? By no means. The fundamental conclusion is that development interventions should be clear about the instruments they can use for micro-enterprise promotion, and the results they can expect. Targeting micro-enterprises can be divided in three groups: 39 Necessity entrepreneurs should be targeted though social programmes for poverty alleviation. Most necessity entrepreneurs usually only create their own job. Neither do they exhibit entrepreneurial ambitions, nor do they create additional employment. Projects addressing this group are of high social importance, but can neither expect much self-financing nor sustainability of the approach.40

4 The second larger group is made up of entrepreneurs who choose not to grow, as e.g. lifestyle firms. This group usually only needs a little support to make their life easier, e.g., through addressing external factors. Development interventions are unlikely to create more employment, but should support this group to stabilize their incomes. The last and probably smallest group is made up of micro-entrepreneurs in arrested development, or truly growth oriented owner-managers.41 This group is likely to create additional jobs and economic growth, and should receive targeted support to help it overcome the growth obstacles. Only when targeting this group can projects expect sustainability through self-financing. Finally, when supporting start-ups, it would be best to focus on businesses that already start with 10 or more employees, and not commence as micro businesses, with 1-9 employees.

This Brief answers some questions, but opens up many others. Future Briefs will be devoted to, for example, the following topics: Business incubators; Cooperatives; Economic aspects of gender; Functional areas; Cool storage and cool transport; Household heating systems; The local development trap; Market assessment; Microcredit; Networks and associations; Paying for business development services; A positive look on underemployment a long-term vision; Private sector and human development. If you would like to contribute a brief for dissemination, please be in touch with stephan.schmitt-degenhardt@undp.org

11 Levie & Lichtenstein, 2008 2 Nichter & Goldmark, 2009 3 Aldrich & Reuf, 2006; Schoonhoven & Romanelli, 2001; Davidsson, 1989; Davidsson, 1991 4

e.g., Sexton & Smilor, 1997; Baum & Locke, 2004; Tominc & Rebernik, 2007; Slevin & Covin, 1997; Stevenson & Gumpert, 1985 5 Davidsson et al. (N.D.) 6 Mead & Liedholm, 1998, based on surveys of over 28,000 MSE in Africa and Latin America. Similar statements are made as well in other studies. 7 World Bank, 2010 8 Gomez, 2008 9 The consequence of this phenomenon is that our focus of attention might have to be more the entrepreneur than the enterprise. 10 It should be noted that a number of factors can be regarded as both, external as well as internal. 11 Beck et al., 2002, also for the following paragraphs. 12 But access to long term loans perceived by owner-managers to be highly important- is not significant. 13 e.g. Schreiner & Woller, 2003 14 A cost benefit analysis was however not included. See: Zandniapour et al., 2004 15 Cooper et al., 1994 16 Usually, the wifes business provides the base-income, allowing the husband to take more risks with his business. 17 Papadaki & Chami, 2002 18 Papadaki & Chami, 2002; USAID, 2005; Nichter & Goldmark, 2009: However, experience increases business survival chances, and the educational level influences business growth once a country-specific threshold is reached (threshold effect of education). 19 Nichter & Goldmark, 2009; Papadaki & Chami, 2002 20 GEM Consortium, 2010 21 Necessity entrepreneurship can be seen as a mixed factor, originating out of external constraints, but resulting in a usually chosen growth capping (satisfycing). 22 Surveys made by the author showed that in El Salvador, about 80% of entrepreneurs preferred a fixed job (under otherwise equal conditions), while in Aceh (after 30 years of civil war), the same percentage preferred self-employment. 23 GEM Consortium, 2007 24 See Federal Reserve Bank of Atlanta, 2011; AngelCapitalWiki, 2012 25 Flamholtz & Randle, 1990 26 Davidsson et al., (N.D.) 27 A survey by Davidssons (1989) showed that 40% of small firm owner-managers did not expect that growth would improve their personal income stream. 28 Wiklund et al. 2003 29 Plous, 1993; Davidsson, 1989; Davidsson, 1991; Wiklund et al., 2003 30 Roper, 1999 31 The Economist, March 3rd 2012; Winter, 1995 32 Miller, 1956; Schmitt-Degenhardt et al., 2002 33 Observations on this growth gap and the arrested development as described in the previous paragraph have been made by the author in El Salvador, Kosovo and Georgia. In the latter case, this gap has probably much to do with taxation thresholds. 34 Based on a survey of 400 micro-enterprise owners in Kenya, Cotter (1996) estimated that only 3.6% of all start-ups are growth oriented. 35 For 1/3rd of households, their micro-enterprise provides less than 50% of the households' income (Base: 7 African countries). Mead, 1999; For India, Banerjee & Duflo (2007) found that about 20% of households with a microenterprise had also further sources of income (20.5% in Peru, 24 % in Mexico, 36% in Pakistan and 47% in Cote dIvoire). 36 Only 10% of start-ups expect to create 20 or more jobs within the first five years of their existence. Autio, 2007 37 Cliff, 1998; Delmar & Davidsson, 1999; Dennis & Solomon, 2001; Human & Matthews, 2004 38 Schmitt-Degenhardt et al., 2002; cf. also Aldrich, 1999; Reynolds et al., 2003; Samuelsson, 2004 39 Cotter, 1996 40 Cf. also Billing & Downing, 2003, who argues that assistance to this type of firms is mostly futile. One could argue that, still, about 25% of micro-enterprises do grow (in terms of employment) at least a little over their lifetime. If thousands of micro enterprises manage to create just one job each, employment in the economy will be boosted. From a cost-benefit perspective, however, a job created in this enterprise segment is likely to be more costly as in the small, medium or particularly large enterprise segment. Therefore, effectively addressing this target group through development projects requires much standardization. 41 See also Gomez, 2008

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