How Policymakers Can Renew Startup Growth
In August 2008, the United States economy lost 259,000 jobs, and the unemployment rate rose to 6.1 percent. The country was in the midst of a stretch of twenty-three consecutive months of job losses. That same month, the startup Airbnb was officially formed. Seven months later, in March 2009, the U.S. economy lost 824,000 jobs, and the unemployment rate rose to 8.7 percent, on its way to peaking at 10 percent shortly after. That same month, the startup Uber launched a prototype, and Airbnb was admitted to startup accelerator Y Combinator.
Today, Uber is valued at $51 billion, and Airbnb is valued at $25.5 billion. The two companies represent the vanguard of both the “unicorn club” and what is variously known as the “sharing,” “peer-to-peer,” or “on-demand” economy. They also have come to represent modern American entrepreneurship, the phenomenon that fuels our economy and ensures job creation and growth.
In fact, in any given year, new and young businesses create nearly all net new jobs in the U.S. economy. Put more starkly: if you want new jobs, then you want new and young firms. Older, established companies tend, on balance, to be net destroyers of jobs.
This apparently straightforward conclusion, however, becomes more complicated when we examine new and young businesses more closely. Each year, tens of thousands of new companies are formed in the United States. Many of these companies don’t survive. On average, 20 percent will fail within two years, and half won’t make it past the five-year mark. Most of those that do survive will not grow significantly in terms of revenue or employment; the vast majority of new and young companies will remain small businesses. Only a handful of young firms grow much more rapidly than most others.
Indeed, much of the net job creation and productivity attributed to startups comes from this small group of fast-growing firms like Airbnb and Uber and those on the Inc. 5000 list of new, young, and fast-growing firms. At the ninetieth percentile, some of these young companies enjoy employment growth rates of between 60 and 100 percent each year. Some of them grow rapidly to fifty employees and then remain there; others grow to employ a few thousand people.
And, importantly for the economy, these young, high-growth firms can be found in every sector, not just high tech. In this respect, the United States is not unique—many developed and emerging economies have similar patterns wherein new companies and high-growth young companies account for nearly all net job creation. Economists describe this distribution by saying that there is a lot of “skewness” among young firms. This skewness, or dispersion, is a feature of entrepreneurial growth and is the heart of dynamism and job creation.
Unfortunately, the United States recently has experienced a “startup deficit,” coupled with a decrease in skewness. The startup deficit has three components, none of which augur well for overall economic growth and productivity.
First, the overall pace of business creation, which had been falling steadily for many years, decreased precipitously in the 2008–2009 recession. As many researchers have found, the startup rate in the United States has roughly halved since the 1980s, creating an overall startup deficit that helps explain the tepid growth of the 2000s and the slow recovery in employment following the recession.8 Indeed, the lower business entry, relative to the 1980s and 1990s, has resulted in not only a startup deficit, but also a corresponding jobs deficit. Had the startup rate been what it was in the 1980s, the U.S. economy would have returned to pre-recession levels two years earlier (i.e., in 2013).
To be sure, the United States has experienced declines in business creation before. Thanks to back-to-back recessions in the early 1980s, new business creation in 1983 was 23 percent lower than it had been in 1977. It jumped back by 13.8 percent in 1984. Likewise, business creation hit a nadir in 2010, when it was 30.9 percent lower than the most recent peak in 2006 (when the highest number of new businesses since 1977 was started). This was a sharper drop in a shorter period of time than in the 1980s, but we have not had nearly the same kind of rebound. Business creation in 2013 was only 4.5 percent higher than the low point in 2010, and still 27.6 percent lower than in 2006.
Second, the large hit that the recession dealt to entrepreneurship created a “missing” or “lost” generation of new firms that were never created.11 And third, the new firms that came into existence during the recession and slow recovery and survived will bear the scars of that period—they will remain smaller and grow more slowly than other businesses. These second and third components of the startup deficit create a python effect that will continue to move through the U.S. economy, adding up to hundreds of thousands of fewer jobs.
In addition to the deficit we are experiencing in all startups, we started seeing a reduction in the skewness of young firm growth even before the recession. The U.S. economy is producing fewer young, high-growth firms that are a principal source of job creation and productivity. Since 2000, there has been a dramatic reduction in high-tech high growth, and particularly a decrease in the larger “superstar” high-growth firms. Those that do exist appear to be growing less rapidly than those of prior generations, and the distance between fast-growing young firms and firms that don’t grow is shrinking, which means lower job creation and productivity. Airbnb and Uber may be household names, but they appear increasingly lonely in that category.
These trends together are contributing to the erosion of American economic dynamism. The core elements of dynamism and entrepreneurial growth are the entrants of new firms, the rapid growth of young firms, the shifting of jobs from less productive to more productive businesses, and the movement of workers into and out of jobs. We have seen the overall pace of job churn (creation and destruction together) falling across the economy, and labor market “fluidity,” which determines the ease and velocity of job finding, has declined, with a corresponding rise in labor market rigidity. A worrisome implication of this latter trend is that the biggest impact of diminished fluidity falls on young workers and those on the margins of the labor force, including the less educated. The quiescence of these important elements of dynamism has contributed to slower productivity growth, slower job creation, slow wage growth, and a sense of pessimism about the American economic future. Regrettably, this decline in economic dynamism has accelerated—and spread to the high-tech sectors.
Nevertheless, despite these ill entrepreneurial tidings and their deleterious effects on job creation, rumors of the death or disappearance of American entrepreneurship may be exaggerated. One of the biggest matters of debate in Silicon Valley at the end of 2015 was whether we were in another tech entrepreneurship bubble that was about to pop. Venture capital financing and angel investing rose last year to heights not seen since the dotcom bubble. The aforementioned “unicorn club” counts nearly 100 members in the United States, with most of those startups reaching the $1 billion threshold only in the last year. Billions of dollars now flow through crowdfunding and marketplace lending sites, and equity crowdfunding is now permitted for non-accredited investors in the United States.
Entrepreneurship is infiltrating large portions of the U.S. economy, even in industries that do not typically see significant new business activity. Ask a banker whether she thinks we’re in an entrepreneurial slowdown, and she’ll point to the hordes of “fin tech” (financial technology) startups that are picking off bits and pieces of traditional banking. Talk to folks in the automobile industry—usually associated with the opposite of entrepreneurship—and you’ll hear about the dozens of VC-backed “auto-tech” startups. Check out the “periodic tables” compiled by CB Insights in areas like insurance, payments, e-commerce, digital health, and more, and it becomes hard to avoid the conclusion that the United States is enjoying a veritable entrepreneurial revolution.19 Driven by the inexorable spread of software, higher computing power, and cheaper server storage, entrepreneurs are “unbundling” entire economic sectors. Further waves of technological change in robotics and artificial intelligence promise more entrepreneurial opportunities.
It seems, then, that the United States has been in the midst of an entrepreneurial explosion in certain sectors and geographic regions. Inevitably, the high tide of startup financing will recede—and high-profile valuation write-downs may be the beginning—but there are some indications that this most recent tech startup boom will have permanent economic benefits. For one thing, the costs of starting a tech company and experimenting with different ideas have come down dramatically. The causes of this cost reduction—cloud computing, server access, etc.—will not go away. For another thing, there is evidence that “hot market” entrepreneurial financing can, in the long run, generate more radical innovations. And, in the more traditional “small business” sector, there are some indications that lending conditions (finally) improved in 2015 after a slow recovery from the recession. That recovery in lending, however, remains uneven across different types of lenders and companies.
How can this frenetic activity be reconciled with data showing the apparent decline of entrepreneurship and the overall “startup deficit”?
Some posit that entrepreneurial quantity and quality have become disconnected. Using a new methodology called “nowcasting,” researchers have found that, while the general pace of new business creation may have slowed, the quality of new businesses has actually risen. Indeed, it’s not obvious that a fall in the rate of business creation is prima facie bad, if quality is going up and if the causes of that fall are benign. The same research has found, however, that, even as entrepreneurial quality has risen over time, there has been a breakdown in the conversion of entrepreneurial potential into growth outcomes.
Another possibility is that existing companies have gotten better at providing internal opportunities for entrepreneurial employees. We know, anecdotally at least, that some large companies are doing more to identify such employees and give them the resources they need, allowing employee exploration, and restructuring to facilitate new idea testing. If “complementary assets” for potential entrepreneurs are more available at their current companies, then, absent a personal preference for starting a business, perhaps many of America’s missing entrepreneurs may have become “intra-preneurs.”
Data also show that, while the creation of new firms may have slowed, there has been a long-term rise in establishment formation by existing businesses. These new outlets also have raised their rates of job creation over time, helping offset the job creation lost from fewer new unique firms. In retail, for example, the displacement of single-location stores by chain or “big-box” stores has created massive productivity gains.27 Likewise, massive investments by large companies in new digital technologies, such as software-defined data centers and cloud computing, are creating new platforms to be potentially exploited by entrepreneurs.
What is perhaps most frustrating is that there doesn’t appear to be a single culprit responsible for the startup deficit and declining dynamism. Researchers, however, have identified several potential causes.
Recent research indicates that demographic change—specifically, the slowing growth of the labor supply since the 1980s—may explain most of the long-term decline in the startup rate. Labor force supply is also constrained by recent trends in labor force participation, which, in the past few years, has fallen to levels not seen for forty years. The recession hastened this decline, and much of it is due to early retirement among aging workers. Many American workers, however, have removed themselves from the labor market out of discouragement.
Feedback loops between these trends only complicate the search for answers. Young firms are more likely to employ young workers, and they also act as a labor “soak” for individuals who are on the margins of the workforce. Sectors with lots of young firms—for example, restaurants, administrative services, temp agencies, and construction—are the same sectors that typically serve as entry points for young workers and the marginally attached. It’s no coincidence, then, that, as the number of startups has decreased, unemployment among young workers and those with lower levels of education has grown, along with growth in the number of discouraged workers. The two trends reinforce each other: a startup deficit, producing a shortage of young firms, limits the opportunities for these groups of potential employees to find work, and the supply of young firms is slowed when these workers leave the labor force out of discouragement. The stalled labor force participation rate, compounded by an aging population, doesn’t generate much optimism for change.
Increasing labor market constraints and strong intellectual property protection also may be hindering the movement of people and ideas and the combinatorial process of innovation. A rising regulatory burden may have made new business creation less attractive and growth more challenging. Others speculate that rising income inequality may be the culprit because fewer individuals may have necessary resources to start businesses, or consumers may have fewer resources needed to sustain new businesses.
There are other feedback loops created by the startup deficit, too—with fewer young companies in existence, fewer people get exposure to working in young companies. Entrepreneurship, like many other behaviors, appears to be viral: exposure raises the probability of engaging in it.31 So, less exposure, brought on by the startup deficit, will continue to result in lower business creation. Similarly, there is some speculation that greater specialization in existing jobs and educational programs also suppresses business creation because specialization does not foster the generalist skills that are important for entrepreneurship. Since most new entrepreneurs start businesses from their existing jobs, a shortage of generalist human capital also could translate into lower business creation.
Like many entrepreneurs, we at the Kauffman Foundation are optimists. We expect the trends of lower entrepreneurship and diminished dynamism to turn around. The United States, we believe, is on the verge of a new entrepreneurial boom.
One, perhaps counterintuitive, reason for our optimism is demography: this country is about to experience a surge of labor market entrants, thanks to the millennial generation. The millennials now span the age range between roughly sixteen and thirty-five, and their labor market heft will only grow over the next decade. As the millennials approach the “peak age” for business creation—their late thirties and early forties—we might expect a boost to overall business creation.
Second, the early stages of the technology boom we’ve described, marked particularly by lower costs to start a company and the spread of smartphones, may progress and bolster entrepreneurial activity.34 The entrepreneurial benefits of this IT wave have not been realized fully yet. The explosion of mobile apps for smartphones undoubtedly has been a boon to many entrepreneurs, but it also appears that the initial stages of this new industry have been biased somewhat toward incumbent firms.35 Considerable room for innovation remains, and we are at the point in the cycle when the diffusion of IT will create even more entrepreneurial opportunities than the first stages did.36 We are entering the “learning by doing” stage, in which a greater diversity of entrepreneurs will help realize the full value of smartphones, cloud computing, the Internet of Things, and other technologies.37
This next entrepreneurial wave, however, is not inevitable. Public policy shapes the environment in which entrepreneurs start and grow companies, and policymakers can take specific actions to help foster—rather than inhibit—the era of renewed entrepreneurial growth we see approaching. The decisions made by government at the federal, state, and local levels, therefore, will have a significant impact, and it is certainly possible that public policy could derail our optimistic forecast.
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