Young Businesses Create (And Destroy) Jobs

A new study finds that job creation has very little to do with whether a business is big or small, apart from the fact that young businesses (which are smaller on average) create more jobs than old businesses (which are larger on average).

In other words, mature small businesses aren't actually more prone to create jobs than mature big businesses, while young big businesses may be powerful engines of job creation.

The implication is that policies designed to encourage job creation (as almost all governments want to almost all of the time), should focus on incentives that single out businesses that are start ups, rather than small businesses per se, as many current government programs do.

Of course, there are problems with this approach too. Young businesses are much more likely to fail than old businesses. The percentage of new businesses that fail is atrociously high in the first few years. While young businesses are a powerful force for job creation, they are also a major source of job destruction as the projections upon which they based their hiring often fail to materialize.

Banks don't like to lend to unproven young businesses at affordable interest rates because there is such a high failure rate and because a loan model forces banks to share in downside risk, when loans default and aren't fully repaid, but limits their upside benefit to the interest rate on the loan.

One of the reasons that franchises are so attractive is that they allow investors (be they equity or debt investors) to supply funds to a young business with the kind of confidence about the likelihood of default that is normally possible only in older businesses that have established a long track record of performance.

Short of the franchise model, a very large share of all small businesses are basically franchises without the franchise. Lots of small businesses spring up all over the country using essentially identical business models to similar businesses that have worked on an identical business model for years in similar circumstances, which makes their performance and likelihood of failure predictable.

General stores in small rural towns in the South after the Civil War, and in the early stages of settling the American frontier, main street hardware stores, no name Chinese restaurants, dry cleaners, convenience stores in low income neighborhoods, book keeping services, CPA practices, law firms, plumbing firms, coffee shops, farms, bars, local motels, liquor stores and towing companies are just a few examples of the general concept. Anywhere that economies of scale aren't immense, you will see them.

For all of the business school buzz about innovation, in the world of small business there are ten businesses that thrive copying what somebody else has done that has worked over and over again, for every one that succeeds trying something new or different. Successful franchises frequently do little more than formally describe an already well established and proven business model, and then add branding and quality control.

Programs like small business administration loan guarantees can overcome the reluctance of banks to make these loans, but don't overcome the intrinsic problems associated with making loans to businesses with great potential for intense growth and a high risk of failure, as a business model.

Apart from franchises, which are in many ways really a very performance based executive compensation system and decentralized financing arrangement for what is really a much older medium sized to big business, the risk associated with young businesses is an inherent part of the beast. It will almost always be harder to predict whether a young business will succeed or fail than it is for a mature business.

Of course, that doesn't mean that young businesses using old business models aren't creating jobs. Indeed, young businesses using old or franchised business models may be the most reliable way to create jobs. They are in a growth phase so they need to hire. But, they are doing something that has worked before, so they are less likely to fail and destroy jobs in the process than innovative businesses.

But, "unoriginal businesses" have much potential to create jobs only when they are expanding into "virgin territory" or into an industry whose share of the economy is increasing for some reason. New subdivisions that spring up as people are drawn to new jobs by some primary industry, perhaps a new software company that exports its software all over the world, create a host of new opportunities for "unoriginal businesses" to serve them.

The nation may be saturated with coffee shops, but many communities have no Vietnamese restaurants and lots of people who could come to develop a taste for vietnamese food. If the electric cars that enter the mass market in the 2011 model year catch on, small businesses specializing in electric car maintenance will soon spring up all over the nation.

When young, "unoriginal businesses" expand in saturated territory, or in a declining industry, the new businesses will indeed still create jobs and may not even have a high chance of failure, but they will do so at the cost of destroying jobs in some other firm. When a Home Depot or Wal-Mart moves into town, it creates lots of new jobs, but does so at the expense of existing Main Street businesses. New hair salons and small law firms replace those that shutter their doors when their proprietors retire or change careers.

It is also worth noting that while we are accustomed to big businesses and franchises out competing small, independent businesses, it doesn't always work out that way. One of the most notable recent examples is the department store.

When I graduated from law school in 1994, department stores accounted for 5% of all retail sales in the nation. Today, that market share is about 1.8% and falling, a decline in market share of more than 60%. Whatever edge department stores once had has evaporated. Category killers (like Best Buy), discount chains (like Target), chain botiques, and other ways of selling people stuff have made them obsolete.

Perhaps the best way to think about what department stores used to be is to think of them as shopping malls in the era before shopping malls were invented. What shopping malls did was to disaggregate the task of creating and managing real estate in which many kinds of goods could be sold from the task of operating retail stores. Department stores and their economic successors, shopping malls, let people shop for lots of kinds of things, on foot, without getting out into the weather. But, since different departments in a department store didn't have the same relentless intense incentives to carry their own weight as the separate firms in a shopping mall that go out of business when they don't make a profit, they lost ground to their mall street competitors. Department stores have disintegrated for essentially the same reasons that communism collapsed; unprofitable parts of business ventures were allowed to continue operating and the incentives of important decision makers to perform weren't strong enough.

Indeed, the conglomerate business model, where one large corporation owns disparate businesses, which has been going out of fashion lately in the economy, at its best in businesses like ITT, had a business model that insisted on detailed managerial accounting review of every business unit and ruthlessly insisted that every business unit constitute its own profit center. The successful conglomerates functioned in much the way that the idealized corporate governance model expects shareholders and corporate directors to act (despite the fact that they do not, in practice, act that way for reasons that are a subject of great dispute).