Economic Policy Program

August 2012

Summary: There has been a lot of interest in promoting entrepreneurship in the United States and Europe, coupled with a lot of confusion about how to germinate it and promote it. This stems from a common preoccupation with startups, when the focus should be on high-growth smaller firms that employ others. Where is enterprise growth the best in the United States and Europe, how much job and economic growth do they achieve, and are there policies that can help?

What do High-Growth Firms in the United States and Europe Teach Policymakers?
by Ryan Streeter
Lost in the multi-year debate on both sides of the Atlantic about the relationship between austerity and economic growth is that the nature of the latter, growth, matters a great deal to getting the relationship right. Not all growth is equal. If, for instance, tax policy favors larger companies who enjoy tax-sheltering advantages not available to smaller, younger companies, the end result could be job loss or stagnation even as the larger companies grow. Approximately 60 to 70 percent of all jobs in OECD countries have historically been in small and medium-sized businesses, including manufacturing jobs, so making life harder for smaller firms will naturally have a negative effect on jobs. The overall GDP figures for an economy typically roll all business activity into one number, and as a result we policymakers often draw conclusions about policys effect on business performance in too general a manner. Nevertheless, policymakers have learned in the past few decades not only that smaller businesses are essential to regional economic health, but that the entrepreneurial activity that creates them is also essential. It has only been in recent years that we have begun to fully appreciate one of entrepreneurships truly critical contributions to the economy: job growth. It turns out that the creation of new enterprises is so essential to job growth that without new firms, a countrys large companies simply cannot provide the new jobs necessary if an economy is to grow. The simple hypothetical scenario laid out above is therefore more than merely a thought experiment. If policymakers place too great a burden on emergent enterprises, the labor prospects for the larger population are greatly diminished. So You Care about Entrepreneurs? So What? Many thought leaders and elected officials have grown more accustomed in recent years to appreciating entrepreneurships role in economic vitality. Yet few of them have learned to make an important distinction that has really only become clear through new research in the past decade and it is a distinction that makes all the difference. That is, entrepreneurship matters to a countrys or regions economy not just because it results in new firms, but because the fast-growing young firms that entrepreneurs create produce a

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disproportionate share of the new jobs that employ young and older workers alike. In short, policymakers have learned to respect startups. But the important economic reality is not merely startups, but startups that ultimately begin growing at rates far above the national average. These startups grow into the new, vibrant firms that create the jobs of the future. Until now, policymakers aided by the celebration of entrepreneurs common in the media and on university campuses have begun thinking about startups, but they have done little to understand what fast growth looks like and why it matters. For instance, the World Bank has shown over and again that countries with low corporate taxes, a strong legal and regulatory environment, good governance, and low levels of red tape also enjoy high levels of business startups. The World Bank has also shown that, perhaps unsurprisingly, the economic downturn in 2008 hit new businesses especially hard.1 Scott Shane, a respected authority on entrepreneurship, writes that the Great Recession had a more adverse effect on incorporated entrepreneurs in the United States than on the unincorporated, meaning that businesses employing people other than the owner were hit hard.2 Some commentators have noted that entrepreneurship rises during a recession, but this is owing almost entirely to the fact that a number of individuals start their own business because of dim prospects elsewhere. Businesses that employ others besides the founder, as Shane notes, have taken a beating in the past few years. All of this is true. Its also an incomplete picture of economic vitality. Most research on new firms has focused on formation that is, how many new companies start each year. Startups are only part of the picture, though. More important to job creation are young, fast-growing firms. Some have termed these types of enterprises gazelles. The OECD, for example, defines a gazelle as a firm under five years old with an annualized average growth
1 New Firm Creation, Viewpoint, The World Bank Group, note no. 324 (September 2010): http://rru.worldbank.org/documents/publicpolicyjournal/324-new-firm-creation. pdf 2 Scott Shane, The Great Recessions Effect on Entrepreneurship, Federal Reserve Bank of Cleveland (March 24, 2011): http://www.clevelandfed.org/research/commentary/2011/2011-04.cfm

The World Bank has shown over and again that countries with low corporate taxes, a strong legal and regulatory environment, good governance, and low levels of red tape also enjoy high levels of business startups.
rate over three years of 20 percent or more.3 Whatever we call them, it is important to understand their unique characteristics, since many of them find ways to grow even during tough economic times. For instance, a 2011 study of high-growth firms in the United Kingdom showed that during the 2007-2010 economic downturn, the number and share of high-growth firms in the U.K. remained constant compared to earlier, better times. Compared to their share of all firms, highgrowth firms punch above their weight in job growth. According to the report, they represent the most important source of growth in recessionary times. 4 It is also important to note that these companies are not necessarily high-tech startups but rather represent a full spectrum of industries, from mining to banking. Figure 1 shows that over the past decade, high-growth firms have represented a small share of total firms and yet more than half of all jobs in the U.K.. This proportion changed little in the recessionary period between 2007 and 2010. The report also points out that higher-growth firms had lower rates of insolvency during the recession than other firms, indicating not only that rapid growth is possible in

3 High-Growth Enterprises: What Governments Can Do To Make A Difference, OECD (2010), p. 16: http://www.oecd.org/document/8/0,3746, fr_2649_34197_46477000_1_1_1_1,00.html 4 Vital Growth: The Importance of High-Growth Business to the Recovery, NESTA (March 2011), p. 7. www.nesta.org.uk/library/documents/Vital_Growth_v19.pdf

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Second, we have been too preoccupied with small businesses, many of which dont grow. However much small businesses are the backbone of Western economies, it does not follow that all small businesses are equal. Some are stagnant in terms of income and employee growth, and others fail. Our recognition of the importance of small business has too often led to our inability to see that small businesses with high rates of growth are the real job creators in a given countrys economy.

Figure 1: Percentage of High-growth Firms and Percentage Employment

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0% Firms Non high-growth firms

2002 to 2005

Employment

Firms

2005 to 2008

Employment

High-growth firms

Source: Analysis of ONS Business Structure Database, Vital Growth, p. 5.

bad times but that without it, things would have been even worse. Focus on Firm Growth More than Firm Creation Understanding the implications of findings such as those in the U.K. report is essential to understanding why entrepreneurship is important. Its not just any entrepreneurship that matters, but the kind that results in high growth. Furthermore, most high-growth firms are fairly young. The emphasis on the rate of growth and age is fairly new. It helps us recalibrate the preoccupation weve had with entrepreneurship over the past two decades, which suffers from two weaknesses: First, a large share of small businesses are single-owner firms that employ no one. Many studies count all new firms as evidence of entrepreneurship, even if those firms are only comprised of the founder. That is, a sole proprietor who sets off on his or her own as a consultant is counted as a new firm, even if no one else is employed. These are sometimes highly lucrative for the individual but otherwise rarely significant contributors to the economy.

If we focus only on startups as a measure for entrepreneurial growth, we get a different picture than if we look at highgrowth firms. Anders Hoffmann has Firms Employment 2007 to 2010 written a highly insightful and useful paper showing that Europe looks at least as entrepreneurial as the United States if we use startups as the measure of entrepreneurship. However, Hoffman argues, Europes biggest challenge is getting more high-growth firms.5 When we compare OECD countries startup rates, Figure 2 is the result. The United States does not look all that different than Europe. When we compare OECD countries by highgrowth firms as a percentage of all young firms, however, we see a picture like Figure 3. Hoffmann rightly concludes that Europes biggest entrepreneurship challenge is on the creation of more high-growth firms. Europe is well-advised to pursue policy options that are likely to generate faster growth among smaller, younger firms. In the United States, we see that without fast-growing young firms, it is almost impossible to achieve job growth. According to Dane Stangler of the Kauffman Foundation: Just 1 percent of companies those growing the fastest generate roughly 40 percent of new jobs in any given
5 Anders Hoffmann, Promoting Entrepreneurship: What are the real policy challenges for the EU? FORA, Danish Ministry of Economic and Business Affairs (2009), pp. 5ff.

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in the economy, yet generate 10 percent of new jobs each year.6 Stangler points out that the average company in the economy as a whole adds two to three jobs per year. The top 1 percent of firms measured by growth rates add on average 88 jobs per year. A large majority of these companies end up with between 20 and 249 employees, and a fair percentage grow upwards of 2,500 employees.7 Obviously, more of this kind of growth is in any nations interest. This reality manifests itself in interesting ways at the regional level. For instance, a recent study by the Indiana University Kelley School of Business shows that in the heart of Midwestern America Indiana in this case all new job growth during the most recent economic expansion came from homegrown smaller firms that grow year after year, and companies that have moved into the state from outside. Dispelling the notion that fast-growing firms are mainly technology or services companies, a large share of the job growth was in manufacturing. Existing large companies, on the other hand, shed jobs during this time period, 2003-2008 a period of economic growth.8 It is worth pausing to reflect on that thought, as the authors point out. One normally assumes that periods of expansion result in big companies getting bigger. Not so, at least not if bigger means more jobs in this case.
Turnover Employment

Figure 2: A Comparison of US and EU Business Start-up Rates

16%

14%

12%

10%

8%

1998 1999 2000 2001

6%

4%

2%

0%

Source: SBA Firms Size Data and Eurostat Business Demography, from Hoffmann, p. 6.

Figure 3: The Share of High-Growth Firms Among All New Young Firms
30%

25%

20%

15%

10%

5%

0%

Source: Hoffmann, p. 10.

This same principle of firm growth is alive and well in Europe. Perhaps the best picture of the importance of entrepreneur6 Dane Stangler, High Growth Firms and the Future of the American Economy, Kauffman Foundation (March 2010), p. 5. www.kauffman.org/uploadedfiles/high-growth-firmsstudy.pdf 7 Ibid., p. 6. 8 Timothy Slaper and Ryan Krause, Where the Jobs Are: A Report on Job Creation in Indiana, Kelley School of Business, Indiana University (January 2012), pp. 1-2.

year. Most of these, not surprisingly, are young the fastest-growing young firms (between the ages of three and five) account for less than 1 percent of all companies

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States.10 The question then becomes whether a commonality such as this is cultural, policy-driven, or the result of something else. When one looks at the World Economic Forums most recent Global Competitiveness Report and notes that the top five countries are Switzerland, Singapore, Sweden, Finland, and the United States, one can derive varying conclusions. On the one hand, it seems that smaller, more homogeneous countries perform well in virtue of their size and relative consistency of cultural mores. After all, Gallups December 2011 survey of European countries shows that citizens of Sweden, followed by Finland, see the fewest obstacles to starting and running a business in their country.11 This could be the result of relative cultural harmony more than anything. On the other hand, the United States seems to defy the small-and-homogeneous thesis given its demographic diversity, size, and diversity of policy frameworks in its 50 states. So what is going on? Policy Options Hoffman has argued convincingly that cultural differences matter, but that policy matters more. While he acknowledges that some cultural differences are important, he shows that the following five policy areas matter a great deal to making European countries more like the United States when it comes to fostering high-growth enterprises: business restarts, labor market regulation, venture capital, exit markets, and
10 Martin Andersson and Steven Klepper, Characteristics and Performance of New Firms and Spinoffs in Sweden, Research Institute of Industrial Economics Working Paper No. 902 (February 2012). 11 Troubled European Economies Stifle Entrepreneurship, Gallup (December 16, 2011): http://www.gallup.com/poll/151559/Troubled-European-Economies-Stifle-Entrepreneurship.aspx

Source: Audretsch, slide 18.

ship and growth comes from David Audretsch, shown in Figure 4. Compared to incumbent firms, new firms are naturally more likely to fail because of the higher risk that accompanies startups. But when they do survive for a certain period of time, their growth trajectory leaps past that of incumbent firms, which is why their contribution to job growth is so important. Audretsch theorizes that entrepreneurship provides the link between innovation and economic growth. The more of it we have in an innovative economy, especially when some subset of new firms become high-growth firms, the better for growth overall.9 This seems to be the case across countries despite different cultural, political, and policy environments. However different the United States and European countries may be on various matters of policy, when we look more specifically at the characteristics of new firm creation, we see commonalities that might help form the basis for policymakers. For instance, research suggests that spinoffs of existing firms perform better over time than other types of new firms in Sweden, Denmark, Brazil, and the United

9 David Audretsch, Entrepreneurship, Innovation and Economic Growth, OECD, slide 18: http://www.oecd.org/dataoecd/35/1/40808110.pdf

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Figure 5: Administrative Burdens on Start-ups

1998 5.50 5.00 4.50 4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00 2003 2008

Source: OECD Indicators of Product Market Regulation, High-Growth Enterprises, p. 68.

entrepreneurship education.12 Obviously, northern and southern European countries differ widely from each other when it comes to their various policy frameworks for stimulating and growing small businesses. But overall, basic realities such as the facility of venture capital and the ease of employing workers matter a great deal to creating an environment in which new firms can grow quickly. Hoffmans insights can be found within the OECDs new understanding of new enterprise and growth. The OECDs 2010 publication High-Growth Enterprises: What Govern12 Hoffman, p. 26.

ments Can Do to Make a Difference is perhaps the best, most recent attempt to look at the factors driving fasterthan-average growth among businesses and the policy environment that fosters growth. The document consists of a number of country-specific case studies and recommendations.13 Perhaps unsurprisingly, the authors find that no single factor contributes the most to high levels of growth. Highgrowth companies are driven by multiple factors. Perhaps surprisingly, though, the evidence on innovations role in
13 High-Growth Enterprises: What Governments Can Do to Make a Difference, OECD (2010): http://www.oecd.org/document/8/0,3746, fr_2649_34197_46477000_1_1_1_1,00.html

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high growth is mixed. The common casual inference that all innovation leads to above-average growth is not fully supported by all the facts, despite the indisputable fact that innovation matters a lot. There are three important takeaways from the OECD report. First, European countries have made progress in reducing administrative burdens on new firms, which is highly important to encouraging faster growth. For some time, there has been a growing consensus that red tape and other administrative barriers have reduced incentives to start and grow companies. In France, Germany, Italy, and the U.K., for instance, quite a bit of progress was made on this front between 1998 and 2008, as the Figure 5 shows. Second, despite progress on the administrative burden front, large-scaled tax and regulatory reform is still largely out of bounds. Most considered recommendations have to do with the governments role as an active promoter of high-growth enterprises. For instance, providing grants for consultancies, offering advisory services, facilitating access to markets, and favorable tax treatment for startups are all on offer.14 Very little about growth-limiting labor policies is on offer, however. In other words, there seems a reluctance to look squarely in the eyes of the downward drag of tax, regulatory, and labor policies that drive up the costs of hiring and training people. As Hoffman identified labor market regulation as a key policy opportunity, more could be done in this area. Third, we are still early in the learning process about what produces high-growth companies. The authors admit that their paper is really just a first cut. For this reason, as Western economies look south and east and see lots of growth and yet lots of questions about the sustainability of that growth, now is the time to revisit the fundamentals of enterprise growth that will be essential to sustainable prosperity. Policymakers, business leaders, and the media would do well to focus on the following:
14 Ibid., p. 69.

There seems a reluctance to look squarely in the eyes of the downward drag of tax, regulatory, and labor policies that drive up the costs of hiring and training people.
Deep dives into successful regional markets. If firms are growing at rates exceptionally above their nations average, case studies are in order. Assuming the policy environment conditions performance, we need to understand why some companies break out of their current environments limitations and try to answer the question how we can get a greater share of high performers in the wider economy. More probing into the importance of the policies that Hoffman and others have identified. How much does entrepreneurship education matter? What kinds of labor market reforms seem most conducive to firm growth and can they be broadly adopted? How have recent changes to tax law affected smaller firms and how much do they matter compared to other types of changes occurring in the regulatory environment? All of these questions should be answered not in terms of how the policies are affecting startups, but how they are affecting the growth of young firms. Shared learning. Papers are important, but the transatlantic community has a lot to learn from its members experience. If firms are growing exceptionally well in Houston and Stockolm, then perhaps bring together leaders from both environments with others in less dynamic economies to figure out together what the key drivers of growth are and what others can replicate. Young firms are often regarded warily by business and political leaders alike, because failure rates among new businesses are so high. What most observers have missed until recently, however, is that the increase in jobs and

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productivity from those young firms that survive typically outweighs the losses from business failures. Because the dynamics of high rates of growth have not been well-understood, we typically base policy on our understanding of large, established enterprises whose large numbers of employees mask the fact that they typically do not create many (if any) new jobs each year. If Europe and the United States are both to enjoy faster rates of economic growth than the norm over the past decade, it is time to turn that paradigm on its head and make the dynamics of young, fast-growing firms the main subject of our policymaking.

About the Author

Ryan Streeter is a non-resident fellow with the German Marshall Fund of the United States.

About GMF
The German Marshall Fund of the United States (GMF) is a non-partisan American public policy and grantmaking institution dedicated to promoting better understanding and cooperation between North America and Europe on transatlantic and global issues. GMF does this by supporting individuals and institutions working in the transatlantic sphere, by convening leaders and members of the policy and business communities, by contributing research and analysis on transatlantic topics, and by providing exchange opportunities to foster renewed commitment to the transatlantic relationship. In addition, GMF supports a number of initiatives to strengthen democracies. Founded in 1972 through a gift from Germany as a permanent memorial to Marshall Plan assistance, GMF maintains a strong presence on both sides of the Atlantic. In addition to its headquarters in Washington, DC, GMF has seven offices in Europe: Berlin, Paris, Brussels, Belgrade, Ankara, Bucharest, and Warsaw. GMF also has smaller representations in Bratislava, Turin, and Stockholm.