Starting and growing firms

Posted by Niek Huizenga on October 5, 2011

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I’m in Silicon Valley for two and a half weeks now. While I’m writing this blog in a coffee shop in Cupertino, people right and left from me are talking about setting up a new business. Life in Silicon Valley is all about startups, innovation and business. I like it here.

In this blog I’m going to discuss one of the topics of my research: the importance of growing firms and the relevance of the number of starting firms.

The path of the startup

What is a “startup”? In the Netherlands most people see a startup as a new registration at the Chamber of Commerce. According to the latest figures, 70% of these “startups” are individuals that are active in personal services or retail (most of them part-time). In Dutch they are called zzp’er (self-employed without employees). In the Valley they are called contractors and are not seen as entrepreneurs or startups.

There are many definitions of startup. Steve Blank (one of the startup gurus in the Valley) uses: “a startup is an organization formed to search for a repeatable and scalable business model”. Eric Ries (writer of the bestseller “The Lean Startup”) defines startup as: “a human institution creating a new product or service under conditions of extreme uncertainty”. Based on these definitions I use the important elements: a small team, scalability of the business model and uncertainty. To scale you need to have a product. A startup converts and idea in a product and wants to introduce this to the market. At this moment a business angel or VC (venture capitalist) appears. The VC plays a big role in the new strategy and restructures the management where necessary (it is very normal that they install a new CEO). Millions are invested in product optimization, marketing and sales. In a period from 2 to 5 years the firm needs to proof its potential. The exit scenarios of the firm are to be sold or to go public. A return on investment of 500% or more is not unusual.

Many startups try to follow this ideal path and many fail. At least 9 out of 10 do not get funded and a same percentage of the funded startups do not make it. The probability of success is minimal. So why do investors put millions of dollars into these startups? It is all about portfolio management and spreading risks. An investor accepts the high chance of failure because 1 of the 100 startups is going to be a billion dollar company. That big hit compensates the losses by far. This is the way how entrepreneurs and investors deal with risks and returns. It is all about numbers and this makes it important that there are a high number of startups.

The more startups the better?

In the last years the Dutch government and Universities initiated different programs to stimulate entrepreneurship. This had effect. The number of new entrepreneurs (subscribers at the Chamber of Commerce) is one of the highest in all OECD countries. The minister of Economic Affairs proudly Twittered and Youtubed about this. But compared to the OECD countries the Netherlands scores very low when it comes to growing firms. That means that many new entrepreneurs don’t survive, grow or innovate. And if the zzp’ers were excluded as entrepreneurs the figures would look very bad.

The impact of starting and growing firms on an economy also has the attention of the academic world (Henderson, 2009; Shane, 2009; Van Praag, 2010). Empirical evidence shows that more entrepreneurs in a developed country do not create more jobs, innovation and wealth. The political statement “the more entrepreneurs, the better” is under fire. To summarize some of the points in these studies:

  • The majority of entrepreneurs falls into the category “common entrepreneurs” and do not have the ambition or capabilities to develop products and scale a business.
  • Common entrepreneurs cost money because their use of (public funded) subsidies, programs and fiscal benefits.
  • The common entrepreneur creates more value if he was an employees.

The overall conclusion of these studies is that the common entrepreneur does not contribute to job growth, innovation and wealth. They have a high probability of failure or limited ambition and/or capabilities to realize a growing firm. This sound very negative and implies that entrepreneurship is a bad thing. But this is not the whole story because a positive relation was found between firm growth and the level of education of the entrepreneur. Capable entrepreneurs are more likely create jobs and innovate.

Given these conclusions some recommendations were made. The first is reallocating resources and only stimulate and support high potential entrepreneurs. The second is to reduce incentives that make it easy for the common entrepreneur to start a business.

So what about Silicon Valley?

The conclusions of the studies above measure the issue on a macro scale. It does not make a distinction between industries and types of entrepreneurs. In my research I take a look at the IT industry. In the Silicon Valley case there are a lot of startups but also a lot of growing companies. These growing companies are responsible for ground-breaking innovations and a huge number of new jobs. But do the small or failed startups fall into the category “common entrepreneurs”?

An important observation I’ve made is that almost all of the entrepreneurs have an academic (and often technical) background. This may explain the high number of growing firms. But that is not the only reason. Silicon Valley is an entrepreneurial environment with a highly developed infrastructure and culture. The presence of incubators, entrepreneurial Universities and professional VC’s make it possible that talented entrepreneurs have the opportunity to grow their business. The entrepreneurial culture also plays a big role. Networks of entrepreneurs are easy accessible and people are willing to share knowledge and contacts. Role models (like Steven Jobs, Bill Gates, Mark Zuckerberg and many more) gives everybody the idea that their startup can be the next big hit.

So the incentives to start a business are strong, but the habitat is also perfect for talented entrepreneurs to grow their firm. The high number of startups makes it possible that the best startups can go sky high.

— More to come —

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