Entrepreneurship May Work Like A Clock, But It Still Needs Winding: Exploring the Kauffman Study on New Firm Formation

1/15/10Follow @wroush

Like others in the tech-journalism business, we here at Xconomy tend to pore over the latest statistics about the entrepreneurial economy pretty obsessively: how much money venture firms are raising and investing from quarter to quarter; how much they dole out to each new startup in their portfolios; how much these portfolio companies eventually return to their investors through mergers, acquisitions, or public offerings.

But what if none of this really matters? What if it turned out that the number of new companies created by entrepreneurs is pretty much the same every year—and that things like how much money venture firms are handing out, or how many companies are achieving lucrative exits, or how many students are graduating from business school, or how many startup incubator programs are springing up, make no difference whatsoever to the nation’s overall levels of entrepreneurial activity? Would this mean that all the conferences and white papers and blog posts about the best ways to boost innovation and entrepreneurship are, in the end, pointless?

Well, that’s a serious question now—because the last three decades of data, according to a new study from the Ewing Marion Kauffman Foundation in Kansas City, MO, show that the number of new businesses incorporated in the United States holds steady at about 700,000 per year, give or take 50,000. It’s as regular as clockwork. In fact, it’s as if American entrepreneurs were programmed to start 700,000 new ventures every year—in the same way that, say, American parents pass on the genes for red-headedness to roughly 170,000 newborns every year.

You can read all about it in Exploring Firm Formation: Why Is the Number of New Firms Constant?, by Kauffman Foundation senior analyst Dane Stangler and senior fellow Paul Kedrosky. (Kedrosky, a San Diego-based investor, entrepreneur, and essayist, is also an Xconomist, and to complete the disclosures, the Kauffman Foundation is an underwriter of Xconomy’s Startups Channel.) When I first met Stangler at a Kauffman Foundation function last October, he and Kedrosky were still puzzling over the numbers they’d been digging up from places like the Census Bureau, the Small Business Administration, and the Bureau of Labor Statistics, which all seemed to show the same thing: Americans start the same number of businesses every year, come hell or high water.

That is a remarkable and, at least on the surface, counterintuitive finding. As Stangler and Kedrosky point out in their final report, which was published Wednesday, a casual observer might guess that the number of new firms would fluctuate from year to year in response to such major forces as economic recessions or expansions, technological change, and the availability of capital and credit. (We certainly hear the howls of local technology innovators every time venture firms scale back the number or size of Series A rounds.) But these things don’t seem to make any difference in the big picture.

“It’s a real puzzle, and it didn’t appear as if anyone else had noticed it or written about it,” Stangler told me by phone yesterday.

He and Kedrosky might not have noticed the phenomenon themselves if they hadn’t already been examining, for a different study, the question of survival rates for new companies. The percentage of the companies founded in 1990 that were still in business in 1995, they’d found, is almost exactly the same as the percentage of companies founded in 2002 that were still around in 2007. (It’s about 50 percent.) “That was interesting,” Stangler says, “and one of the possible inputs to that is that the number of new companies founded each year is remarkably similar”—which turned out to be the case.

Nobody had noticed this fact before, Stangler speculates, because it’s about constancy, not change: “You don’t stop to think, ‘Why is there not a trend here? You have to recognize the absence of something.”

Being good scientists, Kedrosky and Stangler first checked to see whether there might be something wrong with their instruments—that is, that the data might be wrong or incomplete. But all the datasets they checked showed the same level of consistency in firm formation over time. And even if the incorporation records were undercounting some firms, and thus perhaps missing some level of fluctuation within the uncounted ones, it wouldn’t explain the clockwork consistency in the number of new firms that were counted.

The two researchers also considered the possibility that the period for which they had the best data, 1977 to 2005, was anomalous in some way, and that other eras of U.S. history might show more tumult. But when they examined Census Bureau data covering the period 1944 to 1959, they found that even though the sheer number of jobs created then was lower because of the smaller population, there was still the same eerie consistency.

The single exception was 1946, when more than 600,000 new firms were founded, compared to the base level for the period of 400,000 per year.  (Annual firm formation grew between 1960 and 1977 to the 700,000 level and has stayed steady since then.) In fact, 1946—when so many veterans were returning from overseas, and the wartime economy was being converted back to consumer production—was the only year, out of all the periods Kedrosky and Stangler examined, where they thought they could detect the influence of an “exogeneous factor” on the steady drone of new company formation.

So the phenomenon seems real. But what could possibly explain it? In their paper, Kedrosky and Stangler run through about half a dozen hypotheses; I won’t detail most of them here. In the end, Stangler tells me, only two of the explanations seemed compelling to him.

One is demographic stability. Between 1950 and 1975, the share of the overall U.S. population that was of working age, meaning between the ages of 15 and 64, fluctuated quite a bit. But around 1977, this number settled down, and stayed steady (at about 66 percent) throughout the entire 30-year period the Kauffman researchers examined. If a country has a stable population of relatively young, working-age people, then you might expect the number of new businesses they start every year to be roughly constant. (If there’s any truth to this hypothesis, Stangler points out, then we may be in for some big changes on the entrepreneurial scene, since the approaching retirement of the Baby Boom generation means the non-working population is about to get a lot larger.)

The other explanation that Stangler likes has to do with how we define startups. For most Xconomy readers, the word “startup” probably brings to mind a young company innovating in some area like information technology, energy, or biotechnology. And the rate of formation of those types of startups may indeed be sensitive to factors like whether we’re in the midst of a technological revolution (e.g., the PC or mobile revolutions) or how flush venture capitalists and their limited partner investors are feeling. But in fact, the vast majority of new companies formed every year may be much more prosaic: restaurants, law offices, retail stores, bookkeepers, medical clinics. The demand for such service-oriented businesses may be more or less consistent, tracking only with population levels—which might, one could imagine, induce a consistent number of entrepreneurs each year to act to meet the demand.

“If you just read the glossy magazines, you’d think that all startups are software companies, and if you just read the economics research, you’d think that all startups are in manufacturing, because that’s the sector with the best data,” says Stangler. “But there is this huge gap between those two things and the reality, which is that there are a lot of quote-unquote ‘normal’ companies where people are taking a chance and pursuing an opportunity. The research has not seen them as real entrepreneurs, but they are still going to create jobs.”

If this theory is right, you wouldn’t think that it would be very difficult to test it. But in fact, Stangler says the data on what kinds of companies get created every year is very fuzzy. The Census Bureau breaks companies down into nine huge “super-sectors,” with everything from healthcare to education to R&D getting lumped into one big sector called “Services.” So Stangler says he and Kedrosky will need to do more research to disentangle technology-driven startups from others, and to figure out whether exogenous factors have more impact on entrepreneurship in some sectors than in others.

There’s a big caveat to all of this: The detailed firm formation data that Stangler and Kedrosky located only covers the period 1977-2005, meaning we don’t know yet what effect the Great Recession of 2007-2009 had, or may still be having, on levels of entrepreneurship. “This may be an inflection point where we are going to see a permanent reduction in new firm starts, or maybe a permanent increase as people decide not to go back to big firms,” says Stangler. “That’s a question that won’t be answered for a long time.”

And here’s an even bigger caveat: The fact that new firm formation is so consistent may be irrelevant to the nation’s overall economic health. If other research going on at the Kauffman Foundation is correct, then what really matters for economic growth is how many of the firms spawned each year mature into “high-growth” companies that hire lots of people and change their industries. In any given year, just 5 percent of companies account for two-thirds of the new jobs created, Stangler and Bob Litan, the Kauffman Foundation’s vice president of research and policy, found in a 2009 paper. For an example of this kind of stratification, you need look no further than the search-engine business: Silicon Valley entrepreneurs started scores of search-related startups back in the 1990s, but today only one, Google, really counts. In other words, it could be that “the process rather than the input is what matters,” as Kedrosky and Stangler write.

If all this is true, and if the number of new firms competing to become high-growth firms stays constant no matter what, then how should we answer my original question? (Which was, roughly, whether we really need to sweat the details—things like quarterly swings in venture activity, or the resources going toward the promotion of entrepreneurship on college campuses or through incubator programs like TechStars.) If you want my opinion—and Stangler’s—the answer is yes.

Look at it this way: the United States is doing something right, even though we’re not exactly sure what it is. Year in and year out, in good times and bad, Americans start 700,000 new companies, which, if you think about it, is sort of amazing. It may testify to a certain level of resilience and drive in the American character, or it may have more to do with social policies and cultural factors that encourage and reward risk-taking. Whatever the answer, this is one tendency we don’t want to mess with.

As Stangler puts it, “It’s difficult to prospectively tell which companies will succeed/survive or which ones will be high-growth, so it’s highly important that we have thousands of people trying to do it each year.” So until we understand entrepreneurship better, we can’t afford to stop obsessing over it.

For a full list of my columns, check out the World Wide Wade Archive. You can also subscribe to the column via RSS or e-mail.

Wade Roush is a contributing editor at Xconomy. Follow @wroush

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  • http://www.cictr.com Tim Rowe

    You can’t draw conclusions about lions by counting cats.

    What is clear is that this country’s lions are not fairly distributed. They like to cluster in the places that feed them best. Think about where the Googles, Akamais, Microsofts, and Genzymes spring up. So lets not let up on our efforts to feed the lions!

    The Kauffman Foundation has done research recently looking at the differences between US states’ ability to support startups. They analyzed many factors, and found huge variation. And these differences indeed seem to play out in the flow of venture capital. For instance, they found that Massachusetts was the best state for entrepreneurship in US, looking at factors like the presence of leading tech institutes, like MIT, social acceptance of entrepreneurship, etc. And MA also has the highest venture capital investment per capita of any region in the world. The conclusion: supporting entrepreneurship does make a difference.

    Restaurants, laundromats, landscape services companies and their like provide the majority of employment in the US, and we are blessed to be an entrepreneurial nation that keeps these sectors vibrant. We need those businesses. And we ALSO need the new lions who help us remain globally competitive, by becoming the next generation of global corporations. And by and large, it is our lions who make inroads into improving the quality of human life around the globe, be that through energy efficiency, better healthcare, or better productivity.

    So, I’ll say it again: lets keep feeding the lions!

  • Wade Roush

    @Tim: Well said. I don’t think the Kauffman researchers are suggesting that we should stop feeding the lions (although Paul Kedrosky has argued, in other writings, that the venture industry needs to shrink drastically). I think the work they’re doing is important because it makes us question our long held assumptions — such as the belief, so widely held that it’s almost unspoken, that more venture investment automatically equals more innovation.

    What strikes me when I read Kauffman studies is how little we really know about how entrepreneurship works. If anybody is going to make “entrepreneurship studies” into more of a science, it’s them.

  • http://www.venturemechanics.com Ron Wiener

    Agree with you both. Perhaps stated a little differently, what matters the most is not quantity but qualities of these startups. The very nature of today’s startups, so many of them built on low-cost platforms (VoIP, smartphones, etc.) not generally available five years ago, is dramatically different from the average profile of prior generations of startups. CapEx requirements, time to market, “virtuality” if you will, all different; as are market potential, jobs creation potential, shareholder returns potential, fundability. Any study that is looking strictly at the number of new startups is not gathering the relevant underlying trends.

    Let’s assume all things remaining equal (e.g. population) there is a set % of society that is entrepreneurially minded. Unemployment may encourage a few more people to think about taking a hiatus from the corporate world but without an entrepreneurial mindset and skill set, and a good business idea, how many will actually launch a startup? Not that many. What matters most are the characteristics of the companies being started now versus in years past, not the number. And as Tim pointed out, national statistics are not as revealing as regional comparisons; they are simply too blended to show what’s really going on.

  • http://www.forleapsake.com/blog Dino Herbert

    Those who conducted the Global Entrepreneurship Monitor 2009 Global report stated that the number of new U.S. businesses declined by 24% in 2009. It will be interesting to see what the researchers at Kauffman find for the period from 2006-2009.
    It’s also understandable that the “big boys” will always account for the “lion share” of job creation. This is to be expected. However we cannot discount the effect that the 95% of “normal” firms are having on the economy. Having 33% fewer new jobs annually would definitely be newsworthy.

  • qed

    To Dino Herbet: the 2009 publicity of GEM is not necessarily reliable. PR reports decline, although, on average, there was actually an increase across countries. There is good evidence to suggest that during recessions, the number of attempted start-ups actually increases, when displaced employees attempt self-employment. GEM measures start-up attempts, not actual start-ups.

  • http://www.forexbase.com Pavel Rorecek

    The big question is what percentage of these companies are incorporated in the US just for tax reasons (domestic or abroad) and are actually not founded by real entrepreneurs.

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