Startup myths

Sussex University’s Paul Nightingale and Alex Coad ask why Britain hasn’t created a world-beating California-style tech company:

Over the last 30 years innovation and entrepreneurship have become increasingly prominent concerns for successive UK governments. And yet our record is mixed, to say the least. The economist David Storey has calculated that we spend about £8bn a year supporting small firms in the UK. Having spent this money we should be asking: where are our Googles?

The answer, of course, is that the number of people setting up companies has nothing to do with the creation of innovative high-growth firms. Increasing the former doesn’t make the latter any more likely.

The Demos article led me to Muppets and Gazelles a paper Nightingale and Coad wrote in December. Here, they describe the typical British startup:

The typical entrepreneur is more like someone who starts from an underprivileged position (people with good jobs are less likely to start firms), uses his/her savings to start a low-productivity firm (e.g., a fish-and-chip shop), in an established highly competitive market (e.g., a town with two fish-and-chip shops, but a market that can only support one). As a result, if they are still around in 2 years, which is unlikely, it is only because they have displaced a similar marginal firm. Such firms create a lot of jobs, but also destroy a lot of jobs, and while their owners are happier, they have a fairly marginal impact on the economy.

Most contribute very little to economic growth, simply creating churn by putting other firms out of business before going out of business themselves.

It certainly is the case that a small number of start-ups has a positive impact on the economy, but most of the time, for most of the firms, and for most of the performance metrics, the economic impact of entrepreneurial firms is poor.

We refer to these poorer performing firms as “marginal undersized poor performance enterprises,” or muppets, with the category intended to capture the median small business. The firms are marginal because they lack the ambition or capability to grow or innovate, have high death rates, and are poorly captured in statistics or academic studies. They are undersized because they lack the minimum efficient scale needed to perform on par with incumbents in their sectors and industries. As a result, they are poor performance: they have low productivity and low levels of innovation, and generate churn rather than economic growth.

Furthermore, they say, the high-growth startups rarely come from nowhere. They are usually the descendants of large firms.

Gordon Moore, the founder of Intel, observed that “successful start-ups almost always begin with an idea that has ripened in the research organization of a large company (or university). Regions without larger companies at the technology frontier or research organizations of large companies will probably have fewer companies starting or spinning off.”11 This view is supported by Hvide (2009) who shows that low-quality entrepreneurs emerge from small firms, while high-quality entrepreneurs emerge from large firms (see also Klepper, 2001). These large-firm spinouts are often categorized as small firms even though their ideas were incubated in large firms, highlighting how misleading it can be to treat small and large firms in isolation.

Entrepreneurs who leave large firms do so with the advantage of business education, time to develop their ideas and networks of contacts developed at their employers’ expense. Regions with fewer large companies will have fewer such people. Startups, therefore, are unlikely to be the saviour of already blighted rustbelt towns.

A recent report from the Centre for Policy Studies suggested that there might even be a negative relationship between the number of micro businesses and the number of high value entrepreneurs. It identifies those who have built billion dollar businesses as SuperEntrepreneurs and notes that the number varies as a proportion of the population from country to country.

The proportion of SuperEntrepreneurs is higher in those countries with lower self-employment.

We should not infer cause and effect from this, of course. The authors of the report simply make the observation. It may be that both are reflections of other variables. We know that countries with high levels of self-employment tend to be poorer. It could simply be that richer countries build more big firms per head. Larger and richer countries have more scope to grow large businesses. They also have more state and large firm employment. This provides the grounding and business education enabling former employees to go on to start large firms.

We have become enthralled by the legends of Google and Facebook but these companies are exceptions. It is extremely rare for companies started up by students with little business experience to become large corporations. Jeff Bezos, who spent a decade in large corporations before starting Amazon, is more typical of the successful business builder but his story is not as romantic. Google and Facebook give people the idea that anyone can start a worldbeating business from anywhere. As Nightingale and Coad say, that’s only true in the sense that anyone can win the lottery. The reality is that such firms are extremely rare.

The success of businesses depends on a whole number of variables, not least of which is the presence of large corporations or the state providing the investment which develops entrepreneurs and provides custom for their businesses. Without this ecosystem, it is hard for firms to survive.

As Mariana Mazzucato, author of The Entrepreneurial State, points out:

[A] core problem across the EU is a lack of business R&D spending by larger firms. Whereas business spending on R&D (as a proportion to GDP) is relatively high in both Germany (2.5%) and America (2.6%), in Britain and the Netherlands it is only 1.7%, significantly below the OECD average of 2%. The lowest spenders are precisely those that also have the lowest public spending on R&D: Portugal, Italy, Greece and Spain.

And they are also the countries with the highest levels of self-employment. (See previous post.) Low corporate and state investment deprives smaller businesses of customers and creates fewer people with skills in running large enterprises. In turn, the resulting lack of employment encourages more people to start up marginal businesses. Ever larger numbers of would-be entrepreneurs feed from a shrinking pot.

There are a number of factors which provide the environment in which people create and grow new businesses. Encouraging lots of startups isn’t one of them though. The idea that the more startups we have, the more likely it is that a few of them will turn into high-growth businesses doesn’t stand up to scrutiny. It’s yet another example of fashionable nonsense.