Local & Regional Development Formation and Function of New (and Small) Firms

Local & Regional Development Formation and Function of New (and Small) Firms By Ania Dachowska and Philipp Hollenstein Lecturer: Prof. Gunther Maier

Overview • Small firms vs. big corporations • New and small firms as entrepreneurs • The background on starting a new business • The seed-bed hypothesis • The incubator hypothesis • Regional variations in new firm formation rates • The effects of industry structure • The effects of regional dynamism • New firms: the challenge of survival • New (and small) Firms in Local development • Small firms and regional development policy • Planning on incubators

1. Small firms vs. big corporations • Prior: Small Firms were expected to be less economical they are surviving only because of ... • limited market possibilities • or technical limitations which constrain the possibility of generating economy of scale • The conventional view of an ideal unit was a large firm or large factory exploiting economy of scale • Now: Small Firms and Entrepreneurs are considered as an important part of the economy • rapid growth of new businesses • downsizing among large firms

2. New and small firms as entrepreneurs • Definition: An entrepreneur is a person who has possession of an enterprise, or venture, and assumes significant accountability for the inherent risks and the outcome. It is an ambitious leader who combines land, labor, and capital to create and market new goods or services (Quelle: Wikipedia) • New fims are almost inevitably small and as a result of both they are of an entrepreneurial nature. • Small firms often have an entrepreneurial form business organisation in contrast to the bureaucracy or technostructure of large corporations • more flexible • rapid decision making

2.New and small firms as entrepreneurs • Characteristics of entrepreneurial firms: • they are highly responsive to market forces (power of the small firm is limited) • they operate in markets that are strongly regulated by competition • the firm is independent • Ownership and management is combined and personalized • Decision-makers are risk-takers • little or no power to change market forces • The are small in terms of market share (no power to determine prices or output levels) • They have only few employees (opening and closure has no measurable social impact) An entrepreneurial firm does not compulsory match all these characteristics! And it can not be assumed that all small firms are innovative!

3. The background on starting a new business • Motivation to begin a new business: • Neoclassical theory focus on … (monetary factors) • economical rationality • importance of cost-minimizing • profit-maximizing • In reality non-economic considerations do also play an important role such as … • To be ones own boss • To develop own ideas (self-fulfillment) • To balanced work and leisure • To be rewarded appropriate

3.The background on starting a new business • The age of new entrepreneurs is increasing • In Japan, until 1986, most Japanese new firm founders were in their 30s. • Since 1986, the most founders are in their 40s. • Reasons: • more technological knowledge is required • more financial capability • need to have a strong connection with the previous workplace • maybe nowadays older people are more forced to become self-employed than in the past

4.The seed-bed hypothesis • Between 68% and 90% of new firm founders located in their local area • The reason is that the new entrepreneurs are thoroughly familiar with their home locales, and are well known there. • they are aware of possible premises, • possible workers (members of the family), • understand the characteristics of local labour, • contact to financial institutions (good reputation), • are able to work at the old workplace at the same time (financing the new firm) • knowledge of local markets, • get easy available equipment an suppliers • and are able to make their first entrepreneurial steps in the rooms of their own house (or in the garage)

4. The seed-bed hypothesis • To locate elsewhere would involve a lot of costs and uncertainties in collecting and understanding information on unfamiliar places • This stands in sharp contrast to the neoclassical view where total information is given • The seed-bed hypothesis is also valid for immigrants • In Canada most immigrants who became entrepreneurs lived at least 11 years in Canade before deciding to found a new venture • At the first glance this result support the seed-bed hypothesis but may there can be also an other reason for it.

5.The incubator hypothesis • There are many different types of incubators • local ethnic groups that help to nurture immigrant entrepreneurs • business organizations or educational institutions which spin-off entrepreneurial ventures through the initiatives of former employers are incubators • The original expression refers to long established industrial cores within metropolitan areas as incubators • The rate of new firm formation is positively influenced by the supply of agglomeration economies • New firms will be attracted to areas offering services essential to their operation that they, because of their small size and limited resources, would be unable to provide internally e.g. access to cheap suppliers, markets, transportation, consulting, advertising; create external economies of scale

5. The incubator hypothesis • But there are also diseconomies of scale in such metropolitan centers • problems of crime • obsolescent physical and social infrastructure • long-standing trends of suburbanization and non-metropolitan industrialization (reduce attraction • This lead to some other incubators outside the metropolitan area • Silicon Valley • Boston 128 • One of the big advantages of an incubator area is the access to venture capital • Venture capital is connected with a lot of risks for the lender – therefore many venture capitalists tend to invest into local ventures where they are able to monitor, supervise and assist their partners

6. Regional variations in new firm formation rates • hedifference in the birth rates of manufacturing firms varies among regions • sub-regional variations are greater than those revealed at the interregionalscale Silicon Valley

6. Regional variations in new firm formation rates • UK • therich and fast growing regions of the south and east and weaker in the more peripheralregions • - the regions with the longest traditions ofgovernment assistance for industry perform the worst in terms of new firm formation • birth rates of firms are increasing although, asof the late 1980s, small firms were still relatively less important in the UK economy, forexample, compared to Germany • Europa • -the regions with the highest birth ratesgenerate from 2.7 (Germany) to 6.5 (Sweden) as many new firms (per 10, 000 populationor 10, 000 employees) as the regions with the lowest rates • - Sweden - the highest rates to be located in regions that aresmall in terms of population, while the populous centres ofadministration and education tend to have lower rates • USA • - the natoional variation is even many times larger than in Europa

6. Regional variations in new firm formation rates • Indicatorsrepresenting various regional characteristicssuch as population, demand and employmentconditions and urban industrial structure: • the percentage of smallfirms • the percentage of the population that are managers • the percentage of the populationwith degrees • savings per head of population • the percentage of owner occupied houses • the percentage of the workforce in low entry barrier industries • the regional incomedistribution

6. Regional variations in new firm formation rates • Associationof birth ratesamong manufacturing firms with indicators of regional characteristics • The main determinants of new firm formation atthe regional level (not always statistically proved): • the proportion of small firms in the area • growth in local industrialdemand • the proportion of professional and managerial occupations in the population • the impact of government policy • However • new firm formation rates vary internationally – factorsoperating at the international scale might be ignored as countries are implicitly treated as closedsystems

6. Regional variations in new firm formation rates • isolated regions with small populations (north Scotland and northSweden) have high rates of new firm formation, butin absolute termsthe number of new firms in such regions is likely to be quite small • there may be intangible considerations which arehard to quantify that bear on new firm formation rates • Thepositive association between the existing proportion of small firms in aregion and rates of new firm formation.

7.The effects of industry structure • Small firms cause to exist small firms while large plantsreplace them – reasons: • differences in employee experience and labourrelations • large plants • - employee experience is more likely to bestrictly specialized • - greater employment security • - more attractive non-wage benefits in the form ofpension schemes, vacation rights and pay, medical insurance related benefits • small firms • - employees are more likely to perform a widevariety of tasks • - greater opportunity for them to become familiar with firm’s total business - watching and learning • - jobsecurity is likely be less than in large plants and employees are likely beless inhibited from leaving because of accumulated benefits - pensionbenefits, unionseniority

7.The effects of industry structure • the demand is satisfied by large firms • - they are likely to rely on the head-office for variousservices and on affiliated plants for various parts andprocesses • - for small firms it’s hard to be competitive - workers are relatively unskilled and management functionsrelatively limited to labour supervision and machine maintenance • But the relationships between plant size, ownershipand new firm formation need to be explored in particular contexts, because… • The size distribution offirms varies internationally • Example:the stronger role played by small andmedium size firms in the Japanese andGerman economies than the American or Britisheconomies reflects thestronger tradition of large firms and plants in the formereconomies to create and cooperatewith new and small firms

7.The effects of industry structure • Changes occur over time • In the contemporary period of restructuring there is re-thinking about the relative rolesof large and small firms in favour of the latter - a tendency for firms to increasesubcontracting • the permanent lay-off of managers as well as workers thuscreating a potential pool of entrepreneurs

8.The effects of regional dynamism • Regions which sustain growth over a long period of time aremore likely to generate higher rates of new firm formation than slow growth or stagnatingregions. • Sustained growth encouragesentrepreneurship because: • implies that threshold levels for an increasing number ofeconomic activities are passed • more diversified economies in terms of skills andoccupationsprovide more opportunities for new firms • bigger populations in turnincrease the chances for innovative behaviour • growth is likely to fuel its own spirit ofspeculation and optimism • implies net in-migration and interregionalmigration • emphasizes bettereducated, higher skilled and higher income individuals

8.The effects of regional dynamism • The most important influence onnew firm formation is: • local economic diversity and that population growth andgreater personal wealth revealed 'strong' positiveassociations. • The employment of professionals is positively correlated with new firmformation and such individuals are oftenimportant components of economicallymotivated migration streams - in-migration potentially diversifies therange of skills, ideas, contacts and investment opportunities in a region.

8.The effects of regional dynamism • How the bussiness cycle influences birth rates of new firms? • UK - the 'desperation' hypothesis: • new firm formation rates increase duringrecessions as people who are laid- off are encouraged to invest in their own businesses • US- unemployment during business downturns across a wide spectrumof industries is strongly negatively correlated with new firm formation • Themost important variables during recession and recovery: • economicdiversity • wealth and population growth • the nature of labour relations

8.The effects of regional dynamism • However… • If lay-offs aretemporary or perceived to be temporary and a social assistance programme is ineffect, then this relationship may not be important. • Duringan unusually rapid growth cycle, the leading firms and sectors may be in a position to payhigh wages, salaries and prices and thus ‘crowd out’ smaller firms and pre-empt new firmformation, at least for a time. • But in-migration might be expected to help off-set this effects. • Smaller firms may be more stable than large firmsduring recessions as they were willing to accept lower labour productivity duringperiods of declining demand.

9.New firms: the challenge of survival • Newfirms experience the highest death ratesamong firms of all ages and that death rates are high. • The problems facing new firms can bereviewed within the context of a life cycle model: • 1. Introduction • Newproducts are introduced at which time the firm experience consumer ignorance andpossibly resistance. Sales are typically low, growth slow for a while and profitability hardto achieve. • 2. Take-off • The product becomes accepted and sales grow andprofitability is achieved. • Although the higher the profits the greater the possibility ofcompetition. • 3. Diminishing growth • Growth typically slows downdue to saturation of demand, competition and attainment of a sizethat the owner is ‘comfortable’ with (comfort level). Profits might slip. • 4. Maturity • Sales are static and may simply be replacement sales. There is a needfor product differentiation. • 5. Old age • In the absence of product innovationdecline may set in and firm may die.

9.New firms: the challenge of survival • Problems of strategy formulation and organizationaladjustment in a short period of time. • Introduction Stage • the marketing problem - accesse a sufficient number of customers and develope a market niche, • theaccounting problem - establish a cash flow • the financial problem - typically overcome by use of personal funds and borrowed money from friends, relativesand perhaps banks

9.New firms: the challenge of survival • Take-offStage • The nature of the management, marketing, accounting and financialproblems continue to evolve. • The firm has to develop proper procedures for controland planning and solve the problems necessary for rapid expansion. • Marketing - a more systematic approach to marketing is needed (administration, files, cost allocation,hiring of sales people) - the firm has to access more consumers on a more permanent basis • expansion requires a strategy to reach newcustomers (advertising, identification of customers, personal contact with new markets, innovation of new products) • Employment practices and relations (not in the model) • an expansion involves decisions to hire, train, supervise, establish pay scales, hoursof work, and non-wage benefits • the owners have to handle a varietyof personnel matters • - an increasing amount of paper work and record keeping is required (tax and business laws, medical and insurancerequirements) • - increasing delegation of supervisory responsibilities • - the work force may wish to unionize which would require anentirely different system of labour relations for the firm

9.New firms: the challenge of survival • The life cycle model is an ‘idealization’. In practice the life cycle characteristicsof real firms vary considerably. • In real world some stages can be omitted, some can be quickly reach. • The nature ofthe business challenges facing new firms are difficult and they can evolve rapidly. • New firms have to face theseproblems with little prior experience. • New firms faceconsiderable uncertainty. • All that helps explain the high death rates among suchfirms. • relations for the firm

10.New (and small) Firms in Local development • Contributions of new (andsmall) firms play in local development • Job creation. • This contribution varied by time period and country. • However, even in countries such as the US and UK, where largefirms have dominated, new and smallfirms have increased in importance as job creators. • 2. Utilizing the internal human and capital resources available to them. Influencing external organizations. • - Large firmsare particularly effective in influencing rivals, consumers, suppliers andgovernments. • - Entrepreneurially run firmshave high potentials for fully utilizing their own resources in terms of their ability toeffectively use available labour, space, management and equipment. The ability to makedecisions quickly is another example of such potential. • 3.Increasing capital/output ratio to the extent that new firms utilize the existing stock of 'old' machinery and buildings.

10.New (and small) Firms in Local development • 4. The innovative process. • Small firms of less than 200 employees, in partbecause of the expense involved, have been poor adopters of new technology. However, some studies suggest that theinnovativeness of small firms is better than of large firms. • The scavenging activities of some firms are consistent withthis view. • At the same time, it’s needed to underline their ability to integrate new systems with old equipment in a manner which would not be contemplated by most large firms. • Incremental innovations occur as more or less continuous improvements byengineers and others in productivity, products and services and at least important segments ofsmall firm populations do implement incremental change. • Although not dramatic, cumulativeimpacts of incremental technological change can result in impressive productivity improvementsover periods of time. Indeed, by virtue of their specialization andnarrow focus, small firms are a particularly important source of incremental innovations, thebenefits of which, can be passed on to large firms throughsubcontracting linkages.

10.New (and small) Firms in Local development • 5. Enhancement of local multiplier processes • bytheir willingness to purchase local supplies of inputs of goods and services. • The directimplication of the seed bed hypothesis: • new firms will rely on highly localized suppliers. • 6. Improving levels of self sufficiency in a localeconomy, reducing reliance on imports or at least acting as a relatively cheap form of learning asto whether or not the particular good they are manufacturing is actually viable within a localeconomy. • In this regard, high death rates among new and small firms is not simply a waste ofresources as the entrepreneur and locality can learn from such disappointing experiences.

10.New (and small) Firms in Local development • 7. Implying local control which enhances a region's potential determine its own future • and realize its own development potential. Local control of an economy may also have • implications for the cultural, social and educational vitality of a region. • But the opportunism of entrepreneurs may generate socially undesirable outcomes in the • form of hyper-competition, labour exploitation wyzysk and environmental degradation. • Anyimplications of new firms for local development does of course depend on their establishmentand survival.

11. Small firms and regional development policy • New firm formation and the small firm sectorin general has acquired a higher profile in regional and local development polices in manycountries. • Stimulationprogrammes in support ofsmall firms. • At the beginning industrial stimulation programmesfavoured the attraction of large scale branch plant operations. However, it was noticed that small firms are needed. • Thegoals of small firm stimulation programmes: • to encourage the creation of new firms • to encourage the consolidation and expansion of small firms • The policies in differentforms and mixes provide: • financing • information and advice • services • access to foreignmarkets • infrastructure • In recent years there has been growing concern for promotingnetworks of small firms, especially high tech firms - sience parks.

11. Small firms and regional development policy • Financialsupport: • Banks are highly conservative ingiving loans to new firms, they consider a new/small firm a potential customer if its accounts reveal highprofitability, high liquidity and a low gearing ratio. • New firmshave distinctive financial problems, notably a lack of capitalization at start-up, and then a lack of capital to finance growth. • Support is justifiable to overcome a financial gap which is temporary. • Controversis: • financial markets are there and any financial gap reflects a lack of knowledgeand/or financial competence • financial help is limited to new firmowners and does not extend to employees who are also tax payers • the efficacy of large public sector bureaucracies - the emphasis of bureaucracies on procedure, qualifications causes that in many new firms die

12. Planning on incubators • Industrial parks and estates of course have been along established feature of regional development policy • From the1950s to the 1970s, however, the main purpose of industrial parks/estates was to providethe physical infrastructure to attract large scale branch plants . • With the shift in regional and local development policy towards small firms, however, efforts have been • made to design industrial parks which hopefully will act as incubators to new high techfirms. • Industrial parks provide: • factory space • incubator buildings which offer services such as typing, faxing,computing, seminar rooms, video equipment • business advice centres • such socialservices as restaurants • Theseservices may be provided free or at low cost, at least for a particular time period to helpfirms overcome the difficult period of start-up.

12. Planning on incubators • Innovationcentres and science parks • - they provide the impetus for new firm formation in high tech activities • - offer some form of incubator help, in some cases including venturecapital help • Difficulties in meeting their expectations: • The importance of new firm formation varies among science parks. Cases are known where: • 30% of Science Parktenants are new firms • 10% are new branches of existing firms • themajority of facilities are relocation decisions by small and large firms • Theeffectiveness of science parks in promoting university-entrepreneurial links and linkages among park tenants. • Doubtsabout the job potentials of new high tech firms.

12. Planning on incubators • In practice, available evidence suggests that planning for incubation, whether withrespect to manufacturing firms as a whole or high tech firms in particular, is problematical. • At the local level, there are successes and failures, and perhaps in a high tech context, attempts to clone Silicon Valley have been predominantly frustrating exercises.

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Local & Regional Development Formation and Function of New (and Small) Firms