The Gap Between Large and Small Companies Is Growing. Why?

By Matt Dallisson, 10/09/2019

Research and news headlines are replete with the idea that traditional large companies can’t innovate, and that smaller digital companies will render many larger ones extinct. While we’ve seen numerous startups of the last thirty years not only disrupt businesses but become the megacorporations of today, we wondered whether this disruption is accelerating with the momentum of digital revolution. In particular, we wanted to see whether large established corporations are being increasingly displaced by new technologies, or whether they’re actually leveraging digital and other new technologies to innovate and grow.

Contrary to the popular notion, we find that large corporations are more and more likely to maintain their dominant positions, while small corporations are less and less likely to become big and profitable. And part of the reason for this growing corporate divide between big and small firms is the growing R&D expenditures of large firms. Our results support Lou Gerstner’s thesis that the elephants are not basking in their past glory, but can indeed dance and are even becoming nimbler.

In the chart below, you can see the annual, inflation-adjusted difference between the median market values of the largest and smallest public companies (the top 30% and bottom 30% of firms, by market value of equity), listed on U.S. stock exchanges. It is evident that from the mid-1990s, the size difference between the large and small increased continuously and rapidly, except for during the recession years of 2008-2009. This gap, in 1981 dollar value, reached almost $3.5 billion in 2017. In 2017 dollars, this gap amounts to $8.8 billion. Since we examine median values, this difference is not driven by the runaway success of a few companies like Apple and Amazon. When we also examine the large and small companies separately, we find that the former are getting bigger while the latter largely stagnate.

The performance gap between the large and small increases too. The difference in median return on operating assets was 15% in the 1990s, but has recently doubled to 30-35% — an enormous gap in profitability of operating assets. Inspecting the two groups separately clarifies that the large companies are getting more profitable, whereas the small ones suffer from chronic unprofitability. In fact, both the median return on operating assets and the median profit margin of the small companies turned negative during 2015-2017.

Moreover, the gap in the fraction of companies reporting annual losses widened too: while 10-15% of the large companies reported annual losses in recent years, that number is an ominous 60-65% of the small companies. So, almost two-third of small companies can’t cover their expenses, despite the booming economy. The widely touted nimbleness and creativity of small enterprises isn’t evident in the data.

When we examine the main driver of enterprise performance and growth – the rate of investment in tangible and intangible (R&D, brands, technology, human resources, etc.) assets – we find a dramatic increase in the gap between how much large and small companies invest in intangibles. The chart below shows, for example, that the difference between the mean annual R&D spending of large and small companies grew from less than $20 million in the 1980s to almost $120 million in 2017 (inflation adjusted to 1981 dollars). On average, a large company spent $330 million on R&D in 2017, while the average small company spent a paltry $6 million – obviously insufficient to keep pace with a large competitor, except through a fortuitous discovery. The decreasing productivity of R&D investments makes matters worse for small companies.

A similar pattern of a growing divide exists for SG&A (sales, general and administrative) expenses, which often include intangibles spending, such as on IT, brands, human resources, and unique business process. Clearly, large firms have increased their investments on innovation and intangible expenditures and are not basking in their glories. For example, large retail firms and banks are capitalizing on advancements in artificial intelligence to aid their legacy operations.

A naysayer may argue, “This is all normal.” Amazon, Netflix, and Microsoft were, once upon a time, small companies too, but grew to be large and dominant. Many of the currently small companies will surely fare similarly. What’s the problem?

The problem lies in the most surprising of our findings: the small size trap. Simply stated, it becomes harder for small companies to “escape” their class. Whereas, until 2000, 15% to 20% of small companies became medium-sized or even large companies each year, this percentage was cut in half by 2017. We find similar evidence in the large size category. Until 2000, 75% to 80% of large companies remained in their group next year, but that percentage increased to 89% recently.

We also look at a different measure of group stickiness―the correlation between a company’s size rank from one year to the next. The higher the correlation, the greater the likelihood that a small company remained small and a large company remained large. This correlation increased over time, most notably for small companies, for which it now stands at 90%. In other words, if you are a small company this year, you are increasingly likely to remain a small company next year.

The process of small companies growing organically to capture dominant positions, typical of the 1980s and 1990s (see: Microsoft, Amazon, Netflix, Amgen, Oracle, Cisco), seems more and more difficult. At the same time, large companies seem less likely to yield their dominant positions.

On one hand, this is good news: large companies are innovating and maintaining their dominant positions through innovation, scalability, and first mover advantage. On the other hand, the fact that smaller companies are increasingly likely to be excluded from the growth does not bode well for our economy, which, over the past century, has led the world by creating global corporations based on entrepreneurial ideas and pursuits.

How can a manager of a small firm escape the small size trap? We constructed a statistical model to distinguish between companies that remained small versus those that grew much larger. We find that the latter had a substantially higher investment in intangibles, larger debt raised (to finance investment), and fewer annual losses than the perennially small. Escapees had a relatively higher asset base and were younger than those left behind. Notably, investment in physical assets (property, plant, equipment), share buybacks, dividend payments, and acquisitions were negatively associated with the likelihood of escape.

We also constructed a model to distinguish between the companies that remained large versus those that dropped down from this class. The significant factors aiding the success of large companies were investments in intangibles and physical assets, share repurchases, dividend payments, and length and size of their dominant position. While there are significant differences between the success factors for large and small firms, a common theme is intangible investments. Exclusive control over customers’ data could aid entrenchment of large digital companies.

In sum, we find waning evidence for the idea that large companies do not innovate and that their business will soon be disrupted by small firms. The investment and growth opportunity set of small companies is shrinking, and their nimbleness and grit is increasingly under pressure. In contrast, the large companies are thriving, investing in innovation and intangible assets at an increasing pace, and seem better prepared to weather challenges from small companies than portrayed in literature.