some definitional difficulties in new firms research

Some Definitional Difficulties in New Firms ResearchAuthor(s): Colin MasonSource: Area, Vol. 15, No. 1 (1983), pp. 53-60Published by: The Royal Geographical Society (with the Institute of British Geographers)Stable URL: http://www.jstor.org/stable/20001873 .

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area 1983 Volume 15Number]

Some definitional difficulties in new firms research

Colin Mason, University of Southampton

Summary. The definition of a new firm is not a clear-cut or unambiguous issue. The main definitional difficulties concern four aspects of the formation process: the start-up date, early changes in activity, independence and newness.

Recent statements on research priorities in industrial geography have emphasised the need for studies of new firm formation, the early growth of such enterprises and the processes behind spatial variations in new firm births (Wood, 1978; Hall and Diamond, 1981). Proposals for such a redirection of research effort have been prompted by three

main factors. Firstly, components of change studies have highlighted the relatively minor role played by industrial movement which has, at least until recently, attracted a disproportionate amount of research attention, and the importance of the other processes of employment change: in situ growth and decline, closures and new firm formation (Gudgin, 1978; Dennis, 1978; Dicken and Lloyd, 1978). Secondly, recent research has shown that indigeneous performance is more significant than either inherited industrial structure or industrial movement in accounting for spatial variations in manufacturing growth and decline (Fothergill and Gudgin, 1979; 1982). In part, indigenous performance reflects how firms in each area at the start of the period fared, compared to their competitors in the same industry in other areas, but it is also a func tion of contrasts in rates of new firm formation. Thirdly, new firms research has been advocated because of the demise of traditional policy approaches to the regional problem which relied on attracting mobile industry to areas of high unemployment (Damesick, 1981) and the consequent interest in evolving alternative spatial policies

which place much greater emphasis on developing an area's indigeneous potential. These developments in the research and policy contexts have already stimulated

some studies of new firms (Gudgin, 1978; Johnson and Cathcart, 1979; Lloyd, 1980; Cross, 1981). Because of the relevance of the topic it seems extremely likely that these studies will be followed by many more investigations of new firm formation. However, in view of the very considerable input of research time necessary in order to identify and collect information on new firms (Brinkley and Nicholson, 1979) it seems inevitable that the majority of such studies will be restricted to just one sub-region or region.

Attempts to investigate spatial variations in rates of new firm formation and contrasts in the characteristics of the enterprises themselves will therefore have to compare the results of independently conducted studies undertaken in contrasting spatial environ

ments (for example, Storey, 1981). Naturally, it is vital in such exercises to ensure that identical phenomena are being compared. However, few studies make explicit their definition of a new firm, yet what constitutes a new firm is by no means self-evident. Indeed, the definition used-whether it is explicit or implicit-may significantly influence both the number of new firms identified in any time-period and also their characteristics. This paper focuses on the main definitional difficulties in new firms research. These concern four aspects of the formation process: the start-up date, early changes in activity, independence and newness.

53



54 Some definitional diffwulties in new firms research

Start-up date

If the aim is to calculate formation rates over a particular time-period or to perform time-series analysis then it is clearly crucial to identify the precise date of start-up of each new enterprise. However, the formation date is not self-defined. As a number of authors have pointed out, the start of a new business is frequently a long drawn out affair Johnson and Cathcart, 1979; Lloyd, 1980). In many cases new firms initially operate from a bedroom, garage or garden hut and often are started on a part-time basis. Only when the viability of the enterprise has been demonstrated are formal premises sought and the founder or founders commit themselves to running the business on a full-time basis.

The definition of the start-up date must therefore, to a certain extent, be arbitrary. One approach is to equate the start-up of a new enterprise with the date it registers as a limited company. However, registration does not necessarily imply that the firm is actively trading. Some registered companies never trade but are simply legal con trivances ('paper companies'), perhaps set up for tax reasons, while others are formed by company agents for sale ' off the shelf' at a later date (Hadden, 1977). Scott (1980) noted that of all companies registered in Scotland in 1969, 23% had never traded. Data on incorporations also includes some subsidiary and other non-independent companies.

An even more serious problem of this approach is that by no means every firm adopts limited liability status, with the propensity of a firm to register varying according to its industrial sector. Incorporation is high in manufacturing and in wholesaling and construction but is low in the remainder of the service sector where sole traders and partnerships are the norm (Hadden, 1977; Bolton, 1971). One indication of the under counting involved in equating a new firm with its date of incorporation is provided by a survey, undertaken during the first half of 1981, of 52 manufacturing firms in South Hampshire which started trading during or after 1976 (Mason, 1982). Only 32 (62%) of these businesses had limited liability status, with the unincorporated firms not only including very recent start-ups (less than one year old) but also some which had begun trading in 1976 and 1977.

Evidence from the survey suggests that some new firm founders are deterred by the cost of incorporation. This comprises a ' one-off' charge for registration and the annual cost involved in getting their accounts professionally audited and then filing this information with the Registrar of Companies. In addition, many founders face con flicting advice from their professional advisors. Solicitors generally encourage incor poration because of the legal protection which it offers (although this advantage is nullified if the founder has pledged his home or some other financial asset in order to obtain a bank loan) whereas accountants tend to be less enthusiastic because it does not confer tax advantages, at least in the early years of a new business. However, the balance of advantages and disadvantages of incorporation is unlikely to remain fixed over time, at least in financial terms. Indeed, according to Hadden (1977, 220):

At the very lowest levels of profit there is virtually no tax differential between incorporated and unincorporated businesses, and the apparent and rumoured advantages of incorporation at the middle range of income levels, from say ?5,000 to ?50,000, are largely wiped out by the-close company rules. It is only where the business is of such a size as to earn regular profits above this level that there is a clear and consistent advantage to be obtained from incorporation.

Consequently, in those industries where the rate of incorporation is high it seems fair to assume that the majority of unincorporated new firms which successfully negotiate



Some definitional difficulties in new firms research 55

the start-up phase to become established will eventually take out limited liability status once its advantages outweigh the disadvantages. The date of incorporation will there fore not necessarily always signify the start of a new firm but might instead signal the consolidation of the business. A further implication is that incorporation data will exclude unsuccessful start-ups, that is firms which do not survive long enough to reach the situation where the adoption of limited liability status becomes advantageous.

An alternative approach, suggested by Johnson and Cathcart (1979), is to define the start-up date on the basis of when the new firm takes on its first full-time employee, on the grounds that this usually represents its first major resource decision. Obviously, this definition will exclude those firms without any employees, but as only four firms in the South Hampshire survey (Mason, 1982) did not provide full-time employment for anyone other than the founders (although two did employ part-time workers), it seems likely to involve only limited undercounting of new enterprises. However, firms

which only provide work for the founder or founders might be more common in the service sector where the founder's family frequently acts as a source of unpaid labour (Scase and Goffee, 1980). Perhaps a more serious problem is that the date on which a firm recruits its first full-time employee may not be a particularly accurate indicator of when it actually started. In the South Hampshire survey, 10 of the remaining 48 firms had traded for at least one year before taking on any full-time staff. On the other hand, in view of the evidence from Johnson and Cathcart (1979, Table I) that 54% of newly incorporated businesses in the Northern Region recruited their first full-time employee at least one year before incorporation, it is probably more useful than the date of incorporation as a proxy for the formation date. Clearly, alternative definitions of the start-up date of a new enterprise are by no means certain to correspond.

A further difficulty of basing the start-up date on the recruitment of the firm's first full-time employee is that it cannot accommodate new firms which use self-employed labour. Some new firms find it advantageous to employ labour to undertake specific jobs at pre-negotiated rates. Not only does this offer flexibility in coping with a fluctu ating workload, as in the boatbuilding and construction industries, since staff can be taken on and shed in line with the amount of work available, but it also allows the firm to avoid the impact of employment protection, labour relations and social insurance legislation (Scase and Goffee, 1980). The South Hampshire survey identified nine firms (17%) which used self-employed contractors, although only four (8%) relied exclusively on this type of labour (Mason, 1982).

There is, of course, no '.correct' method of defining a firm's start-up date. The main point is simply to emphasise that the number and types of new firms identified in any time-period is sensitive to the method of defining the date of start-up.

Changes in activity

A change in the new firm's activities is a relatively common feature of its early develop ment. In particular, it is not unusual for a new business to start in the service sector but to switch to manufacturing at a later date (Brinkley and Nicholson, 1979). Twelve new firms in South Hampshire (23%) were identified as having begun trading on the basis of non-manufacturing activity (distribution, servicing, repair, consultancy) and only subsequently undertook manufacturing (Mason, 1982). For a number of these firms the introduction of manufacturing represented a logical diversification of their activities, while in other cases a start based on non-manufacturing offered a low cost and minimum risk method of entry and provided a way of raising sufficient capital to commence manufacturing at a later date.



56 Some definitional diffiwulties in new firms research

This tendency for firms to move from non-manufacturing to manufacturing raises one further difficulty in any attempt to define the start of a new enterprise. If only new manufacturing firms are being considered, the start-up date could either be taken as the commencement of trading or the inception of manufacturing. Not only will alter native definitions affect the number of new manufacturing firms that are identified in any time-period, but it could also influence the types of enterprises that are included. Brinkley and Nicholson (1979) point out that the transition from non-manufacturing to manufacturing is a particularly common feature of successful enterprises, a con clusion which is supported by Mason (1982).

Two related issues serve to further confuse the picture. Firstly, Lloyd (1980, 15) has described new manufacturing firms in Greater Manchester and Merseyside as being ' characteristically balanced on the service-manufacturing margin', with many moving easily from retail and wholesale service activities into manufacturing and back again. Secondly, a characteristic of some new manufacturing firms, especially in the elec tronics and engineering sectors, is that they design and market their own product, and perhaps undertake final assembly and testing, but most or all of the production is sub contracted to specialist firms. Again, this strategy is consistent with risk minimising behaviour. Evidence from company profiles in the business press indicate that some firms which begin on the basis of subcontracting will, at a later stage, assume responsi bility for at least some of their own production.

These dynamic characteristics of new firms, particularly in their early years, thus suggest that caution should be exercised in using any definition which is based on their activities at one point in time.

Independence It might be expected that a new firm would invariably be defined as one which is inde pendent of any other enterprise. However, this is not always the case. Keeble (1976, 117) defines a new manufacturing firm as 'involving the creation of an entirely new enterprise which did not formerly exist as a manufacturing organisation ', while Gudgin (1978, 140-41) defined new manufacturing firms as ' concerns which begin production for the first time'. As these authors admit, such definitions not only include new firms

which are founded by one or a small group of individuals with a particular idea or skill, but also cover the setting up of a new manufacturing firm by an existing non

manufacturing firm or by a consortium of firms. Similarly, in the Department of Industry's Record of Openings and Closures an enterprise new to manufacturing (ENM) is defined to include both firms not previously in existence and ' the opening of a new establishment by an enterprise previously in existence but not operating a manufacturing unit' (Pounce, 1981, 8). The latter category accounted for 15% of total end-year employment in ENMs started between 1966 and 1975 in the United

Kingdom. However, non-founder based new firms are very dissimilar economic types from

enterprises which are founded by one or a small group of individuals, having different economic problems and possibly different economic stimuli (Johnson, 1978). They are also likely to have substantially different characteristics, notably in terms of size and capitalisation. Indeed, non-founder based new firms are much more akin to branch plants. It is therefore more meaningful to separately identify each category by adopting Johnson and Cathcart's (1979, 270) definition of a new firm as 'one which has no obvious parent in any business organisation', although in practice this distinction is not always possible to make. As case studies in the business press demonstrate (for



Some definitional difficulties in new firms research 57

example, Financial Times, 1981), it is not unknown for large enterprises to supply venture capital to new firms.

Even if new firms are defined strictly so as only to include enterprises which are founded by individuals or groups of individuals, this does not fully resolve the indepen dence issue. The South Hampshire survey showed that in a significant minority of new manufacturing enterprises (12 out of 52), each with two or more founders, one of the founders already owned and managed his own small firm and acted either in a part-time capacity or as a ' sleeping partner' in the new business. This arrangement provided the full-time founder(s) with a source of business experience and a ' track record' to impress the financial institutions, and in some cases the part-time founder either supplied some personal capital to launch the enterprise or offered the necessary security in order to obtain outside finance. The founder or founders of a further eight new firms (15%) launched, owned and concurrently managed two businesses; each business was legally independent of the other, with the share capital of the second firm

owned by the founder or founders rather than by their first firm (Mason, 1982). Thus, just as there are ownership and management links in the corporate sector via inter locking directorates (Scott and Hughes, 1976; Johnson and Apps, 1979), so there are also significant management and ownership ties in the small firm sector between legally independent businesses.

The independence of even founder-based new firms is thus by no means a simple and clear cut issue. Of course, there is no ' correct' definition of independence; rather, as Johnson and Cathcart (1979) suggest, it is more meaningful to talk in terms of a spectrum of legal independence. But here again, the precise definition chosen will

affect both the number of new firms identified and their characteristics. For their study of the Northern Region, Johnson and Cathcart (1979, 270) defined new manufacturing firms as 'businesses, none of whose principal founders was at the time of formation, a director, shareholder, sole proprietor or partner in any other business'. Applying this strict definition to the South Hampshire survey (Mason, 1982) would have resulted in the exclusion of between 9 (17%) and 16 (3l1 %) new businesses, depending on how the 'principal founder' is defined, with many of the more successful firms falling into this category.

New firms which are set up on the basis of a licensing agreement serve to further confuse the independence issue. In this situation the firm manufactures a product or undertakes a process as a result of gaining access to some form of technology-a patent, trade-mark, copyright or simply 'know-how '-which is owned by another, usually large, firm and which receives some financial remuneration (such as a royalty payment on every sale) in exchange. The new firm is therefore legally independent but is in a technologically dependent situation. However, this is not a particularly common basis for establishing a new firm (Low and Crawford, 1982): for example, the South

Hampshire survey identified only two new manufacturing enterprises which had been set up on the basis of a licensing agreement (Mason, 1982).

The independence issue is similarly bedevilled in situations where a new business is set up on the basis of a franchise, an increasingly popular method of new firm forma tion, particularly in the service sector. Franchising involves an organisation with a

market-tested product or service (the franchisor) establishing a contractual relationship with franchisees who set up their own legally independent businesses to operate under the franchisor's name and to market the product or service in the manner specified. In return, the franchisor is usually paid a royalty by the franchisee. The advantages to the franchisor are twofold. First, it enables the product or service to achieve a rapid and extensive geographical coverage with most of the capital put up by the franchisees



58 Some definitional difficulties in new firms research

themselves. Second, it overcomes potential management constraints on expansion. Because the franchisees are working for themselves they will be motivated to work

much harder than if they were company employees. From the franchisee's perspective the system reduces the hazards of setting up a business (Stanworth et al., 1982;

Financial Times, 1982a). A quite separate but no less significant issue involves the economic dependence of

one legally independent firm on another which occurs when a new firm is reliant on just one or a small number of dominant customers (Johnson and Cathcart, 1979; Lloyd, 1980). Johnson and Cathcart (1979, 270) are therefore clearly correct in arguing that ' the links between an established business and a new operation can be complex and

varied '.

Newness A further key element in any definition of a new firm is that such enterprises should be 'new', that is adding productive or service capacity to the economy. This feature is clearly implied in the definitions by Keeble (1976) and Gudgin (1978) which were

quoted earlier. But here again, close scrutiny of the new firms sector reveals that new

ness is not a straightforward issue and might also more appropriately be conceived as a spectrum. At one extreme, many new firms are certainly started from scratch with the founder gathering together the necessary factors of production in order to begin trading. The increasingly common phenomenon of the management buyout (Coyne and Wright, 1982), where the management team of a subsidiary company purchase it from the parent firm in order to run it as an independent enterprise, probably represents the other extreme. From a legal standpoint this development certainly results in the creation of a new company, although the only significant change is likely to have involved the ownership of the firm. Between these two extremes are situations

where a new firm is formed on the basis of buying-up an existing independent company which might be actively trading or could be in liquidation. In these circumstances new

ownership, new management and capital are injected into the enterprise. In short, as Brinkley and Nicholson (1979) point out, the creation of a new firm

in the legal sense does not always represent a significant recombination of resources.

But equally, some succession changes and turnabout situations, although based on

pre-existing legal entities, may be new firms in every other sense.

Conclusion New firm formation is by no means a clear-cut and unambiguous concept. Moreover, the definition of a new firm is not simply a research issue but also has considerable relevance for policy-makers. Recent government schemes to encourage new firm forma tion include precise definitions of the types of businesses that qualify for assistance.

Clearly, the definitions adopted will determine the numbers of eligible firms and may, in turn, influence the success of the measures. For example, the Business Start Up Scheme is a tax allowance for individuals subscribing in ordinary shares issued by new companies. In order to qualify, the investor must not be an employee, partner, share holder, director (unless unpaid) or otherwise 'connected' with the new company. To be eligible, the company must have been incorporated less than five years ago, must not have any subsidiaries or themselves be under the control of another company, must be engaged in manufacturing, retailing or wholesaling trades and must be involved in a bona fide new venture. Firms which take over part of the trade of another company are thus excluded (Finance Act 1981, c.35). These conditions prevent many new firms



Some definitional diffwulties in new firms research 59

and potential investors from benefiting under the scheme. In view of this it is perhaps not surprising that the early response has been disappointing (Financial Times, 1982b).

Similarly, the Small Workshops Scheme, introduced in March 1980, which gives a 100% capital allowance for expenditure on the construction of industrial buildings of 2,500 sq ft or less, is restricted to premises which are occupied by firms engaged in ' a trade which consists in the manufacture of goods or materials or the subjection of goods or materials to any process' (Department of Industry, 1982, 7). But as noted earlier, it is not always possible to identify new firms in this way; many change their activities from month to month, others undergo a transition in output, while some sub contract all their production. Investors have therefore been concerned not to let their premises to otherwise satisfactory tenants for fear that they will lose their capital allowance if, in due course, the tax inspectors do not classify them as manufacturing trades. Consequently, many of the small workshop premises built under the scheme have remained vacant for long periods as landlords waited for tenants with the 'right '

qualifications (Department of Industry, 1982). One estate agent recently estimated that 65% to 70% of potential tenants have been turned away because they do not qualify under the scheme (Financial Times, 1982c). The 1982 Budget has widened the eligibi lity rules to include maintenance, repair, storage and warehousing activities, provided that the goods and services are connected with an acceptable industrial process, but this modest amendment seems unlikely to have any appreciable impact on the numbers of firms able to benefit under the scheme (Financial Times, 1982d).

This paper has not attempted to suggest a 'correct' definition of a new firm for use by researchers and policy makers; indeed, a 'correct' definition does not exist. Rather, its intention has simply been to highlight areas where the definitional problems are particularly evident and to demonstrate that different definitions can markedly alter both the number of new firms identified in any time-period and also the characteristics of the resulting 'population

` of such enterprises. Two implications follow from this.

First, it is essential to ensure that similar definitions have been used when any attempt is made to compare the results of independently-conducted surveys of new firm forma tion. Secondly, every study of new firms should contain an explicit statement of the definitions used in order to facilitate the interpretation of its findings.

Acknowledgement The survey of new manufacturing firms in South Hampshire was undertaken while in receipt of SSRC Grant HR 6796.

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60 Some definitional diffwulties in new firms research

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and Reg. Devel. Stud., Univ. of Newcastle-upon-Tyne, Disc. Pap. 11

Johnson, P. S. and Apps, R. (1979) 'Interlocking directorates among the UK's largest companies',

Anti-Trust Bull. 24, 357-69 Johnson, P. S. and Cathcart, D. G. (1979) 'New manufacturing firms and regional development: some

evidence from the Northern Region', Reg. Stud. 13, 269-80

Keeble, D. (1976) Industrial location and planning in the United Kingdom (London) Lloyd, P. E. (1980) 'New manufacturing enterprises in Greater Manchester and Merseyside', North West

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studies and public policy implications ', paper to Conf. on Technol. and Product Licensing for the Small

and Medium Sized Firm, Univ. of Bath Mason, C. M. (1982) 'New manufacturing firms in South Hampshire: survey results', Geogr. Dept., Univ.

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Pounce, R. J. (1981) Industrial movement in the United Kingdom, 1966-1975 (London) Scase, R. and Goffee, R. (1980) The real world of the small business owner (London)

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Industrial decline and regeneration Industrial decline and regeneration is the proceedings of the Anglo-Canadian Symposium held in Edinburgh in 1981 and organised by the Industrial Activity and Area Development Study Group. It is produced with a soft cover, has 300 pages and is numbered ISBN 0 900475 04 8. The cost is ?5 00 plus ? 1 .50 package and post. Cheques should be made payable to the Department of Geography, University of Edinburgh. All enquiries should be made to L. Collins, Department of Geography, University of Edinburgh, Drummond St., Edinburgh EH8 9XP.



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