Liability of Smallness and Newness in Entrepreneurial Firms

Introduction

The historical record contains few examples of a smaller underdog winning out over a larger opponent; the story of David and Goliath is the exception rather than the rule. This scarcity of examples is due in large part to the so-called liability of smallness, which suggests that smaller firms are more vulnerable to competition — a constraint that is especially significant for entrepreneurial firms that begin as smaller entities with less experience and fewer resources than their larger competitors. The liability of smallness is further aggravated by the liability of newness, whereby start-ups are viewed less favorably than longer-established firms.

To gain fresh insights into these issues, this paper provides a review of the relevant literature concerning the liability of smallness, the liability of newness, and how some real-world firms have responded to these constraints. A discussion of how smallness exacerbates the decline and demise of firms is followed by an analysis of firms that are especially vulnerable to these forces. Finally, an examination of how smaller firms can be assisted is followed by a summary of the research and its key findings in the conclusion.

Background and Overview

Small firms are the lifeblood of the American economy. In fact, only about 2 percent of companies in the United States have more than 100 employees, and small firms represent the fastest-growing segment of the national economy, accounting for 75 percent of all new jobs created each year (Heneman & Berkley, 2002). In some ways, smaller firms would appear to hold a competitive advantage over their larger, well-established counterparts. After all, smaller companies can be leaner, nimbler, and more cost-effective, and they can exploit niche opportunities more efficiently than larger, more cumbersome, and bureaucratic enterprises. In this regard, Poole and Van der Ven (2004) report that, "while large generalist organizations occupy the center of the market, small specialist organizations exploit peripheral niches. Further, the rate of resource exploitation is believed to be much stronger for specialist organizations, allowing specialists to reach a better fit with their environment" (p. 138).

Furthermore, Knoke (2002) reports that well-established, larger firms can also suffer from two types of liabilities: a liability of obsolescence, in which inertial forces lock organizations into outmoded strategies and structures adopted in their early years, rendering older firms less able to adapt to rapidly changing environments; and a liability of senescence, in which rigid devotion to accumulated rules and routines reduces their efficiency compared to younger, more flexible organizations even in stable environments (2001, p. 48).

Nevertheless, a growing body of research on new firm failure rates indicates that two liabilities are central to understanding the effects of being smaller and newer on start-ups. The first, the liability of newness, holds that new firms fail because of a combination of internal and external factors (Zacharakis, Meyer & DeCastro, 2002). The second, the liability of smallness, concerns the difficulties small firms experience following their initial launch (Zacharakis et al., 2002). According to Zacharakis and his associates, "the newness/smallness framework identifies problem factors — both internal and external — which inhibit new venture success" (p. 1). These two liabilities are discussed further below.

As the term implies, "bigger is better" when it comes to a company's size and its ability to survive in an increasingly competitive and globalized marketplace. For example, Heneman and Berkley (2002) emphasize that "small businesses face different concerns than those of larger organizations. The concept of liability of smallness suggests that small organizations, relative to larger ones, face problems of access to financial and material resources that make it difficult to compete and survive" (p. 53). Likewise, Frese (2000) reports that "large-scale research has shown that there is a liability of smallness. This means that those who start out with a high amount of capital are more likely to succeed than those who start out with little capital, because they have a head start right at the beginning. Good equipment makes it possible to grow more quickly than when one has poor tools" (p. 107).

Indeed, larger firms are much like larger planets or stars in that their stronger gravity attracts more material to them, while smaller bodies attract very little in comparison. Organizational ecology theory similarly suggests that size confers structural advantages that compound over time. Chengalur-Smith, Sidorova, and Daniel (2010) suggest that the same effects can be observed in the business world, where larger enterprises enjoy the lion's share of resources and support while smaller firms go wanting. They emphasize that "organizational size is the first among the key demographic factors that have been shown to influence organizational legitimacy and, consequently, the ability to attract resources and support from others" (2010, p. 657). These assertions may seem overstated, but the research to date and the experiences of tens of thousands of failed small businesses lend support to these claims. Chengalur-Smith et al. note that "smaller organizations have several disadvantages compared with large organizations, primarily due to difficulties in raising capital and creating organizational routines when their resources are stretched thin" (p. 657).

While alternatives exist for raising capital, the harsh reality is that talented human capital remains elusive for many smaller companies simply because they cannot compete with larger counterparts in terms of pay, benefits, and working conditions. As Chengalur-Smith et al. add, "in competing with large organizations for labor input, small organizations are at a major disadvantage, since they cannot offer the long-term stability and internal labor markets that large organizations are thought to have" (p. 658).

For many consumers choosing between products offered by a well-known corporation such as Johnson & Johnson or Procter & Gamble and those offered by a recent start-up, the choice is clear: they will opt for the known quantity more often than not. Chengalur-Smith and her associates note that "large organizations seem more legitimate because their size is taken as an indicator of prior success and future dependability. Together, these disadvantages underlie a liability of smallness as originally described by Aldrich and Auster (1986)" (p. 658). Unfortunately for start-ups, their liabilities do not end with size alone but also include the length of time they have been in operation.

The only cure for the liability of newness is to survive in the competitive world of business long enough to no longer be regarded as "new" — a feat that eludes a significant percentage of start-ups. According to Chengalur-Smith et al. (2010), "the liability of newness proposition suggests that a young or new organization is likely to have lower legitimacy and a higher chance of failure" (p. 659). While their larger competitors innovate and follow established processes efficiently, smaller firms must devote significant time and energy to creating those systems from scratch. As Chengalur-Smith and her associates note, "the explanation for this phenomenon is that young organizations expend significant amounts of time and effort on coordinating new roles for the individual actors and on their mutual socialization. Therefore, they may be less efficient than the more established organizations with which they are forced to compete" (p. 659).

Clearly, the longer a company stays in business, the more credibility it accrues through an accumulating track record of customer service and reliable products. This places start-ups at a distinct disadvantage because they must formulate from scratch what their larger competitors take for granted. Chengalur-Smith and her colleagues (2010) also emphasize that "emerging organizations may face intense selection pressures as they could lack formal goals and clear boundaries. In addition, they are more vulnerable because they lack bases of influence and stable relationships with external constituencies, and hence lack legitimacy" (p. 659). Brinckmann, Salomo, and Gemuenden (2011) reinforce this point, reporting that "new ventures face a liability of newness and a liability of smallness. The fledgling new firm's competitiveness and growth depend on the founding team's capacity to acquire resources and to configure them in a value-creating fashion" (p. 218).

Response by Smaller Firms

Finally, the liability of newness can operate in favor of larger, more established companies because of the relationships they build over time — relationships that can make or break a company, particularly in the short term. As Chengalur-Smith et al. conclude, "older organizations are likely to have established social networks, including supplier and client groups, which makes them more resilient to minor variations in the environment, and makes it easier for them to attract and retain resources" (2010, p. 660). Larger firms also enjoy the advantage of accumulated resources in a self-sustaining process. As Frese (2000) points out, "larger firms are much more successful than smaller ones. Obviously, success is highly related to size — bigger firms are, by definition, more successful because they have grown more" (p. 170). Although size matters, it is not the only key to success in business, and these issues are explored further below.

Lacking a sling and smooth stones, smaller firms must compete with their larger Goliath counterparts in innovative ways. Because they do not enjoy the same levels of resources, credibility, and experience as their better-established counterparts, smaller companies must identify niche opportunities that are being overlooked or underexploited by larger companies (Poole & Van der Ven, 2004). Other authorities suggest that small size can work to a start-up's advantage. In this regard, Lucas (2012) cites the following as essential ingredients for overcoming the twin liabilities of newness and smallness:

Be the right size for your customers, market positioning, and for accomplishing the firm's vision, mission, and strategy. Many customers would rather be a larger account of a smaller firm than the reverse. Being too small to exploit an opportunity is a problem, but growing faster than a firm can support is no less problematic. Use smallness as a competitive advantage by providing superior customer service. Use smallness as a definition of "freer" — to become more nimble and responsive to market conditions and changes. Deploy resources more intelligently; a few great employees may be far more valuable than hundreds employed by larger companies. Treat everyone as an idea machine, since innovative ideas can come from internal and external customers alike. Learn from, but do not imitate, the successes of larger competitors. Major corporations enjoy enormous resources that allow for false starts and experimentation. Start-ups do not enjoy these same resources, but they can identify what works best in other companies and apply those best practices for their own purposes. Start-ups must avoid attempting to match larger competitors product for product; rather, they must add their own value in unique ways (pp. 2–3).

Another entrepreneur describes how he survived the twin liabilities by establishing strategic partnerships with select larger companies. According to Morin (2012), "you need to overcome this liability by partnering with larger firms, and by making certain that your communications — web, phone, written, and so on — are 100% professional and credible" (p. 1). In a "nice guys finish last" type of analysis, Morin (2012) suggests that small firms should "fake it until they make it": "with technology as it is today, it's easy to appear larger than you are, until such time as you can become truly large and credible. Money, time, and effort you spend here will be very well rewarded; if you cannot get past the credibility gap, you cannot pass go, and your business will go nowhere" (Morin, 2012, p. 2). Unfortunately, many small enterprises do end up going somewhere — but the bankruptcy court is no place for an aspiring entrepreneur.

Conclusion

Given the wide array of obstacles and challenges faced by small businesses at launch and the inordinately high failure rate experienced by most, the truly remarkable finding that emerged from the research was that anyone tries starting a new small business at all. Despite the twin liabilities of smallness and newness, tens of thousands of entrepreneurs try their luck each year — and it is a good thing they do. The research showed that small businesses are the driving force of the American economy, and the vast majority of all businesses in the United States are small- to medium-sized enterprises, with the former significantly outnumbering the latter.