When the current Ethiopian government came to power in 1991, it strived to create a climate that would support private sector development and entrepreneurship. Almost 20 years later, however, the role of the private sector in the economy remains limited, and is well below that of regional peers such as Uganda or Tanzania. While an abundant empirical literature on Ethiopian urban labor markets, SMEs and their constraints exists, this paper presents a simple theoretical model of firm start ups and skill shortages with imperfections in the labor markets and the business climate. The model captures several stylized facts that characterize the Ethiopian urban labor markets, and is used to analyze policies aimed at encouraging SMEs and the formal private sector, in particular subsidies to entrepreneurship and employment of skilled labor.