Small Firm Growth in Developing Countries Simeon Nichter† University of California, Berkeley Lara Goldmark* Development Alternatives, Inc.

March 4, 2009

Forthcoming, World Development



[email protected]; T: 510-642-6323; F: 510-642-9515; 210 Barrows, UC Berkeley, Berkeley, CA 94720 * [email protected]; T: +212 (0) 37-65-83-57; F: +212 (0) 37-63-95-28; 28, Avenue Mehdi Ben Barka, Souissi, Rabat, Morocco

SUMMARY

Although the vast majority of firms in developing countries are micro and small enterprises, few will ever expand beyond a few employees. This study explores factors associated with small firm growth. We discuss key findings for four types of factors: (1) individual entrepreneur characteristics; (2) firm characteristics; (3) relational factors (such as social networks or value chains); and (4) contextual factors (such as the business environment). We conclude by drawing implications for development practitioners.

KEYWORDS

Microenterprise; Small Enterprise; Entrepreneur; Growth; Value Chains; Business Environment.

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1. INTRODUCTION What explains small firm growth? Many commonly held beliefs about small firm growth are shaped by well-publicized stories about a few extraordinarily successful entrepreneurs. According to these stories, firm growth is propelled by the almost single-handed efforts of a dynamic, hardworking entrepreneur (usually male) who slaves around the clock for years in his garage—until one day, “the big break” comes. At this point, some combination of investors and customers recognize the value of the entrepreneur’s unique product idea and “poof,” the fledgling business expands rapidly and becomes a household brand name. The truth is that we know very little about micro and small enterprise (MSE) growth. Research suggests that even in the United States, high-growth companies rarely begin with a “winning product idea” that catapults the lone entrepreneur from garage to swanky boardroom (Collins and Porras, 1994; Ormerod, 2005). And if the above scenario is unlikely when the garage in question is located in Palo Alto, California, it becomes downright implausible if the start-up is based in a place like La Paz, Bolivia; Nairobi, Kenya; or Dhaka, Bangladesh. Despite the creativity and diligence of many developing-country entrepreneurs, few of their firms will ever experience substantial growth. Surveys of over 28,000 micro and small enterprises in Africa and Latin America reveal that less than three percent of MSEs expand by four or more employees after startup (Mead and Liedholm, 1998; Liedholm, 2002). Another rigorous study in Mexico finds that in a given year just 12 percent of owner-only firms expand, and that larger microenterprises have a higher probability of contracting than expanding (Fajnzylber, Maloney and Rojas, 2006). Yet aggregate MSE growth reveals a remarkably different picture. For example, the survey of 28,000 MSEs in Africa and Latin America suggests aggregate employment growth in the sector of nearly 17 percent per year, at least double the GDP growth rate in most countries studied (Mead and Liedholm, 1998). This impressive growth is typically fueled by a narrow group of highly performing firms. These

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firms, known as “gazelles” in the US literature (Birch, 1987; Boston and Boston, 2007), vastly outperform their peers and drive aggregate employment growth for the small business sector. Why do some MSEs expand rapidly, while others stagnate? To explore this important question, we investigate factors associated with MSE growth. First, we briefly discuss the overall importance of MSEs and our research methodology. Then, we explore numerous factors associated with small firm growth. We discuss key findings for four types of factors: (1) individual entrepreneur characteristics; (2) firm characteristics; (3) relational factors (such as social networks or value chains); and (4) contextual factors (such as the business environment). While this study focuses primarily on developing countries, we also draw some comparisons with findings from developed countries. We conclude by drawing implications for MSE development practitioners. 2. THE ROLE OF MICRO AND SMALL ENTERPRISES Following previous studies, we define MSEs as firms with up to 50 workers, which engage in non-primary activities and sell at least half of their output. In both developing and developed countries, the vast majority of firms are MSEs. For example, approximately 97 percent of firms in Mexico and Thailand are MSEs (Kantis, Angellini, and Koenig, 2004; Simmons, 2004). In the U.S., over 96 percent of businesses similarly have fewer than 50 employees (US Small Business Administration and Census Bureau, 2004). Official statistics frequently underestimate the number of micro and small enterprises, leading some researchers to argue that actual figures may be twice as high as what is reported (Mead and Liedholm, 1998). The MSE sector generates substantial employment and economic output in many countries. Their share of overall employment tends to be higher in developing countries, which are typically more focused on small-scale production (Tybout, 2000). Studies in five African countries (Botswana, Kenya, Malawi, Swaziland and Zimbabwe) found that MSEs generate nearly twice the level of employment as registered, large-scale enterprises and the public sector (Mead and Liedholm, 1998). In many Latin American countries, micro and small enterprises employ over half the working population. An ILO study (2003) 3

examining firms with fewer than 10 workers found that they generated 58 percent of total employment in Paraguay, 54 percent in Mexico, and 53 percent in Bolivia. With respect to economic output, the contribution of the MSE sector varies considerably across countries. MSEs contribute approximately 31 percent of overall GDP in the Dominican Republic, 13 percent in Kenya, and 11 percent in Pakistan (IDB, 1998; Daniels, 1999; SMEDA, 2002). Official statistics may underestimate MSEs’ contribution to GDP—for example, some experts argue that Kenyan MSEs actually generate 40 percent of GDP, not 13 percent (Daniels, 1999; Gamser, 2003). 3. RESEARCH METHODOLOGY This study builds on a comprehensive survey of the literature on small firm growth. Based on this secondary research, we provide a synthesis of numerous factors associated with MSE growth, draw parallels between findings in developing and developed countries, and discuss implications for development practitioners. We identified key publications using a systematic methodology.1 Most of the studies cited in the present article are published in peer-reviewed academic journals. Before citing studies, we assessed the rigor of their quantitative and qualitative analyses, particularly in the case of non peer-reviewed publications. For example, we considered the extent to which econometric studies address issues such as endogeneity, omitted variables bias and selection effects. With respect to qualitative studies, we examined aspects such as the number of respondents and sampling techniques employed. In this article, we explicitly identify studies that are particularly rigorous or employ exceptionally large sample sizes. To complement our comprehensive survey of articles, books and working papers, we conducted interviews with numerous academics and practitioners recognized for their expertise in the field of small enterprise development.2 These interviews enabled us to explore emerging hypotheses, clarify nuances about topics with inconclusive or controversial data, and identify themes for additional research. The present article examines a wide range of studies considering heterogeneous contexts and samples. This breadth provides many insights, but also requires caution. Generalizations can be 4

misleading; they should be questioned and re-examined in each country and market context. Some factors that influence growth are relatively simple to define and measure, such as a firm’s age. Others are more complex, such as the characteristics of value chains in which small firms operate. We do not claim to provide an exhaustive review of all factors linked to MSE growth. Instead, we offer an overview of key factors in the literature on MSE growth in developing countries. This article defines firm growth as an increase in the number of employees over time. The majority of studies on small firm growth employ this metric, although some scholars (especially those focused on developed countries) use alternative metrics such as revenue or asset growth. The vast majority of researchers studying small firm growth in developing countries rely on employment growth because it is often extremely difficult to obtain reliable financial data for small firms (e.g., Mead and Liedholm, 1998; Bigsten and Gebreeyesus, 2007; Robson and Obeng, 2008). Even when MSE owners do not keep written records, they can usually recall their number of employees over time. 4. INDIVIDUAL ENTREPRENEUR CHARACTERISTICS We now discuss individual entrepreneur characteristics for which there is significant empirical evidence from developing countries: education, work experience, and gender. Numerous growth factors examined in the developed country literature are understudied in developing countries. For this reason, we do not include below factors such as entrepreneurial motivation (e.g., linked to small firm growth in Sweden by Delmar and Wiklund 2008) and entrepreneurial team composition (e.g., linked to small firm growth in Italy by Colombo and Grilli 2005). (a) Education Intuitively, one might expect higher levels of formal education to spur MSE growth by enhancing firm capabilities. For example, formal education may provide entrepreneurs with a greater capacity to learn about new production processes and product designs, offer specific technical knowledge conducive to firm expansion, and increase owners’ flexibility. While most empirical evidence indeed suggests that

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firms with better-educated owners and managers are more efficient (e.g., Burki and Terrell, 1998; Tan and Batra, 1995), greater complexity emerges when examining the relationship between education and MSE growth in developing countries. Developing-country MSE owners and workers often have relatively low levels of education. One reason is that despite recent advances, primary education completion rates remain only 55 percent in SubSaharan Africa, 78 percent in South Asia, and 89 percent in Latin America (World Bank, 2001). In addition, MSEs tend to have less-educated owners and workers than larger firms (Orlando and Pollack, 2000; Soderbom and Teal, 2001). Educational disparities across firm size are especially striking at the university level: for example, 21 percent of microenterprise owners in Chile have Bachelor’s degrees, compared to 42 percent of small-firm and 55 percent of medium-firm owners (Alvarez and Crespi, 2003). The lower level of educational attainment among MSE owners and workers is remarkable when contrasted with developed countries, where those with higher education are more likely to be selfemployed (Woodruff, 1999). One reason for this contrast is that the poor in developing countries often create survival-oriented MSEs due to a lack of alternative employment opportunities. Given the relatively low level of education within the MSE sector in developing countries, do MSEs with more highly educated owners tend to grow more quickly? On the surface, the evidence appears contradictory. For example, an Inter-American Development Bank (IDB) study found that secondary school attainment had no discernible impact on firm growth in Latin America (Kantis, Angellini and Koenig, 2004). On the other hand, numerous studies in Sub-Saharan Africa suggest that entrepreneurs completing secondary school have more rapidly growing firms in Kenya and Zimbabwe, but find no significant effect of primary education on MSE expansion (McPherson, 1991; Parker, 1995; Mead and Liedholm, 1998). Some clarity emerges when recognizing the threshold effect of education.3 MSEs with more highly educated owners tend to grow more quickly, but a country-specific threshold must be reached to observe this growth effect. For example, whereas a threshold of secondary education may identify high 6

growth potential in the African countries just mentioned, a higher threshold of university education appears to exist in Latin America. Although the IDB study found that secondary school attainment has no effect on MSE growth, it also reveals that six of every ten Latin American entrepreneurs with highgrowth firms are university graduates (Kantis, Angellini and Koenig, 2004). Despite various potential benefits, education may also harm MSE performance if owners divert their attention to other attractive business opportunities. Research on small manufacturing firms in Chile found that university education did not induce higher efficiency. Some highly educated owners paid little attention to monitoring their labor force in part because they were distracted by other activities (Alvarez and Crespi, 2003). (b) Work Experience Small business owners often learn on the job. Work experience may contribute to MSE growth in at least two ways: directly, by expanding the capabilities of MSE owners and employees through the acquisition of skills and knowledge; and indirectly, by expanding entrepreneurs’ social networks. Entrepreneurs with more years of work experience typically have faster-growing MSEs. For example, one study found that Kenyan entrepreneurs with at least seven years of work experience expanded their firms more rapidly than those without such experience (Parker, 1995). While the benefits of on-the-job experience are frequently mentioned, the importance of prior work experience may be even more helpful, especially if that experience came within the same sector or in small to medium-sized enterprises. An IDB study of high-growth entrepreneurs provides telling insights about the importance of not only skills, but also business contacts gained during past employment (Kantis, Angellini and Koenig, 2004). Among Latin American and East Asian entrepreneurs, contacts were found to be a key benefit of work experience, helpful in identifying business opportunities, obtaining financing and other resources, and alleviating management challenges.

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Unfortunately, some developing regions are characterized by a systematic lack of opportunities to gain any relevant work experience. In particular, Africa has few medium-sized companies for entrepreneurs to gain work experience, a phenomenon known as “the missing middle.” For this and other reasons, MSE owners and workers in Ghana have an average of only five years of work experience, compared to ten years for their counterparts in larger firms (Barr, 1998). Within developed countries, there is mixed evidence linking prior sector experience to small firm growth. Numerous studies find a nonexistent or even a negative relationship between work experience and growth (Cooper, 1993; Storey, 1994). For example, Storey (1994) suggests that if any pattern emerges, it is the association of longer work experience in a sector with slower firm growth. On the other hand, a more recent panel survey of 1,000 entrepreneurs in the Netherlands found that entrepreneurs’ prior experience, when in the same industry as their startups, improves firm growth, survival and profitability (Bosma et al, 2004). (c) Gender and Household Women own and operate the majority of MSEs in many developing countries, in part because of the ease of entry and their limited access to alternate opportunities (Rubio, 1991). Studies across nine countries in Africa and Latin America found that on average 61 percent of MSEs are owned by women, ranging from 46 percent in Malawi, Kenya and the Dominican Republic to 84 percent in Swaziland (Mead and Liedholm, 1998). Yet women often face particularly difficult challenges that suppress the growth of their firms. In some cases, women may also choose not to grow their firms. The developing country literature identifies numerous gender-related challenges to MSE growth. Women typically face asymmetrical rights and obligations limiting their labor mobility and burdening them with disproportionate household responsibilities (Downing and Daniels, 1992). One econometric study based on Guatemalan data suggests that the high marginal value of home time for women during certain periods of their lives is the principal constraint to growth of female-owned firms (Kevane and Wydick, 2001). In some countries, women face relatively greater problems with innumeracy, illiteracy,

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and a lack of business skills (ILO, 1999). In addition, women commonly have unequal access to markets. For example, research in Gujarat, India found that 36 percent of female entrepreneurs sell to purchasers who come directly to their homes, compared to 20 percent of their male counterparts (Kantor, 2005). As a result of such factors, women also frequently focus their MSEs on a relatively narrow range of industries. At the same time, women-owned MSEs often play a crucial role in increasing and diversifying household incomes. Women may operate MSEs with small but regular contributions to income, thus facilitating their husbands’ entrepreneurial aspirations. Following such survival strategies, women may strive to grow laterally; instead of specializing in their MSEs by expanding their size, they may opt to diversify by creating additional firms (Downing and Daniels, 1992). What consequences do the challenges and strategies mentioned above imply for MSE growth? Empirical evidence suggests that women’s MSEs tend to grow more slowly than those owned by men. For example, Mead and Liedholm (1998) found that employment in male-headed MSEs grows an average of 11 percent a year, versus 7 percent for female-headed MSEs. This difference in growth rates is partially due to the location of women’s MSEs in slow-growing sectors, but a statistically significant difference remains even when controlling for sector. Similarly, IDB research in Latin America and Asia found that only one in ten firms growing to at least 15 employees is woman-owned (Kantis, Angellini and Koenig, 2004). One contributing factor to the slower growth of female-owned MSEs is their high probability of being physically located within the household. An ILO statistical report (2004) indicates that 80 percent or more of “homeworkers” (defined as “industrial outworkers who work at home”) in developing countries are women. Household firms are not only significantly smaller on average, but also are less likely to grow than other MSEs (Mead and Liedholm, 1998). Despite the growth constraints discussed in this section, women are often highly effective firm owners. For instance, a study in the Dominican Republic found that female-owned textile MSEs have higher levels of labor productivity than those owned by men, even though they experience slower growth 9

(cf Downing and Daniels, 1992). Women-owned MSEs have also been found to have comparable closure rates due to business reasons as firms owned by men (Mead and Liedholm, 1998). In the developed country literature on small firm growth, most studies do not find gender to be significantly associated with firm growth; those that do are in disagreement about whether women-owned firms are likely to grow faster or slower (Storey, 1994). One qualitative study that set out to identify gender-based differences in rural microenterprises in Sweden concluded: “the actual finding was that there are few differences” (Sandberg, 2003). Although the developed country literature often construes women entrepreneurs as less likely than their male counterparts to seek firm growth, several researchers argue that this applies to only a subset of women-owned firms (Hill, Leitch and Harrison, 2006; Harada, 2007; Chaston, 2008). As is true for other factors, categorizing MSEs only as women versus men-owned firms may generate a “false universalism” which ignores the heterogeneity of small firms (Marlow and Patton, 2005). 5. FIRM CHARACTERISTICS Certain firm characteristics are associated with MSE growth. This section explores the relationship between MSE growth and three widely studied firm-level factors in the developing country literature: firm age, formality (or informality), and access to finance. Other factors, such as technology, location and sector, are discussed only to the extent that they relate to these three variables. (a) Firm Age The relationship between firm age and small firm growth in developing countries is particularly robust. Young MSEs grow substantially more rapidly on average than their older counterparts. Studies in both Africa and Latin America show that young MSEs are more likely to show high rates of growth compared with MSEs that have been in existence longer (Parker, 1995; Mead and Liedholm, 1998). An IDB study reveals that the major expansion of dynamic enterprises occurs during their third year of operation (Kantis, Angellini and Koenig, 2004), and other studies suggest that the average growth rate of firms decreases with age (e.g., Burki and Terrell, 1998). 10

Why might young MSEs grow more quickly than older MSEs? A seminal theoretical paper by Jovanovic (1982) offers one possible explanation. Jovanovic proposes a learning model in which a firm expands quickly at first, and then tapers off its growth as it approaches its optimal size. Although growth slows, productivity is expected to increase as the firm ages and the owner comes to learn the company’s optimal size of operations. On the other hand, some studies in developing countries suggest that firms actually suffer productivity losses as they age (Burki and Terrell, 1998). Firms may fail to invest sufficiently in existing or emerging technology, leaving them with relatively outmoded equipment and hindering productivity levels relative to younger firms. In reality, a firm’s growth rate is likely to fluctuate as it has both positive (learning-by-doing, increases in productivity) and negative (crises, decreases in productivity) experiences during its lifetime. Recognizing that the relationship between firm age and growth may be more complex, several researchers have developed frameworks based on a life-cycle approach: (1) Churchill and Lewis’s (1983) model breaks the growth continuum into stages of development. At each stage of a firm’s life, different factors become important, such as owner objectives, managerial skills, access to capital, technology, and human resources. (2) Several typologies (e.g., Mitra and Pingali, 1999; Mitra, 2002) highlight issues specific to family or women-owned firms, such as: a strong identification of individuals with their business; establishing a balance between family and business concerns, and the link between an entrepreneur’s source of motivation and the growth trajectory of her firm. (3) Another approach identifies dominant types of crises that small firms face and links solutions to these problems with different growth stages. Examples are starting and cash crises, delegation and leadership crises, finance and prosperity crises, and succession crises (Patel, 1995). Researchers of developed country MSEs have also explored the relationship between firm age and growth. Most studies find that older firms experience less growth (e.g., Evans, 1987; Variyam and

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Kraybill, 1992; Heshmati, 2001), consistent with the developing country literature. Some studies report mixed results. For example, Heshmati (2001) finds that while younger firms experience faster employment growth in Sweden, older firms experience faster growth in assets and sales. Within the developed country literature, researchers often pay close attention to the effect of firm size as well as firm age. In the 1980s, a debate emerged surrounding Gibrat’s Law, which posits that firm growth is independent of size. Contrary to this theory, numerous empirical studies find that smaller firms in developed countries in fact grow more quickly (e.g., Evans, 1987; Hall, 1987; Variyam and Kraybill, 1992). (b) Formality (or Informality) Informality is common in developing countries. The ILO (2004) reports that the share of the informal economy in the non-agricultural workforce reaches 55 percent in Latin America, 45 to 85 percent in Asia, and nearly 80 percent in Africa. For the purposes of this paper, informality refers to businesses that are unregistered yet derive income from the production of legal goods and services. 4 In terms of sheer quantity, the number of informal firms often dwarfs the number of officially registered enterprises. Not only does informality in itself reduce the chances for growth, but it is also associated with several other characteristics that make growth difficult. Although small, informal MSEs may be able to circumvent government regulations and taxation, as they grow they risk becoming more visible, creating disincentives to expand beyond a certain size (Snodgrass and Biggs, 1996). Informal firms may therefore need to “keep their heads down,” ruling out large size and rapid growth, as well as close relations with formal firms (Winter, 1995). Contracts with international or government buyers, for example, may be off-limits for many informal firms because they require legal documentation that these MSEs lack. And while many firms in developing countries have problems accessing financial and legal systems, informal enterprises face even greater difficulties in obtaining formal credit and assistance from law enforcement agencies and courts.

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For these and other reasons, informal MSEs tend to grow more slowly than do their formal counterparts. An econometric study in Côte d’Ivoire found that formal status has a positive effect on firm growth, even when using instrumental variables and controlling for size, age and efficiency of firms (Sleuwaegen and Goedhuys, 2002). Analysts at McKinsey and Co. argue that informal companies tend to be subscale, subinvested and subskilled, and that they also tend to produce substandard products and services (Capp, Elstrold and Jones Jr., 2005). While such an assessment may be overly pessimistic, the Côte d’Ivoire study suggests formal firms are more efficient for two reasons: formal firms enjoy a larger range of production factors and a broader choice of input suppliers (Sleuwaegen and Goedhuys, 2002). Certain MSE characteristics make it particularly likely that they will operate in the informal economy, a point underscored by McPherson and Liedholm’s (1996) empirical research in African countries with divergent policy and regulatory environments. They found that the likelihood of registration did not depend on country. Rather, certain types of MSEs are less likely, ceteris paribus, to be registered—those that are one-person firms, rural, owned by women, operated within the household, or located in certain sectors. (c) Access to Finance For various reasons ranging from a lack of collateral to bias against small firms, MSEs tend to face greater financial constraints than do larger firms. An IFC study of 10,000 firms across 80 countries found that credit is mentioned more frequently by smaller firms as a constraint on growth (Schiffer and Weder, 2001). MSEs in developing countries apply for and receive formal bank loans relatively infrequently, and thus typically rely on other types of credit such as trade credit, overdrafts, and informal loans (Bigsten et al, 2003). Microfinance institutions also provide important sources of financing for MSEs, but their outreach is typically more limited than that of traders who frequently provide working capital in cash or kind, especially in rural areas (Swinnen, 2005). Because of limited access to capital, entrepreneurs across the world typically start firms primarily through their own savings (Mason, 1998). For example, a study of over 14,000 microenterprises in 13

Mexico found that owners mostly used their own resources and savings (61 percent) or those of their family and friends (14 percent) to launch their firms (Hernandez-Trillo, Pagan and Paxton, 2005). Developed country researchers have identified similar trends, including a range of creative mechanisms used by small firms to leverage tangible and intangible assets, known as “bootstrapping” (Lahm and Little, 2005; Neeley, 2003). Even after MSEs overcome the start-up hurdle, a lack of credit frequently hinders their growth during earlier years, because younger firms tend to find financing even more difficult than older firms (Schiffer and Weder, 2001). Over the life of the firm, growth also can be hindered by credit constraints that curb investments for maintaining or improving technology. In some contexts, evidence suggests that microenterprises funded through external sources (e.g., bank loans and credit from buyers or suppliers) are more efficient, but it remains unclear whether this finding simply reflects ex ante screening by selective creditors (Hernandez-Trillo, Pagan and Paxton, 2005). Although many MSEs have limited access to capital, it is often unclear whether credit represents a binding constraint on firm growth. Few empirical studies have explicitly tested the positive link between access to finance and MSE growth. The findings from one econometric study, based on a random sample of 225 MSEs producing garments in Nairobi, Kenya, suggests that further research is needed (Akoten, Sawada and Otsuka, 2006). The authors argue that credit access is not a significant determinant of firm performance, and that the factors significantly affecting credit access are different than those affecting the growth and profitability of garment firms. As development finance practitioners have long preached, a loan does not create a viable business opportunity. Like many of the factors discussed in this article, access to finance may be necessary but is not a sufficient condition for MSE growth. 6. SOCIAL NETWORKS This section explores the relationship between social networks and MSE growth. The term “social networks” is used here to refer to relationships between individuals.5 Having an extensive social 14

network is a valuable asset, which can help an entrepreneur obtain access to information (e.g., leads about profitable business opportunities) as well as resources (e.g., credit). While social networks can enhance MSE growth in any context, they can be critical to firms’ growth prospects in environments with pervasive market failures. The literature points to the role social networks can play in helping entrepreneurs overcome obstacles related to transaction costs, contract enforcement, and regulation. Examples include buyer-seller bargaining with acquaintances in Morocco’s bazaar economy (Geertz, 1978); the overwhelming preference of Ghanaian firms to do business with individuals they already know (Fafchamps, 2000); Jewish diamond merchants in New York lending gems to each other overnight for inspection without contracts to save lawyer fees (Portes and Landolt, 1996); and MSE owners turning to experienced neighbors for help in registering a new business. Entrepreneurs often take advantage of opportunities to invest in social networks when there is an apparent payoff in terms of MSE growth. For example, a family may opt to perform specific ceremonies when planting cocoa, given that it will later depend on additional labor and resources from others within the social network (Berry, 1993). Quantitative studies confirm the importance of social networks—for example, an econometric study of small-scale manufacturing in Ghana found that entrepreneurs with larger and more diverse sets of networks are more productive (Barr, 1998). Connections “across” different groups may enhance mobility and be especially useful for MSEs trying to overcome regulatory or other obstacles. Social networks also have numerous potential downsides for MSE growth. In some cases, social networks may be too expensive for or inaccessible to the poorest entrepreneurs, or may systematically exclude or provide unequal access to resources for marginalized entrepreneurs such as women. Social networks may be deeply rooted in societal traditions, making them difficult for outsiders to gain entrepreneurial opportunities. Other potential downsides of social networks include requests for profit distributions, unequal access to resources, and a lack of stability. For example, research in Bali showed that social networks can actually serve to hinder economic production, as social claimants preferred profit distributions instead of reinvestment necessary for growth (Geertz, 1978). Last, the sustainability of

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social networks is also an issue. If a network grows, a greater number of participants offer increased resources for MSEs, but the network’s usefulness may also decline as it becomes more inclusive. Partially for this reason, immigrant groups often segregate by spatial location to avoid overloading duties on network members (Luo, 1997). 7. VALUE CHAINS Value chain characteristics can help us understand whether, and what type of opportunities for growth are available to small firms. A value chain, which is narrower than a sector, traces the flow of competing products from the input stage to the final consumer.6 Agricultural marketing specialists developed this concept in the 1950s and 1960s within “commodity systems analysis,” which was later termed “sub-sector analysis” by development practitioners (Goldberg, 1974; Boomgard et. al, 1992). In recent years, value chains have been adopted by researchers writing on business strategy, industrial development, and globalization (Porter, 1998; Humphrey and Schmitz, 2000). Within a given value chain, MSEs may be involved in any number of activities, including primary production, assembly, and service provision. An important dimension of growth or potential growth in a value chain is strong demand from the end market, whether local, regional or international. While an increase in the volume of goods demanded by the end market may provide opportunities for MSE growth, the type of goods demanded can be just as important. A sophisticated consumer in local markets is one of the best indicators to predict whether developing-country firms—and by implication, MSEs—are likely to participate in the value-added functions of production. Fairbanks and Lindsay (1997) refer to the ways in which demanding customers in the home market give international producers their competitive edge. According to Fairbanks, “if you can sell shoes to an Italian woman, you can sell shoes anywhere in the world.”7 A similar example is the international success of Brazilian bikinis (Infomat, 2005). Brazilians possess a large, diverse, and sophisticated consumer base for bikinis, and producers, both large and small, have turned that to their advantage when selling in distant markets.

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Without demanding local consumers, it is less likely that developing-country firms, especially MSEs, can access the higher margins and value-added functions associated with international high-end market segments. MSEs may not interact directly with developed country firms but rather act as subcontractors to large developing-country manufacturers (Nadvi, 1995; Carr and Chen, 2003). In such cases, the pathways to growth may be blocked. In addition to the nature of demand, there are a number of sector characteristics that favor the participation—and survival over time—of MSEs. One of the most enduring works on small enterprise development by Staley and Morse (1965) identifies five characteristics of industry functions that bode well for small firm participation: 1) seasonal activities; 2) low capital requirements; 3) relative labor intensiveness; 4) non-repetitive production processes; and 5) small production volumes. Additional characteristics may be industry or product-specific. In agriculture, for example, specific crop strains may offer advantages to smallholders, depending on the inputs, land conditions and other requirements associated with their cultivation. Also important is the organization of the value chain, especially inter-firm relationships and power dynamics. Models described in the literature range from buyer-driven (top-down and not very conducive to MSE participation) to producer-driven (seen in sophisticated, high-tech chains) to network or non-hierarchical chains where power relationships are more balanced (Pietrobelli and Rabelloti, 2004; Gereffi, Humphrey and Sturgeon, 2005). In sum, key attributes of value chains linked to MSE growth include: (1) the nature of demand, (2) sectoral and industry characteristics, and (3) power relationships. 8. INTER-FIRM COOPERATION Virtually all firms interact with other firms. This section explores the relationship between interfirm cooperation and MSE growth.

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(a) Vertical Linkages Individual firms form vertical linkages with their buyers and suppliers. Vertical linkages can facilitate MSE growth by expanding a firm’s set of viable business opportunities and improving firm capabilities. Agreements with buyers can decrease the risks and costs associated with entering new markets by providing a guaranteed flow of orders, critical information about market requirements, and, in some cases, a reduced need for capital investments (Aw, 2002). Sometimes, relationships with larger firms can help link rural industries to urban and international markets. In addition to fostering growth through expanded business opportunities, vertical linkages can lead to improved firm capabilities by providing opportunities for learning and innovation—such as when corporate buyers assist with quality, maintenance, and technical issues (Berry, Rodriguez and Sandee, 2002)—or when input suppliers offer training or information related to the use of improved technologies. (b) Horizontal Linkages Similar firms may group themselves or be organized by an outside party to work together—these are referred to as horizontal linkages. Among the many legal and organizational options to institutionalize horizontal cooperation are cooperatives, associations, consortia, producer groups, and other collaborative structures. Horizontal linkages can help MSEs overcome many of the disadvantages of being small, such as providing a way to consolidate production, improve their negotiating position with buyers or suppliers, access market information or services, or lobby for political or regulatory changes (Goldmark and Barber, 2005; Steen, Magnani and Goldmark, 2005). Clusters (geographic and sectoral agglomerations of enterprises) may also facilitate MSE growth by enhancing horizontal, as well as vertical, linkages. Clusters inevitably involve external economies: one firm’s investments spill over to other firms in the cluster (Schmitz, 1999). In addition, clusters may involve consciously pursued joint action, such as sharing machinery or developing a product together (Schmitz, 1999). In cases where clustered firms seek to serve the same market, both competition and cooperation can drive innovation critical to firm performance. Of course, the mere presence of clusters 18

does not guarantee dynamic growth for MSEs (McCormick, 1999). However, in many cases participation in clusters as well as investment in horizontal linkages can facilitate MSE growth. (c) Supporting Markets Services provided through supporting markets—such as finance; consulting, legal, and tax advice; market information; and skills training—are often directly related to improvements in capacity. For example, skills training may allow firms to offer new products, while finance may allow them to produce greater volumes. Access to market information or new technologies, on the other hand, may help firms seek or respond to new opportunities. Supporting services may be offered directly to MSEs on a fee-for-service basis, or embedded in firm relationships; that is, delivered through vertical or horizontal linkages. While the absence or weakness of supporting markets is often identified as a constraint to MSE growth (Field et al, 2000; Gibson, Hitchins and Bear, 2001; Lusby and Panlibuton, 2002), it remains uncertain and widely debated whether the development of supporting markets actually stimulates MSE growth. Markets tend to grow vertically first, stimulating growth in supporting services only once there is a critical mass of products flowing through the chain (Steen, Magnani and Goldmark, 2005). As is the case with loans, supporting services are most likely to lead to firm growth in the presence of viable business opportunities. 9. CONTEXTUAL FACTORS Contextual factors play a major role in shaping the opportunities of MSEs in developing countries. Most obviously, the overall state of the economy directly influences the availability of profitable business opportunities. Growth opportunities wax and wane as the business cycle evolves. It is hardly a surprise, then, that MSEs tend to grow more quickly during periods of overall economic growth (Liedholm, 2002). There are, however, some important nuances in the relationship between MSE growth in developing countries and the business cycle: the overall MSE sector often expands during economic downturns due to an increase in survivalist-type activities, although individual MSEs may stagnate or contract (Liedholm, 2002). An econometric study found evidence of a push and pull dynamic in 19

Nicaragua: individuals become self-employed and start up microenterprises during bad economic times, and then leave for salaried jobs when the economy is strong (Pisani and Pagan, 2004). In severe economic crises, MSEs may be more resilient than their larger counterparts. During the East Asian economic crisis, many small-scale firms fared better than larger companies in Indonesia (Berry, Rodriguez and Sandee, 2002), and microenterprises were the most likely to repay their loans to Bank Rakyat Indonesia (Patten, Rosengard and Johnston, 2001). Macroeconomic and relative price volatility is also an important issue for MSE growth, as experience has shown in Latin America and Sub-Saharan Africa (Tybout, 2000). A recent survey of 500 MSEs in Ghana found that entrepreneurs perceived their three greatest problems to be inflation, high interest rates, and depreciation of the local currency (Robson and Obeng, 2008). Surveys of 10,000 firms in 80 countries by the IFC found that both inflation and the exchange rate tend to afflict MSEs more than larger firms (Schiffer and Weder, 2001).8 In many developing countries, credit market failures also pose a constraint on small firm growth. MSE owners often claim that insufficient credit is their most pressing obstacle, though entrepreneurs’ perceptions may not necessarily correspond to actual barriers to growth. The IFC study found that more than any other obstacle, financing was ranked as one of firms’ top three challenges (Schiffer and Weder, 2001). The regulatory and institutional environment in developing countries—notoriously burdensome when compared with developed countries (World Bank, 2006)—frequently hampers small enterprise growth. An econometric analysis of firm-level data in 54 countries suggests that financial, legal and corruption challenges disproportionately constrain the growth of smaller firms (Beck, Demirguc-Kunt and Maksimovic, 2005). For instance, strict regulations and high taxes may keep firms small and informal (De Soto, 1989). Regulatory and institutional challenges may deter MSE owners from making growthenabling investments, while special subsidies and trade protection offer greater benefits to larger firms, who are often more capable of lobbying (Tybout, 2000). Smaller firms more frequently report

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government policies to be unpredictable, and this uncertainty may be yet another factor reducing growthenabling investments (World Bank, 2005). Ironically, government policies that aim to benefit MSEs may suppress growth if they provide disincentives for employment expansion. For example, India offers attractive incentives to small enterprises, but by some accounts, these measures backfire because growth beyond a specified level entails losing valued benefits (Little, Mazumdar and Page, Jr., 1987; Mitra and Pingali, 1999). The manufacture of certain products in India is reserved for small firms, which reduces incentives for firm expansion (World Bank, 2005). Some owners even split up their MSEs into several enterprises in an effort to make them look smaller (Kashyap, 1988). Similarly, a recent study in Brazil showed that the “Simples” program, which offers tax benefits only up to a certain size of firm, induces formalization but causes firms to shrink (de Paula and Scheinkman, 2007). While there appears to be consensus on what constitutes a negative business environment, much less has been written about what a positive one looks like. There are a few generally agreed-upon characteristics, however: a stable macroeconomic environment; the existence of mechanisms for contract enforcement and dispute resolution; consistency, so that business owners know what to expect and can assess risks; an uninhibited flow of capital for foreign and domestic investment; a flexible labor regime; access to information; and investment in education and technology. 10. IMPLICATIONS FOR DEVELOPMENT PRACTIONERS The vast majority of micro and small enterprises in developing countries never expand beyond a few employees. But a few highly performing MSEs experience rapid and substantial growth; their expansion drives most of the aggregate growth in the MSE sector. This study has explored numerous factors associated with small firm growth. Based on the evidence presented, Table 1 provides an overview of the relationship between each factor and MSE growth in both the developing and developed country literature (Columns 1 and 2). Existing studies provide considerable insight about these factors, but less is known about factors’ relative importance or how they interact with each other. 21

Investigating the mechanisms by which these factors affect MSEs can help to clarify whether they actually cause firm growth, or are just associated with other growth determinants. There are various plausible mechanisms, but we highlight two channels that we believe deserve particular emphasis in future research—opportunities and capabilities. More specifically, actors can enhance MSE growth by: (1) expanding profitable business opportunities, or (2) enhancing firm capabilities to harness opportunities. Opportunities for profitable business activities clearly affect the ability of an entrepreneur to expand his or her firm. However, profitable business opportunities are a necessary but insufficient condition for firm growth.9 To take advantage of these opportunities, entrepreneurs must also possess appropriate capabilities, such as skills, resources and technology. This article has provided preliminary insights into the potential effects of growth factors on opportunities and capabilities. Based on these insights, Table 1 (Columns 3 and 4) provides initial hypotheses about how each factor may affect firm growth through opportunities, capabilities, or both. [TABLE 1 HERE] Further research should pay close attention to how factors shape firms’ opportunities and capabilities, as well as to other mechanisms by which factors potentially affect MSE growth. Factors influencing both opportunities and capabilities may offer more powerful levers for development programs. If further research supports this hypothesis, development practitioners designing programs to stimulate MSE growth may consider focusing on “dual-mechanism” factors such as education, work experience or inter-firm cooperation. Many MSEs in developing countries lack both profitable business opportunities as well as capabilities such as skills, resources, and technology. These firms demonstrate the least proclivity toward growth, and their owners may focus instead on firm survival. Despite their lack of growth, these MSEs frequently play important social and economic roles. Even if they do not experience employment growth,

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they often provide essential sustenance for their owners and workers. In some cases, slow or nonexistent firm growth may also be attributable to entrepreneurs’ competing interests. Women MSE owners, for example, may be especially likely to use business proceeds to purchase household necessities, to invest in parallel enterprises, or to assist their offspring in launching new firms. Should micro and small enterprise development programs try to “pick winners,” focusing only on those firms most likely to grow? For example, should programs avoid informal, female-owned firms located in the household? We emphatically answer no. Many development practitioners and developing country policymakers find the “picking winners” formula to go against the very principles and goals around which their programs are conceived, not to mention being politically difficult to implement. Rather than simply “picking winners,” micro and small enterprise development programs should be clear about their objectives. Practitioners should avoid unrealistic objectives such as “broad-based MSE expansion,” because a wide range of evidence from both the developing and developed world shows that only a small subset of MSEs are likely to grow substantially. Practitioners should thus be clear, for example, whether they aim to unleash the untapped growth potential of latent gazelles, or if they aim to stabilize incomes of the poor by providing assistance to survivalist MSEs. Such questions are crucial for designing MSE development programs. Although all MSEs are likely to benefit from certain types of interventions—such as alleviating market failures in credit—latent gazelles are likely to require substantially different types of specialized development assistance than survivalist MSEs. Being explicit about objectives is a basic but all too often overlooked step in developing effective, customized programs. Of course, programs with multiple objectives will often face difficult tradeoffs. How to balance these objectives should be considered explicitly from the outset. The present study can be employed as an important input for designing customized MSE development programs to achieve specified objectives. Developing effective programs for the entire “MSE sector” is often especially challenging because the sector represents the vast majority of firms in nearly all countries. The MSE sector is both large and heterogeneous, so segmentation can play an 23

important role in developing tailored programs. A segment is a group of firms that shares relatively similar key characteristics (such as growth trajectory, opportunities and capabilities), but that is substantially different from other segments. Using several of the variables examined in our study, Figure 1 provides an example of a potential MSE segmentation in a given country. Numerous segments would likely be identified, but for illustrative purposes we highlight and discuss below two potential segments, “latent gazelles” and “survivalist MSEs.” [FIGURE 1 HERE] When based on rigorous analysis of quantitative and/or qualitative data in a particular country or region, segmentation can enable practitioners to tailor interventions to the specific needs of MSE segments. Although a thorough discussion of segmentation methodologies is beyond the scope of the present article, the primary tasks for development practitioners would include:10 (1) Identify potential segmentation variables – Our study provides an important contribution by identifying variables linked to MSE growth, opportunities, and capabilities. Through brainstorming, practitioners can identify other measurable variables that may also be used to segment the MSE sector in their particular country or region. (2) Create an MSE segmentation frame – To determine which identified variables should be included in the frame (i.e., placed on the vertical and horizontal edges of Figure 1), practitioners would analyze which variables best predict characteristics such as MSE growth, opportunities, and capabilities in their country or region. Depending on local resources and data availability, practitioners may rely more heavily on quantitative analysis (e.g., factor analysis or cross-tabulations of survey data) or on qualitative analysis (e.g., interviews or focus groups across different variables). (3) Define homogeneous segments – To define segments, practitioners can use quantitative and/or qualitative analysis to examine characteristics such as growth, opportunities and capabilities of firms within each individual cell in the segmentation frame. Collapsing cells that are relatively similar across these or other key characteristics enables practitioners to define a tractable number of homogenous

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segments. For example, four cells are collapsed in Figure 1 to define the hypothesized “survivalist MSEs” segment. (4) Create segment profiles – To deepen understanding of the particular attributes of each newly defined segment, practitioners can use existing quantitative and qualitative data. Where resources are available, focus groups—each made up entirely of MSEs from a given segment—may be helpful. (5) Prioritize target segments – Practitioners can prioritize these newly defined segments based on explicit program objectives. For example, MSE programs specifically aiming to stabilize income of the poor may choose to focus efforts on segments such as “Survivalist MSEs.” (6) Develop customized interventions – Segment profiles enable practitioners to develop customized interventions tailored to the specific needs of respective segments. Once these programs are developed, practitioners can easily identify which segment a firm belongs to and what customized interventions (or services) it should receive or have access to, based on objective variables in the frame (e.g., owner’s education, formality, etc. in Figure 1). The recognition that not all small firms will grow, combined with a rigorous segmentation that profiles what different types of MSEs are most likely to need, offers a powerful alternative to traditional small enterprise development programs. Traditionally, donors have conducted “needs assessments” to identify the constraints affecting small firms in a particular region, country or sector. This type of research, however, frequently makes implicit assumptions that are not accurate for all MSEs. For example, many traditional programs assume that entrepreneurs aim to grow their firms, and as a result interventions may be designed with the sole purpose of stimulating such growth. These programs may be deemed to be failures and discontinued if they do not result in broad-based MSE growth. New approaches to design, intervention, and evaluation cycles based on the insights of this and future studies offer the potential for improved development outcomes.

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ENDNOTES (1) To identify the most influential studies on small firm growth, we used the Web of Science to determine the 100 most frequently cited articles in each five-year period over the past 50 years. To consider recent research (that may not yet be cited), we reviewed every article published on small firm growth in the past five years and employed Google Scholar to find relevant working papers. To ensure that we reviewed important books on the topic, we solicited recommendations from experts listed below. (2) Experts interviewed include Thorsten Beck (World Bank), Albert Berry (University of Toronto), Ronald Cooper (U.S. Small Business Association), Gustavo Crespi (University of Sussex), Antonie de Wilde (World Bank), Brian Headde (U.S. Small Business Association), Hugo Kantis (Universidad Nacional de General Sarmiento), Juan Jose Llisterri (Inter-American Development Bank), Donald Mead (Michigan State University), Reshmi Mitra (XLRI Jamshedpur, India), and Carlos Moreno (SODIMAC Colombia). Although the present article integrates findings from each interview, the article does not necessarily reflect the views of all experts and we are solely responsible for its content. (3) Interview with Donald Mead, 2004. (4) In other words, all economic activities that would generally be taxable were they to be reported to the state (tax) authorities (Schneider, 2002). (5) Social networks refer to micro-level relationships between agents in an economy. Social networks can be considered individual assets, but are distinct from physical and human capital because they include interpersonal relations (Portes and Landolt, 1996). (6) In addition to the sub-sector focus of the value chain literature, many empirical studies (particularly in developed countries) explore how sector and location influence firm growth (e.g., Audretsch, 1995; Audretsch and Dohse, 2007; Tong et al, 2008). (7) Presentation at the Brazilian National Development Bank (BNDES) in April 2001.

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(8) The findings of both Schiffer and Weder (2001) and Robson and Obeng (2008) provide an indication of firm owners’ perceptions of factors affecting their MSEs, and not necessarily the actual impact of these factors. (9) Interview with Donald Mead, 2004. (10) Segmentation is a widely used methodology in the fields of business and marketing, but is rarely used in development. This overview of the steps involved in segmentation is based on the excellent discussion in Barron and Hollingshead (2002) and Yankelovich and Meer (2006). BIBLIOGRAPHY Akoten, J. E., Sawada, Y., & Otsuka, K. (2006). The determinants of credit access and its impacts on micro and small enterprises: the case of garment producers in Kenya. Economic Development and Cultural Change, 54(4), 927–944. Alvarez, R., & Crespi, G. (2003). Determinants of technical efficiency in small firms. Small Business Economics, 20(3), 233–244. Audretsch, D. (1995). Innovation, Growth and Survival. International Journal of Industrial Organization, 13, 441–457. Audretsch, D., & Dohse, D. (2007). Location: A Neglected Determinant of Firm Growth. Review of World Economics, 143(1), 79–107. Aw, B. Y. (2002). Productivity dynamics of small and medium enterprises in Taiwan. Small Business Economics, 18(1), 69–84. Barr, A. M. (1998). Enterprise performance and the functional diversity of social capital. Centre for the Study of African Economies, University of Oxford, Working Paper Number 65. Barron, J. & Hollingshead, J. (2002). Making segmentation work. Marketing Management, 1. Beck, T., Demirguc-Kunt, A., & Maksimovic, V. (2005). Financial and legal constraints to growth: Does firm size matter? The Journal of Finance, 60(1), 137–177. Berry, A., Rodriguez, E., & Sandee, H. (2002). Firm and group dynamics in the small and medium enterprise sector in Indonesia. Small Business Economics, 18(2), 141–161.

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Table 1: Growth Factors and MSE Growth, Opportunities and Capabilities

Growth Factor

1. Link to MSE Growth (Developing Countries)

2. Link to MSE Growth (Developed Countries)

3. Impact on Opportunities (Hypothesized)

4. Impact on Capabilities (Hypothesized)

Education of Owner (Above Threshold)

+

+

+

+

Work Experience of Owner

+

+

+

+

Gender (FemaleOwned)



0





Firm Located in Household







Firm Age (Older)



0



Informality





0

Access to Finance

+

+

0

+

Social Networks (Strong, Diverse)

+

+

+

+

Value Chains (Favorable*)

+

+

+

0

Inter-Firm Cooperation (Favorable)

+

+

+

+

Business Environment (Favorable)

+

+

0



Note: Cells marked with 0 values if literature suggests no association with MSE growth or no hypothesized direct impact on opportunities/capabilities. Blank cells indicate factors with considerably less evidence in the developed country literature. *Assumes the presence of one or more of the following: (a) strong and sophisticated demand; (b) sectoral characteristics that allow for MSE competitiveness; (c) power structures that allow for MSEs to flourish.

35

Figure 1: Segmentation of MSEs in a Hypothesized Country

36

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