SMEs, startups, and innovation—Review of a complex relationship—Part 1 (Note)

Usefulness of the article :Startups and SME innovation are increasingly the focus of attention in both public debate and political discourse. This is reflected in the adoption of public policies that support innovation and growth. Recently, the recovery plan and the PIA (Investment and Innovation Plan) have allocated part of their budgets to this area. In this context, this note seeks to clarify the role of these companies in the innovation dynamic and their weight in the economy (Part 1). This first note is therefore aimed in particular at an audience discovering the subject or looking for key figures. To go further, in a second note (Part 2), we look at the difficulties specific to these companies that could justify specific public support. In addition, we have looked at the risks associated with the expansion of the startup population and the potential remedies that could be brought to bear.

Part 1 – Innovative start-ups: why and how many?

Summary:

• SMEs and startups play a very important role in the production of so-called disruptive innovations. However, more than for reasons of comparative advantage, this seems to be explained by incentive mechanisms.
• Conversely, small and young companies seem to encounter greater barriers to innovation. Market failures that affect all companies have a greater impact on this population.
• In France, SMEs represent the vast majority of companies but a minority of innovation spending, as is the case worldwide. In recent years, however, there has been a real boom in the ecosystem of innovative SMEs, both in terms of the number of startups and venture capital financing.
• This trend appears to be structurally sound. The Covid-19 crisis has not led to a sharp contraction in venture capital funds or a decline in startup activity.

In October 2020, WIPO published its 13th edition of the world’s most innovative countries. This caused quite a stir in France. The country rose four places, from^16th to^12th. In 2021, it gained another place to reach^11th position.

Among the factors determining the level of innovation, WIPO highlights access to financing and support from public authorities. Innovation is a key element of growth and international competitiveness, but also in the direction of the economy, both in terms of health and environmental transition. As a result, the organization called for the efforts and improvements made to boost the sector in recent years not to be undermined by the Covid-19 crisis.

This French success has been attributed, among other things, to the development of the « startup » ecosystem in France. Interest in the latter shows no sign of waning with the major investment plan launched on Tuesday, October 12, 2021, by French President Emmanuel Macron. The plan gives pride of place to private R&D and disruptive innovation, in which small and young companies play an essential role.

With innovation by small businesses becoming a central topic of public debate, this two-part note aims to take stock of the situation. In this first part, we will attempt to shed light on the role of small businesses in driving innovation (Why innovative SMEs?). We will then provide some key figures on the activity of these players in France (How much innovation by SMEs?).

1) Why small businesses play an essential role in the innovation process

The question of the ideal profile for an innovative company has been an important topic in both theoretical and empirical research.

The best-known theoretical opposition is that between Schumpeter and Arrow.

Schumpeter recognizes that large companies with strong market power and/or operating in a concentrated market have a greater capacity for innovation. For him, there are two reasons for this. On the one hand, they have a comparative advantage in this area. Concentrated markets, organized as oligopolies or monopolies, reduce the uncertainty associated with innovation activities because it is easier to anticipate the actions and reactions of other agents. In addition, large companies with a certain degree of monopoly power can more easily generate profits, which means they have a greater capacity to self-finance R&D activities, which are inherently risky. On the other hand, these companies are driven to innovate in order to maintain their market power and prevent new entities from competing with them^[1].

Conversely, Arrow, in 1962, argued that increased competition for goods (product market competition) tends to encourage investment in R&D. According to him, this is due to the « replacement effect. » This effect is an incentive mechanism. A monopoly has little incentive to invest in R&D because its expected gains from innovation are limited by the large size of its current market. A significant portion of the results of its innovation will only replace its pre-existing results.

Since these two theories were developed, empirical research has painted a more nuanced picture of reality, in which the two theories do not oppose each other but coexist.

In summary, and therefore imperfectly, research tends to establish that small and large companies are complementary in their innovations. This can be explained by incentive mechanisms. Large companies are more inclined to invest in incremental or process innovations. Indeed, by innovating, part of their new sales will come from cannibalizing their old product, and their growth expectations are limited. In this sense, small companies have a disproportionate weight given their share of total R&D investment in the production of disruptive innovation.

In terms of comparative advantage, it is clear that large entities have greater access to financing. Among other things, small businesses have less self-financing capacity. In addition, they have more limited access to capital markets. There are multiple factors that explain this phenomenon, including their lower collateral, the greater perceived risk associated with their financing, and their lower capacity for diversification in R&D activities. For young innovative companies, the lack of information, particularly on their past activities, further increases the risk associated with their financing.

Conversely, some argue that SMEs have a comparative advantage in conducting disruptive innovation. One hypothesis argues that the importance of managerial influence within large groups creates a loss of control for R&D teams, affecting the conduct of more fundamental research projects. While this hypothesis is regularly put forward, there is no consensus on the matter.

Finally, it is important to emphasize that not all SMEs are innovative, far from it. In short, there are three categories of SMEs:

• Traditional SMEs never undertake innovation.
• Adopting SMEs have a relatively low innovation profile. However, they regularly invest in R&D to acquire, adopt, and apply new technologies. They represent the majority of innovative SMEs.
• Finally, pioneering SMEs invest in developing and combining technologies to achieve innovations that are new not only for the company but also for the market. They are the target of public policy and the subject of debate. This subset includes a significant proportion of JEIs (Young Innovative Companies) or startups.

It must remain very clear that while SMEs are strategically important in the innovation dynamic, they represent a marginal share of total expenditure. R&D is a highly concentrated activity. The top 2,500 most innovative companies in the world accounted for 90% of R&D expenditure in 2019 and the top 100 for more than 50%, according to WIPO.

Ultimately, despite their scarcity, SMEs play a key role in the innovation dynamic. The incentive mechanisms at work make innovation activities between SMEs and large companies (LCs) complementary rather than substitutive. However, the existence of specific difficulties, particularly financial ones, reduce their capacity in this area. In this sense, the proliferation of public aid programs targeting SMEs can be welcomed.

2) Some figures on innovative SMEs in France and Europe:

SMEs represent the vast majority of companies in France in terms of volume. Excluding micro-enterprises, they represent 96% of registered entities in France and 36% of FTEs (full-time equivalents). If micro-enterprises are included, these figures rise to 99% of the total population and 46% of FTEs. They therefore have a significant weight in the economy^. However, their weight in R&D activity is much lower.

SMEs account for 46% of total jobs but only 19% of R&D jobs and 15% of expenditure^[4]. They are therefore very much in the minority here.

There are few figures available on the sub-population of startups in France. In fact, there is no legal definition of this category of enterprise and therefore no national statistics. However, several institutional and private publications provide an idea of their demographics and dynamics in France. Recently, Philippe Englebert drew on his sources in a book to paint an initial picture of the economic weight of startups, their dynamics, and a representation of their financing. It is on this cross-referenced data that we base our figures here[5].

In terms of stock, startups represent a marginal share of SME activity. In terms of numbers, EY estimated the number of startups at 9,400 in 2017 and Dealroom at 20,000 in 2020. Compared to the 3.7 million French SMEs, their weight is therefore marginal. Employment within French startups is estimated at around 450,000 people, including 300,000 to 400,000 in France (5 to 6% of employment within SMEs). These figures may therefore seem negligible compared to the attention they attract.

However, two arguments can be made against this. On the one hand, startups are destined to grow, merge, or disappear. These statistics therefore only include entities that are still in the making. Furthermore, the weight of startups is itself growing. In 2018 and 2019, they are estimated to have accounted for 10% and 15% of job creation in the private sector, respectively. Startups also stand out in terms of revenue growth. In 2018, SMEs (non-financial companies) achieved revenue growth of 5.3%; that of startups for the same year was estimated at 20%. The share of revenue generated by exports was 4.3% for SMEs and 56% for JEIs. They are therefore growing faster but are also more internationalized.

In order to support these companies with high growth potential, but which are nevertheless very risky, the most suitable form of financing is venture capital (VC). The development of funds specializing in this segment will therefore be a crucial factor in the vitality of the sector. In France, the activity of these funds has tripled since 2015, reaching a total of €5.4 billion in 2020. 2021 is already shaping up to be a record year for French Tech, with more than €5 billion ^raised in the first half ^{of the year.} The development of these funds therefore supports the expected activity of these entities as a whole. Last year, France accounted for 23% of the amounts raised in Europe, neck and neck with Germany (22%) but well behind the United Kingdom, which accounted for 54% of the amounts invested.

This expansion of the startup ecosystem appears to be solid. Indeed, the first available indicators show that VC activity did not collapse during the Covid crisis. This is noteworthy because, like any risky activity, the capital segment is highly volatile. In France, the amount invested in startups and the number of transactions are even growing for 2020 and the first half of 2021, according to the EY startup barometer (see figure 2).

Figure 4- Decline in venture capital financing following the Covid-19 crisis, source: WIPO 2020

Conclusion

Small businesses and startups play an essential role in the innovation dynamic, particularly in the disruptive innovation segment. However, they remain a minority in terms of R&D spending. Their importance is therefore more qualitative. It also stems from their growth momentum and their contribution to job creation.

However, they remain more fragile. In particular, their access to the financial market is more restricted. In addition, they face certain barriers to innovation that are specific to them (see Part 2). Dedicated public support may therefore be justified.

The growth of venture capital funds and the emergence of a pool of startups in France seem to reflect an effective national policy. However, the development of these segments is creating new challenges that will need to be addressed.

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