WHY ENTREPRENEURSHIP IS ON THE DECLINE

Four reasons why startups are slowing down.

Entrepreneurship has never been more celebrated in American culture, but, at the same time, the number of companies being launched is declining. This Inc. article explores several possible explanations.

Leigh Buchanan
Inc.

Last fall, around the time Facebook announced it was buying WhatsApp for $19 billion, a flurry of studies offered a startling revelation: The U.S. startup rate has been falling for decades. The Kauffman Foundation, citing its own research and drawing on U.S. Census data, concluded that the number of companies less than a year old had declined as a share of all businesses by nearly 44 percent between 1978 and 2012. And those declines swept across industries, including tech. Meanwhile, the Brookings Institution, also using Census data, established that the number of new businesses is down across the country and that more businesses are dying than are being born. All this at a time when entrepreneurship had reached its cultural apex and was widely viewed as the sole sizzling ember in an otherwise cooling economy. The business and academic worlds were left slack-jawed: How could this be?

The implications are huge. “New businesses are disproportionately responsible for the innovation that drives productivity and economic growth, and they account for virtually all net new job creation,” says John Dearie, executive vice president for policy at the Financial Services Forum. “I would say, as a policy person, this is nothing short of a national emergency.”
The underlying worry is churn. In a dynamic economy, businesses are born, grow, and die; jobs are created and lost; and resources are reshuffled according to their best use. If there are fewer new companies and more aging ones, then labor and capital hang tight in old industries. The economy is not refreshed and growth slows.

What’s behind this drop off? Every reader of Inc. knows, of course, that launching and running companies is not for the faint-hearted. In his book Where the Jobs Are: Entrepreneurship and the Soul of the American Economy, Dearie and his co-author interviewed more than 200 founders about the challenges of building businesses. Their subjects cited five: insufficient access to capital; difficulty finding people with the right skills; immigration policies that keep talent out; onerous taxes and regulations; and economic uncertainty. Those go a long way toward explaining why companies struggle to scale. But they offer only a partial explanation for why fewer companies start in the first place.

Understanding why something isn’t happening is tougher than understanding why it is. Is this just a statistical anomaly? Or has the state of American entrepreneurship fundamentally changed? Experts speculate that a host of factors may have contributed to the decline in ways large and small. The data points to four likely explanations.

It’s a generational problem
Steve Jobs was a Boomer. So is Richard Branson. Also Bill Gates. And Oprah Winfrey. And Ben. And Jerry.

The Boomers are a startup-happy bunch–over the past decade, the portion of founders in their 50s and 60s has increased, according to Kauffman data. By contrast, the portion of 20- and 30-year-old entrepreneurs has declined. In 1996, young people launched 35 percent of startups. By 2014, it was 18 percent. “We’re now past the peak demographic bulge we got from the Boomers,” says Dane Stangler, Kauffman’s vice president of research and policy. The Millennials, meanwhile aren’t expected to start launching companies en masse for five to seven years.

And, while technology is young people’s oxygen, risk may be their carbon monoxide. According to the Global Entrepreneurship Monitor (GEM), a consortium of academic teams in more than 70 countries, until last year 25-to-34-year-olds were significantly more worried about failure than 35-to-54-year-olds. But there’s a hopeful sign for startup rates: In the past year, young people have begun to display more confidence. In 2014, just 34 percent of 25-to-34-year-olds said fear of failure would prevent them from starting a business, down from 41 percent a year earlier. Still, this remains a cautious group. “The fear of failure among 25-to-34-year-olds can reflect a greater level of caution, and a preference for more stable employment when there is high uncertainty and a less favorable environment for entrepreneurship,” says Donna Kelley, a professor of entrepreneurship at Babson College and GEM team leader for the United States. Massive student debt can also contribute to young people’s fear of risk.

The broader problem may be that U.S. population growth is shrinking. That alone explains part of the decline of the startup rate, says Robert Litan, an economist at Brookings. “On the supply side, if you have fewer people, there are fewer companies being formed,” he says. “On the demand side, a slowing population means less demand for new products.”

The population is also graying. “Look at Europe and Japan, both aging societies, and their entrepreneurship rates are way, way down,” says Lee E. Ohanian, a professor of economics at UCLA. “I don’t see how Japan is going to get out of this, because it’s a very closed society.” The United States, though, still has a chance, says Ohanian. “If we do immigration right and bring in lots of talented, ambitious people who see opportunities here, then we may be able to reverse this.”

It’s the big guys soaking up the oxygen
Established businesses have always held the edge, and the larger those businesses become, the fewer the startups that sprout. “If you are a city or state with a rising concentration” of chain stores, or branches of existing businesses, “you see a faster decline in your startup rate,” says Litan.

Given that existing American companies opened roughly 50 percent more branches in 2011 than they did in 1978, the challenge for startups is clear. Back then, 80 percent of “new establishments” were startups; the rest were new locations of existing businesses, according to data from the Federal Reserve Bank of Cleveland. Today, that number is down to 60 percent. Panera has more than 1,880 restaurants, and for consumers that’s great. It’s less great for the baker who dreams of starting Capucine’s Croissant Café. (Thirty years ago, the rise of big-box stores–now in decline–rained similar punishment on small and young businesses.)

Economic development officials also tend to favor known quantities looking to expand. “If I had a headline tomorrow that said, ‘1,000 Call Center Jobs Move to Community X,’ I would have everyone in town high-fiving me,” says Karl R. LaPan, former chair of the National Business Incubation Association. “If my headline said, ‘Five Three-Person Businesses Started Last Year,’ it would end up on the back page.”

The growing dominance of established players in the retail and services sectors has a rough parallel in the tech industry. New research from Play Bigger, which advises business leaders on creating new markets, found that tech companies today achieve market-cap milestones–$500 million, $1 billion, $5 billion–three times faster than they did 15 years ago. Almost as soon as they are invented, major categories are dominated by what Play Bigger calls “category kings,” which own 70 percent or more of the market share. “You have this giant player and a series of weak number twos, threes, fours, fives, and sixes. And those disappear pretty quickly,” says Play Bigger co-founder Al Ramadan. “The saying used to be ‘A rising tide lifts all boats.’ That is no longer true.”

Size isn’t the only problem; longevity plays a role as well. The share of companies aged 16 or older has increased by about 50 percent since the late ’70s, according to Brookings. That includes not just the Walmarts of the world but also the major internet companies, which we tend to view as forever young. If Amazon were human, this year it could legally drink. Next year, Google would be able to vote.

We celebrate enduring businesses for good reason. But to the extent they crowd out newcomers, innovation takes a hit. “The major innovations of the past century and a half–the telegraph, the automobile, refrigeration, air conditioning, computers–they all came from entrepreneurs,” says Dearie.

Large, established companies also tend to hog talent. That says more about why new companies don’t grow than about why they don’t start–unless that talent is a fence-sitting entrepreneur. “Is it just a lot easier for me to go to Google than to start a new company?” says Ian Hathaway, an economist at Brookings. “Probably. The pay and the perks are amazing. Economists don’t want to put these things into their models. But I can tell you, as both an entrepreneur and a student debt holder, they absolutely factor into it.”

It’s a problem of funding
If startup rates were determined by how many tech companies have proved their ability to scale, then the future of entrepreneurship would be golden.

In 2014, VC firms invested $48 billion in deals, the most since 2000. But professional investors have showered more love on mature companies than on infants. Research by Mattermark, which tracks startup data, shows that between 2005 and 2014 the size of seed investments made by VCs stayed flat. The size of C, D, and E rounds, by contrast, roughly doubled. The number of small seed rounds has recently dropped, according to PitchBook, with investments below $500,000 declining 61 percent between the first quarter of 2013 and the fourth quarter of 2014. Below the VC level, angels and seed funds have proliferated as startup costs have decreased. But even angels’ interest in fledglings is down.

“If you look at when people are getting money, it is way past the startup phase,” says LaPan. “There is a dearth of capital for idea, pre-seed, and seed startup companies.”

To point out that investors favor the tech industry is as unnecessary as to state that people who eat out prefer to do so in restaurants. Internet and software companies accounted for two-thirds of VC investments in 2014. Angels are similarly lopsided, with internet companies accounting for almost half of investments, according to the Halo Report. At least investors are becoming slightly more agnostic about geography. Hathaway says that in 2009, two-thirds of metro areas received no first-round money. By 2014, that number had dropped to just north of half.

Some places far from Palo Alto and New York City feel strong. “I will speak with authority: There is certainly not a decline in new businesses in technology here,” says Troy Henikoff, managing director of Techstars’ Chicago branch. “The funding is increasing, and the exits are increasing. The numbers are going up, up in Chicago.”

But even where capital is becoming more accessible, other forms of support may not be. The number of accelerators and incubators continues to expand. But LaPan says too many of those programs target companies with proven customer demand, validated business models, and savvy management teams. In addition, the large number of industry-specific programs doesn’t necessarily reflect the interests of far-flung entrepreneurs. “What if I want to start a business in health care, but my closest support is a financial-services seed accelerator?” LaPan says. “The vast majority of entrepreneurs start businesses where they are located. If we’re so oriented around specific sectors, how is anybody going to start a business?”

Of course, for the roughly 95 percent of entrepreneurs not in professional investors’ orbits, this all sounds like a discussion of “Who gets the foie gras?” while they make do with Spam. For Main Street startups, bank loans remain hard to come by. Nationwide, only about half of businesses with less than $1 million in revenue secured any credit in 2014, according to the New York Fed. (Numbers are not broken out by age.) The credit crunch extends to individuals–something friends, family, and entrepreneurs all happen to be. Home equity, so popular with founders in the 2000s, is the gift that stopped giving. And while crowdfunding looks promising, enactment of the Title III section of the JOBS Act that would allow small businesses to sell equity to the public has been postponed until the end of the year or longer. “We’ll wait and see how the regulations come down,” says Stangler.

Actually, it may not be a problem at all
Maybe entrepreneurial activity isn’t ebbing as much as we think it is. Maybe we’re just not looking in the right places.

Entrepreneurship has actually been on the rise since 2011, according to GEM, which surveys individuals and national experts rather than the government data that Kauffman and Brookings rely on. As a result, GEM turns up not just new businesses but also people in the embryonic stages of starting businesses.

Kelley calls them nascents. Nascents “may identify in the Census as ‘I am employed by somebody else.’ But they are actually entrepreneurs and getting started,” says Kelley. The rate of nascent entrepreneurship has almost doubled since 2010, from 4.8 to 9.7 percent. (How many of those will result in new companies, though, is anybody’s guess.)

Nascents aren’t the only founders traveling subradar. Brookings research indicating a declining number of new businesses counts only startups with more than one employee, “on the theory that these are at least potentially going to be real businesses,” says Litan. Given our reliance on young companies for new jobs, that decision is justifiable. But it overlooks the tens of millions of soloists (more than 40 percent of the U.S. work force by 2020, predicts Intuit), whose holiday parties fit in a coat closet. In the game of entrepreneurship, they are the wild cards.

Soloists are an extreme example of a trend: startups losing not just steam but also scale. In terms of employees, the average startup was a third smaller in 2011 than in 2001, according to research by Gary Kunkle, an economist and founder of research firm Outlier. Many of these businesses lack resources or ambitions to grow. But some stay small by choice, because technology makes it possible and the rewards of being nimble make it desirable.

The assumption is that most startup soloists fall into the former category. They are reluctant entrepreneurs sloughed off in corporate downsizings who “hang out a shingle and become a designer on my own or an accountant on my own,” says Kunkle. “They might think, ‘That’s what I did for a big company, and now I’ve been freed of that–mostly not of my own volition. I need to find some source of income.’ ” Less reluctant but comparably unambitious are retirees who want to stay active, not to build something of scale.

But anecdotal evidence suggests a growing number of soloists consider their status a competitive advantage. These people may not be “real businesses” by Litan’s definition. But while they don’t create jobs in the traditional sense, they inject entrepreneurial energy into the economy. At the top end of the soloist market, “we see independent professionals and teams that come together on a project basis,” says George Gendron, former Inc. editor and founder of the Solo Project, a media, research, and education company for independent professionals. “More virtual teams have managed to create enough of a footprint that they can tackle really big projects.” For example, Mavens & Moguls, a network of 48 independent marketing professionals founded by Paige Arnof-Fenn, Zipcar’s first CMO, has won work from Delta Airlines, Colgate, Sprint, and Virgin, among others.

Ambitious soloists are also potential sources of innovation. If a few coalesce around a promising idea, “they may decide they want to raise capital, build a team, and grow,” says Kunkle. And another startup is born.

One hopeful sign is that all who have identified the decline are optimistic about its correction. Stangler says he expects to see a “huge rebound” as the economy improves. He is particularly upbeat about changing demographics, viewing young people as founders-in-waiting rather than as missing in action. “I’m pinning a lot of hope on the Millennials,” he says. “Ten years from now, we’ll have more people in their 30s than ever before in history. I would expect that to bode well for business formation.”

Certainly Millennials have been socially and culturally primed for entrepreneurship: Their vaunted individualism and idealism suggest they are temperamentally suited as well. And when the time comes, they may be the best-educated entrepreneurs in history. An informal survey by Inc. of top business schools found interest in entrepreneurship programs at least holding steady and in some cases growing substantially. At Northwestern’s Kellogg School, for example, enrollment in entrepreneurship courses more than doubled between 2011 and 2014.

Litan cites additional positive developments, including the ebbing of recession anxiety. Technology too will play a part, he says. Startup and operational costs will decrease, thanks to cloud computing. More platforms like the iPhone will likely emerge. And 3-D printing and associated technologies will bring manufacturing within the reach of new businesses.

Litan adds that while the public and policymakers are right to worry about the startup decline, aspiring entrepreneurs needn’t sweat it. “If you’ve got the motivation and you’ve got the idea, then it shouldn’t make any difference to you,” he says. “Because you are going to be the exception.”

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