Jeremy M. Kronick - Five Policies to Scale our SMEs

From: Jeremy M. Kronick

To: Canada’s Governments

Date: March 20, 2023

Re: Five Policies to Scale our SMEs

These days, it often feels like we don’t agree on much. But higher income growth is one thing all Canadians should be able to support.

One way to achieve this growth is to see young businesses grow into large ones. While not every business aspires to grow into a Magna, Lululemon, or Dollarama, or is capable of pulling it off, most still want to move from start-up to thriving enterprise. We need to create the conditions for them to succeed.

An overwhelming majority of Canadians – approximately 90 percent in the private sector – work in Small or Medium-sized Enterprises (SMEs). This validates their importance to the nation, but ideally, more of them would grow into large businesses. That failure is a major contributor to the gaping labour productivity advantage the US enjoys over us. SMEs employ only 47 percent of US workers, and the rest work for larger, typically higher productivity companies.

And yes, the US economy has many other inherent advantages, most notably in this context its much larger domestic market. However, if anything, that makes it more imperative that our SMEs grow, since economies of scale are critical for businesses to reliably reach markets beyond domestic borders.

That is simply not happening enough. Only 2 percent of mid-sized Canadian firms grow into companies with more than 500 employees.

How do we create the conditions for more SME scaling?

First, we must identify why we face the problems we do.

There are two leading reasons that ambitious firms fail to grow, even if their business idea is solid with access to markets not blocked by trade barriers or other obstacles. First, they may lack financial backing/access to capital, and, second, they may lack important skills, e.g. management.

In most cases, there is probably some combination of the two, which makes investigation of barriers and policy solutions to both issues worthwhile.

On skills, the evidence suggests that:

1. Larger firms have higher management scores (quality of management) than smaller firms;
2. Canada’s SMEs rank higher than many OECD countries in management scores…but;
3. They lag the US, which holds true across the distribution, i.e. below the mean there are more Canadians at almost all scores and above the mean there are fewer.

On access to capital, Canada’s SMEs face a punishingly high interest spread relative to large firms. In fact, looking at Canada’s traditional comparators (the US, France, Sweden, the UK, Italy, Australia, and the Netherlands), no one ranks higher. Pair that with a dearth of alternatives, for example the scarcity of private investors in Canada at the $2- to $5-million deal size, and a problem emerges.

In a similar vein, Plant (2017) finds in his study comparing similar tech companies that received VC funding in the US versus Canada, that Canadian firms wait longer before they start raising funds, raise funds less often, and raise less money over time.

What we are left with in Canada is:

1. A failure to grow promising SMEs into larger companies that boost productivity;
2. Scope for improvement in management skills of these SMEs; and
3. Large interest rate spreads on debt financing that highlight the need for better access to the kinds of patient capital necessary to scale up.

While governments have acknowledged the need to grow SMEs, they have not acted with enough urgency. Howell (2022) has done an extensive review of existing US policies and one of her primary conclusions is that “program design can be more important than the amount of funding.” Using that philosophy, here are five initiatives extracted from our recent work that could boost SME growth:

1. Emulate the US Small Business Jobs Act, which exempts from taxation capital gains realized on the sale of certain small business shares held for at least five consecutive years;
2. Follow Israel’s lead in permitting SMEs with a successful liquidity event (e.g. an IPO) to re-invest those proceeds into innovation with no capital gains tax if done within two years;
3. Subsidize consulting services for young SMEs as a way to boost management skills;
4. Commit to getting open banking off the ground, which will improve competitiveness on the supply of debt, bringing down interest rate spreads.
5. Look for ways to increase institutional investor participation in the VC sector. For example, increased government participation through Crown corporations in existing private funds to boost scale, perhaps creating more fund of funds.

Stronger growth in incomes should be something we all want. Boosting productivity is the most sustainable way of achieving this goal. Growing businesses into large enterprises will close the productivity gap. We need a plan. These are the key elements.

Jeremy M. Kronick is Director, Monetary and Financial Services Research at the C.D. Howe Institute.

To send a comment or leave feedback, email us at blog@cdhowe.org.

The views expressed here are those of the author. The C.D. Howe Institute does not take corporate positions on policy matters.