Monthly Archives: Февраль 2014

Internationalisation and the small business

Kevin Ibeh

24.1 Introduction

This chapter is concerned with internationalisation of small and medium-sized enter­prises (SMEs). It starts with some reflections on the now-established status of SMEs as international market actors and the economic and technological imperatives that have driven policy making and research on SMEs’ internationalisation since the 1970s. It next considers theories of smaller firm internationalisation, covering such relevant approaches as the incremental internationalisation models, the network theories, and the arguably integrative resource-based perspectives. Further discussions centre on the factors that stimulate SMEs’ internationalisation; the range and variety of barriers that impede them from so doing; the decision-maker and firm-specific characteristics that enhance the likelihood of successful internationalisation among SMEs; and the policy initiatives for assisting the internationalisation of SMEs across OECD countries.

24.2 Learning objectives

This chapter has five learning objectives:

1 To explain internationalisation and discuss the various ways in which it can be attained.

2 To appreciate the changing face of SME internationalisation, including its under­lying dynamics.

3 To present the major theories for explaining SME internationalisation and identify the critical decision-maker, firm and environmental influences on the phenomenon.

4 To examine the major barriers and problems that impinge upon SME internation­alisation.

5 To review the policy measures and institutional mechanisms commonly employed to assist SME internationalisation and make relevant recommendations.

Key concepts

■ internationalisation process ■ ‘stages’ ■ networks ■ resource base ■ barriers

■ policies

24.3 Internationalisation

Firm-level internationalisation has witnessed a phenomenal level of growth since the latter part of the twentieth century. Driven largely by the remarkable, and even revolu­tionary, changes in their external environments, companies, large and small, have increasingly embraced the international growth path as a way of leveraging techno­logical, organisational and inter-organisational resources, and reducing business costs and risks (Ibeh, 2000; Royer, 2004). SMEs are not insignificant actors in this chang­ing landscape. As recent OECD findings suggest, internationalised SMEs account for about 25-35% of world’s manufactured exports, with their export contribution to GDP representing 4-6% for OECD countries and 12% for Asian economies (OECD, 1997a).

This seems very different from the period, not too long ago, when internationalisa­tion was regarded as the domain of large corporations. Based on their presumed lack of internationalisation potential, small firms were largely ignored by most governments, policy makers and researchers, seeking to promote national economic position through greater firm-level internationalisation. This explains why the dominant theories and models of internationalisation — product life-cycle, market imperfection, internalisation/ transaction cost and the eclectic paradigm — have an essentially multinational enter­prise (MNE) focus, explaining the conditions under which MNEs extend and establish their activities, particularly production, overseas.

The serious difficulties experienced by western MNEs during the 1970s and early 1980s, and the knock-on effects on their national economies, however, served to expose the weakness of this exclusive reliance on the large firm. Assailed by such developments as the oil crisis of 1973-74, depressed global demand, intense international competi­tion from Japan and the newly industrialising countries, and revolutionary new tech­nologies, western MNEs lost their grip on world trade and were forced into plant closures, down-sizing and process re-engineering. Their governments soon reacted with massive programmes of de-regulation and privatisation. From the ashes of resulting redundancies, however, emerged many new small firms — their formation fuelled by rising trends in outsourcing, greater demand for services, and microelectronics (Bell, 1995). Subsequent evidence of the small-firm sector’s economic contribution was reported in a number of studies, notably the Bolton Commission’s (1971) in the UK; Birch’s (1979, 1981) in the US; and Storey and Johnson’s (1987) in the European Community.

Concerns were, however, expressed about the disproportionate under-representation of small firms in the international market. Cannon and Willis (1983), for example, observed that while small firms accounted for nearly 25% of the UK’s gross national product, they contributed less than 10% of all manufactured exports. Even more insightful was the indication that a significant proportion of SMEs with exporting potential had restricted themselves to domestic operations, in the erroneous ‘belief that size is an insuperable disadvantage’ in internationalisation (Bolton, 1971). It was hardly surprising, therefore, that policy makers, faced with burgeoning trade deficits and an inert large firm sector, would begin to focus on developing the little-tapped export potential of smaller firms (Bell, 1995). This favourable policy climate transformed SME internationalisation into an important area of inquiry — a situation that has continued to date.

24.4 Concepts, context and extent

The term ‘internationalisation’ commonly refers to the process of increasing involve­ment in international operations (Welch and Luostarinen, 1988; Bell et al., 2004). It describes the continuum that stretches from the firm’s first import activity or extra — regional expansion or domestic internationalisation to full globalisation (Wiedersheim — Paul et al., 1978; Luostarinen, 1994). Full company globalisation is characterised by the establishment of manufacturing plants and marketing affiliates across major inter­national regions; extensive outsourcing of inputs and marketing of outputs across bor­ders; and worldwide integration and coordination of resources and operations in pursuit of global competitiveness. Sometimes used interchangeably with globalisation (its most evolved form), internationalisation is attained through a variety of international mar­ket entry and development modes (Young, 1990). These include: direct and indirect exporting; licensing; franchising; management contract; turn-key contract; contract manufacturing/international sub-contracting; industrial cooperation agreements; con­tractual joint venture; equity joint venture; strategic alliances; mergers and acquisitions; and wholly owned subsidiaries.

A number of authors have tried to classify internationalisation modes. This chapter employs Luostarinen’s (1980) approach, whose distinctions between home and overseas production, and direct and non-direct investments, offer useful insights into under­standing SME versus large firm internationalisation. In general terms, the progression from home-based internationalisation modes to overseas production modes, and from non-direct investment modes to direct investment modes, is marked by increased resource commitments/transfer and risks. Given their obvious resource (financial and managerial) and attitudinal (to risk/control) differences, small and large firms have tended to adopt divergent internationalisation modes. Indeed, SMEs are more likely to supply their international markets from domestic production bases (through indirect and direct exporting, and sales/service subsidiaries). This explains why the bulk of the literature on SME internationalisation originates from exporting research.

According to a recent report (OECD, 1997), SMEs’ share of export in each of the surveyed OECD and Asian economies ranges between 15% and 50%, with 20% and 80% being active exporters (Table 24.1). In general, SME internationalisation is greater in small, open economies and less in larger, more self-contained economies. This, however, is not always the case. France and Italy still have 30% and 70% of exports respectively contributed by SMEs, while internationalisation in small, open economies like Australia, Malaysia and Greece is less than might be expected (OECD, 1997).

That SMEs are not restricting their internationalisation forays to exporting, how­ever, is evident in the rising trend towards small firms’ adoption of more direct forms of international marketing, including low-level foreign direct investments (FDI), strategic alliances, licensing, joint ventures and similar cooperation-based modes (Young, 1987; Dimitratos et al., 2003). A recent study (OECD, 1997) indicates the extent of SME internationalisation thus:

About 10% of SMEs are engaged in FDI and about 10% or more foreign investment appear to be attributable to SMEs. Around 10 to 15% of SMEs have licences, franchises or other arrangements with firms outside their home country… It is estimated that about 1% or less

Table 24.1 Estimates of the extent of SME internationalisation

Exports from SMEs (%)

Percentage of SMEs exporting

Notes

Australia

n. a.

5 to 10

0-100 employees

Belgium

20

0-500 employees

Canada

14

5-200 employees

Denmark

46

<500 employees

Finland

23

France

M 26

Greece

n. a.

n. a.

SME exports as % of

industry turnover = 15-20%

Ireland

25

Italy

52.7

<500 employees

68

51-100 employees

80

101-300 employees

83

301-500 employees

Japan

13.5

<300 direct

30-35

<300 indirect

Netherlands

26

<100 indirect + direct

17

0-9 employees

43

10-99 employees

67

100+ employees

Portugal

No figures available

Spain

18

<20 employees

50

51-100 employees

70

101-200 employees

Sweden

36

<200 employees

Switzerland

40

UK

16-20

US

11

12

China

40-60

Republic of Korea

40

Indonesia

10.6

Chinese Taipei

56

Thailand

10

Malaysia

15

Singapore

16

Vietnam

20

Source: OECD (1997a)

of SMEs (30,000 to 40,000) can be said to be global, in the sense of being active in multiple countries and/or across several continents, or having the ability to operate wherever they see fit. . . another 5 to 10 % of SMEs in manufacturing. . . can be said to be extensively inter­nationalised. . . (with) a further 10 to 20% . . . active in up to three foreign countries.

These internationally active SMEs are growing faster than their domestic counter­parts. Those in niche markets and new (including high-tech) industries constitute the fastest-growing segment (20%), while those in traditional industries (around 50%) internationalise incrementally via exporting. It would, indeed, appear that most SMEs now see internationalisation as not only fashionable but imperative. This is based on the realisation that pressures from inward internationalisation are likely to be most unkind to firms that stand still and are not internationally active. As the OECD (1997) reports, probably less than 40% of SMEs are insulated from any effects of globalisa­tion and the proportion of such firms (mainly small service providers) is expected to contract further to 20%. This does not imply that service firms are not active interna­tionally. Many play an increasingly important international role (Erramilli and Rao, 1990; Sharma, 1993; Hellman, 1996), although measurement difficulties prevent an overall picture of the extent of service SMEs’ internationalisation. It should be noted, nevertheless, that the easily measured physical manufactured exports are often accom­panied by significant international SME service activity, including customer service, design, distribution, marketing, etc. (OECD, 1997).

24.5 Explaining SME internationalisation

Firm internationalisation has been studied from both the perspective of export devel­opment (involving mostly SMEs) and the emergence of the MNEs (Bell and Young, 1998). Focusing on SME internationalisation, four theoretical approaches can be identified:

■ incremental internationalisation (or stage of development) models,

■ network theory,

■ resource-based perspectives (incorporating business strategy, contingency and inter­national entrepreneurship perspectives).

24.5.1 Incremental internationalisation (or stage of development) models

A number of ‘stage’ models have emerged to explain the process of a firm’s develop­ment along the internationalisation route. Common to all these models is the view of export development as a sequential, ‘staged’ process. All have their roots in the behavioural theory of the firm (Cyert and March, 1963) and Penrose’s (1959) theory of the growth of the firm. According to the ‘stage’ theorists, firms adopt an incremental, evolutionary approach to foreign markets, gradually deepening their commitment and investment as they gain in international market knowledge and experience (Johanson and Vahlne, 1977, 1990). Firms are also believed to target neighbouring, ‘psychically close’ countries initially, and subsequently enter foreign markets with successively larger psychic distance. Psychic distance refers to extent of proximity in geography, language, culture, political systems and business factors like industry structure and competitive environment (Zafarullah et al., 1998).

Pioneering this approach was Johanson and Vahlne’s (1977) model of knowledge development and increasing foreign market commitment, which built on Johanson and Wiedersham-Paul’s (1978) study of the internationalisation behaviour of four Swedish firms from their early beginnings. They found that the internationalisation process was the consequence of a series of incremental decisions, rather than large, spectacular foreign investments. Four different stages were identified in relation to a firm’s inter­national involvement: no regular export; export via independent representation (agents); sales subsidiaries; production/manufacturing. As Johanson and Vahlne (1990) stated: ‘the firm’s engagement in a specific foreign market develops according to an establish­ment chain, i. e. at the start no export activities are performed in the market, then export takes place via independent representatives, later through a sales subsidiary, and, even­tually manufacturing may follow’.

A further dimension was added to the internationalisation process model by Wiedersheim-Paul’s et al. (1978) work on pre-export behaviour, which extended the establishment chain backwards to include a pre-export stage. Export start was found to be influenced by the interplay between ‘attention-evoking factors’ and the individual decision maker, and the environment and history of the firm, including experience in extra-regional expansion (domestic internationalisation). Thus, the establishment-chain model attempts to explain the whole process of a firm’s internationalisation, from the pre-export stage to post-export stage, including FDI.

Cognisance should be taken of the differences in perspectives adopted by these ‘stage theorists’. Anderson (1993) for example, distinguished between the ‘Uppsala internationalisation (U) models’ and ‘innovation-related (I) models’. While the former clearly refers to the models that emerged from a Swedish school of that description, the composition of the latter is not so clear. It seems appropriate, however, to include as innovation-related models those works that present export development as an innovation-adoption cycle (Lee and Brasch, 1978; Reid, 1981) and those that see it as a ‘learning curve’, influenced by external attention-evoking stimuli (e. g. unsolicited orders or enquiries) and internal factors, such as managerial ambitions and excess capacity (Bilkey and Tesar, 1977; Cavusgil, 1980; Czinkota and Johnston, 1982; Crick, 1995). The actual number of ‘stages’ undergone by internationalising firms also differs according to models, but this, as observed by Anderson (1993), ‘reflects semantic dif­ferences rather than real differences concerning the nature of the internationalisation process’. Anderson’s (1993) major criticisms, however, are ‘the lack of proper design to explain the development process’, the absence of clear-cut boundaries between stages, and the lack of ‘tests of validity and reliability’.

The incremental internationalisation models have also been faulted on grounds of limited applicability. Indeed, many studies involving firms from small domestic mar­kets, service firms, high-technology firms, knowledge-intensive firms, entrepreneurial firms, subcontractors and international new ventures have reported evidence that counter the incremental approach (e. g. see Bell, 1995; Etemad, 2004). As Bell (1995) explains, stage theories use linear models to explain dynamic, interactive, non-linear behaviour. Clark et al. (1997) observed that the establishment model was one of several paths to FDI, noting that ‘firms often bypass the intermediate stages to FDI’. The remarks by Bell and Young (1998) that the incremental internationalisation models merely identify the internationalisation patterns of certain firms, but not of others, and that they fail to explain adequately the processes involved seem to reflect the consensus position on the topic. Madsen and Servais (1997) sought to clarify the situation by categorising internationalising firms into three. First, the traditional exporters whose internationalisation patterns largely reflect the traditional stages model; second, firms that leapfrog some stages, for example late starters that have only domestic sales for many years, but then suddenly invest in a distant foreign market; and third, the born global firms. Suffice it to say that ‘the stages theory has merit in its use as a framework for classification purposes rather than for an understanding of the internationalisation process’ (Turnbull, 1987).

Findings supportive of the ‘psychic distance’ concept have been reported in a variety of studies, including Styles and Ambler’s (1994) research, which concluded that ‘firms should focus on those countries which are closest in ‘psychic distance’ for early export endeavours’. There have, however, been refutations of the psychic distance concept, most notably by Czinkota and Ursic (1987) and, to a lesser degree, by the ‘network school’ (Johanson and Mattsson, 1988). The latter ascribes limited relevance to the concept in the face of vastly improving global communications and transportation infrastructures, as well as increasing market convergence. Evidence of ‘client follower­ship’ has also been reported (Bell, 1995), which is inconsistent with the ‘intuitive logic’ (Sullivan and Bauerschmidt, 1990) of the psychic distance concept. O’Grady and Lane’s Canadian study further identified a ‘psychic distance paradox’: operations in psychically close countries are not necessarily easy to manage, because assumptions of similarity can prevent executives from learning about critical differences (O’Grady and Lane, 1996).

Despite valid criticisms, the stage of development perspective remains a significant contribution to the understanding of SME internationalisation. Prior to its emergence, internationalisation was essentially theorised and discussed in terms of the MNE. It is also the case that its focus on initial internationalisation attracted considerable research attention and illumination to SME internationalisation, extending even to the pre-export stage. The postulations on psychic distance may now appear dated, given recent advancements in IT, but few would disagree that they resonate with the market selection pattern intuitively associated with exporters (Madsen and Servais, 1997). Criticisms of the model, based on its failure to reflect the internationalisation beha­viour of entrepreneurial, high-technology, knowledge-intensive and service firms, are acknowledged. Nevertheless, most studies involving firms in mature industries have been consistent in supporting the model’s basic propositions.

24.5.2 Network theory

Another significant strand of internationalisation research was the development, from international industrial marketing, of the network or interaction and relationship con­cepts. The basic tenet is that internationalisation proceeds through an interplay between increasing commitment to, and evolving knowledge about, foreign markets, gained mainly from interactions in the foreign markets. These interactions — dynamic, evolving, less-structured — yield increased mutual knowledge and trust between international market actors and, subsequently, greater internationalisation commitment. In summary, ‘a firm begins the export process by forming relationships that will deliver experiential knowledge about a market, and then commits resources in accordance with the degree of experiential knowledge it progressively gains from these relationships’ (Styles and Ambler, 1994).

In network theory, markets are seen as a system of relationships among a number of players including customers, suppliers, competitors, family, friends and private and public support agencies. Strategic action, therefore, is rarely limited to a single firm, and the nature of relationships established with others in the market influences and often dictates future strategic options. For example, firms can expand from domestic to inter­national markets through existing relationships that offer contacts and help to develop new partners and positions in new markets. At the same time, network relationships may restrict the nature of a firm’s growth initiatives.

Internationalisation driven by customer/client followership, or what Hellman (1996) referred to as ‘customer driven internationalisation’, has been seen in service, high — technology and knowledge-intensive sectors (Bell et al., 2004; Ibeh et al., 2004). As observed by Johanson and Mattsson (1988), a firm’s success in entering new inter­national markets is more dependent on its relationships with current markets, both domestic and international, than it is on the chosen market and its cultural character­istics. This subtle shift from the core Uppsala internationalisation model (the psychic distance concept) was further endorsed by Johanson and Vahlne’s (1992) remarks that many firms enter new foreign markets almost blindly, propelled not by strategic decisions or market research, but social exchange processes, interactions, and networks.

A growing body of evidence exists on the role of network relationships in SME inter­nationalisation. Coviello and Munro (1995, 1997), for example, found that successful New Zealand based software firms are actively involved in international networks, and that they outsource many market development activities to network partners. As they observed, ‘the network perspective goes beyond the models of incremental interna­tionalisation by suggesting that firm’s strategy emerges as a pattern of behaviour influ­enced by a variety of network relationships’. Coviello and Munro’s evidence, while supportive of network theory, recognised the occurrence of internationalisation stages, albeit in a much condensed and accelerated form. This attempt to reconcile the network perspective with the work of the stage theorists and the ‘international new venture’ scholars also formed the substance of Madsen and Servais’ (1997) theory-building effort.

There is no doubt that the network perspective has brought immense value to the understanding of the internationalisation process, particularly among SMEs. It pre­sents a view of SME internationalisation that should be seen more as a complement than an alternative to the incremental internationalisation model. More importantly, it moves discussion away from the largely sterile debate, which, until recently, raged for and against the Uppsala model. It can, arguably, be credited with stimulating recent efforts being made towards a more holistic view of small firm internationalisation (Madsen and Servais, 1997; Bell and Young, 1998; Ibeh, 2001; Bell et al., 2003). It is to this emerging perspective that the discussion now turns.

24.5.3 Resource-based perspectives (business strategy, contingency and international entrepreneurship perspectives)

A major recent development in the SME internationalisation research has been the increasing adoption of the resource-based theory as an integrative platform for explain­ing firm-level internationalisation (Bell and Young, 1998; Peng 2001; Ibeh, 2001, 2005). As Bell and Young (1998) explained, ‘the resource-based perspective presents a holistic view of the firm’, such that decisions on country market choice, mode of entry, and product strategies are made not on a stand-alone basis, but within a coordinated framework of resources and capabilities (whether internal or externally leveraged), as well as environmental (including competitive) realities. They elaborated that ‘firms will have a different mix of resources/competencies and resource/competence gaps, and their strategic responses to these allow for the possibility of different paths to growth and internationalisation’. It could be argued that the resource-based theory of inter­nationalisation is actually a more grounded restatement of the business strategy and contingency frameworks. It would appear to have met the need ‘to root contingency frameworks within an underlying theory’. As its proponents observe, there is a close relationship with contingency approaches, which are designed to show the influence of a range of internal and external variables. This perspective is equally implicit in the business strategy frameworks and the recent work on international entrepreneurship.

The business strategy perspective proposes a strategically planned, rational approach to internationalisation, such that decisions on foreign-market entry and servicing strategies (entry mode) are made in the context of the firm’s overall strategic develop­ment, and guided by rigorous analysis of relevant internal and external environmental factors (Young, 1987; Young et al., 1989). This is consistent with Chandler’s (1962) view that ‘structure follows strategy’. It also reflects the Turnbull et al. (1987) conclu­sion that a company’s stage of internationalisation is largely determined by the operat­ing environment, industry structure and its own marketing strategy. The business strategy perspective is implicit in much of the mainstream export literature, notably Aaby and Slater’s (1989) model (widely referred to as the ‘strategic export model’); Namiki’s (1994) taxonomic analysis of export marketing strategy; Cavusgil and Zou’s (1994) path analysis of export marketing strategy and performance, as well as Reid’s contingency framework (Reid, 1983a).

The contingency approach to internationalisation views foreign expansion and export mode choice as severally influenced and situation-dependent. Reid (1983a) argued that: ‘since exporting results from a choice among competing strategies that are guided by the nature of the market opportunity, firm resources and managerial philosophy, it represents a selective and dynamic adaptation to the changing character of the foreign market. . . Market factors and requirements are, therefore, closely intertwined with deciding whether to go international and what form this expansion should take’. Reid (1983b, 1985) further employed the economics-orientated transaction cost theory to explain firms’ export mode decisions as dependent on the costs involved in initiat­ing, negotiating and coordinating export transactions, reflecting Williamson’s (1975) observation that transactional considerations are ‘typically decisive in determining which mode of organisation will obtain in what circumstances, and why’.

International entrepreneurship researchers have generally sought to explain the beha­viour of such recently identified firm categories as ‘born globals’, ‘global start-ups’, ‘international new ventures’, ‘born internationals’, ‘rapidly internationalising firms’, ‘committed internationalists’ and ‘micromultinationals’, by highlighting the quality of their knowledge assets (including the knowledge and experiential resources embedded in their top management), internationally focused entrepreneurial orientation, privileged access to network resources, social capital, and other market-based assets, among others (Oviatt and McDougall, 1994a, 1994b; Bell, 1995; Knight and Cavusgil, 1996; Madsen and Servais, 1997; Jones, 1999; Dimitratos et al., 2003; Etemad, 2004; Ibeh,

Young and Lin 2004; Ibeh, Johnson, Dimitratos and Slow, 2004; Zahra, 2004). Accord­ing to this emerging literature, firms, including SMEs, would seem to have become more entrepreneurial and sophisticated with regard to their appreciation of interna­tional growth opportunities and feasible entry mode options; this has, thus, resulted in a faster pace of internationalisation (rapid internationalising firms) and more ambiti­ous entry mode selection behaviour (micromultinationals).

A common denominator of these frameworks is the recognition that international­isation is affected by multiple influences and that a range of the firms’ international­isation decisions, incorporating products, markets and entry modes, are made in a holistic way. There appears to be an increasing realisation of this extended base of internationalisation parameters. This is apparent in the emerging trend towards a more inclusive and holistic explanation of firm (particularly small firm) internationalisation. Having identified partial and situational relevance for each of the existing interna­tionalisation models, Bell and Young (1998) invited more attention to their ‘potential complementarities’. Researchers seem to have accepted this challenge. For example, Coviello and Munro’s (1997) study of New Zealand software SMEs reported evid­ence of incremental internationalisation, network-driven internationalisation, as well as accelerated internationalisation (international new ventures), similar to the range of propositions offered by Madsen and Servais (1997) in their conceptualisations on ‘born globals’. It will be interesting to see what other explanatory frameworks will emerge in the growing area of small firm internationalisation. Of more immediate relevance, however, is the role of internal (firm/decision maker) and external (environ­mental) factors that stage theorists, network scholars, resource-based theorists, business strategy and international entrepreneurship scholars have identified as significant to SMEs’ initial internationalisation decisions.

24.6 Stimulating internationalisation

To initiate and subsequently develop international activity, a firm must first be influ­enced by stimulating or ‘attention evoking’ factors. The nature of these stimuli may offer invaluable insights into why some SMEs successfully internationalise while others do not. Building on previous typologies of internationalisation stimuli, Albaum et al. (1994) identified the following four categories:

■ internal-proactive — factors associated with the SME’s own initiative to exploit its unique internal competencies (e. g. potential for export-led growth);

■ internal-reactive — responding to pressures from the internal environment (e. g. accu­mulation of unsold goods);

■ external-proactive — active exploitation by management of market possibilities (e. g. identification of better opportunities abroad);

■ external-reactive — reaction to factors from the external environment (e. g. receipt of unsolicited foreign orders).

Nevertheless, research on initial internationalisation suggests that stimuli are not suf­ficient on their own. They need to be supported by facilitating factors associated with the decision maker, the organisation and the environment. These factors constitute the real impetus behind the firm’s decision to go international.

24.6.1 Decision-maker characteristics

Decision-maker characteristics are generally considered to have, in Brooks and Rosson’s (1982) words, ‘a decided impact on export decision’. All the major review articles on empirical exporting research have similarly concluded on the decisive importance of decision-maker characteristics. As Reid (1981) noted, ‘empirical evidence points exclu­sively to the decision makers’ attitude, experience, motivation and expectations as pri­mary determinants in firms engaging in foreign marketing activity’. This is particularly so ‘in small firms, where power, particularly decision-making power, is generally con­centrated in the hands of one or very few persons’. According to Miesenbock (1988), ‘the key variable in small business internationalisation is the decision maker of the firm. He or she is the one to decide starting, ending and increasing international activ­ities’. Empirical findings on the specific decision-maker characteristics that increase the likelihood of SME internationalisation have, however, been inconsistent. This is par­ticularly true of findings on decision makers’ age and level of educational attainment. Garnier’s (1982) remarks that it was not possible to ascertain whether there were statistically significant differences between managers of internationalised and non­internationalised firms with respect to age and level of education would appear to reflect the available evidence.

With regard to international orientation, variously defined as foreign education or work experience, travel, foreign birth or world-mindedness (Boatler, 1994), the balance of empirical evidence is that decision makers of internationalised SMEs are likely to have spent part of their lives abroad, and are generally less affected by for­eign business-related uncertainties. Miesenbock (1988) concluded, from an extensive review of the literature, that ‘the external contacts of the decision maker seem to be the most important objective characteristic’. Closely related to international orientation is another characteristic that may be referred to as international ethnic ties or contact networks. There is growing evidence that decision makers whose contact networks (see Chapter 16) are internationally spread are more likely to exploit international market opportunities than those who lack such ties. Jackson (1981), indeed, found the Zionist links of British Jews to be significant in explaining the flow of Israeli exports into Britain. Further supportive evidence has been reported by Crick and Chaudhry (1995) and Zafarullah et al. (1998) in their respective studies of British-Asian and Pakistani SMEs (see Chapter 10).

Decision makers’ psychological traits are a further set of variables that have been widely studied. A large number of empirical findings have associated decision makers of internationalised SMEs with such characteristics as: favourable perception of ex­porting risks, costs, profits and growth; more positive attitudes towards exporting; aggressiveness and dynamism; flexibility; and self-confidence. As observed by Ford and Leonidou (1991), ‘firms with a decision maker perceiving risk in the export market as being lower versus risk in the domestic market, profits in the export market as being higher versus profits in the domestic market, and costs in the export market as being lower versus costs in the domestic market are more likely to become exporters’.

Nevertheless, as Miesenbock (1988) stated, ‘the explanatory power of psychologically — oriented research in internationalisation. . . (is) controversial’.

24.6.2 Firm characteristics and competencies

Very few issues in SME internationalisation research have as much empirical support as the positive link between management support, commitment, perceptions and attitude, and internationalisation behaviour. As Aaby and Slater (1989) remarked, ‘management commitment and management perceptions and attitudes towards export problems and incentives are good predictors of export (behaviour)’. Studies have also found a much higher propensity to internationalise (export) among firms with market (or organisational) planning or exploration. As Aaby and Slater (1989) concluded, ‘the implementation of a process for systematically exploring, analysing, and planning for export seems to be a very powerful discriminator between. . . exporters and non­exporters’.

Findings on the impact of firm size (whether measured by employee number, sales, ownership of capital equipment, financial capability or a combination of criteria) on internationalisation behaviour have been mixed, if not outright controversial. The balance of evidence, however, suggests the importance of size, particularly in initiating international activity. As a general rule, larger firms are more likely to internationalise than small firms. Beyond some point, however, exporting would appear not to be cor­related with size, a view corroborated by Withey’s (1980) critical mass of 20 employees for crossing the internationalisation threshold. Reid (1982) explained it thus: ‘absolute size using traditional indicators (assets, employees, functional specialisation and sales) predominantly affect. . . (small firms’) export entry’. The above standard does not, however, apply to SMEs in high-technology, knowledge-intensive and service sectors (Bell, 1994). Indeed, the use of e-commerce and online marketing via the web and Internet is increasingly removing whatever deterrence size brings to internationalisa­tion of SMEs, even in traditional industries (see Chapter 22).

The SME’s industry or product type has also been found to influence international market entry. As Tybejee (1994) remarked, industry membership, or the structural characteristics of the industry determine the conditions in which a firm competes and consequently its internationalisation. Garnier (1982), for example, in a study of Canadian printing and electrical industries, reported that ‘the most immediate cause of export(ing) … is the nature of the product or service offered by the exporting firm’. While SMEs in industries characterised by low skill level, low intrinsic value, bulkiness and high transportation costs are less likely to internationalise, those in sectors marked by short life-cycles are ‘motivated to accelerate their entry into the international mar­kets’ (Tybejee, 1994; McGuinness and Little, 1981). Another firm characteristic that appears to influence an SME’s internationalisation is its history, including previous experience of extra-regional expansion, importing experience or ‘inward internation­alisation’. Such experiences and attendant (networks) relationships have been found to be significant precursors of internationalisation.

Empirical studies on SME internationalisation have also underscored the import­ance of firm competencies. It has, indeed, been suggested that ‘firm competencies are probably more important than firm characteristics’ (Aaby and Slater, 1989). The specific dimensions of firm competency which, on balance, have been empirically supported include: technology intensity; research and development (R&D); systematic market research; product development; unique product attributes and quality; distri­bution, delivery and service quality; and advertising and sales promotion.

24.6.3 Characteristics of the firm’s environment

Relative to larger firms, SMEs tend to lack the necessary resources and political clout to control their operating environment. Empirical findings can broadly be categorised into two: those related to the firm’s domestic environment and those concerned with foreign (target) market attractiveness.

As observed by Miesenbock (1988), ‘the home country of the firm also determines the performed export behaviour’. The legal system ‘may facilitate (e. g. tax advantages in exporting) or complicate (e. g. foreign exchange regulations) international business. The same holds for infrastructure (e. g. distribution facilities or impediments).’ The Wiedersheim-Paul et al. (1978) model of pre-export behaviour and Garnier’s (1982) theoretical model of the export process in a small firm both reflect the impact of the domestic environment. The former suggests that firms’ location within an ‘enterprise environment’ facilitates an efficient exchange of information as well as creating ‘pos­sibilities for “contagion transmission” of ideas from other firms, in different stages of expansion’. Garnier (1982) also sees general characteristics of the environment as well as industry in which small firms operate as affecting their decision ‘to export or refrain from so doing’. Bilkey (1978) and Pavord and Bogart (1975) identified ‘adverse home market conditions’ as a push factor in export initiation, one example being ‘home mar­ket saturation’.

With respect to the foreign (target) market environment, studies have reported for­eign government-imposed barriers and poor infrastructure — road and telephone sys­tems — to be significant impediments to export market choice. Ford and Leonidou (1991) concluded that ‘firms producing products which have to be modified in order to conform with the rules and regulations of foreign governments. . . are less likely to become exporters’. Further discussions on these and related issues are undertaken in the next section on internationalisation barriers and problems.

24.7 Barriers in SME internationalisation

This section reviews empirical evidence on the obstacles that confront SMEs at dif­ferent stages in the internationalisation process, including the export initiation stage. Leonidou (1995) defined export barriers as ‘all those attitudinal, structural, opera­tional and other constraints that hinder the firm’s ability to initiate, develop or sustain international operations’. Different classificatory schemes have been used in the litera­ture with respect to these problems. In an extensive review of export barrier research, Leonidou (1995) combined his earlier framework with Cavusgil’s (1984) into a ‘two­dimensional export barrier schema’ (Kaleka and Katsikeas, 1995). This identified four categories of problems:

■ internal-domestic

■ internal-foreign

■ external-domestic

■ external-foreign.

24.7.1 Internal-domestic

These problems encompass obstacles emanating from within the firm, and relating to its home country environment. They include: the lack of personnel with requisite infor­mation and knowledge about export marketing, including expertise in handling such problems as foreign government regulations; negative perceptions of risks involved in selling abroad; and management emphasis on developing domestic market activities, particularly large-sized domestic markets.

24.7.2 Internal-foreign

These problems arise mainly from the SME’s limited marketing ability and are experi­enced in the foreign (target) market environment. For some SMEs, international mar­ket entry is inhibited if product modifications are required to meet foreign safety or health standards or customers’ specifications. As Moini (1997) remarked, ‘adapting a product to foreign standards may require a large initial investment which many non­exporters lack’. Similar difficulties have also been reported with regard to providing repair and technical services, pricing as well as communicating with overseas customers. Other typical obstacles here include both high transportation cost and transportation, service and delivery-related difficulties.

24.7.3 External-domestic

These problems emanate from the SME’s domestic environment, but are typically beyond its control. Among the most cited obstacles in this category are the vast amount of time and complex documentation involved in international marketing. Also often reported is the absence of adequate government support — incentives and infrastruc­tural — to overcome internationalisation barriers and the lack of reasonable access to (or prohibitive cost of) capital needed to finance internationalisation.

24.7.4 External-foreign

These problems originate from outside the SME and are typically experienced in the international markets. Several studies have reported on the inhibiting impact of foreign government-imposed restrictions, including exchange rate, import and tariff regulations. Equally problematic for the SME is the development of reliable overseas contacts/ distributors/representatives, including the overcoming of language and cultural differ­ences. Other often-cited internationalisation barriers in this category are the intensity of competition in international markets or SME’s lack of price competitiveness and the difficulties of getting payments.

The nature of a firm’s response to these obstacles depends broadly on the back­ground decision-maker and firm characteristics, specifically organisational size, inter­national business experience, international market research orientation and export involvement. Inexperienced exporters, relative to regular exporters, perceived strict import quotas and confusing import regulations as much more important in hindering their entry into the Japanese market (Namiki, 1988). Marginal exporters, compared with their more active counterparts, have significantly different perceptions of shipping complexity, uncertainty of shipping cost and complexity of trade documentation. Similar conclusions were reached by Tesar and Tarleton (1982) in respect of passive and aggressive exporters among their Wisconsin and Virginia sample; and Bell (1997) with regard to occasional, frequent and aggressive exporters.

It appears, also, that firms at different stages of internationalisation face problems of differing types and severity (Bell, 1997; Bilkey, 1978; Bilkey and Tesar, 1977). A three-nation study by Bell (1997), for example, reported that while ‘finance-related problems often intensify with increased international exposure . . . marketing-related factors tend to decline as firms become more active in export markets’.

24.8 Policy and institutional support for SME internationalisation

This section highlights the existing policy frameworks and support programmes that underpin SME internationalisation in most OECD countries. Currently used measures can be classified into direct and indirect, in terms of whether they are specifically designed for export development, or with a general aim of enhancing SME overall competitiveness — internationalisation benefits being only implied (Bell, 1994). As observed by Seringhaus and Rosson (1991), direct assistance encapsulates ‘an array of programmes that range from awareness-creating, interest-stimulating, research support, export preparation, export market entry, to export market development and expansion — focused activities’. These have been categorised broadly by Crick and Czinkota (1995) into export service programmes (e. g. seminars for potential exporters, export consult­ancy and export financing) and market development programmes (e. g. dissemination of sales leads to local firms, participation in trade shows and preparation of market analyses). Indirect assistance extends to those aspects described as economic infrastruc­ture (Owualah, 1987), whether hardware (financial, fiscal, and plant and machinery leasing) or software (training, advice and information). They are generally aimed at effecting structural and process change within companies (Seringhaus and Rosson, 1991) and are often integrated into the industrial policy implemented by various gov­ernments at central and/or regional levels (Bell, 1994). Such programmes also, increas­ingly, seek to facilitate the adoption of innovative new technologies and best practices (including networking) among firms. Programmes of direct and indirect support include

■ providing access to foreign market information;

■ providing some form of financial assistance (export credit or foreign investment guarantees, venture capital, grants and subsidies);

■ improving SMEs’ capability through management advisory services and help with R&D and technology;

■ providing SMEs with a better business environment, by facilitating networking and sub-contracting arrangements and offering simplified, one-stop assistance units, industrial parks and arbitration assistance.

Importantly, the extent of involvement of the government and the private sector in actual support provision varies between countries. While government involvement appears to be dominant in countries such as the UK, Ireland and Canada, others like Finland, Denmark and Germany tend to emphasise private sector leadership in support provision. Yet, a few others, notably France, The Netherlands and Austria, seem to provide highly rated support at both public and private sector levels. Granted that no firm conclusions have been reached regarding the relative merits of public versus quasi­public sector support mechanisms (Bell, 1997), it is safe to suggest that ‘delivery sys­tems that make use of existing and potential private sector activities are more likely to be cost-effective’ (OECD, 1997a).

Despite the sophistication and comprehensiveness of policy measures available in advanced (as well as developing) economies, empirical findings on SMEs’ level of awareness, usage and satisfaction with these programmes have been generally negative. This highlights the challenging nature of the task of seeking to improve SME interna­tionalisation policy — a task the concluding section attempts to address.

24.9 Chapter summary

It would appear from the unremitting pressures of globalisation drivers that the trend towards SME internationalisation can only intensify. The OECD’s (1997a) prognosis of a continuing shrinkage in the percentage of SMEs insulated from (inward) globalisa­tion effects implies also that SMEs that ignore internationalisation realities risk losing their competitiveness. This makes it even more imperative that as many SMEs as pos­sible are given whatever support is necessary to encourage their internationalisation.

A consensus appears to have emerged among academic researchers and policy makers that SMEs negotiate varying paths to internationalisation. Having been exten­sively and successfully challenged, the ‘stage’ approach would seem to have lost its traditional hegemony to a more inclusive, integrative view of SME internationalisa­tion. This perspective, recently articulated by Bell and Young (1998), presents extant frameworks — incremental models; network-driven, including the accelerated ‘born internationals’ perspective; and the rationalistic strategy/resource-based models — as complementary rather than competing explanations. It is now clear that while some SMEs internationalise in an incremental manner, others accelerate through the process, driven possibly by their existing network relationships or entrepreneurial factors, and yet others adopt a rational, strategy-based process involving some consideration of relevant internal and external factors. Thus, it behoves policy makers to seek greater understanding of SMEs as the objects of their policy measures. Such an understanding should inform the segmentation of these SMEs for policy-making purposes and sub­sequently lead to needs-based targeting of appropriate assistance and support.

The idea of segmenting assistance targets is not new in the literature and is integral to the much-criticised stage models. What should, perhaps, be new is the rethinking of the segmentation framework, such that the ‘stage-by-stage’ approach is seen, not as the way, but as one of the ways to internationalise — across a spectrum that includes network — driven, including accelerated internationalisation as well as strategy/resource-based internationalisation. Hopefully, this perspective would translate to a broadening of the focus of programmes supporting SME internationalisation beyond their traditional exporting emphasis (Bell, 1994). Whatever the approach taken, policy makers should recognise the existence of different internationalisation pathways. For incrementally inclined firms, usual methods of assistance targeting based on stages of international­isation may be appropriate. SMEs at lower stages may need intensive information support and one-to-one counselling to nudge them along their learning curve, while those at more advanced stages may require more experiential-type knowledge and per­haps assistance aimed at easing the financial obstacles facing foreign target customers (Crick and Czinkota, 1995). Proper acknowledgement of the reality of accelerated internationalisation should imply, for example, programmes of support for network building and activation among SMEs. Existing efforts in this direction, at industry, national and regional levels, should be strengthened. It seems appropriate, also, to widen the assistance programmes on offer to reflect a more diversified mix of interna­tionalisation possibilities than is currently the case, such that SMEs who wish to estab­lish joint venture operations overseas or engage in strategic alliances, or even acquire a production plant abroad, would find requisite support and encouragement. Given also the widely appreciated opportunities offered by e-commerce and online marketing, SMEs should be sensitised and supported with appropriate training and consultancy to optimise the benefits of Internet-based internationalisation.

To target SMEs and their decision makers effectively with the appropriate competence-enhancing support, it may be useful to employ a classification scheme built around their current characteristics and competencies, thus: internationalised entrepre­neurial firms; internationalised less entrepreneurial firms; non-internationalised entre­preneurial firms; and less internationalised non-entrepreneurial firms (see Figure 24.1).

For the non-internationalised, less entrepreneurial SMEs, the focus should be on improving the entrepreneurial and international orientation of their key decision maker(s) through seminars and workshops, export information provision, sponsorship to trade fairs, and ‘experiential knowledge assistance programmes’ (Knight et al., 2003). This should also involve introducing an external agent (Wiedersheim-Paul et al., 1978) on a part-time or consultancy basis. Ideally, non-internationalised SMEs, lacking in entrepreneurial orientation, should be assisted in the search for, and employment of, managers with requisite profiles: experienced, internationally orientated and connected decision makers. Other measures that may be useful here include encouraging net­working and linking them with foreign customers. The latter could be particularly crucial given the strength of empirical evidence on the impact of unsolicited orders from abroad in stimulating initial internationalisation.

As the name indicates, non-internationalised entrepreneurial SMEs have not yet internationalised but appear to have the right entrepreneurial disposition to do so. This category of firm, by definition, is likely to have top management or key decision mak­ers with the requisite characteristics. Their resource gap may arise from any areas of firm competencies — product quality and technology, market intelligence or intermedi­aries’ network. These areas of resource slack would have to be addressed in order to

Figure 24.1 Recommendations to assist SME internationalisation by SME categories

Entrepreneurial Less entrepreneurial

[IV]

Encourage best practices — R&D, IT, innovation Facilitate participation in network structures Mitigate operational problems: assist foreign customers, ease market access, etc.

[III]

Seek positive reinforcement Deploy liaison officer/problem­solver

Encourage networking; export clubs

Establish mentoring scheme

[II]

Assist to redress competency gap

Provide consultancy support and training

Ease access to available support Introduce mentoring scheme Encourage best practices — R&D, IT, innovation, networking

[1]

Introduce change agents Provide training/information support

Help with foreign market contacts

Encourage networking Establish and utilise international market brokers

Internationalised

Non-internationalised

Source: Adapted from Ibeh (1998)

enable these firms to internationalise, as they apparently wish to do. Potentially useful support measures may comprise providing access to market survey reports, assist­ing with consultancy and foreign market contacts and networks, including mentoring relationships.

Internationalised, but less entrepreneurial SMEs are those that have found them­selves in the international market, but appear to lack a strong motivation for so doing. Such firms may have started exporting accidentally, through the receipt of unsolicited foreign orders or allied external-reactive stimulus (Albaum et al., 1994). The policy focus here should be on ensuring that such SMEs receive positive reinforcement from their international market experience. Suggested measures include: providing requisite assistance — information, training, counselling; easing operational problems; second­ing ‘change agents’ or helping them to employ more decision makers with requisite qualities; and encouraging private sector organisations to draw them into their networks, hence giving them opportunities for sharing of experiences and learning.

Finally, the policy focus in respect of internationalised entrepreneurial SMEs should be on shoring up their key competencies and renewing their international and entrepre­neurial vision. Such firms should be equipped to continually respond to the inevitable

competitive challenges of an increasingly globalised market through appropriate adjust­ments and innovations in products, processes, organisations, markets and technology (Hyvarinen, 1990; OECD, 1997a). Increased attention needs to be given to relation­ships with key market actors (regular market visits and so on), particularly given the strength of empirical support on the potential benefits of so doing (Styles and Ambler, 1994, 1997; Bell, 1994). SMEs in this category, relatively speaking, need less assistance from the government and its relevant agencies. The direction in which government assistance would, nonetheless, be most appreciated is the minimisation of operational or access problems in foreign markets (Katsikeas, 1994; Morgan and Katsikeas, 1995). This is the standard service provided by government to its businesses, the most not­able example, arguably, being the US government’s deployment of their might in favour of their international companies. Policy makers can also make a real differ­ence by facilitating sectoral and/or industry-level export cooperative arrangements among SMEs to assist them in meeting the increasingly stiff competition from other regions (Arnould and Gennaro, 1985). The potential benefits of this initiative may be quite immense, extending to cost-sharing in R&D and technology sourcing, more innovative and quality products, better reputation of a country’s products in export markets, better leverage in relationships with distributors, agents, government officials (domestic and foreign) and, indeed, a whole lot of other network-related spin-offs (Ibeh, 2000).

Franchising and the small business

John Stanworth and David Purdy

23.1 Introduction

At its best, franchising is an avenue into self-employment offered by franchisors (owners of a ‘tried-and-tested’ business format) to franchisees (typically aspiring small business­men and women), in exchange for payment of a one-off front-end fee followed by an on-going royalty (Hoy and Stanworth, 2003). Based on the principle of ‘cloning’ suc­cess, a principal tenet of the franchise fraternity is that franchise failure rates are low.

From the viewpoint of small business researchers, franchising has been argued to be of particular importance, since most franchisors still are, or have recently been, small businesses themselves and most of their royalty-paying franchisees are also small busi­nesses. Thus, in principle, franchising offers a route to growth for the would-be franch­isor and small business opportunities with limited risk for would-be franchisees.

This chapter examines the advantages and disadvantages of franchising from the viewpoints of franchisor, franchisee and the wider society. It also examines growth rates, internationalisation, job creation, management challenges, future trends and, not least, risk levels. What emerges here is a striking similarity between the failure rates of young franchise systems and conventional small businesses at the same stage of development.

23.2 Learning objectives

This chapter has four learning objectives:

1 To gain a basic understanding of the nature of a business format franchise.

2 To gain an understanding of the symbiotic nature of the franchisor-franchisee relationship.

3 To illustrate that franchising may be viewed as a growth strategy for small busi­nesses or, alternatively, as a strategy for large businesses penetrating what have con­ventionally been recognised as small firm markets.

4 To demonstrate the potentially contentious nature of statistics issued by commercial bodies with an interest in promoting their particular business sector.

Key concepts

■ franchising ■ enterprise ■ growth ■ symbiosis ■ survival rates

■ service economy

23.3 Franchising and enterprise

A franchise can be defined as comprising a contractual relationship between a franch­isee (usually taking the form of a small business) and a franchisor (usually a larger business) in which the former agrees to produce or market a product or service in accordance with an overall ‘blueprint’ devised by the franchisor. The relationship is a continuing one with the franchisor providing general advice and support, research and development, and help with marketing and advertising. In return, the franchisee usu­ally pays an initial franchise fee and also an ongoing royalty or management service fee, normally based on the level of turnover and/or a mark-up on supplies purchased from the franchisor. The franchisee provides the capital for the outlet and is a legally separate entity to the franchisor.

Though the franchisor is usually a ‘larger’ business than the franchisee, in only a handful of cases does the franchisor truly meet the description of ‘large’. Most franch­isors remain very much small and medium-sized enterprises (SMEs) with no more than a small handful truly qualifying as large and these are almost inevitably American in origin (e. g. McDonald’s, ServiceMaster, Coca-Cola, Pepsi-Cola, Holiday Inn, Burger King, Kentucky Fried Chicken, Pizza Hut, Kwik-Kopy, Budget Rent-a-Car). Overall, in the UK, the average franchise involves around 30-40 outlets according to the British Franchise Association’s statistics and could thus still certainly be considered an SME, if not a small business per se.

23.4 The nature of franchising: entrepreneurship or dependence?

At one extreme, it has been argued that the franchised enterprise is, in reality, a man­aged outlet featuring in the larger marketing pattern of another truly independent business — that of the franchisor (Rubin, 1978: 223-33). This distribution strategy has certain advantages for the larger enterprise but, just because the manager of the outlet has a capital stake in the business dressed up in the language of entrepreneurship, that is no reason to confuse a franchise outlet with a genuinely independent business. This is not to say that the arrangement cannot be highly beneficial to both parties but illusion should not be substituted for reality in a rigorous analysis of the status of the franchised outlet.

At the other extreme, the franchised small business may be viewed as an emerging form of independent small business in advanced industrial societies whose distinguish­ing characteristic is its overt and close relationship with another, usually larger, enter­prise. This association might be seen as being little different, except in degree and the explicit form it takes, from that now found between many small businesses and other firms with whom they do business. In an increasingly interdependent economy, such a close association may simply be seen as a reflection of the fact that ‘no firm is an island entire of itself’.

The independence of the small firm can never be absolute and is often difficult to assess accurately in practice. Any small enterprise, whatever its form, is part of a wider network of economic interaction summed up in the economist’s notion of ‘the market’ and, arguably, it is from this source that the main limitations on independ­ence are derived. Whilst, economically, franchise relationships may appear to render franchisees highly dependent at a contractual level, at an operational level higher levels of independence may manifest themselves than appear likely at first sight (Stanworth, 1984).

The pioneering Bolton Committee researchers in the UK were attracted to the idea of classifying the roles of small firms according to the type of market they supply (Bolton, 1971: 31-32). Accordingly, they located small firms along a typology of reliance upon large firms:

■ Marketeers — those firms that actually compete in the same or similar markets as large firms (e. g. computer software companies, fashion merchandise manufacturers and restaurants).

■ Specialists — those firms that carry out functions that large firms do not find it eco­nomic to perform at all, though they may include large firms among their customers (e. g. repair and maintenance in the building industry, jobbing engineering and spe­cialised retail outlets such as bookshops).

■ Satellites — where the small firm is highly dependent upon a single larger business for the majority of its trade. The degree of dependence may be even greater if the large customer actually designs the product or service and merely sub-contracts its manufacture or supply, as appears to be the case with a franchise. Franchisees would appear to fall under this category.

Product franchises, embracing the fields of car and petroleum distribution, the soft drink bottlers (Coca-Cola, Pepsi-Cola, Seven-Up, etc.) and, in the UK, tenanted public houses, are often categorised as ‘first generation’ franchises and almost totally side­lined from most mainstream debates on modern franchising. The terms franchising and business format franchising are now used practically interchangeably in the franchise industry generally.

The relevance of business format franchising is perhaps best illustrated by US statistics, which apportion just $200bn of a total of over $600bn franchise industry sales turnover to business format franchising. However, something in the region of 3,000 from a total of 3,500 franchisors and 400,000 from a total of 500,000 franch­isees reside in the business format sector (Sen and Lee, 1994).

In a nutshell, business format franchises are typically SMEs. However, given that the franchisor levies a royalty-based charge on the franchisee’s level of turnover rather than profit, pressures to achieve market penetration and growth are institutionalised rather than optional. This can be achieved by expansion within a given franchise out­let or by expansion of the overall population of outlets — often involving multiple outlet ownership by more successful franchisees. For instance, this is particularly com­mon in the field of fast-food franchising where, in the US, it is not uncommon for 50% of a franchise company’s outlets to be owned by less than 20% (and sometimes less than 10%) of its franchisees. A single large franchisee may own several hundred outlets (Bradach, 1994). Multiple ownership in other sectors appears less common and, in the UK, it is estimated that 82% of franchisees operate just a single unit (The NatWest Bank/British Franchise Association Franchise Survey, 1993, published March 1994).

Previous research has shown that approximately one-in-three of franchisees has prior experience of independent self-employment and that levels of prior educational attainment and previous earnings tend to correlate with the buy-in costs of particular franchises. Thus, individuals taking relatively high-cost franchises in a field such as fast print are more likely to be graduates and have professional backgrounds than, say, individuals taking up relatively low-cost carpet-cleaning franchises.

23.5 The advantages and disadvantages of franchising

The following section is assembled from three main sources, namely the published litera­ture on franchising, previous research and discussions with key figures in the industry, and will be presented under four headings dealing with the franchisor, the franchisee, the consumer/local economy and, finally, the national economy.

23.5.1 Advantages and disadvantages to the franchisor Advantages

■ Franchising enables the franchisor to increase the number of distributive outlets for their organisation’s product or service with limited capital investment. It is the franch­isees who provide much of the capital with their stakes in the business.

■ Since the franchisee owns their own business, they are assumed to be highly motiv­ated to maximise growth and profitability. This situation may be compared with that of a manager of a retail outlet who is a direct employee of the parent company. Generally, such a manager earns a fixed salary (with possibly an element of bonus incentive incorporated) and lacks the extra incentive to succeed, which may result from a personal financial investment in the business. A successful franchisee, with increasing profits, can be expected to contribute to the success of the franchisor.

■ A franchise unit, being locally owned, is claimed to be readily accepted by the com­munity as being a local business. It is not clear how far this is true, however, since very often local people may not be aware that a franchised unit is in fact owner-managed.

■ The franchisor has limited payroll, rent and administrative overheads, because the very nature of the operation requires franchisees to be self-employed. Franchisees are themselves responsible for the staffing arrangements and operating costs of their particular outlets.

■ As well as franchisors achieving a wider distribution network for their product or service, the nature of most franchise contracts ensures that franchisees are in some measure ‘tied’ to the franchisor. They are often obliged to purchase equipment from or through the franchisor plus, as in the case of fast-food franchise restaurants, the necessary ingredients that go to make up the final product.

Disadvantages

■ It may be difficult for the franchisor to exercise tight control over the franchisee sim­ply because they are not a direct employee of the franchisee and cannot be closely supervised. In turn, the poor reputation of one outlet, in terms of product quality or service, can be damaging to the general trade name and reputation of the franchisor and, in turn, the whole franchise organisation.

■ A franchisor cannot always be certain that a franchisee is declaring their true level of business activity. Many franchisors employ a central accounting system to com­bat this though no system can be expected to be totally successful in this respect.

■ If the franchisor believes that a franchisee has become demotivated and is not run­ning their outlet efficiently, there is relatively little that can be done in the short term as long as the franchisee is operating within the terms of the contract.

■ The management of a franchising company is limited in its flexibility. Conventional companies can move more quickly to exploit market potential when a modified selling strategy is required. However, to bring about changes can be a lengthy and cumbersome operation when dealing with individually owned franchised outlets. Any changes need to be carefully handled to avoid conflicts stemming from perceived threats to the franchisee’s independence.

■ There may be problems of information feedback from the franchisee to the franch­isor. This can result from the franchisee’s desire for independence or simply from channels of communication not being as well developed as they might be in company-owned and managed outlets.

■ The franchisor is faced with a paradox. The franchise method of business tries to capitalise on the personal attention and service that characterise the owner-managed business. However, the franchisor’s need for a standardised product or service, together with a uniform presentation, needed to give customers a sense of reliabil­ity and dependability, clashes with the former.

■ The franchisor may have difficulty in recruiting suitable franchisees who: see franchising as an attractive method of doing business; are motivated towards self­employment; and have the necessary capital available for investment.

23.5.2 Advantages and disadvantages to the franchisee Advantages

■ It is possible for an individual to run their own business yet gain the advantages and economies of scale of a larger company. Here the advantages range from initial and ongoing training to centralised buying, ongoing product/service and market research.

■ If the product or service has already achieved brand awareness, this relieves the franchisee of many of the normal demands of the sales and marketing function and allows them to concentrate on other aspects of the business. Most franchisors undertake both national and local advertising campaigns to keep franchisees’ pro­ducts or services firmly in the public mind.

■ It is claimed that franchisees require less capital than would be the case to equip a business independently. The franchisor can help with raising bank loans, site-selection, head leases on properties, and getting the business open and running smoothly. However, franchise investment levels tend to be fairly high and it could be argued that one could start a business successfully for a similar investment (or less perhaps) without the obligations imposed by a franchisor.

■ Many franchisees operate within a defined territory, which involves the franchisor giving an undertaking not to set up another competing outlet within a given geo­graphical radius. However, there is nothing to stop another franchisor, or other conventional competition, moving into the same area if it appears attractive and lucrative.

■ There are other franchisees in the same network with the same challenges and prob­lems and so any individual franchisee can use them as a source of non-threatening help and advice.

Disadvantages

■ The tight control exercised by the franchisor in order to regulate the way in which the product or service is presented to the consumer may leave little opportunity for the franchisee to impose their personality on the business.

■ Should the trade name of the franchise become tarnished, perhaps through mis­management by the franchisor, or the shortcomings of other franchisees, then it is possibile that the franchisee may suffer simply because they are seen by the public as a representative of the franchise organisation in question.

■ The service provided by the franchisor may constitute a heavy expense to the franch­isee. The franchisee may be obliged to purchase equipment and ingredients from the franchisor that they could have bought more cheaply from other sources. Also, man­agement service fees and charges may be high.

■ There is the possibility that the franchise agreement may not fulfil the franchisee’s expectations, both in terms of anticipated sales and profits and also possibly in terms of the franchisor not fulfilling their obligations.

23.5.3 Advantages and disadvantages to consumers and the local economy Advantages

■ Consumers may have the convenience of an extended-hours service. Many franchises operate on the basis of long hours of service in order to maximise their markets and many independent businesses, not bound by agreements to provide such service, may choose not to do so or may lack the resources.

■ Franchisees, as owner-managers, should be able to offer a highly personal service.

■ Although all franchised outlets are independent and separate, consumers can locate them under a single trade name and apply their knowledge of one outlet to all others because of uniform presentation and consistent standards of quality. Conversely, if a consumer is dissatisfied, they need not waste time with other outlets.

■ If a conventional small business fails, dissatisfied customers may not get satisfaction. In the case of a franchise, failure rates may be lower and, in any case, customers can, in the final analysis, contact the franchisor.

■ Franchisees receive training from their franchisors, usually ranging from between 2 and 12 weeks. A portion of this will usually involve hands-on training in existing outlets run by other franchisees. Such training can be expected to add to the stock of business training and knowledge in the local economy.

Disadvantages

■ Franchising may reduce levels of diversity in local economies due to their stress on standardisation.

■ Franchising may ‘export’ money out of the local regional economy in terms of pay­ments made to franchisors and may ‘import’ goods and services from the franchisor rather than from small suppliers locally.

23.5.4 Advantages and disadvantages of franchising to national economies

For individuals seeking self-employment opportunities but lacking the necessary ex­perience and know-how, franchising can offer an avenue of opportunity. For others, already in business on a modest scale, a franchise as an addition, or alternative, to their existing business may offer the possibility of growth levels unlikely to be achieved by their existing business.

The role of the industry as a ‘shop window’ of business formats appears to have been recognised by leading franchisors who, over time, appear to have become gener­ally less informative in response to early-stage enquiries. This has occurred in response to instances of individuals searching out information, under the guise of a potential franchisee, only to subsequently emerge in competition rather than in partnership.

The high level of publicity generated by the franchise industry, plus the steady flow of books and seminars, magazines and manuals, on the topic all act to reinforce this role. Overall, the franchise industry almost certainly plays a positive role in publicis­ing and popularising the notion of self-employment.

23.6 Franchising in the US: history and more recent trends

Franchising is more developed in the US than in any other country. Also, research and data gathering are far more advanced in the US than elsewhere. Thus, much of what is known about franchising tends to be American in origin and other countries look towards the US experience as heralding the nature and scale of future developments in their own economies.

As a result of the large-scale development of franchising in the US, it is the major exporter of franchising on a global scale and American experience is invariably quoted

Source: Trutko, Trutko and Kostecka (1993)

(or misquoted) in justification of franchising in the UK and elsewhere. Three US statis­tics are quoted above all others:

■ Franchising accounts for approaching 35% of all retail sales in the US.

■ Franchising accounts for 10% of GDP in the US.

■ Franchising expanded by around 300% between 1975 and 1990.

Allied to these claims is an assumption that franchising is both a low-risk business option and a largely recession-proof business strategy. All of the above statistics appear essen­tially true. However, as Figure 23.1 illustrates, inflation-adjusted figures for the growth of franchising in the US over recent years pull down the overall growth figure for 1975-90 dramatically from 284.6% to 58.5%, and the average annual growth rate from 9.4% to 3.1%. Moreover, in six years of this 16-year period, franchise growth in the US was either zero or negative (Trutko et al., 1993). The franchise industry in the UK appears completely unaware of the existence of the latter adjusted statistics. (The data terminate in 1990 due to the abandonment of an annual survey of US franch­isors and franchisees by the US Department of Commerce.)

Although academics, researchers and bodies such as the International Franchise Association (America’s franchise association) use the terms ‘franchising’ and ‘business format franchising’ almost interchangeably, the fact remains that, for statistical pur­poses, ‘product’ and business format franchises are usually grouped together in the US. In 1990, 48.4% of all franchising sales stemmed from the automobile and truck sec­tor and a further 18.0% from franchised gasoline service stations.

Whereas product franchising grew by only 42.4% in inflation-adjusted (constant) dollars in the US between 1975 and 1990, against an overall sector figure of 58.5%, business format franchising grew by 115.5%, or around 5.1% in real terms per annum.

The expansion and contraction of franchising in the US seems to have closely fol­lowed general economic trends (Trutko et al., 1993: 3-19). Between 1975 and 1989, GNP in the US grew by 52.7% in real terms against a comparable growth in franchise sales of 58.5%. The decline in franchise sales (in real terms) between 1979 and 1982 again closely reflected the wider economic situation. As the US economy recovered during the mid-1980s, franchise sales reflected the upturn, as they did the subsequent downturn towards the end of the 1980s.

Interestingly, however, whilst franchise sales performed relatively well between 1975 and 1990, the number of franchise establishments in the US grew by only 13.3% com­pared with a 48.4% increase in the number of establishment units in the US as a whole. It is predicted that this trend will continue with franchisors concentrating on generat­ing higher profits per establishment in the future rather than expansion via increased outlets (Trutko et al., 1993: 9-12). In this sense, franchising could be said to be limit­ing the number of small business outlets.

The largest 88 US franchisors had more than 500 franchise units in 1986 and accounted for two-thirds (65.0%) of all franchise sales and establishments. By way of contrast, one-third (33.9%) of all franchising systems had ten or fewer establishments and accounted for about 1% of sales and establishments.

Despite the overall dominance by large systems, there is some evidence that smaller systems have played an increasing role in recent years. Also, earlier thoughts that franchising might simply represent a temporary phase in a company’s growth plans appear largely unfounded since the level of franchisee-owned stores appears to have been virtually unchanged since 1975 at 81.5%.

Women and minorities appear to have increased their representation in franchising in recent years though both groups are less visible than might be expected in terms of their general participation in the labour force at large. The evidence indicates that around 10% of franchise units are owned outright by women plus another 20% owned by women in alliance with men. Around 5% of franchise units were owned by minorities in 1986 compared with an 8.8% ownership level of US firms generally. This is despite government schemes targeted specifically at increasing the level of minority representa­tion. Although there are no comparable figures collected for the UK, the position appears broadly similar, albeit with a heavy concentration of minority franchisees in the field of fast-food franchising.

It is felt by many that the help afforded by franchisors in setting up new franchisees, particularly those with no prior business experience, renders franchising user-friendly for women and minorities.

23.6.1 Franchise growth factors

A number of factors in particular are considered to have aided the general growth of franchising in the US in recent decades. First, the growth of the US economy since World War II. Second, ‘downsizing’ policies exercised by large corporations that have released corporate executives with the necessary financial resources, experience in busi­ness management and a reduced faith in corporate security, often willing to consider self-employment.

Further, the post-war ‘baby boom’ increased both consumer spending levels and the numbers of potential franchisees during the 1970s and 1980s. At the same time, the number of women in the US civilian workforce increased from 27.5 million in 1970 to 47.4 million in 1989 — a participation rate up from 42.6% to 57.2%. The growth in the numbers of working women and dual-income families led to increased needs for support services such as day care services, educational products and services, home cleaning, fast-food, home-delivery food and other services.

In addition, technological changes heralded a revolution in electronic data processing and materials handling. Technological benefits have often been made more available to small franchise outlets than small conventional small firms due to the economies of scale delivered by the franchisor. Retailing in particular appears to have benefited from technological advances.

23.6.2 Franchising in the UK: current trends

According to trade association data, the experience of franchising in the UK is of appreciable growth for several years prior to 1990, when it dipped. Thereafter, in real terms, the trend in combined sales turnover was one of modest recovery, stabilising from 2000 onwards (see Figure 23.2 and Table 23.1).

Table 23.1 Key indicators for business format franchising in the UK, 1993-2004

Year of data collection (reported in following year)

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

1. Number of franchise systems

Building Services

49

39

48

45

47

Catering, Hotels

64

55

58

58

65

Cleaning Services

15

15

19

23

27

Commercial and Industrial Services

49

55

60

68

81

Direct Selling, Distribution, etc.

32

51

72

75

78

Domestic and Personal Services

25

25

24

39

40

Employment Agencies, Training

11

15

19

22

24

Estate Agents, Business Transfer Agents

15

16

16

21

20

Parcel and Courier Services

12

13

15

19

21

Quick Printing, Copying, Graphic Design

7

8

8

13

12

Retail

84

86

92

110

106

Vehicle Services

25

28

35

39

39

Dairy (as reported or deduced)

8

8

8

9

8

Total number of UK franchise systems

396

414

474

541

568

596

642

665

672

677

699

718

Change on 1993 value

+4.5%

+19.7%

+36.6%

+43.4%

+50.5%

+62.1%

+67.9%

+69.7%

+71.0%

+76.5%

+81.3%

1998 onwards: European Franchise Federation

categories adopted (p. 19, March 1999 report)

Hotel and Catering

85

97

100

116

114

113

117

112

Store Retailing

99

91

94

91

86

86

89

91

Personal Services

83

94

111

114

113

111

110

131

Property Services

106

111

114

125

140

147

152

165

Transport and Vehicle Services

62

66

68

75

76

72

76

64

Business and Commercial Services

125

130

148

141

140

145

152

152

Dairy (as reported or deduced)

8

7

7

3

3

3

3

3

568

596

642

665

672

677

699

718

The ‘headline’ number of franchise systems quoted in the source reports for 2001 (671 systems) and 2003 (695 systems) data do not fully reconcile with the corresponding sector analyses.

23 • Franchising and the small business

T

Ln

Table 23.1 (cont’d)

Year of data collection (reported in following year)

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2a. Estimate of franchised units/outlets by sector

Building Services

1,015

925

1,000

960

1,080

Catering, Hotels

3,380

3,095

3,070

3,245

3,675

Cleaning Services

1,520

1,510

1,625

1,510

1,775

Commercial and Industrial Services

845

1,085

1,105

1,115

1,595

Direct Selling, Distribution, etc.

2,030

2,910

3,315

3,730

3,995

Domestic and Personal Services

675

1,110

880

1,655

1,680

Employment Agencies, Training

505

530

600

765

830

Estate Agents, Business Transfer Agents

505

435

405

435

430

Parcel and Courier Services

675

1,095

1,120

1,395

1,520

Quick Printing, Copying, Graphic Design

675

635

570

560

600

Retail

3,385

4,515

4,355

4,500

4,785

Vehicle Services

1,690

1,555

1,655

1,630

2,035

Dairy

8,000

7,000

6,000

5,300

5,100

Total number of UK franchisee units/outlets

24,900

26,400

25,700

26,800

29,100

30,000

35,150

35,600

34,500

34,395

33,815

31,363

Change on 1993 value

+6.0%

+3.2%

+7.6%

+1 6.9%

+20.5 %

+41.2%

+43.0%

+38.6%

+38.1%

+35.8%

+26.0%

1998 onwards: European Franchise Federation

categories adopted (p. 19, March 1999 report)

Hotel and Catering

4,725

6,015

6,395

7,120

5,655

5,800

6,394

6,381

Store Retailing

4,290

4,275

4,275

4,200

3,760

4,260

4,391

4,578

Personal Services

3,660

4,295

5,060

3,315

3,435

4,125

4,540

4,282

Property Services

3,540

3,570

3,960

4,440

5,560

5,260

5,545

6,174

Transport and Vehicle Services

3,280

3,105

3,365

3,470

3,520

2,700

2,554

2,408

Business and Commercial Services

4,505

4,240

7,845

8,655

8,570

8,650

8,591

4,740

Dairy

5,100

4,500

4,250

4,400

4,000

3,600

1,800

2,800

29,100

30,000

35, ISO

35,600

34,500

34,395

33,815

31,363

2b. Franchise units/outlets — average number

per franchise system

63

64

54

50

51

50

55

54

51

51

48

44

Change on 1993 value

+1.4%

-1 3.8%

-21.2%

-18.5 %

-19.9%

-1 2.9%

-14.9%

-18.4%

-19.2%

-23.1%

-30.5%

3a. Combined franchise unit sales turnover

(1990 ‘peak’ = £5.2bn)

£5. Obn

£5.Sbbn

£5.9bn

£6.4bn

£7. Obn

£7.4bn

£8.9bn

£9.3bn

£9.2bn

£9.5bn

£9.65bn

£9.1 bn

Change on 1993 value

+10.0%

+18.0%

+28.0%

+40.0%

+48.0%

+78.0%

+86.0%

+84.0%

+90.0%

+93.0%

+82.0%

U. K. Retail Price Index: ‘All Items’ January

1987 = 100

137.9

141.3

146.0

150.2

154.4

159.5

163.4

166.6

171.1

173.3

178.4

183.1

U. K. Retail Price Index: Rebased to January

1990 = 100

115.4

118.2

122.2

125.7

129.2

133.5

136.7

139.4

143.2

145.0

149.3

153.2

452

Part 3 • The small business

3 b. Combined franchise unit sales turnover — 1990

RPI-adjusted values

£4.3 bn

£4.7bn

£4.8bn

£5. Ibn

£5.4bn

£5.5bn

£6.5bn

£6.7bn

£6.4bn

£6.6bn

£6.5bn

£5.9bn

Change on 1993 value

+7.4%

+11.5%

+1 7.5%

+25.0%

+28.0%

+50.2%

+54.0%

+48.3%

+51.2%

+49.2%

+37.1 %

4. Direct employment in business format franchising

Total franchise unit/outlet employees

(excluding Dairy)

152,300

149,400

187,200

227,100

235,200

257,500

no disagt

iregated d

‘tails show

n from 19

>9 onward

Franchisees (allowing for multiple unit

ownership)

11,000

12,300

11,700

12,100

11,500

18,300

ditto…

Spouse/partners if active and not included in

employee total

3,500

4,200

4,800

6,600

6,800

6,600

ditto…

Employees at system HQs + system locations

elsewhere

9,700

1 6,400

10,500

10,800

13,100

14,900

ditto…

Dairy employment

1 2,000

10,000

8,500

7,500

7,200

6,000

ditto…

Total

188,500

192,300

222,700

264,100

273,800

303,300

316,900

316,000

324,900

326,000

330,000

327,000

Change on 1993 value

+2.0%

+18.1%

+40.1 %

+45.3%

+60.9%

+68.1%

+67.6%

+72.4%

+72.9%

+75.1%

+73.5%

NB 1993: No data shown for system employees

‘elsewhere’

S. Franchisee employment — average per franchisee

unit/outlet

7.6

7.3

8.7

9.9

9.4

10.1

9.0

8.9

9.4

9.5

9.8

10.4

(Total No. UK Employees + Total No. UK

Franchisee Units) Change on 1993

-3.8%

+14.5%

+30.2%

+24.3%

+33.5%

+19.1%

+1 7.3%

+24.4%

+25.2%

+28.9%

+37.7%

6. Franchisee unit/outlet sales turnover — average

per employee

£26.5k

£28.6k

£26.5k

£24.2k

£25.6k

£24.4k

£28. Ik

£29.4k

£28.3 k

£29.1 к

£29.2k

£27.8k

(Total UK Sales + Total No. UK Franchise

Employment) (ф) Change on 1993

+7.8%

-0.1%

-8.6%

-3.6%

-8.0%

+5.9%

+11.0%

+6.8%

+9.9%

+10.2%

+4.9%

7. Franchisee unit/outlet sales turnover — average

per franchisee outlet

£200.8k

£208.3k

£229.6k

£238.8k

£240.5k

£246.7k

£253.2k

£261.2k

£266.7k

£276.2k

£285.4k

£290.2k

(Total UK Sales + Total No. UK Franchisee

Outlets) (ф) Change on 1993

+3.8%

+14.3%

+18.9%

+19.8%

+22.8%

+26.1%

+30.1 %

+32.8%

+37.5%

+42.1%

+44.5%

8. Franchise unit/outlet sales turnover — average

per franchise system

£12.6m

£13.3m

£12.4m

£11.8m

£12.3m

£12.4m

£13.9m

£14.0m

£13.7m

£14.0m

£13.8m

£12.7m

(Total UK Sales + Total No. UK Franchisee

Systems) (:;:) Change on 1993

+5.2%

-1.4%

-6.3%

-2.4%

-1.7%

+9.8%

+10.8%

+8.4%

+11.1%

+9.3%

+0.4%

9. Proportion of franchisees claiming to be

profitable

87.5%

87%

90%

94%

92%

89%

90%

95%

93%

91%

95%

88%

23 • Franchising and the small business

(ф) Unadjusted financial values (i. e. using the values in 3a., as contained in the original reports)

Source: RP02 Retail Prices Index (RPI) all items, Office for National Statistics (April 2005); Annual Franchise Surveys, NatWest/British Franchise Association (February/March 1995-2005)

23.6.3 Franchising worldwide

A survey of franchise associations undertaken in 1995 by Arthur Andersen revealed some marked differences between the number of franchise systems in the respondent countries and regarding the corresponding number of franchisees (see Figure 23.3). At the forefront is the US (population 266 million at the time), but Canada (29 million) and Australia (22 million including New Zealand) — each also a ‘land of opportun­ity’ — have relatively large numbers of franchisees compared with their total popula­tion. All three of course had strong colonial ties to the UK. Some large-population countries were not included in the survey data — such as China (1210 million), India (952 million), Indonesia (207 million) and Russia (148 million) — but data collection can be problematic in emerging markets, especially where there is no franchise asso­ciation. Each of these missing countries is known to have a small number of franchise systems.

In the UK, the franchise industry has been strongly influenced by developments from the US. In the mid-1970s, the British Franchise Association was formed by eight franch­ise companies:

■ Budget Rent-a-Car (vehicle rentals)

■ Dyno Rod (drain cleaning and hygiene services)

■ Holiday Inn (hotels and motels)

■ Kentucky Fried Chicken (fast-foods)

■ Prontaprint (fast-print services)

■ ServiceMaster (carpet and furniture upholstery cleaners)

■ Wimpy International (fast-foods)

■ Ziebart (vehicle rust-proofing services).

Only two of the above (Prontaprint and Wimpy) were distinctly British and even the latter was based upon an imported US idea, albeit developed by a British company. This dominant representation of US involvement in franchising has continued with US companies exporting to Britain largely via the medium of granting ‘master licences’ for an individual or company in Britain to develop their format nationwide.

This situation of high-profile US involvement in international franchising is one that wins favour at the highest levels in the US, as summarised in a recent analysis by Eroglu (1992: 19):

From a balance-of-payments perspective, international franchising is considered (in the US) as a safe and speedy means of obtaining foreign currency with a relatively small financial investment abroad. It is notable in that it neither replaces (American) exports nor exports (American) jobs, all these reasons making this business arrangement one of the most pre­ferred and government-supported forms of international involvement.

The attitude of the US government here appears plain and one which recommends itself to other governments — the message is that home-produced franchises, particu­larly those with export potential, can be fruitfully considered for targeted support.

Figure 23.3 Country franchisee populations: number of franchisees vs total population

23 • Franchising and the small business

Notes: The above franchise data was derived from a survey of the franchise associations in 40 countries, which achieved a 90% response rate. The population and GDP values are estimates (1996 and 1995, respectively).

Ln

Ln

Source: Swartz (1995); Central Intelligence Agency (1996)

23.7 Ease of entry into franchising

The franchise industry is not without members who are regarded by their peers as hav­ing staged an entry into franchising by other than ‘textbook’ methods. Usually, this has involved selling franchises to members of the public before the business involved had been properly tried and tested. In fact, on such occasions, it has been literally tried and tested on its early franchisees. When this happens, it is not necessarily the case that the franchisor in question has deliberately set out to defraud the public by selling franch­ises prematurely. Rather, the explanation may lie in ignorance or over-enthusiasm. In the author’s own past career as a small business trainer, there were occasions when an individual would attend a start-up course with the intention of selling franchises in the new business idea within weeks or months of starting up in business.

The conventional wisdom in the industry is that any completely new small business will need at least two years in order to establish itself in terms of testing out sales, mar­keting, product/service, pricing and staffing strategies. After all, every small business start-up plan inevitably requires considerable modification during the initial months of its implementation. High failure-rate figures, particularly during the first 30 months of operation, verify this fact.

Having established a basic business formula, the owner should then, ideally, estab­lish an identical outlet in another location. The process of finding new premises, hiring personnel, organising a launch and all the other tasks accompanying a new outlet open­ing is an essential test of the owner’s ability to replicate the success achieved in the founding unit. Again, there will be a steep learning curve here and the process could well take a further two years.

Finally, three key documents need to be drawn up prior to beginning franchising. First, an operating manual committing to paper detailed instructions for the guidance of franchisees when running an outlet for themselves; second, a franchise contract, stipulating the legal obligations of both parties — franchisor and franchisee — and, fin­ally, a franchise prospectus as a marketing tool for use in recruiting franchisees. All three documents require a great deal of time, hard work and, usually, expensive external help from consultants, solicitors and accountants. Then begins the process of recruit­ing and training new franchisees and this, again, is liable to prove time-consuming and expensive since the business involved has no previous experience or public awareness to draw upon.

Overall, adopting a ‘textbook’ approach, a business starting up from nothing may well find itself involved in five years of hard work before it recruits its first franchisee. The founder(s) will find that they are not simply involved in testing out one business idea but two — a conventional business configuration plus an allied franchise format. Obviously, the final package has to be one capable of yielding notably better financial returns than the average small business since these must satisfy the franchisee’s income needs, service banks loans and pay off loan capital, plus sustain the franchisor’s needs for management services fees, amounting to usually around 10% on sales turnover.

Once a franchise company is well established, it will find a range of specialist ser­vices and advice on offer from bodies such as the British Franchise Association and specialist units in the clearing banks. The weakest link in the chain of development is almost certainly at an earlier stage — between establishing a conventional small business with franchise potential and launching it as a fully-fledged franchise opera­tion, without short-cuts being taken that could prove disastrous later.

Obviously, the above timetable can be safely reduced in the case of an already well- established SME wishing simply to convert to a franchise format by cloning its previous success, but the risks are still high. A report commissioned by the US Small Business Administration estimates that initial franchise development costs can exceed $500,000 (Trutko et al., 1993: 7):

The development of a business from a proven concept through to the sale of its first franchise is typically a long, expensive and risky process for the franchisor. Even excluding the costs of direct management involvement, the franchisor bears sizeable ‘upfront’ costs for developing a programme before it can be marketed to franchisees.

They also similarly identify the early stage of entry into franchising as a difficult time for the franchisee since: ‘Prospective franchisees are often reluctant to use professional advisers to evaluate franchise offerings because of the cost and/or difficulty of identi­fying an attorney in the area of franchising.’ Without doubt, most specialist franchise advisers see their principal area of vested interest as that of undertaking work for franch­isors rather than franchisees.

23.7.1 Franchise contracts

The franchise relationship is governed, in the legal sense, by a written contract which commonly spans 30-40 pages in length and can be even longer. These contracts usu­ally run for a specified period of time though are usually renewable. The most typical contract length is five years followed by ten years.

The most detailed comparative work on franchise contracts is that undertaken by Professor Alan Felstead of the Centre for Labour Market Studies at the University of Leicester, England. He compared 83 different franchise contracts on six main compon­ent elements:

■ guarantees granted to franchisees of territorial exclusivity;

■ franchisor’s rights to unilaterally imposed changes to their operating manuals;

■ post-termination restrictions on competition;

■ franchisor’s stakes in franchisees’ businesses via ownership of sites, telephone lines or equipment;

■ franchisor’s rights to police the quality of the franchisees’ output; and

■ the franchisor’s imposition of output targets.

Felstead (1993: 115) constructed an Index of Contractual Control (Figure 23.4). Each element of control is allotted a score of zero if absent, 1 if present and, where appro­priate, 2 if present in a stronger form. Although this scoring mechanism does not ‘weigh’ each of the components against one another, it does enable identification of ‘hard’ franchise systems (where the degree of contractual control is high) from ‘softer’ forms systems (where the degree of contractual control is low and franchisees enjoy greater degrees of autonomy).

Figure 23.4 Index of contractual control

COMPONENT ELEMENTS Score

a) Non-exclusivity:

TOC o "1-5" h z Exclusivity guaranteed in territory………………………………………………………… 0 49.4%

Qualified exclusivity…………………………………………………………………………… 1 16.9%

Non-exclusive franchise………………………………………………………………………. 2 33.7%

b) Performance targets:

None………………………………………………………………………………………………… 0 62.7%

Turnover targets/expansion triggers…………………………………………………….. 1 37.3%

c) ‘Stake’ in tangible business assets:

No ‘stake’ evident in contract………………………………………………………………. 0 33.7%

‘Stake’ in telephone lines/sites/equipment……………………………………………. 1 66.3%

d) Operations manual:

No rights to unilateral change………………………………………………………………. 0 12.0%

Rights to unilateral change by franchisor……………………………………………….. 1 88.0%

e) Post-termination restrictions:

None………………………………………………………………………………………………… 0 13.3%

Non-compete or non-solicitation………………………………………………………….. 1 25.3%

Both non-compete and non-solicitation…………………………………………………. 2 61.4%

f) Monitoring of output quality:

No rights to police system……………………………………………………………………. 0 41.0%

Rights to inspect/communicate with clients on reasonable notice 1 10.8%

Rights to inspect/communicate without notice………………………………………. 2 48.2%

INDEX OF CONTRACTUAL CONTROL

‘Soft’ franchising (0-3) 13.3%

‘Medium’ franchising (4-6) 65.1%

‘Hard’ franchising (7-9) 21.7%

Source: Felstead (1993)

Around two-thirds of the systems examined fell in between the two extremes, with the overall distribution ‘scores’ skewed towards the ‘hard’ end. Felstead (1993: 116) feels that franchisees occupy an ambiguous position of being neither fully in control of ‘their’ business nor fully controlled:

First, despite operating without close and direct supervision, franchisees are required to oper­ate within procedures laid down and often subject to unilateral change. Moreover, franch­isees are sometimes committed to adhere to franchisor-set performance targets, and, in any case, to give the aim of the franchisor (turnover maximisation) primacy in the running of the business. Secondly, while they appropriate the profits (and losses) of the business, they do so only after they have made turnover payments to the franchisor. Thirdly, although franchisees buy or lease much of the physical business apparatus, some parts remain in the hands of the franchisor, and some have franchisor-imposed restrictions on their use both during and after the currency of the agreement. Furthermore, franchisees have no ownership rights in the intangible business assets — they simply ‘borrow’ the business idea, trading name and/or format.

Felstead also traces a number of instances of franchisor-franchisee litigation. One par­ticularly interesting case involved a Prontaprint franchisee in the UK who declined to renew his contract but continued to trade in the identical line of business and in the same premises, albeit under a different name. He lost a legal judgement on the grounds that:

■ he was still drawing benefit from the Prontaprint name via repeat business and, for some time at least, being listed in local directories as ‘Prontaprint’; and

■ the franchisee was deemed to have had little understanding of the print business prior to being trained by Prontaprint.

The latter fact may explain the frequently expressed franchisor preference for franch­isees without prior experience in the operational line of the franchise.

23.8 Franchisee success and failure rates

Research results (Stanworth and Purdy, 1993) identify quite clearly two principal appeals that franchising holds for ‘potential franchisees’. One is ‘independence/chance to be your own boss’ and the other access to a ‘proven business system’. Whilst both were chosen frequently and almost to the exclusion of other possible appeals of franch­ising, the precise ordering varied, depending upon whether or not respondents had prior experience of self-employment (see Figure 23.5).

Some causes of SME failure are seen as being due to ‘generic’ causes and should actually be remedied or reduced by franchising (Cross and Walker, 1987). These are:

■ under-capitalisation,

■ absence of economies of scale,

Figure 23.5 Main appeal of franchising: by current employment status

■ lack of business acumen,

■ inability to survive intense competition in sectors (such as retailing) where barriers to entry are low.

Franchising should reduce the probability of failure among franchisees due to such ‘generic’ causes, on condition of course that the franchisor’s responsibilities are met and that the appropriate back-up services expand at a rate sufficient to cope with any growth of the franchise network. Thus, attempts by the franchisor to expand too quickly or, alternatively, to simply generate profits through the accumulation of once — and-for-all front-end fees, will act to the detriment of franchisees.

Failures due to ‘franchising-related’ factors, as opposed to ‘generic’ factors, are cited by Cross as falling essentially into five key categories:

■ Business fraud, such as the use of celebrities to attract franchisees to ill-founded franchise schemes in the US during the 1960s and 1970s.

■ Intrasystem competition, involving franchise outlets being located too close together and cannibalising each other’s sales while maximising the franchisor’s sales-based royalties. Also, company-owned outlets may be sited close to franchisee-owned outlets.

■ Insufficient support of franchisees, encompassing advertising support, pre-opening programmes and management assistance.

■ Poor franchisee screening (possibly fuelled by a drive to maximise front-end fees), resulting in a mismatch between franchisee’s attributes and criteria for success.

■ Persistent franchisor-franchisee conflict.

Mittlestaedt and Peterson (1980) have conducted work in this area that suggested franchise failure rates running at around 5% and turnover at around twice that level. Padmanabhan (1986) concluded that franchise operations fail generally less often than independents but that the opposite may be true of business services and automotive franchises. Ozanne and Hunt (1971) identified an annual failure rate of 6.7% among fast-food franchise systems but concluded that the actual failure rate could be two or even three times as high. The same went for franchisee failure rates that were lower on a percentage basis, suggesting that franchisee failures tended to be concentrated in smaller franchise systems.

In summary, we still lack any harmonised methodology for assessing failure rates and the differences between franchised business failures and independents is almost certainly much less than the impression given by promotional books and franchisee recruitment packages. However, the most honest and accurate statement that can be made on the issue of comparative failure rates probably remains that made by Housden (1984: 226):

It has been claimed that as well as helping in the creation of new businesses, franchising sub­stantially reduces the subsequent rate of failure in such businesses. . . No firm evidence has yet been produced to support this contention, but it seems probable to assume that franchised outlets of a reputable system are less likely to fail than independently-owned outlets, because of the franchisor’s vested interest.

Statistics published in the US appear to underline the possible effects of franchisor fees and market saturation in influencing franchisee failure rates and profit returns. Bates (1994a: 4) drew up a sample of 7,270 small businesses started between 1984 and 1987 drawn from the US Census Bureau’s Business Owners Database. Using 1987 as a base­line (year 1), he tracked these businesses through to 1991. Bates found that 34.9% of franchise businesses failed compared with 28.0% of non-franchise businesses. Pre-tax income levels were also higher for independent businesses. Bates concluded that the dif­ference in performance rates between franchised outlets and other small businesses was based in part on differences in industry distribution, with franchises over-represented in retailing and under-represented in services. Among other possible reasons for these findings, he includes:

■ the recruitment by franchise companies of candidates poorly qualified to become franchisees;

■ the saturation of key franchise markets;

■ the high level of franchisor fees and royalties.

He hypothesises that what might once have been a prudent route to small business suc­cess may now be undermined by excessive competition and/or fees relative to the value of franchisor services.

It should be remembered that, whilst a franchisee should, and hopefully will, receive the kind of professional managerial help and advice that is not normally available to SMEs, this is only delivered at a price and often a substantial one at that — typically an on-going rate of around 10% levied on sales turnover (in addition to front-end start-up fees and charges). Many SMEs would almost certainly not make total profits of this magnitude and, by any measure, this kind of royalty regime is likely to take in the region of half the total profits of even a well-run franchised outlet. In short, the royalty regime is a heavy burden for outlets to bear, particularly where conditions of recession and market saturation also take their toll.

23.9 The quality of jobs created in franchising

Very little research has been undertaken concerning the quality of jobs provided by the franchise industry in terms of pay, training and job satisfaction levels. However, most franchised businesses tend to involve a limited range of products and services and appear to lend themselves to low-skill/low-pay human resource strategies. After all, franchise company outlets are essentially non-unionised small firms operating on the basis of human resource strategies devised by the franchisee. This is a fruitful area for future research and there are already movements on the part of researchers interested in becoming involved in this as aspect.

Felstead (1993: 200) has presented some evidence that is, in all probability, fairly typical of the industry and thus generalisable. He makes the point that franchisees, in attempting to improve their profits, may be more motivated to save money on their payroll bills than by increasing turnover levels since the latter attracts a 10% (or there­abouts) levy by the franchisor whereas the former does not. Felstead conducted a comparison of franchised and non-franchised high street printers in the East Midlands (Felstead, 1988). He found that those who worked for franchisees were more likely to be young, government-sponsored (i. e. on training schemes) women workers in receipt of payment levels and non-pay benefits (such as holiday pay) substantially below those paid by the industry’s more traditional employers.

Felstead says that these findings are corroborated by a survey of American fast-food restaurants, indicating that, despite the common characteristics that employees of company-owned and franchise restaurants exhibit, wages and especially fringe benefits (paid holidays, sick leave, uniform allowance, free meals, etc.) are greater for workers employed in company-owned stores than those employed by franchisees (Krueger, 1991; Katz and Krueger, 1992).

23.10 Chapter summary

The worldwide growth of franchising appears set to continue on a long-term basis. The growth of franchising overall (in real terms) is strongly dependent on the performance of the economy as a whole. Against this, business format franchising, concentrated upon more service-oriented activities, is likely to experience growth rates notably faster than those applying for franchising as a whole.

A number of factors appear likely to promote future growth. First is the general worldwide decline of traditional manufacturing industry and its replacement by service — sector activities. Franchising is especially well suited to service and people-intensive economic activities, particularly where these require a large number of geographically dispersed outlets serving local markets.

A second factor is the growth in the overall popularity of self-employment. Most governments throughout the world are looking towards self-employment and small business as an important source of future jobs. As franchising becomes increasingly well known and understood, it is likely to appeal to a growing number of people. Alongside this trend, we may expect to see an increase in the number of franchise opportunities. This process will be assisted, not least, by large companies following the current trend towards divestment from centralised control of an increasing propor­tion of their business activities. A notable example in the UK has been the franchising of domestic milk-delivery. Increasing female workforce participation will continue the current trend towards dual-career and dual-income families, resulting in both the need and the resources to purchase services. Home service franchises (cleaning, maiding, lawn-care, house-minding, etc.) are likely to feature here, as are childcare and child development services.

The demands of an ageing population in many countries will also create opportun­ities, ranging from the need for special diets to special needs in the fields of leisure and care. In the US, the healthcare industry is turning to franchised medicine, ranging from private-duty nursing agencies to the provision of alternative medicine. Greater aware­ness of health issues generally will also throw up opportunities in sectors ranging from food to exercise and counselling services. Entertainment and leisure activities will also offer additional franchise opportunities, ranging from travel agencies to ventures such as miniature golf courses, dance studios, specialist movie theatres, etc. American experience suggests that growth levels in the number of franchised outlets are unlikely to match growth levels in sales turnover figures, since franchise outlets tend to be larger than the average conventional small business in turnover terms.

On balance, it does not appear that franchise operations substantially displace conventional small businesses. Where they do challenge them, it is often because they act as a new force in the field with the flexibility to respond rapidly to changes in tech­nology and market demand. They themselves may then subsequently be threatened by exposure to similar market forces, thus rendering their businesses and their profit margins more vulnerable than they and their franchisees would have expected or hoped. However, it is obviously untrue that those who eat at McDonald’s do so with­out any measure of substitution concerning their former eating habits, or that cus­tomers of Kall-Kwik or Prontaprint still place their customary orders with traditional print firms. Encroachment and additionality appear to have developed hand-in-hand, usually aided by developments in technology, customer tastes and consumer spending power.

If we look at the quintessential icon of the industry — fast-food franchising — it is unlikely that it has not in some measure diverted trade away from more traditional providers in the field (many of them almost certainly small independents). However, the conditions fuelling a market restructuring here were almost certainly the develop­ment of technology capable of producing food quickly on a standardised basis, and a growth generally in trends towards convenience foods and eating out. Similarly, in the field of fast print franchising, new technology reduced the training and skill levels required to produce print copy and final product from years to weeks. The result is that print products can now be produced in hours rather than days, using cheaper and less skilled labour, while relocating from manufacturing premises off the high street to ‘business service’ premises on the high street. An additional key factor assisting the growth of fast print franchising was the trend of large firms in the 1980s to divest themselves of many internal services, and ‘buy in’ instead.

When a franchise first comes into being, it ideally requires some ‘unique selling point’, giving it an advantage over its competitors. Over time, however, competition arrives to challenge its market position. This may come in the shape of new franchise operations but may, equally, take the form of conventional small business operations.

Women and minorities appear to have increased their representation in franchising in recent years in the US. Although both groups are less visible than might be expected in terms of their general participation in the labour force at large, the evidence indi­cates that around 10% of franchise units in the US are owned outright by women plus another 20% owned by women in alliance with men. Around 5% of franchise units were owned by minorities in the US in 1986 compared with an 8.8% ownership level of US firms generally. This is despite government schemes targeted specifically at increasing the level of minority representation.

The help afforded by franchisors in setting up new franchisees, particularly those with no prior business experience, renders franchising a potentially fruitful route for increasing female and ethnic participation in small business. Thus, any government assistance to franchising is best advised to be targeted at indigenous franchises — par­ticularly those with export potential and the facility for spreading jobs and enterprise among ethnic groups where opportunities might otherwise be lacking.

E-commerce and the small business

Nigel Lockett and David Brown

22.1 Introduction

This chapter looks beyond the extraordinary developments in information and com­munication technology (ICT), particularly e-commerce and e-business, to the oppor­tunities and challenges presented to small businesses by the emerging digital economy. E-commerce is but one, albeit high-profile, element of the e-business revolution in which small and medium-sized enterprises (SMEs) are able to utilise modern technologies to conduct business in new and innovative ways. Whilst business to consumer (B2C) e-commerce attracts much attention, over 85% of e-commerce revenues are generated within the business to business (B2B) sector. Furthermore US B2C e-commerce retail sales, whilst rapidly approaching $20bn per quarter, still represent only 2% of US retail sales across all sectors. Figure 22.1 shows the threefold rise in sales over the past four years.

Clearly there is considerable variation across market sectors with some sectors dom­inated by online sales, such as low-cost European airlines where over 95% of ticket sales are online. E-business, however, is more than e-based transactions and extends to new business models and new processes, both internal and external, many of which are collaborative. Dealing with such ICT-led change requires any company to constantly evaluate and respond appropriately. However, the strategic, organisational and financial impact on small businesses can present particular challenges. Unlike large firms they are unlikely to have the human and financial resources to appreciate fully the threats and the emerging opportunities from new ICT, such as broadband or 3G mobile technologies.

To discuss the implications of these radical developments the chapter is divided into three main sections. First, the context for e-business in small businesses is developed, including: definitions, government policies, nature of e-business engagement and the barriers and drivers to adoption. Second, three main strands of theory relating to e-business in small businesses are reviewed, namely: ICT adoption, inter-organisational networks and e-business models. Recent research into the role of aggregation and intermediaries is also discussed since this is likely to prove to be highly significant for small businesses and their engagement in e-business. Finally, the importance of trusted third parties is considered.

Figure 22.1 US online sales by quarter

(D

<2

fD

О

Online sales__________ Percentage of retail sales

Source: US Commerce (2005)

22.2 Learning objectives

1 To understand the challenges and opportunities of e-business for small businesses.

2 To appreciate the current levels of engagement of small businesses in e-business.

3 To understand the strategic context and impact of e-business in small businesses.

4 To appreciate the role of aggregation and intermediaries in e-business adoption by small businesses.

Key concepts

■ e-business ■ e-commerce ■ ICT adoption ■ networks ■ intermediaries

■ aggregation

22.3 E-commerce in context

Governments in many leading economies, including the UK, have established national policies to encourage small businesses to adopt ICT, particularly e-business, and have

set benchmarked targets to monitor their progress. Research between 1999 and 2004, within the UK government’s authoritative Department of Trade and Industry (DTI) series of International Benchmarking Studies, suggests that this adoption is proving more problematic then anticipated:

the trend of smaller businesses ‘clicking off’ is unmistakeable. It is particularly marked in the UK, and has been sustained for the last three years. . . smaller businesses face a real hurdle in moving beyond simple e-commerce to becoming true ‘e-businesses’ . . . smaller businesses, more than any, need someone to help them exploit the technology, but no one’s set up to do it.

(DTI, 2004: 14)

However, the DTI’s most recent study suggests some improvement with the UK’s micro and small businesses showing significant gains in the uptake of websites and trading online (DTI, 2004: i). Other studies looking across various industrial sectors in Europe (European Commission, 2004b) present a more varied and complex picture. Clearly the use of ICT in large companies tends to be more complex and sophisticated than that in small businesses. This often translates into more intensive and advanced e-business practices. Even in those sectors, such as the automotive and chemical indus­tries, that are international leaders in e-business adoption, there remains a significant ‘digital divide’ between the large companies and the many small businesses within their supply chains.

It is within this context of the relative low engagement by small businesses in the more complex e-business technologies, resulting in a perceivable ‘digital divide’ between large and small firms, that this chapter seeks to explore how individual firms and groups of firms approach engagement in e-business.

22.3.1 Definition of e-business and e-commerce

E-business and e-commerce have been variously defined to mean the same, or different, concepts. Kalakota and Whinston (1996) defined e-commerce from four perspectives, namely:

■ Communication — as the delivery of information, products/service or payments over telephone lines, computer networks or any other electronic means.

■ Business process — as the application of technology towards the automation of busi­ness processes and workflows.

■ Service — as a tool that addresses the desire of firms, consumers and management to cut service costs while improving quality and increasing the speed of service delivery.

■ Online — as the capability of buying and selling products and information on the Internet and other online services.

Turban et al. (2004) in their widely cited book state: ‘we use the term electronic com­merce in its broadest scope, which is basically equivalent to e-business.’ In the important UK Cabinet Office’s e-commerce@its. best. uk report, which became the early reference point for much of government policy, it is stated: ‘what the government describes as e-commerce is recognised in industry as e-business’ (Cabinet Office, 1999). The report, however, made a distinction between process and transactional e-commerce, namely:

Figure 22.2 Elements of e-business activities

External

processes

Within

Between

Between value chain partners

Business to

Business to

Business to

establishment

establishment

business

government

consumers

E-business

E-commerce

Internal

processes

Source: European Commission E-Business Watch initiative (2004)

■ process — B2B activity for intermediate goods and a wide variety of information.

■ transaction — both B2B and B2C activity for final products and services.

Currently, the DTI defines e-commerce as ‘any form of business transaction carried out electronically over public telephone systems’ and uses a progressive model of e-adoption. In this model e-commerce is defined as ordering and paying online, thus reducing transaction costs, whereas e-business is seen as supply chain integration, so that manu­facture and delivery become seamless. This is a helpful distinction.

Confirmation of this distinction can be seen in the recently introduced European Commission E-Business Watch initiative (European Commission, 2004b), which tracks e-business activity in Europe and states ‘e-commerce will be taken to cover external transactions, and it therefore may be seen as a sub-group of e-business activities’ (Figure 22.2).

The E-Business Watch benchmarking programme also went further and proposed a detailed scoreboard of e-business technologies and applications (Table 22.1).

Over time the clear trend has been towards using e-business as the broad term for all ICT-supported activities and e-commerce to be more directly concerned with transactions. This chapter adopts that convention and e-commerce is taken to be trans­action focused and defined as: selling or buying of goods or services using electronic communication networks. Similarly e-business is viewed as transaction, process and collaboration focused and defined as: the use of electronic communication networks to transact, process and collaborate in business markets. Hence in this definition e-business incorporates e-commerce.

Within these definitions there is a broad spectrum of applications from simple e-mail and websites to the more complex applications of customer and supplier integra­tion, which are collaborative in nature. It is the latter higher-complexity applications that may provide the major economic and competitive benefits; yet in 2004 UK small businesses were typically four times less likely than larger firms to be engaged in these higher-complexity collaborative applications (DTI, 2004).

Table 22.1 Scoreboard of e-business technologies and applications

Area

Number

Indicator

ICT infrastructure

1

Internet access

2

Broadband Internet access

3

Intranet

4

Extranet

5

Employee’s access to e-mail

E-commerce

6

Website

7

Online selling

8

Online procurement

9

B2B e-marketplace

E-business processes

10

Online collaboration

11

eCRM

12

IT-supported ERP

13

Online working hours tracking

14

E-learning

Source: European Commission E-Business Watch initiative (2004) (www. ebusiness-watch. org)

22.3.2 Nature of e-business engagement

The recent and rapid emergence of e-business applications has been primarily as a result of the availability of a low-cost, ubiquitous electronic communication network — the Internet. Telecommunication, technology and service companies have emerged or evolved to provide a range of e-business services or web services designed to exploit existing and emerging communication infrastructures. Typically these companies are known as application service providers (ASPs) and variously defined as:

■ ‘third-party entities that manage and distribute software-based services and solutions to customers across a wide area network from a central data facility’ (Webopedia, 2005);

■ ‘provides a contractual service offering to deploy, host, manage and rent access to an application from a centrally managed facility, responsible for either directly or indirectly providing all the specific activities and expertise aimed at managing a soft­ware application or set of applications’ (Gillan et al., 1999);

■ ‘a secure, flexible and integrated approach to delivering differentiated business value by combining the systems and processes that run core business operations with the simplicity and reach made possible by Internet technologies — IBM’ (Amor, 2000).

The technology used by ASPs to deliver services relies on ‘thin-client’ application server products, such as Microsoft’s terminal server and Citrix’s WinFrame applications, addressing client devices, such as PC and Windows terminals. The use of web browser technologies on the client devices both reduces the sophistication of the client device (thus reducing purchase and support costs resulting in a lower total cost of ownership) and increases the interoperability of devices (as more devices incorporate web browsers). Whilst ASPs are external to organisations, larger enterprises can use these technologies to provide ‘in-house’ services, which effectively moves applications off PCs on to application servers, resulting in central control over application cost, usage and sup­port. The provision of these hosted applications, by ASPs, on a rented basis is viewed as of particular relevance to small businesses.

The new (hosted) applications that facilitate e-business are very different from tra­ditional (resident) applications in one main regard, namely that the user interface, application software, data processing and data storage can be located on different and multiple software and hardware platforms, and can be provided and supported by dif­ferent entities (Figure 22.3).

They are, in essence, hosted services accessed by the user via a simple interface, such as a web browser, over electronic communication networks, such as the Internet. This is a fundamental change in the relationship between user, hardware and software and presents opportunities for new business models for service provision. Typically these hosted applications are offered on a rental or fee basis, rather than the traditional pur­chase model. The fee typically includes the use of the software and the provision of the processing and storage platforms, but not the provision of the electronic communica­tion network. Importantly, these electronic communication networks are increasingly being considered as ubiquitous and are rapidly evolving from the public Internet through virtual private networks to grid computing and 3G mobile platforms. They provide the communication platforms on which ASPs can deliver hosted services. Service providers, however, come in many guises including ASPs, storage service providers (SSPs), network

Figure 22.3 Architecture for e-business applications

Table 22.2 Classification of e-business application complexity

Proposed classification

Examples

Complexity

Communication

Marketing

Productivity

E-commerce

Collaborative

Enterprise

Market-place

Collaborative enterprise

Collaborative platform

E-mail, web access Website

Microsoft Office, intranet Buying and selling online Extranet

Financials, sales for automation, vertical applications E-marketplaces

Supply chain management, customer relationship

management

Emerging platforms

Very Low

Low

Low

Medium

Medium

High

High

Very High Very High

Source: Adapted from Gillan et al. (1999)

service providers (NSPs), content service providers (CSPs) and wireless application ser­vice providers (WASPs).

To begin to understand the issues involved in e-business engagement we need to classify e-business applications, as there are significant differences between e-mail and e-marketplace applications both in terms of complexity and added value. The intro­duction of the EC E-Business Watch synthesis report represented an important move towards tracking e-business engagement across 15 industry sectors and over a range of e-business applications throughout all EU Member States (European Commission, 2004b). The report concluded that access to ICT was no longer a barrier to e-business uptake with connectivity at 84% for small businesses. It stated: ‘the use of e-mail and the www has become nearly ubiquitous in the business world’ (European Commission, 2004b: 7). However, this indicates an oversimplification evidenced by the tendency to equate e-business with e-mail usage and web access. A classification for e-business applications based on application complexity is shown in Table 22.2.

Importantly, this classification of application complexity stresses the roles of col­laboration and interaction as key features of e-business applications, and recognises the resultant increase in complexity. This taxonomy of e-business complexity incorporates both technical and organisational factors. For example, both the security technology issues underpinning higher complexity hosted applications, and the perceived com­mercial risk of storing sensitive client information in third-party data centres increase with higher complexity. In this way application complexity provides a meaningful framework in which to consider, compare and analyse e-business engagement. Using this classification recent survey data (EC, 2003b; DTI, 2004) is analysed to show the level of e-business engagement by small businesses in terms of application complexity (Figure 22.4).

In summary, Figure 22.4 suggests that most small businesses appear comfortable with e-mail and web access (lower complexity, about 80%), are tentative with the use of the Internet for online buying and selling (medium complexity, about 30%), but have little or no engagement in the high or very high complexity applications, such as e-marketplaces, supply chains or inter-organisational collaborative networks (less than 10%). This is despite the early promise of ASPs facilitating such access to complex

100

□ EC EU □ EC UK ■ DTI UK □ UK Average

75

С

Qi

E 50

<u

ci

IQ

Cl

С

25

Very High

Very Low Low Medium High

Application complexity

Source: EC (2003b); DTI (2004)

applications. Hence the trend in Figure 22.4 is not merely surprising in terms of the early expectations of engagement, but raises the important question of what this relative lack of engagement will mean not only for small businesses but also the larger organ­isations that have significant numbers of small businesses in their supplier networks.

This ‘digital divide’, which is evident in the widely differing rates of e-business adoption, has crucial theoretical and policy implications. Regarding theory, our under­standing of ICT adoption by small businesses is largely characterised by the single firm as the unit of analysis and by a user perspective. Less well understood theoretically is the impact on adoption of other factors including the ‘provider’ perspective, the signi­ficance of ‘application complexity’, the role of aggregation and not least the behaviour of small businesses within networks such as supply chains. Regarding policy, the cen­tral belief that Internet access per se would be the key to increasing adoption of higher complexity applications for all firms has been shown to be inadequate as over 90% of UK businesses now have access to the Internet, but without a corresponding increase in their use of the more complex e-business applications.

23.3.3 Drivers and barriers for e-business engagement

The reasons why businesses, both small and large, choose to adopt e-business tech­nologies are important in order to identify the value and benefits businesses have either achieved or believe they will achieve. Recent DTI studies (2003c) have highlighted a number of drivers or enablers to ICT adoption, including: increasing business turnover; increasing customer base in existing markets; communicating better with customers;

more efficient operations; communicating with workforce; enabling better financial management; operating more effectively with suppliers; improving delivery of goods and services; and better integration of business processes. Increase in turnover is con­sistently identified as the main driver to adoption. Drivers highlighted by other authors include: cost reduction; business partnership development; providing quality service; meeting customer/supplier demands; and creating/gaining competitive advantage (Hawkins and Prencipe, 2000; Clegg, 2001).

In terms of barriers to engagement many studies have been conducted in order to identify the barriers to ICT adoption by all enterprises, and small businesses in par­ticular (DTI, 2003c). These highlighted a number of barriers to adoption, including: security; risk of fraud, concerns about confidentiality, set-up costs; running costs; not enough customers with online access; employees without IT skills, lack of information or knowledge. Security is consistently identified as the main barrier to adoption.

The broad theme of e-business engagement by small businesses, central to this chap­ter, is developed further below through a review of the relevant theory and later by considering recent research initiatives.

22.4 Understanding e-business within small businesses — theory and practice

In terms of informing our understanding of e-business and small businesses three main strands of theory are relevant. The first is the adoption of ICT by small businesses, including the diffusion of innovation. The second is the concept of aggregation and of inter-organisational networks as an organisational form. The latter provides the wider context within which the third strand of theory dealing with the emergent e-business model literature is discussed, with particular attention focused on the role of new intermediaries.

22.4.1 ICT adoption by small businesses

The broad antecedents for a theoretical appreciation of ICT adoption by small busi­nesses are studies of technology transfer and the diffusion of innovations. Technology transfer can be seen as largely purposeful and is characterised by planning and delib­erate actions. In contrast, innovation through diffusion is seen more as a natural process. In reality both mechanisms of technology transfer and diffusion are likely to coexist. However, this distinction, highlighted by Chakrabati and Rubenstein (1976) in their study of interorganisational technology transfer, is helpful since policy makers need to delineate the areas of intervention for facilitating e-business engagement, while recognising that other mechanisms will be at play.

Although studies on the adoption of e-commerce by small businesses are relatively recent, research antecedents are well established. Rogers’ work on the diffusion of innovations (1962, 1995, 2003), whilst initially neither ICT nor SME-focused, has evolved to incorporate diffusion networks and critical mass in order to appreciate the adoption of interactive innovations, such as the Internet (1995: 313). The early work of Rogers took a provider (or supplier) perspective and identified the characteristics of innovation, which would impact on its rate of diffusion including such factors as com­patibility, complexity, observability, relative advantage and trialability. In particular Rogers highlights the important roles of change agents (intermediaries) in influenc­ing innovation decisions, including developing a need, establishing communication, diagnosing problems, creating an intent to change and then action. Theoretically the role of the intermediary as a means of facilitating the diffusion of complex ICT has been observed by a number of other authors, most notably Swan and Newell (1995) and Newall et al. (2000).

Within the specific domain of ICT adoption by small businesses, recent studies utilising Rogers’ model of innovation include Kendall et al. (2001) and Mehrtens et al. (2001). These two studies provide support for the applicability of the model when related to e-business engagement by small businesses. Many other authors have con­tributed and three themes of work can be identified which, although overlapping, can usefully be separated, namely technological, strategic and organisational. All three strands can be interpreted within the long-established technology-push and need-pull models of technology innovation adoption in information systems (IS) (Zmud, 1984; Chau and Tam, 2000). These models typically identify ‘push’ factors, such as Govern­ment initiatives or technological drivers, and ‘pull’ factors, such as organisational crises or market opportunities.

The first literature theme, and arguably the most prolific, is the technological theme that views adoption as an outcome of a complex process of evaluation, frequently informal, by small businesses of multiple factors both external and internal. These factors are frequently cast as enablers or barriers to adoption (Lefebvre et al., 1991; Cragg and King, 1993; Walczch et al., 2000; Mehrtens et al., 2001; Windrum and Berranger, 2003). Iacovou et al. (1995) focused on the single technology of electronic data inter­change (EDI) and identified perceived benefits, organisational readiness (resources) and external pressures (competitive and non-competitive) as the critical factors in adoption. Since EDI is a complex application (but not necessarily Internet-based) these findings may be particularly relevant in the adoption of similar, higher-complexity e-business applications.

The second theme is that which emphasises the strategic logic in the decision to adopt ICT (Blili and Raymond, 1993; Kowtha and Choon, 2001; Sadowski et al., 2002). In this context small businesses can be both victims and beneficiaries depending on their degree of proactivity. Blili and Raymond (1993) showed that IS planning was increasingly critical for SMEs as technology became more central to their products and processes, and they concluded that IS planning needed to be integrated with business strategy. Hagmann and McCahon (1993), however, concluded that in reality few small businesses plan their adoption of IS and that the limited planning that was evident was focused on operational improvements and was not concerned with competitiveness. The notion of strategic information systems planning in small businesses is further developed in Levy and Powell (2000, 2003) and Levy et al. (2001). This strand of research has resulted in frameworks, such as Levy’s ‘focus domination model’, to help position and integrate ICT investments — some of which could be e-business applica­tions. A model of the strategic use of IS by small businesses was proposed by Levy and Powell (2000, 2003) consisting of three interdependent factors, namely strategic con­tent, business context and business process.

The third theme is that which takes an explicit organisational stance, and frequently that of the owner-manager and the social parameters within which the firm operates. As such, the approach counters the strategic or technological emphasis of the first two strands (Blackburn and McClure, 1998; Fuller and Southern, 1999; Poon and Swatman, 1999; Southern and Tilley, 2000; Quayle, 2002). An important observation of Southern and Tilley is that ‘when small firms use IT complex relations unfold. It is by no means a simple linear development whereby observers can expect an incremental build up of knowledge and expertise on ICT to be established within the firm’ (1999: 152). In the context of the adoption of increasingly complex e-business applications this view appears highly pertinent. Indeed this explicit organisational stance is very important in the context of the ‘technology-push/need-pull’ models applied to small businesses, since the analysis of social factors can identify the antecedents that need to be satisfied before the initial decision to adopt can be made.

22.4.2 Inter-organisational networks and aggregation

Since the medium — and higher-complexity e-business applications are essentially col­laborative in nature the theoretical perspective of organisational networks is particu­larly relevant for explaining firm behaviour. Although ‘networks’ have always existed the recognition of networks as a distinct organisational form, amenable to analysis and theoretical development, is more recent (Granovetter, 1985; Thorelli, 1986; Miles and Snow, 1986; Provan and Milwood, 1995). As products have become increasingly mod­ular and knowledge distributed across organisations, firms have recognised an increas­ing requirement to collaborate with other firms both formally and informally (Baldwin and Clark, 2000). Consequently, the locus of innovation and adoption is no longer the individual or the firm but increasingly the network in which a firm is embedded (Jarillo, 1998; Ebers, 1997; Powell et al., 1996; Furtardo, 1997). The importance of the strength of ties in the supplier network for productivity has also been demonstrated (Perez and Sanchez, 2002) and the standards necessary for a technology to function across dif­ferent markets depend increasingly on networks of firms (Munir, 2003). For smaller firms the ability to gain access to new technologies is one of the principal reasons for engagement (Grandori and Soda, 1995) and cross-industry networks have been shown to play an important role in the diffusion of complex technologies (Erickson and Jacoby, 2003). These theoretical developments have been complemented by other advances on many different fronts: strategy, competition and collaboration (Doz and Hamel, 1998); network structure and embeddedness (Granovetter, 1985; Shaw and Conway, 2000); trust and governance (Johannisson, 1986a; Ring and Van de Ven, 1994); classification and evaluation (Cravens et al., 1996; Sydow and Windeler, 1998). What all these above theoretical contributions have in common is that they were developed outside a specific e-business context (i. e. offline). Nevertheless they provide many of the antecedents for the later emerging concepts of e-business networks (i. e. online).

The concept of business aggregations is well understood. These emerging, stable, non-equity based collaborative arrangements have become increasingly important as a means of reducing cost (Contractor and Lorange, 1998; Zajac and Oslen, 1993) or to increase revenue (Contractor and Lorange, 1998) or to mitigate risk in response to

Figure 22.5 Taxonomy of aggregations for SMEs

Association

Network

Limited

Cluster

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a:

о

(U

2

cn

OJ

Q

Low

Degree of integration

High

Source: Brown, D. and Lockett, N. ‘The Potential of Critical Applications for Engaging SMEs in E-Business’, 2004, European journal of Information Systems, Vol.13 No.1, Palgrave Macmillan, reproduced with permission of Palgrave Macmillan

economic factors (Ebers, 1997). Such aggregations have generally been termed strategic networks and Jarillo’s definition has been widely adopted:

Strategic networks are long-term purposeful arrangements among distinct but related for profit organisations that allow those firms in them to gain or sustain competitive advantage vis-a-vis their competitors outside the network.

(Jarillo 1988: 32)

Even within the above definition there are many possible manifestations of the network form and many ways of classifying them. In short, all inter-organisational networks (IONs) are aggregations but not all aggregations are networks. This presents potential difficulties in comparing ION research. Grandori and Soda (1995) differentiate networks by the extent to which the links between organisations are formalised and networks are termed bureaucratic, social or proprietary. A further classification from Cravens et al. (1996) links the type of network relationship (from short-term, transactional to long­term, collaborative) to the degree of unpredictability, and hence risk, in the environ­ment. In the context of small businesses, Brown and Lockett’s (2004) classification draws on the above, particularly Grandori and Soda, and links the degree of structure (informal to formal) to the degree of integration (independent to integrated) — see Figure 22.5.

Within the broad concept of aggregation this taxonomy locates ‘networks’ as one form of strong or complex aggregation that can be contrasted with other weaker or simpler aggregation forms — a distinction useful when considering the nature of a small business’s engagement in an aggregation and the role of any intermediaries. Whilst online aggregation, at small business or industry level, was seen as a way of engaging the small business, consideration needs to be given to existing offline aggregations or groupings. Small businesses operate in business markets comprising relationships within their supply chain or industry sector, which can range from simple to com­plex in nature. The degree of structure (informal to formal) and degree of integration (independent to integrated) provides a taxonomy suitable for both online and offline aggregations and comprises four types:

■ Limited — any relationships are loose and participants are independent, charac­terised by little or no aggregation. Intermediaries range from local business groups to more sophisticated organisations.

■ Association — including trade associations and professional bodies, where reputa­tion is enhanced by membership and structure is high, but businesses remain largely independent.

■ Cluster — forming part of an identifiable business market, business cluster or eco­nomic cluster (Porter, 1998) where small businesses are increasingly dependent on complex linkages within a sector, but structure is low.

■ Network — represents a more highly developed form of cooperation that exhibits both relatively high structure and integration. In the literature these networks are often implicitly described from a large business perspective.

The reality of practice challenges our theoretical understanding of both the adoption by small businesses of e-business and the emergence of aggregations as a meaningful development within the context of adoption. Here aggregation is defined as any group­ing of enterprises where there is evidence of inter-organisational relationships that go beyond simple transactions. These aggregations can range from local retail traders campaigning for improvements to their local infrastructure to the highly developed supplier-based networks of the aerospace industry.

22.4.3 E-business models

The final strand of theory is the emergent e-business model literature, which includes insights into alternative business models and changing industry structures as a result of Internet-based technologies. A number of authors have offered broad conceptualisa­tions of e-business models (Amit and Zott, 2001; Timmers, 2000; Hamel, 2000; Alt and Zimmermann, 2001; Afuah and Tucci, 2001; Weill and Vitale, 2001; Currie, 2004). Other authors have developed models specific to particular situations. Examples include: business-to-business (B2B) vertical supply chains (Kalakota and Robinson, 2000) and value adding intermediaries (Earle and Keen, 2000).

The need to encourage e-business engagement by small businesses has been readily acknowledged by industry and government but just how this was to be achieved, par­ticularly with the more complex e-business application areas, remained unspecified. When examining the uptake of e-business among small businesses the concepts of collaborative networks, interdependence, power and trust provide important contribu­tions. For example, whether owner-managers use adversarial or collaborative approaches to purchasing relationships may impact on their adoption of ICT (Cox and Hines, 1997). Similarly, the scope for intermediaries to play a crucial role in the support and provi­sion of SME-orientated e-business applications has been noted (Currie, 2002, 2004; Smith and Kumar, 2004; Mazzi, 2001). In the specific context of ASP models and small businesses, several critical and reflective analyses have recently emerged (Kern et al., 2002; Susarla et al., 2003). In the main, all the above contributions reinforce the

Figure 22.6 eTrust Platform

general significance of intermediaries as trusted third-party facilitators of IT diffusion, as noted by Swan and Newell (1995) and Newell et al. (2000), and cited earlier. However, the setting for these latter authors’ works was not SME-specific. A conceptualisation that is small business grounded and focuses on intermediaries and their role in facilitat­ing e-business engagement by small businesses is the eTrust Platform (Figure 22.6).

22.4.4 Aggregation and intermediaries in e-business adoption

The eTrust Platform conceptualisation of the role of intermediaries in the digital eco­nomy discussed above highlights the relationships between multiple small businesses and the intermediaries necessary for online aggregations of small businesses to function. There are three kinds of intermediary. The role of the technology intermediary is to provide the ICT infrastructure on which services can be provided and could include hardware, security and communications. The role of the enterprise intermediary is to provide the services including applications software, hosting and consultancy. The technology and enterprise intermediaries can be considered as generic. In reality these functions could be provided by one or more organisations. The community intermediary, however, is specific to a particular aggregation. It has a critical role in gaining the com­mitment of potential participants to enter the e-aggregation and can be considered as a trusted third party. It is the community intermediary, providing a broad governance function, which is a distinguishing characteristic of the eTrust Platform conceptualisa­tion. A trade association would be an example of a potential community intermediary.

Three major findings have emerged from recent research, which focused on the role of aggregation and intermediaries in engaging small businesses in the more complex, high value-adding e-business applications (Brown and Lockett, 2004, 2005; Lockett and Brown, 2006). The research serves as a guide to how small businesses, through aggrega­tion and the support of intermediaries, can access in a cost-effective way sophisticated applications. Given the growing trend towards hosted applications outlined earlier in the chapter more small businesses are likely to follow the trusted platform route. The findings are summarised below.

22.4.5 Emergence of critical e-aggregation applications

Community intermediaries, such as trade associations, confirmed the importance of SME-focused applications that attempted to meet a specific, important and common need by the group of small businesses. In some cases community and enterprise inter­mediaries collaborated in order to identify both the initial business needs of the small businesses within the aggregation and any subsequent desirable modifications to the critical e-aggregation applications. Early examples of critical e-aggregation applications developed in this collaborative way included:

■ project management — for the construction industry (www. biwtech. com/)

■ dairy herd management — for dairy farmers (www. milknet. sac. ac. uk/)

■ community management — for knowledge-based workers (www. pcg. org. uk/)

■ advertising artwork management — for artwork agencies (www. adfast. co. uk/)

■ field management — for the organic farming industry (www. organicecology. com/),

where a critical e-aggregation is defined as: an e-business application, promoted by a trusted third party, which engages a significant number of small businesses by addressing an important shared business concern within an aggregation. In the main these critical e-aggregation applications were relatively new and in the early stages of development but already they appeared to be successfully measured by the level of uptake. Commun­ity intermediaries reported that some service providers of critical e-aggregation applica­tions took the lead and developed the applications without a guaranteed market for the product. These service providers had identified community intermediaries early in the application’s development and sought to establish collaborative arrangements that mitigated the risk and developed trust.

Critical e-aggregation applications are characterised as offering new functionality that was valued by aggregation members, was developed by interaction with com­munity intermediaries and used a ‘one-to-many’ business model. On this basis these e-aggregation applications can be seen as ‘critical’ both in terms of functionality and perceived importance. The innovative nature of these ‘critical e-aggregation applica­tions’ was the single most important factor for using the application.

22.5 Importance and role of trusted third parties

Trusted third parties proved to be key in establishing the confidence necessary for small businesses to engage in the more complex e-business applications. There was recogni­tion by many community intermediaries that existing trusted offline relationships, be they a lead company in a business network or a trade association, could be import­ant in recruiting small businesses to online services. Trade associations, in particular, identified a new role for themselves as a sponsor or facilitator, rather than a direct provider of e-business services.

The trusted third parties in e-aggregations exhibited several characteristics. First, they deliberately worked with service providers (enterprise intermediaries) to appreci­ate the business needs within the aggregation and develop the e-business applications to meet these needs. Second, they were aware of the accumulation of valuable informa­tion about the aggregation resulting from interaction with the e-business application. Third, they participated in activities that attempted to increase e-business application engagement of small businesses in the aggregation. These activities included: shaping users’ perceptions; identifying and introducing the innovation to sub-groups within the aggregations; promoting (targeting) it to and through key actors; and providing incen­tives to early adopters.

In addition to the contribution made by the community intermediaries to the devel­opment of specific applications and to facilitating access to small businesses they had two further roles that derived directly from their trusted third-party status. First, as negotiators of the service fees charged either directly to users or themselves, and second, they acted as negotiators for the service level agreement with the service providers. Considering the importance of these agreements in the context of hosted applications, this implies a high level of trust on the part of the users, but also for many of them an indication of their dependence.

22.5.1 Evidence of increased structure and integration

From the research it appears that small businesses engaged in aggregation-based e-business applications had a propensity for further integration. This observation indic­ates that the impact of critical e-aggregation applications could be of strategic import­ance as it changes the very nature of these inter-organisational networks. First, the critical e-aggregation applications increased the degree of structure by standardising the format of information in order to facilitate information exchange. Second, the degree of integration was increased by the use of these critical e-aggregation applications. Significantly, the general effect of the critical e-aggregation applications was to move the inter-organisational networks towards the ‘network’ type shown in Figure 22.4.

In terms of the future outlook for small businesses’ engagement in e-business the role of critical e-aggregation applications and of trusted third parties appears to be pivotal. Despite this, however, there is little evidence of national or regional agencies having identified this as one possible method of achieving their stated objectives of increasing e-business engagement by small businesses. One notable exception is the Australian gov­ernment’s Information Technology Online (ITOL) programme which acts as a catalyst by funding projects to existing aggregations dominated by small businesses and offer­ing strong supporting evidence of the emergence of e-aggregation applications (NOIE,

2005) . There have been 13 rounds of funding since 1996 resulting in the selection of over 100 collaborative e-business projects that encourage the adoption of e-business solutions by small businesses across a broad range of industry sectors and geographic regions. Recent examples include: Beef Industry Genetics, which sought to provide Inter­net delivery of modern breeding methods through collaboration with beef producers (www. breedobject. com); and Flinders Ranges Online Reservations for the tourism accom­modation industry, which enabled customers to book and pay for accommodation over the Internet in a secure manner and receive immediate confirmation (www. frabs. com. au).

22.6 Chapter summary

This chapter presented three main areas relating to e-business and the small firm. First, the context was developed for e-business in small businesses including: definitions, government policies, nature of e-business engagement and the barriers and drivers to adoption. Second, three main strands of theory relating to e-business in small busi­nesses were reviewed, namely: ICT adoption, inter-organisational networks and busi­ness models. Finally, recent research into the role of aggregation and intermediaries was discussed since this is likely to prove to be highly significant for small businesses and their engagement in e-business, and has policy implications.

In terms of e-business adoption, recent surveys indicate high levels of connectivity and usage of very low complexity applications, such as e-mail and web browsers, among small firms in the UK, Europe and North America. One recent study concluded that connectivity was no longer a barrier to e-business engagement. This suggests that most small businesses appeared comfortable with e-mail and web access (lower com­plexity). However, as application complexity increased levels of engagement declined significantly, indicating that small businesses are tentative about use of the Internet for online buying and selling (medium complexity), but had little or no engagement in the high or very high complexity applications, such as e-marketplaces, supply chains or inter-organisational collaborative networks. From a theory perspective there are a number of important issues. A particularly important one is the relevance of network theory for understanding firm behaviour, including small businesses, and the fact that the introduction of new cost-effective ICT can create new partnerships and relation­ships. Viewed in this way firms are members of aggregations and the final part of the chapter visited recent research that highlighted the particular benefits to small busi­nesses acting within aggregations. In direct contrast to firms acting alone, the evidence is that small businesses acting as part of an aggregation with a trusted intermediary are more likely to be engaged in higher complexity e-business applications. These critical e-aggregation applications are both sophisticated and meet the particular needs of both the small businesses and the service providers in a cost-effective way.

Strategy and the small business

Colm O’Gorman

21.1 Introduction

This chapter introduces the concepts of strategy and competitive advantage and their relationship to the management of small firms. Within the study of organisations the strategy concept is typically considered in the context of large firms. Do the concepts of strategy discussed in the literature apply in the context of small firms? We might expect them not to as small firms typically have fewer resources and are often organ­ised differently from large firms. Small businesses also differ from large businesses in their perception of opportunities and their commitment of resources to new opportu­nities (Stevenson and Gumpert, 1985). Large organisations are typically characterised by an administrative management style. The resources that the business controls drive the growth and development of the business. Large businesses consider investment pay-off in the medium to long term. In making strategic moves, the large business will typically analyse the opportunity and make a one-off commitment of resources. In contrast, the small business is typically characterised by a lack of resources and man­agement skills and by an entrepreneurial form of management. Small businesses can respond quickly to opportunities but may not be able to commit large amounts of resources to a new opportunity. Therefore, the small business manager tends to commit small amounts of resources, in a number of different stages, as opportunities emerge.

However, small need not be a competitive disadvantage. Small size can increase the flexibility of the business in responding to customer requests and to market changes. Small size can mean that the business can be more flexible in terms of production sys­tems (Fiegenbaum and Karnini, 1991) or in terms of price. Small size may mean that the business is faster to respond to changes in the market. Small businesses may be less risk adverse and more inclined to initiate competitive actions (Chen and Hambrick, 1995).

The differences between small and large firms mean it is often inappropriate to com­pare them in terms of the strategy-making process or in terms of the strategies associ­ated with success. Therefore it is important to consider strategy specifically in the context of the small firm and to consider how the characteristics of the small firm impact on how strategy is made and what strategies are associated with success. So, in reading this chapter bear in mind the following questions: What does strategy mean in the con­text of a small firm? Is it realistic for the small business to define its strategy and its strategic position? Should a small business have a formal strategy? Should a small firm ‘plan’ its strategy? What strategies should a small firm pursue? Can a small business reposition itself strategically?

The first part of this chapter outlines the strategy-making process in small busi­nesses, highlighting the fact that this is a highly informal and ad hoc process in most small businesses. The advantages of a formal strategy-making process are then dis­cussed. The second part of the chapter reviews research on the success strategies of small businesses. This review suggests that successful small businesses pursue ‘focused’ strategies and emphasise competitive advantages such as flexibility, fast response times and closeness to the customer. Innovation can also provide the small business with an important competitive advantage. The chapter concludes by highlighting structural and strategic weaknesses that impact on the choice of strategy and the strategy — making processes of small businesses. These weaknesses make it difficult for the small business manager to develop a clear competitive advantage. One of the most significant structural characteristics of small businesses that influences the strategy-making pro­cess is the centrality of the owner-manager. Strategic weaknesses include the lack of financial and managerial resources, reliance on a small customer base and poor tech­nological competence.

21.2 Learning objectives

1 To appreciate the strategy-making process in small businesses.

2 To recognise the importance of focused and differentiated strategies for small businesses.

3 To understand the strategies that are associated with success in small businesses.

4 To introduce the strategic weaknesses of small businesses.

Key concepts

■ Strategy ■ competitive advantage ■ focus strategy

■ the strategy-making process

21.3 What is strategy?

Strategy is about two questions: ‘What business(es) should we be in?’ and ‘How do we compete in a given business?’ (Hofer, 1975). Drucker (1977) referred to these two challenges in terms of effectiveness and efficiency. Efficiency means doing things right — ensuring that day-to-day operations are managed well; effectiveness refers to ensur­ing that the business is doing the right things — that the focus of the business is correct in the context of customers, competitors and industry trends. Efficiency ensures short­term survival by producing a profit from existing activities, while effectiveness ensures long-term survival by focusing the business on activities that will continue to produce profits in the future. The essence of a good strategy is that it is feasible, that is, it is con­sistent with the resources and skills of the business; that it provides a clear competitive advantage; and that there is a ‘fit’ between the business and its external competitive environment (Rumelt, 1991).

The outcome of a strategy should be a clear competitive advantage. A competitive advantage is an advantage that is valued by customers and which distinguishes the busi­ness from competitors. The source of a competitive advantage can be conceptualised in terms of the strategic positioning of the business or in terms of its resources and skills. The positioning approach emphasises the need for the business to achieve ‘fit’ with the external environment. To develop a strategy the business must have a clear under­standing of its market and of its competitors. The ongoing success of the business is dependent on its ability to maintain the ‘fit’ between itself and a changing environment.

The resource-based perspective argues that the source of a competitive advantage is the resources and capabilities of the business (Barney, 1991). By developing or acquir­ing resources the business can develop sustainable competitive advantages. Resources confer competitive advantage if they are hard to imitate, if they are heterogeneous (i. e. different from the resources that other businesses have) and if there is uncertainty as to the value of the resource. However, the value of resources can only be understood in the context of the market in which the business is operating and in the context of a particular moment in time. Of particular advantage to firms are having what are referred to as superior core competences and capabilities (Prahalad and Hamel, 1990). Core competences and capabilities refer to areas of activities within the firm that deliver added value to customers or allow the firm to operate more efficiently. In the context of small firms it is necessary to consider both superior competences and areas where the firm might have inferior competences and capabilities relative to competitors (Almor and Hashai, 2004).

The concept of strategy has different meanings in different contexts. Mintzberg pro­posed that strategy can be defined in five different ways, that is as a plan, as a ploy, as a pattern, as a position and as a perspective (Mintzberg and Quinn, 1991). Strategy as a plan refers to the intended actions that management have developed. When these plans refer to a specific decision they can be described as ploys. Mintzberg argues that not all strategies are planned but that in many situations strategy can be inferred from a pattern in a stream of decisions that management have made over time. Strategy can also refer to the position that the business has adopted in the external environment. This position can be defined in terms of the market that the business serves and the position that competitors have adopted. Finally, strategy can be conceptualised in terms of how a business perceives itself and its external environment; that is, in terms of the shared values and beliefs that guide the decisions made by the business.

21.4 Strategy making in the small business

In many cases the owner-manager of a small business may not formally articulate the business strategy or engage in any formal planning. However, there is a strong rela­tionship between the owner-manager and the strategy pursued by the small firm. The strategy chosen by the owner-manager is likely to reflect the personal priorities and goals of the owner-manager (Kisfalvi, 2002). In turn, the owner-manager’s personal priorities are likely to be determined by their own life experiences and prior work experiences. Furthermore, it is widely argued that the entrepreneur places a lasting ‘stamp’ on their company that influences the choice of strategy, organisational culture and managerial behaviours within the firm (Mullins, 1996). However, over-reliance on industry experience can result in a ‘me-too’ or ‘copy-cat’ strategy and no clear com­petitive advantage. In many industries with low barriers to entry, the cycle of ‘me-too’ new start-ups results in low profitability and high failure rates for small businesses.

Others have argued that strategy making in new and small firms is characterised by improvisation (Baker, Miner and Eesley, 2003). Improvisation describes a process whereby design and execution of a strategy occur simultaneously. Bhide (1994) argues that new ventures typically lack a planned strategy. Strategy in the ventures he studied emerged over time, with entrepreneurs responding flexibly to customer requirements. The ventures he studied typically faced significant capital constraints at start-up. There­fore, Bhide (2000) argues that in the context of new firms the key strategic challenge is the acquisition of resources. So rather than focusing on market position and com­petitive advantage Bhide suggests that the entrepreneur engages in creative ways of attracting resources and in generating sales. He argues that this process is unplanned and is typically characterised by ‘guess work’.

One approach to developing a strategy is to engage in a formal planning process. However, there is evidence to suggest that formal and comprehensive planning systems are rare in small businesses. The planning processes observed in most small businesses have been described as ‘informal, unstructured and sporadic’ (Cohn and Lindberg, 1972) and as ‘a passive search for alternatives’ (Bracker, 1982). The structure of the small business and the centrality of the entrepreneur mean that all ‘strategic planning’ is typ­ically concentrated in the owner-manager. The owner-manager may see no advantage in formalising the planning process that they use to develop the strategy of the business. Often the owner-manager will see disadvantages such as the potential loss of control, the loss of secrecy and the loss of flexibility.

The reality of strategy making and planning in the new venture context is that it is opportunistic and informal rather than formal. Founders analyse ideas parsimoniously and they integrate analysis and implementation (Bhide, 1994). However the lack of formal planning does not imply the absence of strategic thinking. Planning can be thought of as any reflective activity that precedes the making of decisions (Foster, 1993). Strategy change in new and small businesses may reflect a process of experimentation (Nicholls-Nixon et al., 2000). As such, the owner-manager seeks to determine the nature of the competitive environment and how best to compete in this environment by engag­ing in a process of trial and error learning.

21.4.1 The arguments in favour of adopting a formal planning system for a small firm

While formal planning systems may be uncommon in small firms there are some reasons for advocating that owner-managers engage in more systematic planning. Planning is generally perceived as a crucial element in the survival of new and small businesses (Kinsella et al., 1993; Hisrich and Peters, 1992; Jones, 1991). The models of planning suggested for small businesses have been adopted from the strategic management literature. However, small businesses differ from large businesses with regard to their planning needs and processes (Curtis, 1983). Small business generally do not have the resources to plan and purchase external advice and support; they are very susceptible to small environmental changes; owner-managers may not have the necessary experi­ence for managing all aspects of a small business; and owner-managers cannot devote a lot of time to consciously working through plans because of day-to-day work pres­sures. A consequence of this is that owner-managers tend to have a shorter and more functional emphasis on planning. The essential components of a successful planning process in a small business are that the owner-manager is central to the planning pro­cess; the owner-manager and, where relevant, managers, must have sufficient time to devote to the planning process; and effective planning will only be possible if sufficient internal information is available. This means that an adequate financial record keep­ing and financial control system should be in place in the business. Financial informa­tion must be timely and accurate.

Business plans are essential if entrepreneurs are to acquire external financial sup­port. By planning, the chances of success are increased as the right battlefield to suit one’s skills is chosen (Hay et al., 1993). Timmons (1994) argues that plans give the new business a results orientation that it would otherwise not have; that they force the new business to work smarter so that goals can be attained in the most effective and efficient manner possible; and that planning results in the consideration of alternatives that may not otherwise have been thought of and this allows planners to choose the optimum way of approaching a problem and, at the same time, it also makes them think ahead.

There are two main roles and uses of plans. Plans are used as communication devices and as aids to controlling the business’s factors of production (Mintzberg, 1994; Baker et al., 1993). The preparation of a business plan by an owner-manager is often seen exclusively as an external communications device. For some owner-managers a plan is written merely to improve legitimacy and satisfy demands from external agencies in order to acquire funding (Frank et al., 1989). A clear description of how the entre­preneur will exploit the business opportunity allows investors to decide whether the project is a worthwhile investment and assess the risk attached to it. The second role of a plan is as a control device. Plans provide benchmarks against which subsequent performance can be evaluated. This is particularly important in small businesses as the owner-manager’s time tends to be consumed by day-to-day management issues. The benefits of formal planning for small businesses are as follows:

■ A Statement of goals and objectives — a formal planning system will require key managers and promoters to state the goals and objectives of the business. Essential to planning is the choice of a future direction, for, ‘if you do not know where you are going, any road will take you there’ (The Koran). By clearly specifying objec­tives, promoters and staff should be more focused in their daily work activities.

■ Efficient use of time — by engaging in a planning process the owner-manager and, where appropriate, the directors of the business should make better use of their own management time. Planning should result in the identification and monitoring of a small number of key success factors.

■ Consideration of alternatives — a formal planning system allows the small business to explicitly consider alternatives for its development. This may include addressing issues such as succession planning in family businesses.

■ Better internal management and staff development — by focusing on the future development of the business a planning system should highlight the need for inter­nal systems and processes and the future staff and managerial requirements of the business. The owner-manager should be able to develop these processes and systems in advance of the actual need. In many cases the development of these internal sys­tems and structures will facilitate the strategic development of the business.

■ Better financial management — planning systems are closely tied to financial systems. In order to plan, the small business will need a basic financial system that provides timely information on current performance. This should improve the financial con­trol of the business and result in better decisions.

21.4.2 Planning and financial performance in small business

Within the literature on small business, research on planning has concentrated on estab­lishing a link between planning and performance. Many researchers make the inference that the ultimate survival of a small business is dependent on the presence of formal planning activity (Bracker and Person, 1986). There is evidence that small business failure is linked to a lack of planning activity (Bracker and Pearson, 1986). However, this research on the significance and impact of planning in small businesses has proved to be inconclusive (Stone and Brush, 1996; Schwenk and Shrader, 1993; Cragg and King,

1988) .

Schwenk and Shrader (1993) reviewed studies on the relationship between planning and financial performance and found conflicting results. In a comparative study between planners and non-planners, Cragg and King (1988) found no correlation between planning activities and financial performance. They also found a negative correlation between planning and size of sales and marketing team. Within this sample, however, younger firms performed better than older ones. Bracker and Pearson (1986) compared small mature firms in terms of age, size and planning history. They concluded that level of sophistication of planning had a positive impact on financial performance; younger firms performed better than older firms, as did firms with a longer planning history.

In many cases, the act of planning cannot necessarily be correlated with the success of a business venture (Robinson and Pearce, 1984). It is possible that the contribution of planning to new and small businesses cannot be measured quantitatively. Rather than compare planning and financial performance a more useful measure of planning might be the amount of vicarious experience that the owner-manager acquires by under­taking the planning process. Planning helps focus owner-managers on their resources, their market and their product; in this way, it could be argued that the main contribu­tion of planning to a business is an increased level of environmental awareness. Similarly, the absence of planning cannot be used as the sole explanation of business failure. In fact, it has been argued that a higher proportion of unsuccessful firms coordinate written plans and performance, set goals and monitor goal achievement (Frank et al.,

1989) .

21.4.3 Reasons for the absence of formal strategic planning in small businesses

Research suggests that most new and small businesses do not plan (Bhide, 1994; Stratos Group, 1990; Robinson and Pearce, 1984; Curtis, 1983). In many cases the structure of the small business is such that the owner-manager is intimately linked to all day-to — day activities. This allows the entrepreneur to control the direction of the business on a day-to-day basis. Where there is a planning process, it is often seen as a separate activity from the day-to-day management of the business rather than as a tool for improving day-to-day management. There are several barriers that inhibit the practice of planning in new and small businesses:

■ Clear sense of strategic direction/position — most owner-mangers have a clear sense of the strategic position and direction of their business. Management activity is typically focused on striving to implement more effectively the strategy chosen at start-up.

■ Centrality of the owner-manager — The close proximity of the entrepreneur to envir­onmental issues often makes objective judgement difficult (West, 1988).

■ Environment context — Many small businesses operate in highly turbulent envir­onments. Formal planning may be counter-productive in such environments as it reduces the strategic flexibility of the business (Chaffee, 1985; Fredrickson and Mitchell, 1984).

■ Rigidity of formal systems — Formal planning systems may be too rigid for a small business (Mintzberg, 1994). The small business often relies on its flexibility and speed of response as a competitive strength and a formal planning system with tight financial controls may restrict the responsiveness of the small business. Once a plan is developed, there are so many links between issues and areas that one change can upset the whole plan. In addition, some goals are planned in ‘lock step immutable order’, which means that the entire plan can be ruined by one unexpected difficulty (Timmons, 1994).

■ Lack of time — the owner-manager is typically involved in the day-to-day manage­ment of the business and may not have the time to invest in formal planning. Many owner-managers have to complete administrative and record-keeping activities out­side work hours.

■ Lack of experience — owner-managers typically have little formal management training and little exposure to budgeting, controlling or planning systems.

■ Lack of openness — owner-managers typically are sensitive about their business plans and performance. They are slow to share this information and key decisions with staff or external advisers.

■ Fear of failure — the explicit statement of goals and objectives, an essential element to a planning process, may result in a failure to achieve these goals and a sense of overall failure by the entrepreneur. By avoiding stating the goals and objectives of the business the entrepreneur can avoid commitment to any one direction or goal.

21.5 Success strategies in small firms

The owner-manager must choose where to compete and then, given a particular envir­onmental or industry context, how to compete (McDougall and Robinson, 1990). These choices have a significant and lasting effect on the organisation and its performance (Mintzberg and Waters, 1982; Quinn and Cameron, 1983). The choice of competitive strategy within a market determines the financial performance of the organisation: if the ‘wrong’ market is chosen performance may be low. However, most owner-managers of small businesses adopt a ‘me-too’ or ‘copy-cat’ strategy — replicating what has been done before.

Small firm performance can also be explained in terms of other factors such as industry structure and the entrepreneurial orientation of the owner-manager. Industry structure impacts on the success of new ventures and has a critical impact on the choice of strategy (Sandberg and Hofer, 1987). Periods of high-demand conditions, such as industry growth and industry maturity, offer better opportunities for the small busi­ness than do periods of low demand such as the emergent stage of the product life­cycle (Carroll and Delacroix, 1982; Romanelli, 1989). However, while market choice is a critical managerial decision, it is not a choice that is, or can be, subject to frequent change. The choice of environment is constrained by the owner-manager’s past experi­ence and by previous choices made, and is therefore not an active decision variable (Eisenhardt and Schoonhoven, 1990).

Recently, research has argued that firms characterised by an ‘entrepreneurial strategic orientation’ have higher levels of performance (Covin and Slevin, 1991). An entrepre­neurial strategic orientation means that the firm is more willing to innovate, is more prepared to take risks and is more proactive than competitors. As such, entrepre­neurial orientation captures aspects of the firm’s decision-making styles, methods and processes (Wiklund and Shepherd, 2005).

More commonly, researchers focus on the strategic attributes of successful small businesses. Success is typically measured in terms of existing competitive position and the change in this position over time. Measuring success in a small business context is inherently difficult, as success should be related to the owner-manager’s objectives rather than measured in terms of competitive, financial or market success. Studies on the strategies pursued by small businesses typically focus on some measure of success in terms of these latter criteria rather than in terms of the owner-manager’s personal definition of success.

21.5.1 Choosing ‘where’ to compete: a broad or narrow focus?

The small firm might choose to appeal to a narrow market niche, hoping to capture a relatively high market share, or to compete by appealing to a broader range of cus­tomers. That is, the firm can choose to be a specialist or a generalist. The appeal of focusing on a narrow segment is that the small firm’s resources can be targeted or con­centrated and the firm can build a strong reputation and customer loyalty with this tar­geted customer base. The prescriptive advice from the strategy literature is typically that the small business should focus on market niches; that is, it should be a ‘specialist’.

Porter (1985) argues that a focus strategy is most appropriate for smaller businesses. According to Porter, the business pursuing a focus strategy competes by selecting a seg­ment or group of segments in its industry and by tailoring its strategy to serving these segments to the exclusion of others. By optimising its strategy in the target segments the business with a focus strategy achieves a competitive advantage even though it does not possess a competitive advantage for the whole market.

Some research suggests that small firms that focus achieve superior performance. For example, research studies of microbreweries and of local wineries suggest that small firms that compete more narrowly are more successful. Other research suggests that high-growth small businesses pursue market niche strategies. The essence of a market niche strategy in the context of many small businesses appears to be the avoidance of direct competition with both larger and smaller competitors. The evidence from the studies of fast-growth businesses in Ireland and the UK suggests that, despite attempts in the research to control for sector influences on growth by choosing ‘matched pairs’, high-growth companies rarely competed directly with low-growth companies (Storey, 1994; Kinsella and Mulvenna, 1993).

Research on low market share competitors has suggested a number of strategies that the smaller share business can successfully employ. The most common conclusion of these studies is that the smaller business should avoid head-to-head competition by seeking out protected market niches (Cooper et al., 1986; Buzzell and Wiersema, 1981). Combined with this strategy of segmentation, the smaller share competitor should seek to differentiate its product offering and should offer a high-quality product.

Studies of successful medium-sized companies have suggested that a market niche strategy is an important characteristic of these companies. Cavanagh and Clifford (1983: 10) concluded that ‘most winning companies are leaders in market niches, often in markets they have created through innovation’. Research evidence from the UK sug­gests that market position is an important characteristic of fast-growth businesses (Macrae, 1991; Solemn and Stiener, 1989). This research suggests that while the choice of overall sector may influence profitability and growth, the choice of specific market position is more important to the performance of an individual enterprise.

The empirical identification of a market niche strategy in small businesses is fraught with operational and definition difficulties. It is difficult for researchers to define pre­cisely the product market a business is competing in. How does a small food manu­facturer producing speciality frozen deserts for supermarkets define their product market arena? Such a business could define its business very narrowly, ‘a producer of premium frozen deserts for supermarkets’, or broadly, ‘a desert producer’. The classification of its competitive strategy will be a function of the choice of business definition and more importantly this definition may broaden as the business seeks to grow and expand. Neither Kalleberg and Leicht (1991) nor Westhead and Birley (1993) were able to pro­vide conclusive evidence of market niche strategies among fast-growth small businesses in the UK. Biggadike (1976) compared the relative attractiveness of a niche strategy and an aggressive market-share-seeking entry strategy and suggested that the latter is more appropriate for new ventures seeking to establish themselves. He suggested that the poor performance of many new ventures is the direct consequence of limiting mar­ket focus at the time of entry.

The dangers of pursuing a focus strategy are that the business may incorrectly iden­tify a market niche. Unless the business gains a competitive advantage by focusing on the niche then it should pursue a more broadly based strategy. An additional problem of pursuing a focused strategy is that the chosen market niche may be too small for the business to survive or may require that the small business become involved in export markets at a stage when they lack the resources to support these markets.

Rather than focusing on a market niche the entrepreneur might try to gain a large share of the market. Some new businesses must pursue a broad entry strategy because of the large capital investment required at start-up. These businesses are only viable if they achieve high utilisation of their large capital investment. The advantage of a broad market strategy is that if the business is successful it will be on a large scale. Addition­ally a broad strategy might be more attractive to distributors, retailers or consumers. It suggests that there will be continuity in the business and it might include a more com­prehensive service for the customer. Most new businesses do not have the resources to pursue such a strategy and therefore start on a small scale. Despite inconclusive empirical evidence, the prevailing wisdom in the strategy literature is that small busi­nesses should optimise the use of their limited resources by competing in a limited mar­ket niche. In the literature on small businesses the prescriptive advice is that the best way to avoid direct competition with larger competitors is to pursue a niche strategy (Vesper, 1990).

21.5.2 Choosing ‘how’ to compete: cost or differentiation

Having chosen what market to compete in the small firm must choose how it is going to compete within this market. Porter (1985) identified two types of competitive advantage, which he termed cost leadership and differentiation. Based on these two advantages and on the competitive scope of the business, which he classified as either industry wide or focused, he developed three generic competitive strategies, namely cost leadership, differentiation and focus. According to Porter, businesses must choose one of these generic strategies; failure to do so results in below-average profitability.

Research suggests that a differentiation strategy is the most appropriate strategy for small businesses. The limited resources of small businesses suggest that the owner — manager should focus resources and pursue a differentiation strategy. A large number of firms pursuing different differentiation strategies may be successful in the same envir­onment (Eisenhardt and Schoonhoven, 1990; McDougall and Robinson, 1990; Porter, 1980).

Product quality was the most important competitive advantage identified by SMEs across a number of European countries (Bamberger, 1989); in addition, factors such as ‘reliability of delivery’, ‘reputation of firm’ and ‘competence of the workforce’ were ranked as important competitive advantages. Interestingly, pricing factors were only rated 16th out of the 26 factors important to the development of competitive advant­age. New ventures pursuing undifferentiated strategies performed less well than new ventures pursuing differentiated strategies (Sandberg and Hofer, 1987).

There are many ways in which a business may have a better product/service. These include superior product/service performance, faster delivery service, better location, wider product range, personal advice and after-sales service, longer credit terms, more flexible service, personalised attention, etc. It is important that the entrepreneur tries to maximise the number and the extent of advantages that the product/service has. This strategy is often not successful because the ‘better’ service/product that the busi­ness is offering is not of value to customers. Another reason why this strategy is unsuc­cessful is because the small business fails to communicate its better service/product to their customers. This may be because of the financial investment and time required for promotion, advertising and sales support, activities and areas of expenditure that most small businesses consider a luxury.

Porter (1985) proposes that a business differentiates itself from competitors by being unique at something which is of value to buyers. To be sustainable a business’s differentiation must perform unique activities that impact on the customers’ purchas­ing criteria. Porter (1985: 152) identifies several methods that a business can employ to enhance its differentiation. These are:

■ to enhance its sources of uniqueness;

■ to make the cost of differentiation an advantage;

■ to change the rules of competition to create uniqueness; and

■ to reconfigure the value chain to be unique in entirely new ways.

Intuitively most owner-managers believe that a low-cost strategy will be successful — customers should be willing to pay less for the same product/service. However, this strategy is not so easy to pursue and many owner-managers fail to pursue it suc­cessfully with the result that their business performs poorly. To pursue a low-priced strategy the new business should have a lower cost base than competitors. Many small businesses pursue this strategy of lower costs by ensuring that they have lower overheads, by operating outside the tax system, or by using low-cost labour and not costing their own time at the market rate. The danger with this approach is that the entrepreneur may not have identified all the overheads that the business will incur and that as the business develops overheads will increase. The advantage of a low — price strategy is that the new business should be able to attract customers. Lower prices should encourage customers to try the new business and may encourage new customers.

However, this strategy does not always work for small businesses. Often the net effect of lower prices is lower profits for the entrepreneur rather than increased sales. There are a number of reasons why this strategy may not work for the small business. The first is that for many products the price charged is assumed by customers to be a reflection of the quality of the product. Customers may interpret low prices as a sign of lower quality service rather than as a more efficient supplier. To overcome this prob­lem it might be necessary for the entrepreneur to inform customers why they are cheaper, for example ‘cheaper because we buy direct from the factory’.

The second reason why this strategy may not work is that the owner-manager fails to invest in promotion and advertising. The owner-manager may incorrectly assume that a low-cost strategy means not investing in marketing and selling costs. The net effect of this is that the customer is unaware of the lower-cost alternative and the new business remains small. Many small businesses fail to generate revenues to invest in advertising and promotion because of their low prices and turnover.

21.5.3 Innovation as a source of advantage

Within the literature on innovation, researchers have sought to establish a relationship between business size and the level of innovation. An alternative perspective is to com­pare the level of innovation with business profitability, growth and survival. To the extent that this has been done, mostly indirectly by studies examining the characteristics of better-performing companies in a particular size/industry sector, it appears that there is a relationship between better performance and higher levels of innovation. Scherer (1980: 422) concluded that ‘what we find… is a kind of threshold effect. A little bit of bigness — up to sales levels of $250m to $400m at 1978 price levels — is good for invention and innovation. But beyond the threshold further bigness adds little or nothing and it carries with it the danger of diminishing the effectiveness of inventive and innovative performance’.

Innovation may manifest itself in terms of the introduction of new products. Research suggests that the ability to introduce new products is positively related to performance in small businesses (Murray and O’Gorman, 1994; Kinsella et al., 1993; Wynarczyki et al., 1993; Cambridge Small Business Research Centre, 1992; Woo et al., 1989). Other evidence suggests that those businesses that are technically more sophisticated or technologically more innovative are likely to grow faster (Boeker, 1989; Philips and Kirchhoff, 1989). However, it may be that these technically more sophisticated sectors are experiencing faster growth.

Buzzell and Wiersema (1981) used the PIMS database to test which strategies were characteristic of businesses that were increasing their market share position. They found that the strategic factors generally involved in market share gains included increases in new product activity, increases in relative product quality and increases in sales pro­motion, relative to the growth rate of the served market.

Small businesses face a number of disadvantages in trying to be innovative. Most small businesses lack the financial, technical and human resources needed to innovate. The lack of time by the owner-manager for long-term thinking prevents the develop­ment of both technical and market-led innovations. The absence of a marketing func­tion and marketing expertise restricts the development of customer-driven innovations. Even those small businesses that are technologically competent, for example small engineering or software firms, face problems in the management of technology. The competitive strength of these small businesses, their specialist technical knowledge, exposes them to the possibility of being exposed to technical developments outside their area of expertise. This problem is particularly apparent in sectors where devel­opments have been driven by the fusion of two or more existing technologies. The small business typically does not have the expertise or the financial resources to cope with external developments. The solution to this problem often necessitates coopera­tion with other businesses or with universities or technical institutes. However, small businesses are reluctant to cooperate with other businesses. While universities may provide technical assistance they seldom provide access to investment and therefore can only partially solve the problems facing the small business.

21.5.4 Exporting and internationalisation strategies

Exporting or internationalisation can provide the small business with access to larger and more attractive markets (see Chapter 24). However, most small businesses do not engage in any exporting or international activities; in particular, small businesses in the service sector have very low levels of direct international activity. Small firms face significant barriers in trying to internationalise their activities. Of particular signific­ance are a lack of knowledge and resources (Johanson and Vahlne, 1984). However, it is important to note that many small businesses are involved indirectly in interna­tional markets through their sub-supply activities with larger indigenous and multi­national companies. The globalisation of some new high-technology sectors facilitates small companies internationalising at an earlier stage of development than is typical among small businesses (see Chapters 13 and 24).

21.6 The strategic problems of small businesses

Developing a sustainable competitive strategy entails not only developing superior competences and capabilities in some aspects of the business but also in minimising the impact of areas of the small firm where there are inferior competences and capabilities (Almor and Hashai, 2004). The strategic weaknesses that characterise most small busi­nesses are the consequence of the managerial deficiencies of the owner-manager and the resource deficiencies of the small business.

21.6.1 Lack of financial resources

Most small businesses are undercapitalised and are inappropriately capitalised, in terms of both a high debt-equity ratio and an over-reliance on short-term debt (Davidson and Dutia, 1991). Inadequate and inappropriate capitalisation is a significant contri­butory factor to the high levels of failure among new businesses. Poor capitalisation may be the result of the difficulties that new businesses face in raising capital (Hall, 1989) and the low levels of profitability in small businesses (Davidson and Dutia, 1991). When capital is available entrepreneurs may choose debt capital in preference to equity capital due to its perceived lower cost (Brigham and Smith, 1967).

However, the capital structure decision is not purely a financial decision. Strategic factors also determine debt-equity ratios (Chaganti et al., 1995). The desire to main­tain control of the business may increase the use of personal equity investment. The level of personal equity investment by the entrepreneur may reflect the entrepreneur’s ‘insider’ knowledge of the business and his evaluation of the likelihood of success, with low levels of investment resulting in non-value maximising behaviours such as higher chief executive salaries. Entrepreneurs may substitute financial capital with cheaper ‘sweat equity’.

21.6.2 Marketing problems and customer concentration

Small businesses engage in little marketing activity. Most small businesses have few resources to devote to marketing and many owner-managers have no experience of marketing, preferring to devote their time to activities that are more familiar (e. g. production), with the result that little time is spent on either marketing or selling activities. Some of the marketing problems of small businesses relate to their lack of product differentiation. This makes it difficult for the owner-manager to position the product or service as a distinctive offering. A distinguishing characteristic of small businesses is their high dependency on a small number of customers. Research evidence suggests that as many as one-third of all small businesses are dependent on one cus­tomer for 25% or greater of their sales (Cambridge Small Business Research Centre, 1992). This is a high-risk strategy for the small business as the loss of one customer may result in business failure. Finally, owner-managers tend to have very little know­ledge of export markets.

21.6.3 Management resources and human resources

By their nature most small businesses are owner-managed. The owner-manager is required to manage all functions of the business, including operations, finance, staff and marketing. However, the narrow expertise of the owner-manager and the lack of management skills mean that the small business is deficient in a number of these func­tional areas. Most small businesses do not have the resources to hire outside managers to strengthen functional areas of the business. Where resources are available the per­vasive involvement of the entrepreneur in the business may make it difficult for outside managers to function in the business.

Small firms have difficulty in attracting good staff. For many potential employees, a small business will not offer the scope for training and development. Additionally, potential employees perceive working in a small business as a risky career move owing to possible business failure. Due to a lack of resources and low levels of profitability, small businesses often pay lower salaries than competing larger ones.

21.6.4 Over-reliance on the entrepreneur

Most small businesses are characterised by what Mintzberg refers to as a ‘simple’ structure (1979). This structure reflects the personality traits of the owner-manager (Miller and Droge, 1986). Typically the owner-manager is actively involved in the day-to-day management of the business and is often involved in the direct production of the product or the provision of the service. The customer base of the business is typically limited and is known directly to the entrepreneur. The entrepreneur relies on informal communication channels to communicate internally and externally. Due to a lack of time many entrepreneurs keep incomplete and out-of-date financial records and/or spend ‘out of work’ hours updating financial accounts. The benefits of this ‘simple’ structure are that the entrepreneur is in close contact with the key issues of the business and is ‘on the spot’ to deal with problems; quality standards are maintained through direct supervision by the entrepreneur; and staff are involved in the business and engage in frequent informal communication with the entrepreneur. These advant­ages allow the business to respond to the needs of customers in a quick, innovative and flexible manner. It is these latter qualities that many larger bureaucratic organisations are now trying to emulate through de-layering, down-sizing and team work (Kanter, 1984). Others argue that small firms exhibit diversity in how they are organised; that is, in how jobs are divided, grouped and coordinated (Barth, 2003).

However, in many cases it appears that the management style of the owner-manager is the antithesis of good management practices. The skills, competencies and behavi­ours necessary for successful new venture creation become barriers to the growth and development of a business (Kazanjian 1988; Churchill and Lewis, 1983). Traits such as a strong need for control and a high sense of distrust can result in owner-managers engaging in behaviours that prevent the organisation growing (Baumback and Mancuso, 1993; Kets de Vries, 1985; Churchill and Lewis, 1983). Such behaviours might include the centralisation of control and ‘scape-goating’ when activities are not successful (Kets de Vries, 1985). The pervasive involvement of the entrepreneur in the business means that it is difficult for them to attend to important, though non-urgent, issues. Finally, the high need for achievement that drives the entrepreneur may result in the central­isation of decision making (Miller and Droge, 1986).

21.6.5 Lack of systems and controls

Small businesses are characterised by informality and poor information systems. Specifically, small businesses are characterised by poor formal control systems (Huff and Reger, 1987). During the start-up period informality dominates in many aspects of the new business, including its control system (Walsh and Dewar, 1987; Quinn and Cameron, 1983). The lack of information results in poor decision making.

21.6.6 Technological skills

The majority of small businesses can be classified as technology contingent — having no influence on the technological trends and innovations that impact on the business. Most small businesses lack the capacity to investigate and assess new technical developments that might impact on their competitive position. In many cases, a small business oper­ates in sectors that have a stable technological trajectory, allowing it to pursue a reactive strategy, that is, to respond to external changes as they happen. However, with tech­nological developments the technical demands on many small businesses have increased significantly and technological competence has become a prerequisite to survival in many sectors.

21.7 Chapter summary

This chapter outlined research that explores how strategy is formed in a small firm, success strategies in small firms and the strategic weaknesses that characterise small firms. Most small businesses face significant strategic and structural weaknesses. In par­ticular, small businesses lack the managerial skills necessary to develop and implement a strategy. The strategy-making process is typically ad hoc and informal, and frequently the entrepreneur’s personality prevents the sharing of information about the business’s strategic position. There is some evidence to suggest that some strategies, such as a focused market position and a differentiated competitive advantage, are positively associated with success in small businesses. In addition, the importance and signific­ance of innovation as a means of developing competitive advantage was discussed. Strategic weaknesses also prevent the implementation of a strategy. Small businesses are typically characterised by insufficient financial and managerial resources. The lack of financial resources prevents investment in activities such as product development and marketing. The owner-manager’s lack of financial skills means that the information necessary for managerial decisions is not available.

The implications of the research presented in this chapter for the owner-manager are that the development of a clear competitive advantage is essential to both short — and long-term survival. The owner-manager must understand that choices in relation to ‘where’ they compete and ‘how’ they compete impact on the viability and performance of the business. In addition, the owner-manager needs to understand that the structural characteristics of the business and their own managerial style may restrict the devel­opment of both an effective strategy-making process and an effective strategy.

Implications for the policy maker are that most small businesses are characterised by significant strategic and structural weaknesses. For individual small businesses to develop and prosper these deficiencies must be reduced. Clearly, the role of the policy maker is to help the owner-manager in the development of a strategy and competitive advantage. It is important that policy makers appreciate that the problem is not with the strategy formulation process but rather with the development of a clear competi­tive advantage. Pressurising owner-managers to produce formal plans does not assist them in addressing the strategic and structural deficiencies of the small business. Policy makers need to address systematically the strategic and structural deficiencies of small businesses by providing the owner-manager with the opportunity to develop the skills and acquire the resources that are needed for the development and implementation of an effective strategy.