Making sense of SMEs by Dr Peter Kolarz, Policy Consultant, Technopolis Group on 30-Jan-2014

SMEs  are being heralded as the backbone of economic recovery. Over 99% of businesses in the UK are SMEs and they are considerably more likely than large firms to come up with radical innovations and open up new markets and product types. However, the term 'SME' is general in the extreme, applying as it does to over 99% of all businesses in the country. Such a broad-brush term hides the hugely-significant differences that exist amongst SMEs and may even make it somewhat difficult to agree on what the characteristics of an SME are, what exact part of the recovery they might be driving, and what kind of policy support SMEs could / should have.

SME has become a highly-fashionable term. However, for the purpose of clearer representation, clearer advocacy and clearer, more suitable and targeted policy decisions, it is perhaps more suitable to sub-divide into four 'sub-species' of SME.

The lifestyle business

What is it?
These are companies that are based on what might be termed experts, passions and professions; chartered accountants, law firms, trade consultants and, likewise, a great portion of small-scale manufacturers and service providers. These businesses are based on individuals with a certain level of professional training and a desire to deploy that training in a constructive manner.

What is it good for?
These businesses provide several important services and products that individuals and other businesses require. They generate a moderate amount of tax, they may well create a few jobs – maybe just one or two, maybe 20 or 30 – and they most likely provide training opportunities for graduates in the field, perhaps just one every few years, perhaps a handful every year.

What are its problems?
These are the businesses that largely remain invisible. They do not increase exponentially in value, they do not pose opportunities of any significant kind for investors, they tend to be very minor players in terms of innovation or groundbreaking business revolutions.

The churn business

What is it?
This is a very significant share of SMEs: an illustrative example might be a fish and chip shop, opening in a small town that already has three fish and chip shops and a consumer demand for two fish and chip shops.

What is it good for?
These types of SME have little discernible value. At a rudimentary level they might ensure a basic level of quality control: savvy customers will eventually tend towards the better fish-and-chip shop, though this is unlikely to happen in a smooth and economically calculable manner. Simple additional factors like availability of good business location or habit of local clientele easily defeat such issues.

What are its problems?
A churn business will either fail, or push another business more-or-less exactly like it out of the market – hence the name. Especially at this level, business failure often results in dire psychological and often financial consequences for those involved. Neither innovation nor high growth are even remotely likely with these businesses.

The innovating businesses

What is it?
These are the businesses that come up with radical innovations, or, put simply, 'new stuff'. They are often located in the IT sector, but can just as easily emerge from elsewhere. They pioneer new products, services and technologies, without which progress, save for the strictly scientific kind, would be impossible. Think anything from novel apps to intelligent logistics systems and beyond!

What are they good for?
If progress and development wasn’t enough, these businesses often act as catalysts for entire new economic sectors. Knowledge rarely remains private – the new developments pioneered by these businesses eventually (sometimes very quickly!) spill over to other businesses, triggering immeasurable amounts of new economic activity. Furthermore, they often create local 'clusters', geographical locations where several new businesses specialising in the new innovation congregate (think Silicon Valley!). Developments of this kind are based on the fact that early imitators of a new innovation tend to be those who are located in closest proximity to the original innovator. These clusters can be hotbeds of newly required skill and expertise, often leading to international authority and a recognised specialism for the country where the cluster is located. Moreover, innovation is of course a broad term: it may refer to a new product, but can also mean a new process, that is, a new way of doing business, a new way of organising a company or delivering a service. The benefits here might be for the employees or directors of companies, rather than directly for their customers.

What are its problems?
They are extremely risky and tend not to make much money. Sorry to be so blunt, but innovation is a risky business. The vast majority of innovations involve a vast multitude of failed attempts. It may take tens or even hundreds or thousands of unsuccessful attempts before an idea that looked good on paper is successfully turned into a finalised product with wide consumer appeal, or a fully-workable new production or delivery process with no hitches. Eventually, a truly good idea will most likely succeed, provided there are no significant market failures, path dependencies or lock-in problems in the way (eg. electric cars are a non-starter until there is a nationwide infrastructure of recharging points in place). But by the time a business successfully markets an innovative product, with all bugs fixed and a cool design and advertising campaign to show consumers why they should want it, the long, dark process of trial and error, failures, bankruptcies and resignations will already have happened. The final fraction of optimisation conducted by the business that sees the first success is barely still part of the innovation process at all.

The high-returns business

What is it?
These are the businesses that make investors happy. Characterised by low risk and high returns, they have the capacity to increase vastly in value within the shortest possible space of time. Often found in the financial sector, frequently as spin-offs of existing companies and carefully engineered to be value-maximisers.

What is it good for?
These businesses generate a lot of capital for their investors – which is often their primary purpose! A good investor might use that capital to invest in a dozen more businesses of this type.

What are its problems?
High-returns businesses tend not to be innovative. Investors need reasonable degrees of certainty and, as I highlighted before, innovation and certainty do not mix. As noted, innovative businesses stand out by creating benefits for other companies around them, so-called externalities. The problem for investors then is that they cannot appropriate all the benefits of such a business. Economists therefore speak of 'inappropriability' as a key hindrance to wealth creation and economic growth. The high-returns business chiefly needs to be one where all the benefits generated by it are squarely within the realms of that business itself. Rather than innovation or provision of important services to wider society, these businesses tend to be highly artificial, quite possibly the result of financially savvy restructuring of larger companies or, if there is innovation involved, it might be in the form of a narrowly-applicable financial tool. A 'good' investor is furthermore likely to invest their profits from such a business into other businesses very much like it. The chances of investment thus leading to capital for other businesses with a genuine scope for benefit to wider society is then limited.

The big questions

The lines between these four types of SME are of course blurry. Yet, highlighting these different ideal types leads to some serious questions: why should there be help for a fish-and-chip shop that pushes proud fish-and-chip craftsmen opposite the street out of business? Is a steadily stable and successful small accountancy firm worth less, socially, politically, morally, than an artificial spinoff from the City that put ten million pounds into an investor’s portfolio? Is it sustainable that those businesses most likely to trigger entire new economic sectors are least likely to attract investment?

We have more-or-less identified SMEs as the way forward. But for the sake of economic, social, political and, indeed, philosophical coherence, we now need to ask, 'What kind of SMEs?', and why?

Dr Peter Kolarz is a Policy Consultant with the Technopolis Group and a member of the Francis Hutcheson Institute. He is a sociologist with particular interests in globalization, political sociology, political economy and variations of capitalism and can be contacted by e-mail.

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