Almost twenty years after the launch of market reforms, Ethiopia’s highly productive small and medium-sized enterprises (SMEs) remain scarce. This paper presents a simple model of SME start ups with frictions in the business climate and imperfect information in the labor market that characterize the Ethiopian institutional landscape. Since such market failures lead to suboptimal outcomes, the paper examines several mitigating policies. It shows that while subsidizing entrepreneurs’ search stimulates start-ups, it does not induce firms to formalize. Given the large informal sector estimated in this paper, wage subsidies or tax incentives would be less effective for start ups, although they may encourage firms to operate in the formal sector. Subsidies should be phased out with reduction of entry barriers and improved functioning of the labor market. Since unclear property rights are potentially the most severe form of taxation, reforming them is key.