The advent of a growing share of small firms in modern economies raises some intriguing questions. The most intriguing question undoubtedly is why so many smaller firms, which have traditionally been classified as sub-optimal scale firms, can exist. We suggest that, through pursuing a strategy of compensating factor differentials, that is by remunerating and deploying factors of production differently than their larger counterparts, small firms are able to compensate for size-inherent cost disadvantages. Using a sample of over seven thousand Dutch manufacturing firms, we find considerable evidence that such a strategy of compensating factor differentials is pursued within a European context. When viewed through a static lens, the existence of such a strategy, while making small and sub-optimal scale firms viable, suggests that they impose a net welfare loss on the economy. However, when viewed through a dynamic lens, the findings of a positive relationship between firm age and employee compensation as well as firm age and firm productivity suggest that there may be at least a tendency for the inefficient firm of today to become the efficient firm of tomorrow. 5 Are Small Firms Really Sub-Optimal?