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Wednesday, April 6, 2011

The Engine of Economic Growth

The Engine of Economic Growth[1]
Stephen A. Boyko[2]

Small-to-medium enterprises (SMEs) are the engine of economic growth. SMEs consist of small businesses that drive job growth and entrepreneurs that provide innovation for wealth creation.[3] Nowhere is the societal benefit multiplied more effectively and efficiently than through SMEs. Unfortunately, only 72 venture-capital-backed investments went public in 2010 in the U.S. according to data from Thomson Reuters and the National Venture Capital Association. Over the last decade, the annual number of initial public offerings (IPOs) failed to reach 100 as compared to 270 IPOs in the late 1990s. SME IPOs are the fuel of capitalism. The troubling trend of diminishing IPO capital formation is a sign that the engine of economic growth has a low fuel tank.

SME core difficulty in the pursuit of financing is not investor indisposition, but a fundamental failure of the one-size-fits-all (OSFA) approach to governance. Regulatory proposals designed for top-tier, risk-management regimes are disproportionate when applied to the SME market. Top-tier regulatory proponents, Paul Volcker and Arthur Levitt, have defended the added cost of Sarbanes-Oxley by stating, “$5 million down and $1.5 million a year is not too much to pay for a multibillion-dollar international company...”  But what about the SMEs that cannot afford such added costs. Do you treat SMEs as if they were large corporations?

Market segmentation for better governance

When different governance models are combined and treated as similar regimes under a one-size-fits-all deterministic metrics, error is likely. When the volume of commercial activity increases, errors become material. As illustrated in the matrix below, cross-referencing the financial cash flow and operational products construct with their related binary benchmarks provides brightline demarcations and governance models for:
A.  Global corporations: positive cash flow and determinate product demand,
B.  Intrapreneurs: positive cash flow and uncertain product demand,
C.  Small businesses: uncertain cash flow and determinate product demand, and
D.  Entrepreneurs: uncertain cash flow and uncertain product demand.

Financial cash flow

Operational products
Large Corporations with > 500 employees and positive cash flow
SMEs with < 500 employees and uncertain cash flow
Conventional products with
determinate demand
Global Corporations
Small businesses
Unconventional products with
indeterminate demand
Intrapreneurs: corporate innovators
Entrepreneurs: SME innovators

Governance similarities for large scale corporations as referenced by Model A, corporate firms, and Model B, intrapreneurs are:

1.     Management policies and procedures derived from best-practices;
2.     Decision structures based on clearly delegated lines of responsibility;
3.     Personal autonomy limited and controlled through standards, results, budgets, and reporting chain of command.
4.     Conforming environment; and,
5.     Critical mass considerations.

What differentiates Models A and B, is that Model A corporations create conventional products whereas Model B intrapreneurs are likely to be new product and business development oriented. Intrapreneurs are problem-solvers in decentralized corporations that encourage individual initiative. Their main task is determining whether an innovative product can be distributed through conventional channels.

Governance similarities for Model C, small businesses, and Model D, entrepreneurs are:
  1. Independent—do not like someone having authority over them;
  2. Have a high need for achievement—most believe they can do the job better than anyone else can. They tackle problems immediately and are persistent in their pursuit of their objectives;
  3. Self-confident when they are in control of what they are doing. They will strive for maximum responsibility and accountability;
  4. Opportunistic—see different realities and strive to exert their influence; and
  5. Cash-flow dependent—they like to hear the ice crackling under their feet.

Small businesses, Model C, are owned independently and provide conventional products. Such SMEs aggressively market to historical relationships with superior service in a geographic location where they have a comparative advantage. Personally, small businessmen and women tend to work to their comfort level as defined by their community standards. Their desire to preserve capital is greater than their desire to gain additional wealth. This, in part, results from their cash flow dependency and related focus on exit scenarios, access to credit, and tax minimization strategies.

“Entrepreneurs,” Model D, are problem-solvers of unmet societal needs. They provide goods and services that consumers have always wanted to satisfy their “gee-I-wish” needs. They are highly focused individuals who concentrate almost all their energies on their business. Entrepreneurs are independent actors who marshal resources and face uncertainties that change commercial ideas, processes, and/or locations. Entrepreneurs have a unique ability to conceptualize. Entrepreneurship is a way of thinking as much as it is a business concept. It is a behavioral phenomenon, not a personality stereotype. No one has found a personality template that fits all entrepreneurs. They come in every age, gender, race, intellect, background, personality, and character.

What differentiates Models A and B from SMEs (Models C and D) is scale—the 500 employee threshold. What differentiates Model C from Model D is randomness. Small businesses determinate product demand provides a measurable risk profile that can be financed with bank debt. By comparison, entrepreneurial randomness contends with unmeasurable uncertainty as to product demand and cash flow that requires “slivers of equity” from venture capital financing.

Conflationary constraints

A New York Times’ blog recently defined the recession’s gravamen as the under-employment of labor that required a bank dividend holiday to restore “safe” levels of bank capital. Raising the banks’ return on reserves is a disincentive to lending. Small businesses and entrepreneurs would lose much from a capital formation scheme that equates bank safety with capital rationing for SMEs. So much for job creation and innovation.

Unless and until randomness is segmented into predictable, risky, and uncertain underlying economic domains, errors of conflation will continue to result in noncorrelative information that will thwart capital formation.[4] Conflating small business “risk” with entrepreneurial “uncertainty” produces the unintended consequences of contingent and unforeseeable liabilities for market practitioners where failure equates with fraud.[5] This jeopardizes market effectiveness. Holding market participants who deal in uncertainty to the condition of determinism conveys regulatory rights without attendant regulatory responsibilities. Imposing one-size-fits-all commands undermines market resiliency and increases the probability of systemic failure. Such regulation imposes sanctions on unforeseeable events that stifle free market innovation and adaptability.


[1] This article is a revised version of “Exploring Entrepreneurship,” that appeared in the Pace University Journal, http://appserv.pace.edu/emplibrary/GlobalFinanceNewsletterNov04.pdf

[2] Stephen A.  Boyko is the author of "We're All Screwed! How Toxic Regulation Will Crush the Free Market System https://www.sfomag.com/News/news.aspx?ID=1612 . He has over forty years of financial services industry experience that include formulating regulatory policy for the National Association of Securities Dealers (now FINRA) and providing a practitioner's perspective for the privatization of the former Soviet Union in corporate governance and regulatory development of the Ukrainian Capital Market. Contact: n2keco@bellsouth.net

[3] A Kauffman Institute study found a strong correlation between SME start-up rates, growth in GDP, and the employment rate. At a time when large, global companies were outsourcing jobs, SMEs with fewer than 500 employees increased their employment of the private workforce and patented innovations by more than 50 percent.

[4] The concept of segmenting randomness will be more-fully explained in a forthcoming Center for Advanced Defense Studies’ white paper entitled “Randomness: Why it Matters, and What to do about it.”