What is small business? Unraveling the numbers

July 19, 2006

What is a small business? It depends on who you are asking.


According to the U.S. Small Business Administration (SBA), a small business concern is "one that is independently owned and operated which is not dominant in its field of operation." When Congress created the SBA, it sought to ensure that the agency's programs applied only to small businesses -- that's when the definition came about. But, of course, that definition is quite vague.


So the SBA created size standards -- numerical definitions of small businesses that are unique by industry. Today, those size standards are used by the Federal government to determine which businesses are eligible for the SBA's programs, which ones qualify as "small" for procurement purposes, and which are subject to other governmental programs and regulations.


The size standards are represented by number of employees or by revenues and range from 500-1500 employees and from $750,000 to $32.5 million in annual revenues. To simplify the picture for research purposes, the SBA uses the fewer-than-500 employee standard.


But not all government entities follow the SBA's definition of "small." According to Arizona statute, for example, "a small business, including its affiliates, is independently owned and operated, is not dominant in its field, employs fewer than 100 full-time employees, or has grossed less than $4 million in its last fiscal year."



Breaking down the numbers


But debate over the decision about what size cutoff to use for small businesses is only the beginning; measuring businesses by size proves difficult, too.


For example: one report, researched by Lea Farr, associate director of the W. P. Carey School's Spirit of Enterprise Center, stated that the total number of small businesses in Arizona was 651,317. That report was published by the Arizona Department of Commerce in May 2002.


Another report, researched by Tom Rex, associate director of the W. P. Carey School's Center for Competitiveness and Prosperity Research, stated that the total number of small businesses in Arizona was 411,369. That report was published by the Arizona Department of Commerce in July 2006.


The dramatic difference between the two reports stems largely from different definitions of what constitutes a small business and how that is interpreted by different data sources.


The problem, ultimately, is not the numbers themselves. It's that statements about small businesses -- how many there are and their effect on employment -- are most often not footnoted to alert us to how the data were calculated, what definitions are being used, and where the data came from. Those differences, it's clear, can have a profound effect on the numbers.



What is a business?


Some of the differences are common in research, such as those that result from using different sources. But how researchers define businesses is another source of discrepancy in the numbers.


Lea Farr says that anyone engaging in business activities -- whether full-time or part-time, at the industrial park or the garage, in addition to another job or not -- should be counted as a business. "A lot of employers started out as sole proprietors, running their businesses on the side while working full-time day jobs," Farr said.


Rex, on the other hand, thinks that it may be a stretch to include people who do side work as small businesses. According to Rex, that's one of the reasons why he prefers the census bureau's non-employer statistics over other sources -- the census only counts people who reported self-employment (Schedule C) income of more than $1,000, possibly weeding out some side-workers who pay self-employment income tax but do not operate independent businesses.


For Tracy Clark, associate director of W. P. Carey's Bank One Economic Outlook Center, the problem with ambiguous definitions of what counts as a small business is that they may make it more difficult for policymakers to really understand and address the unique problems that businesses of different sizes are confronted with.


"The problems that a business with 10 employees might face -- and the assistance those businesses may need -- are very different than the problems a business with 499 employees might face, and the assistance those businesses may need. By lumping them together under the 'small business' umbrella, we may make it more difficult to really understand them," Clark said.



What we can say about small businesses


Interestingly, no matter how a business is defined, what definition of "small" is used, and where the data come from, a huge percentage of businesses are small.


According to the SBA, small businesses in Arizona (including non-employer firms) make up 99.2 percent of all businesses in the state. Removing non-employer firms from consideration, 97.2 percent of firms are small. Using data from different sources -- the ones Farr used in her 2002 report -- small enterprises make up 98 percent or more of the total number of businesses.


Even changing the cutoff size to businesses with fewer than 20 employees, as Rex suggests in his report, and not including non-employers, small enterprises would still make up 85 percent of all Arizona businesses.


Also relatively consistent is small businesses' share of employment. According to data from the census bureau, using the definition of fewer than 500 employees, small businesses in Arizona (including non-employer firms) employ 55 percent of the state's non-farm private sector employees; not including non-employer firms, small businesses employ 48 percent of the state's workforce.



Why the definition matters


It would be easy to suggest that it doesn't matter how a business is defined -- whether it's actually labeled small, large, or anything in between. Rex says that from an analytical perspective, it's true that the distinction of a "small" business (which isn't very distinct in that it encompasses nearly all businesses) is not very useful.


But from a policy perspective, Rex suggests that the distinction is useful, because small businesses -- which do play an important role in our economy -- need to be encouraged through government incentives. "Without incentives for people to start and run small businesses, we'd probably see a move to a small number of very large companies, reducing competition and potentially driving prices up and quality down," Rex said.


Farr agrees that defining small businesses does matter for policymaking. "It has to matter how we define small businesses so that we can continue to offer programs to help aid and encourage entrepreneurial development," she said.


David Drennon, director of communications at the Arizona Department of Commerce, says that state policymakers do indeed look at the delineation between small businesses and others when considering programs meant to help early-stage companies succeed.


Drennon cites the new Angel Investor Tax Incentive Program as an example of such a program. The tax credit, he says, will "assist early-stage small businesses in attracting the much-needed capital to expand operations and bring new ideas, products and services to market."


But how we define small businesses has implications beyond government incentives, said Mary Lou Bessette, executive director of strategic initiatives for the W. P. Carey School. "Minimizing the red tape that can strangle small businesses is as important as government incentives in terms of helping small businesses succeed," she said.


Bessette added that as leader of Arizona's delegation to the most recent White House Conference on Small Business, she found that it was a level playing field that small businesses most craved -- not government set-asides or incentives.


"The powerful message there was that it's important to understand what a small business is in order to develop policies and regulations that foster small business growth rather than impede it," Bessette said.



Explaining the prevalence of small businesses


According to Clark, the prevalence of small businesses is a characteristically American phenomenon -- one you don't see in Europe, for example -- which fosters a "creative spirit that gives anyone a shot at grabbing the brass ring."


Clark says that small businesses are popular because they give people flexibility. "The prevalence of small businesses in America gives people encouragement to strike out on their own. They'll probably fail the first two or three times, but most people work the bugs out through trial and error and, with enough perseverance, become successful." And with that success, often, comes growth.


Indeed, most big businesses started small (Steve Jobs started Apple in his garage; Michael Dell began his business in his college dorm room; Sam Walton started Wal-Mart with a small corner store in Arkansas; HP began in a rented-out garage; when Jeff Bezos started Amazon he delivered books to the post office in his pickup truck … the list goes on).


Farr explains that programs to help small businesses are important because the enterprises that are tomorrow's Apples, Dells, Wal-Marts, HPs, and Amazons are today small businesses or individual entrepreneurs with a new way of solving an old problem. If large companies are ocean freighters, small businesses, then, are the speedboats that carry us into a more advanced future. "You just can't turn the boat that quickly in big companies," Farr said.



Going solo


While small businesses -- however they're defined -- make up a large majority of all businesses, it is non-employer enterprises that are growing the fastest.


Rex suggests that may be due to changing demographics. "A number of Baby Boomers are entering semi-retirement, retiring from their career-jobs to do work on the side, which qualifies them as non-employer businesses," he said.


Another explanation, Rex suggests, is the rising costs of health care, which may be pressuring companies to hire more contract workers (who aren't given health insurance benefits) than full-time employees (who are).


Bessette believes that an increasing desire to balance work-life and home-life has also been a factor in the growing number of non-employer enterprises. Many, though not all, of these enterprises are created by women seeking harmony between raising a family and pursuing a successful career, she says.


All of those trends -- Baby Boomers' semi-retirement, the increasing popularity of contract workers and a desire for more work-life balance -- are made possible by technology that allows us to work from anywhere.


According to Clark, "the Information Revolution pushes us toward a more collaborative model within which people work together from different places. Technology makes it easier for small groups of people to do interesting and useful work from anywhere."



The take-home message


Trying to unravel the data web covering small businesses is a mind-bending exercise. But at the end of the day, it's clear that small businesses (whether 500-or-fewer or 20-or-fewer) make up the large majority of all businesses in Arizona and in the U.S.


And while it would be useful to have footnotes on all statements about small businesses' effects on the economy, it's probably more important -- from the policy perspective, at least -- to understand the importance of small businesses in keeping our economy competitive and in enabling the entrepreneurship for which America is famous.



Bottom line


  • A "small" business is defined by the SBA as one with fewer than 500 employees and by the Arizona Department of Commerce as one with fewer than 100 employees. 
  • Small businesses in Arizona including non-employer firms (using the definition of fewer than 500 employees) make up 99.2 percent of all businesses in the state and employ 55 percent of the state's non-farm private sector employees. 
  • Even changing the cutoff size for a business to be considered small to 19 employees or less, small enterprises would still make up 85 percent of all Arizona businesses. 
  • Defining small businesses is important in order to create governmental policies (including incentives and reductions in red tape) that encourage entrepreneurship. 
  • Most big businesses started small. 
  • Non-employer enterprises are growing faster than employer enterprises, perhaps due to Baby Boomers' semi-retirement, the increasing popularity of contract work, or a desire for greater work-life balance.