Dear Mr. President: The Office of Advocacy of the U.S. Small Business Administration (SBA) is pleased to present The Small Business Economy: A Report to the President. The American economy is blessed with an entrepreneurial spirit that continues to be the envy of many nations around the world. Small business leaders provide new ideas, employ additional workers, and develop innovative products and services. By investing in their businesses, the small firm owner makes a major contribution to the local, regional, and national economy. Over the past year, the Office of Advocacy has conducted research that documents these points. First, Kathryn Kobe of Economic Consulting Services reconfirmed our knowledge that small businesses account for half of private, nonfarm gross domestic product. Second, Donald Bruce, John A. Deskins, Brian C. Hill, and Jonathon C. Rork find that a state’s ability to generate new establishments is the most important factor that leads to higher gross state product, state personal income, and total state employment. Finally, Larry Plummer, a doctoral student at the University of Colorado at Boulder who served as a visiting research economist in this office, found that new business entrants provide long-term benefits to the local economy; the increased competition might be painful in the short term, but with time, collaborative efforts accrue to everyone’s betterment. These and other studies can be found on the Office of Advocacy’s research page at http://www.sba.gov/advo/research. This edition of The Small Business Economy features two chapters on owner demographics based primarily on the 2002 Survey of Business Owners from the U.S. Census Bureau. In documenting the number of small businesses owned by minorities, women, veterans, and service- disabled veterans, we gain a better understanding of their contributions to the economy. This report also summarizes the economic and small business financial climate in 2006, and examines small business procurement. Generally, the economy and financial markets were supportive of small business growth in 2006. The Office of Advocacy, through its implementation of the Regulatory Flexibility Act of 1980 and Executive Order 13272, has assisted small businesses by helping to reduce the regulatory compliance costs of proposed rules. For instance, in FY 2006, Advocacy’s efforts resulted in cost savings of $7.25 billion in the first year and $117 million annually for small businesses. These are costs that will not be borne by the small business owners as a result of changes in the regulations they comply with. We also feature two chapters from external contributors. Andrew Wolk of the Root Cause Institute and a senior lecturer at the Massachusetts Institute of Technology presents a number of examples of social entrepreneurship across the country and outlines steps governments are taking to promote social entrepreneurs as a mechanism for solving some of our nation’s problems. Some may ask, “What does social entrepreneurship have to do with small business?” A short answer might be that social entrepreneurship exhibits many of the attributes of small business entrepreneurship, serving as an engine of innovation, job creation, and economic growth. Moreover, by bringing together aspects of the public, private, and nonprofit sectors to address a market failure, social entrepreneurs have, in a variety of ways, helped create an economic environment in which private entrepreneurs and small businesses can flourish. The longer answer may be to read on and see how this chapter answers the question. It is an excellent chapter that will provoke discussion in academic and policymaking circles. A second chapter from external contributors, by William Gartner of Clemson University and Jianwen (Jon) Liao of the Illinois Institute of Technology, discusses the need for pre-venture planning. They find that nascent business owners who engaged in business planning during the startup phase and wrote a formal business plan were more likely to open and remain in business. In essence, they suggest that the process of drafting a business plan was essential to the overall success of the venture. While that might seem common sense to many, a debate in recent years has sometimes challenged the need for pre-venture planning as a prerequisite for success. This chapter lends credence to those who suggest that planning matters. In sum, the 26.8 million small businesses in the United States play a vital role in the economic well-being of our nation. The research of the Office of Advocacy continues to document the importance of the entrepreneur in maintaining economic growth, employing workers, bringing new innovations to the marketplace, and remaining competitive in a global economy. Chad Moutray Chief Economist & Director of Economic Research Executive Summary The Small Business Economy 2007 reviews how small businesses fared in the economy in 2006, in the financial markets, and in the federal procurement marketplace, as well as new information about minorities and veterans in business. Chapters 6 and 7 offer guest contributors’ studies of social entrepreneurship and pre-venture planning. In Chapter 8, with its responsibility for oversight of Regulatory Flexibility Act implementation, the Office of Advocacy takes a look at the regulatory environment for small firms. Appendices provide additional data on small businesses and background information on the Regulatory Flexibility Act. The Small Business Economy in 2006 Small businesses continued to be at the core of the continuing economic expansion in 2006. Output rose, business income and profits were up, and unemployment was down. The estimated number of firms and self-employed individuals increased. Output declined from a high in the first quarter, and early 2007 indicators also portrayed a slight slowing of the economy. Small businesses continued to drive employment in early 2006. The overall employment increase of 2.3 percent was low relative to other periods, but occurred in the context of a tightening labor market as unemployment declined to 4.6 percent. In 2004, the most recent year for which firm size data are available, small firms with fewer than 500 employees accounted for all of the net new jobs. According to the U.S. Department of Commerce, Bureau of the Census, firms with fewer than 500 employees had a net gain of 1.86 million new jobs, while large firms with 500 or more employees had a net loss of 181,000 jobs. Small firms employed just over half of the private sector work force and generated more than half of nonfarm private gross domestic product. More than 99 percent of American businesses are small, and the average small employer had one location and 10 employees, compared with 62 locations and 3,313 employees in the average large business. The report reviews data on the costs of doing business for small firms. A 2.8 percentage point decline in the small business share of payroll, from 47.9 percent in the late 1980s to 45.1 percent in 2004, mirrors a 2.9 percentage point decline in the small business share of employment. An appendix to the chapter takes a brief look at sources of data on current small business trends. Small Business Financing The economy continued to grow at a slower, but still healthy pace in 2006, and total business borrowing increased by one-third, from $562 billion in 2005 to $753 billion in 2006. Borrowing by the smaller, nonfarm, nonfinancial businesses declined slightly, from $304 billion to $289 billion. Nevertheless, small business credit continued to expand in 2006 because of favorable economic conditions and a financial market with ample liquidity. The most recent data available indicate that most small businesses use traditional credit, such as credit lines, loans, or capital leases for their business financing needs; most of the increases in small business financing are in credit lines and credit cards. Banks continued to consolidate, with 108 multibillion-dollar banking institutions accounting for three-fourths of total domestic bank assets, nearly two-thirds of all business loans, and 45 percent of small business loans. Equity markets increased at a moderate pace, and the average offering size in the initial public offering market increased, while the number of IPOs dropped slightly. Federal Procurement from Small Firms At the forefront of President Bush’s Small Business Agenda have been efforts to provide greater transparency in federal small business procurement. Improvements recently implemented include new guidance for large businesses subcontracting to small firms, improvements in small business size standards, clarification of the “novation” regulations relating to small businesses acquired by larger ones, initiatives toward more transparency in federal procurement data, and steps to reduce the contract bundling that can leave small firms out of the competition. In FY 2006, according to the U.S. Small Business Administration, small businesses received more than $77 billion, or 22.8 percent of a total of $340 billion in federal government contracts eligible for small business competition. In addition, small firms won an estimated $65 billion in subcontracts with prime contractors to the federal government, for a total FY 2006 estimated dollar value of more than $142 billion in small business contracts. The shares of federal procurement from small women-owned, disadvantaged, veteran-owned, and HUBZone businesses continued to increase in FY 2006 to 3.4 percent, 6.8 percent, 2.6 percent, and 2.1 percent, respectively. The Small Business Innovation Research program encourages small firm innovation by requiring participating federal agencies to devote a percentage of their extramural research and development funding to small firms. A total of $19.9 billion has been awarded to small businesses over the 24 years of the program. In FY 2006, participating agencies received a total of more than 27,000 proposals and made nearly 6,000 awards totaling $1.9 billion. Minorities in Business Recently released information on minorities in the work force and minority-owned businesses includes minority population statistics, labor force participation, age, education, occupation, work schedules, average personal and household income, business ownership, and business dynamics. This update of previous studies on minority-owned businesses primarily uses data from the 2002 Survey of Business Owners (SBO) from the U.S. Census Bureau. Based on the 2002 American Community Survey, the total U.S. population consisted of 68.2 percent non-Hispanic Whites and 31.8 percent minorities. In 2002, minorities owned approximately 18 percent of the 23 million U.S. firms. Black-owned firms had the highest growth rate for several measures between 1997 and 2002: 45.4 percent of the number of firms, 24.5 percent of total receipts for the group, and 16.7 percent of employer firm receipts. Asians also experienced growth in the number of employer firms, 12.6 percent, and in annual payroll, 25.3 percent. American Indian and Native Alaskan owners saw slower business growth and declines in some measures. Their business number grew 2.1 percent. Hispanics or Latinos constituted the largest minority business community and owned 6.6 percent of all U.S. firms, 3.7 percent of employer firms, and 7.4 percent of nonemployer firms. Veterans in Business The new Characteristics of Veteran-Owned Businesses (CVOB) and Characteristics of Veteran Business Owners (CVBO) are the Census Bureau’s most important new data on veterans and service-disabled veterans in business since an earlier report based on 1992 data. The scope of the new reports is also much broader, representing the most detailed information on veterans in business ever released by Census. The data show that veteran business owner respondents to the Census surveys are overwhelmingly male, non-Hispanic, and White. They tend to be older than all business owners and are about as likely as all owner respondents to have bachelor or postgraduate degrees. More than half of employer veteran respondents reported working an average of 41 hours or more per week. The business was the primary source of personal income for 50.9 percent of all owners, 47.5 percent of all veteran owners, and 44.1 percent of all service- disabled veteran owners of the respondent firms. The firms of veteran respondents are older than U.S. firms overall, on average, and are similar in receipts and employment size. More than half of the businesses described by veteran respondents operate from the owner’s home. Almost 16 percent of veteran-owned respondent firms are reported to be family-owned and another 75.2 percent of veteran respondents reported their firms as having only one owner. Social Entrepreneurship Social entrepreneurship—the practice of responding to market failures with transformative, financially sustainable innovations aimed at solving social problems—has emerged at the nexus of the public, private, and nonprofit sectors. This “new breed” of entrepreneurship, in the words of author Andrew Wolk of Root Cause in Massachusetts, “exhibits characteristics of nonprofits, government, and business—including applying traditional, private-sector entrepreneurship’s focus on innovation, risk-taking, and large-scale transformation to social problem solving.” The author details a number of examples of social entrepreneurship efforts, the market failures they address, the innovative approaches they employ, their prospects for financial sustainability, and the ways society benefits. He then details a number of ways various levels of government currently support these kinds of efforts—by encouraging social innovation, creating an enabling environment, rewarding performance, scaling success, and producing knowledge. Pre-venture Planning In any given year, about 7 percent of the working age population in the United States is actively engaged in efforts to start a business. Within about two years, some of these entrepreneurial efforts will result in the creation of new businesses. Given the millions of people and billions of dollars involved in new business startups, important benefits are to be had from insights into ways that entrepreneurs could improve their chances of business success, as well as minimize their losses from investing in nonviable opportunities. Professors William B. Gartner and Jainwen (Jon) Liao provide compelling evidence that engaging in business planning can significantly improve an entrepreneur’s chances of successfully starting a business. They base their research on a unique survey of people in the process of starting businesses in the United States, the Panel Study of Entrepreneurial Dynamics. They compare entrepreneurs who ended up starting a business with those who were still in the process of starting one, and those who quit the process. Those who engaged in business planning during the startup phase and wrote a formal business plan were more likely to be in the group that successfully started a business. Planning matters! The Regulatory Flexibility Act in Fiscal Year 2006 Enacted in 1980, the Regulatory Flexibility Act (RFA) requires federal agencies to determine the impact of their rules on small entities, consider alternatives that minimize small entity impacts, and make their analyses available for public comment. President Bush’s Executive Order 13272, signed in August 2002, gave agencies new incentives to improve their compliance with the RFA. The SBA’s Office of Advocacy oversees implementation of the law. Advocacy efforts helped result in FY 2006 savings to small entities of $7.25 billion in first-year and $117 million in annually recurring regulatory costs. These figures are just one important measure of the effectiveness of the law’s implementation, but they do not capture the totality of Advocacy’s efforts. Often, confidential preproposal communications are where the greatest benefits are achieved in agency compliance with the RFA and in the choice of alternatives that reduce a rule’s impact on small firms. To further enhance implementation of E.O. 13272, the Office of Advocacy introduced online RFA training for federal agencies in 2006. In response to Advocacy’s model state legislation initiative, 19 states had enacted legislation as of 2005, and 11 more introduced regulatory flexibility legislation in 2006. Two states enacted it, and two more governors signed executive orders. As of summer 2007, 37 state legislatures had considered regulatory flexibility legislation and 22 had implemented it by law or executive order. The importance of state regulatory flexibility for small businesses is demonstrated in a real-life example from Arkansas, where new elevator retrofit requirements would have imposed significant financial burdens on small businesses. As a result of the agency’s careful consideration of the rule pursuant to the state regulatory flexibility law, owners of certain types of elevators were given more time to come into compliance and exemptions were allowed in certain cases where the regulation would have caused undue hardship and where reasonable safety could be assured.