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A Loss of Innovation

September 28th, 2005

If the pace of change is rapid, as is so often commented, then it is surprising that small business is not doing better. Returns commonly lag the S & P. Small firms in many segments are losing market share to large. This is particularly surprising in the service sector, where intuitively we might expect that a-guy-behind-a-desk would be an entirely workable, even advantageous, enterprise. Yet in service, small business has seen some of the heaviest losses.

It suggests things left undone, or possibilities unidentified, unexplored. This is amazing, since it has been widely observed that the small firm’s greatest contribution, and advantage, is innovation. I mean this broadly, not just striking scientific discoveries brought to market, but great facility in responding to one-off situations, exchanges that but for the entrepreneur would have been missed. Sometimes these situations turn out to have broad application; sometimes small firms become large. However, entrepreneurs don’t require a public offering or a lucrative buy-out enjoy roaring success or to make significant ripples in the economy. That the small firm has been a major job creation engine is true, and almost a cliché. Beyond that, small firms are noted for the significant investment they make in employee training.

Owners point to taxes, regulation, and foreign competition, but these challenges are not unique to small businesses. New ventures routinely thrive in spite of the forces seemingly arrayed against them. Good luck can’t explain them all.

Regulation creates barriers, but these often stand athwart the path of those trying to break into the majors. There is a sense in which those of more modest scale, which are nonetheless capable of creating not-so-modest wealth, run under the radar.

Free of bureaucracy and legacy costs, one would expect small firms to be far more agile in meeting foreign competition. A quick perusal of major trade issues suggests that the more substantial firms in the more stayed industries have the greatest stake in making the unavailability of cheaper goods from abroad a matter of law.

Peter Drucker has suggested we are living off the capital largely accumulated in the 19th century. The observation is more philosophical than empirical. By reason and intuition, it has some resonance. Quite apart from striking fundamental advances in knowledge, which I take to be most of Mr. Drucker’s point, consider the extent to which we still depend on the mere physical infrastructure built a hundred or more years ago.

Large firms struggle to innovate, and struggle with innovation–their advantage is scale. What investments are made in facility and training and information systems are not readily converted or thrown away. They need time to get the payback; the last thing they need is premature obsolescence because of some new thing. Also, there is the question of bureaucracy. Scale needs administration and administration means bureaucracy with all it dark implications for the cultivation of new ideas.

In this firm’s experience, most significant gains in net worth for the entrepreneur are realized in the first 5 years of operation. (To prove this empirically, over a broader sample, would be a fascinating study, although I am unaware of anything having been done to date.) The truth thereafter, for those who enjoy that success–and there are many, a majority, popular statistics notwithstanding–is that early gains give a modicum of security and comfort. They become enemies of the thirst for the innovation, the niche, the unusual, that begat them. If your statistical sample has 20 firms, 15 of them may be past that 5 year mark, and their bland performance obscures the performance of the 5 star-performing newcomers.

Existence for these 15 firms out of 20 may be comfortable, but they typically succumb to outside forces which completely agitate their quiet pond. Or inside forces: the insidious nature of atrophy is that when we find we need to run, we can only walk. And, if that need for speed is delayed thanks to fortuitous circumstances—often of no credit to the post–entrepreneurial management–we find that although we only need hobble, we can’t even stand.

Many owners would do better, strictly in terms of minimizing risk and maximizing wealth, to sell out and retire, or go work for someone else. The non-decision to neither reinvestigate their entrepreneurial roots or to sell to someone else is a firm’s commuted death sentence.

The idea sounds direr than the experience. Statistics on small firms suggest something less unpleasant. Some proportion of business owners escape [sell, cease operations] with a considerable sum left over, the residual value of the business and the personal wealth harvested from it over years of operation. But that comforting fact doesn’t erase the cost of the damage, nor does it change the situation for the proportion of owners who don’t escape.

There are other alternatives. They have to do with research, discovery, and rediscovery. It is a rediscovery of the world outside, because any established business becomes rather cloistered, a club of vendors, employees, financiers, and customers who are accustomed to what has become an ordinary rhythm of life. They will tolerate an amazing atrophy of the firm around which that part of life revolves before they go somewhere else. It is, within some parameters, a non-competitive market.

Which is why when these things die, they die quickly. The building’s gone, been hauled off brick by brick for decades, only the facade remains. And casual observers, which by this time can include the management, are struck by how quickly the thing fell.

The way firms start and survive is the same way they thrive. It is not a continual state of agitation, but a regular renewal, a purpose to stay ahead of whatever changes continue apace even once the firm’s original pattern is set. It is rediscovering the links between investment, production, quality, and customer. It is reconnecting with the outside world, which before the doors opened for the first time, included everyone.

This gets down to data, but as always, the question is which data. There is no dearth of it, but the relevant data—data which graduates to the status of information, which speaks to the entrepreneurial spirit, is lacking. Relevant data is not all inside; it is preponderantly outside; financial data are only meaningful when clearly linked to non-financial but measurable standards, such as might represent production, capital structure, and customer pricing. Outside data has to refer to industry and economic conditions; are you flying, or are you only riding the tide that raises all boats? Solve the problems that are in your sphere of responsibility; the rest, hedge, which speaks to capital structure as well as actual futures and derivatives. Can this be done is small business with all its limitations in management and business acumen? Obviously yes, some are alreay doing it. To quote Anthony Hopkins, or rather David Mamet, in The Edge, “What one man can do, another man can do.”

If enough men and women who own their firms put this into practice, the evidence will be in small business’ emergence from this apparent slump, reclaiming their position–the rule, not the exception–as the innovators in the economy.