Small Business: A Misunderstood Beast

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Last month, Jay Goltz reflected on his status as a small-business owner. "Over the last 33 years, my business and I have been through numerous recessions, and this is the first time I have seen so much attention given to small businesses," he wrote in TheNew York Times. "It feels both flattering and insulting, comforting and unsettling, honest and disingenuous."

You probably know what he's talking about. "Everyone here knows that small businesses are where most new jobs begin," President Barack Obama said while pitching his jobs bill before Congress.

"Small businesses create millions of jobs in America, and President Obama has failed them," presidential candidate Mitt Romney wailed. 

That's the new theme: If you want to gain fans, praise small business. If you want to destroy an opponent, say they're against small business. In any case, use the words "small business," and you'll win someone's heart.

Most of this is warranted. About half of all private-sector jobs come from a company with fewer than 500 employees. Most new jobs do indeed come from small businesses.

But dig a little deeper, and you'll see how misunderstood the small-business chant can be.

A new paper (link opens PDF) by two University of Chicago economists titled "What Do Small Businesses Do?" dug through the data to separate talking point from fact. What they found might be surprising to everyone except the Jay Goltzes of the world: The vast majority of small businesses are far from economic haymakers, neither creating significant jobs nor engaging in innovation.

"Most small businesses have little desire to grow big or to innovate in any observable way," the paper writes. "Very few small firms report spending resources on research and development, getting a patent, or even copywriting or trade marking something related to the business (including the company's name). Furthermore ... nearly half of all new businesses report providing an existing good or service to an existing market."

As for job creation: "Most firms start small and stay small throughout their entire lifecycle." Industries that attract the greatest number of small businesses actually have below-average job-creation prospects.

Why the disconnect between perception and reality? It boils down to what we think an average small business is. The perception is that most start with a lightning-bolt idea, exploit it, turn it into a company, and attempt to grow that company into a blossoming enterprise like Google (NAS: GOOG) or Microsoft (NAS: MSFT) . Reality is a little different. The average small business is more like a laundromat. Someone takes an existing idea, moves into a market already occupied by competition, hires three workers, and remains a three-person shop for its entire existence.

This isn't a slam against small businesses. They're a big part of the economy, provide vital services, and employ huge numbers of people. Those who go out on their own deserve incredible praise. But if the goal is to grow the economy, create new jobs, and innovate for the future, small businesses shouldn't necessarily be the center of attention.

Instead, the majority of job growth comes from new businesses. The distinction is subtle but important: Most new businesses are small, but most small businesses are not new. The only time the laundromat created jobs was during its founding days. And there's a good chance it will eventually go out of business. As a group, small businesses destroy just as many jobs as they create.

Meanwhile, a study by the Kauffman Foundation found that from "1980-2005, nearly all net job creation in the United States occurred in firms less than five years old." Furthermore, "Of the overall 12 million new jobs added in 2007, young firms were responsible for the creation of nearly 8 million of those jobs." Age, not size, is what's important.

As for innovation, the same subtle difference arises: Most innovation happens in small companies, but most small companies don't innovate.

Who does innovate? What's important is who doesn't even try to, and that's most small businesses. "The vast majority of small business owners do not expect to grow, report not wanting to grow, never expect to innovate along observable dimensions, and report not wanting to innovate along observable dimensions," the University of Chicago study says. Those who aspire to do something new -- rather than someone old, albeit on their own -- are a small niche even among the small-business community. There is, in a sense, a difference between an entrepreneur and a small-business owner.

The takeaway from all of this is that our current policies to grow the economy, create jobs, and spur innovation might be aimed at the wrong crowd. "Often subsidies targeted at increasing innovative risk taking and overcoming financing constraints are focused on small businesses," says the study. "We believe that these targets are better reached through lowering the costs of expansion, so they are taken up by the much smaller share of small businesses aspiring to grow and innovate."

Will that happen? It's moving in the right direction. Obama's jobs bill proposes specific incentives for companies that expand payrolls. Still, most of the proposals are blanket measures that shower money on businesses that, as the study shows, don't even want to expand. We're expecting a lot from small businesses that openly admit that we shouldn't expect much.

As John Goltz would say, that's flattering and insulting, comforting and unsettling, honest and disingenuous.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel owns shares of Microsoft. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Microsoft and Google. Motley Fool newsletter services have recommended buying shares of Google and Microsoft. Motley Fool newsletter services have recommended creating a bull call spread position in Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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