When Covid Leaves, Our Startup Problem Will Remain

The structural issues that discourage entrepreneurship have yet to be addressed.

The recent spike in business registrations, says Victor Hwang, “seems more out of desperation than anything else.”

By Saul Elbein

Before America was America, it was a land of entrepreneurs. Small time tinkerers, merchants, and craftsmen built the prototypes that became the railroads, the steamboats, the repeating rifle, the electric grid, and the dry-goods stores that ultimately became retail giants like Walmart.

That entrepreneurial thread is a powerful, if often unacknowledged, force throughout the nation’s history, says Victor Hwang, formerly vice president of entrepreneurship with the Kauffman Foundation and now founder and CEO of Right to Start, an organization dedicated to supporting entrepreneurship. Hwang has studied why startup numbers dipped so sharply in recent decades before surging during the economic devastation of the pandemic. That famous crowd that threw the tea in Boston Harbor in 1775, he points out, was fighting for the right to do business without royal interference, protesting the monopoly that mandated big corporate control of tea.

Now that big corporate control has become the rule in most sectors, it’s worth noting that that’s a relatively new development. For most of the last 200 years, the American economy was largely a network of independent and artisanal businesses, funded based on personal relationships by community lenders. Even today, small businesses ⁠— those with fewer than 10 employees ⁠— make up 85 percent of hires and are a first introduction to the work force for many.

Small businesses, as research at the Kauffman Foundation has found, are disproportionately important in the creation of both new industries and new jobs. “Big business is net-negative or, at best, neutral in terms of jobs,” says Hwang. “It tends to acquire firms and then squeeze the slack out of them in order to compete with other big businesses.” The net results are cheaper products and fewer jobs.

Small businesses, according to the National Bureau of Economic Research, have also been more nimble, far more able to respond to shocks and changing economic conditions—although, of course, those statistics came before Covid-19 gutted local businesses.  And yet, even before Covid, they were in decline. In 2012, new businesses made up just 8 percent of the number of total businesses; a drop of 44 percent from 1978. Between 1998 and 2010, the share of private sector workers in businesses less than 2 years old fell almost in half, from 9 percent to 5 percent.

Part of this change can be traced to long-term trends and part to short, sharp shocks. The 1970s retail consolidation damaged Main Streets around the country, much the way e-commerce would later undercut big retail; and the 2007 Great Recession was an extinction event for the entrepreneurial economy that many sectors had yet to recover from when the pandemic hit.

Between 2007 and 2019, for example, according to the U..S Census Bureau, 116,000 construction companies closed, along with 54,000 retailers, and 26,000 small manufacturers — factors which led to a fall in home construction, raising prices and depressing home ownership by 8 percent among those under 35, which dampens their ability to use those houses as collateral for the second mortgages and home equity lines of credit that, as Kauffman Foundation research has also found, most new entrepreneurs have to use to capitalize their businesses.

What we are discussing, Hwang said, is less the failure in one sector or class of business than something larger: the slow withering of an entire ecosystem. It is the question, he said, “of the missing economy.” The humble entrepreneurial startup, moving below the radar — the ones that will never be unicorns, and don’t want to — is, Hwang said, “the dynamism of the whole economy. If you think of the economy like the human body, it’s like the stem cells: the regenerative process. It’s what creates new and better things on a constant and renewing basis.”

He paused. “And when they go, and the body is no longer able to renew itself …”

Where is the money?

“I think it’s a great time to start a company,” Bradley Burke, who runs Rice University’s business plan competition, told me shortly before the pandemic. Burke says he’s never seen so much interest either from students or funders, and it is true that technology startups are one of the few sectors that haven’t seen a sharp decline. In fact, tech startup numbers are up 20 percent a year since 2007. But tech accounts for only 2 percent of all businesses. America’s decline in entrepreneurship has been obscured by the often-fawning coverage it gets. When most Americans think startups, they think tech.

Back before the virus, Burke suggested that one reason startups were down was the formerly strong economy. “New startups might be counter-cyclical, in that they grow when the economy is weak and the opportunity cost of starting your own thing is lower.”

It remains to be seen whether the pandemic boom in laid-off workers starting businesses will outlast Covid. (There was a spike in new business registrations in summer 2020, Hwang said, “but it seems more out of desperation than anything else.”) But even if it does, the idea that the appeal of the good corporate paycheck compared to the risky entrepreneur’s life is what keeps startup numbers down reflects a dark truth, said Jonathan Nelson, who runs a Silicon Valley “concierge service” and venture fund that helps firms from outside the Valley, and often the country, get established there. That truth is that the structures of our financial and social system squeeze out competent entrepreneurs with good ideas before they can even get started.

Recently, Nelson spent two years on an SEC advisory committee studying capital formation, which is to say: Why is there so much money available in the Bay Area and so little everywhere else?

This was frustrating, Nelson says, because the SEC does not collect data on privately held companies, and there are half as many publicly traded ones now as in the 1990s. The SEC, he found, spends most of its time protecting investors and maintaining markets ⁠— law enforcement, basically ⁠— which, while important, tends to overshadow the SEC’s official third mandate: encouraging the formation of new capital. “No one hauls the SEC into a Senate hearing because small businesses aren’t getting the capital they need to grow,” Nelson says.

But as Nelson surveyed and interviewed banks and entrepreneurs, and read through research reports from organizations like Kaufman ⁠— which found, for example, that most new entrepreneurs self-capitalize with credit cards and second mortgages ⁠— what emerged through the gloom of incomplete data sets was a picture of a game tilted inexorably in favor of businesses that are already big.

Some of the problems are regulatory, and many feel heartbreakingly petty. Victor Hwang recalled a Kansas City food fair where he met a cheese maker whose potential profits from the event had been wiped out before the business arrived ⁠— because the city required it to get a $200 food license. (One takeaway from the Goldman Sachs 10,000 Small Business Survey was that a majority of business owners felt local regulations were a major brake on the formation of business.)

“Of course the city needs to guarantee safe food,” Hwang says. “But it was November. They didn’t pro-rate it.” Some cities, like Detroit, have experimented with cottage-food exemptions to such laws. But in Kansas City, “It was $200 for them and $200 for a Chili’s.”

As a result, even the iconic American lemonade stand is becoming extinct, in part because all but 14 states require lemonade stands to get permits ⁠— transforming the traditional lesson of the lemonade stand into something equally educational but far less inspiring. “Sure, they learn a lesson about how our system works,” Hwang says, “but is it really the one that we want them to be learning?”

Hwang compared each roadblock in the modern entrepreneur’s path ⁠— the SEC’s lack of interest in capital formation, the difficulty of securing capital, the lack of family wealth in minority communities, people barred from the industries they know best by non-compete clauses ⁠— as pebbles dropped in a stream. When the stream gets blocked ⁠— when a new business doesn’t form, create jobs, hire locally ⁠— it’s impossible to say which pebble did it, and the public never finds out.

Perhaps a more important factor keeping new businesses from starting is one that has been politically charged for years: health care. Nelson, the venture fund owner, says he could never have gotten Hack Fund off the ground without the Affordable Care Act, because his pacemaker counted as a pre-existing condition, which made him uninsurable, and therefore dependent on workplace insurance. Since then, he’s seen two of his founders ⁠— and their companies, and his investment ⁠—nearly ruined by unforeseen medical bills. One, a Latvian used to socialized medicine, called an ambulance after he fell at a New Year’s Eve party and gashed his head.

“It was minor, but bloody,” Nelson says. “By the time I had found out, he had already paid $35,000 in cash for an ambulance ride.” Now Nelson mitigates this exposure with what amounts to his own workplace insurance: He keeps a physician on retainer, who he pays a $5,000 annual retainer to make $100 house calls to the entrepreneurs he funds.

No VC is going to invest in that company

But the healthcare problem is just one manifestation of a system that makes it easier for successful companies to get bigger ⁠— and for a few lucky unicorns to get very big ⁠— than for most new companies to get started. The dark side of today’s startup economy is that the promise of astonishing wins in venture capital ⁠— even if the class is not, as a whole, a great investment ⁠— has sucked up a disproportionate amount of available capital and administrative talent that might otherwise go to service businesses. “You can be a $3-to-$5 million business,” Nelson said, “with great margins, fantastic growth, and 5-10 employees. But no VC is going to invest in that company.”

Once, those traditional small business development deals would have been the province of community lenders ⁠— who might well have known the principals, and made loans as much on social capital and personal relationships as on pure financials. But now those institutions are largely gone; swallowed by the same consolidation that sucked the life from regional Main Streets.

“We found that if you want to get a small business loan from a bank, you need $2 million in annual sales,” Nelson said. “As part of the SEC committee, I talked to a dozen banks about $150,000 dollar loans to new businesses. They were, ‘Yeah, no, why would we do that?’”

Out of thousands of entrepreneurs Nelson talked to in his time on the SEC capital formation committee, only two had used bank debt. And in both cases, they had used it to buy capital equipment. “If the bank can repossess it if you go under ⁠— a new tractor, a new hotel, something physical ⁠— you can get a loan.”

Those who could bootstrap their way to four Baskin & Robbins might then get the capital to acquire a fifth. Entrepreneurs in manufacturing or real estate ⁠— like Nelson’s father, who runs a real estate business in Minnesota ⁠— can get loans against their assets to buy more of the same. But generally only more of the same.

Those without an existing, profitable business with assets and a revenue stream have little choice but to take out a home-equity line of credit or a second mortgage – or to bootstrap. “You don’t have much choice but to bootstrap it,” Nelson said, living lean off the profits from your nascent business, counting on freebies from your social network, like the use of your mom’s proverbial garage.

There are advantages to bootstrapping. The entrepreneur maintains control and avoids the dangers associated with taking on debt. On the other hand, fewer businesses get started, and they tend to grow more slowly.

Hwang describes the capital system as a Soviet-style ice cream shop with just two flavors: all the diversity and complexity of American small business life forced to choose between a two-flavor banking system: VC funding for potential unicorns; slow-and-steady bank loans for businesses with lots of proven revenues, invoices, and real assets; and “get out of my store” for everything else.

“But people shouldn’t be bound by either model,” Hwang said. “And what they should realize: the models being taught to them are actually pretty dated. Neither one feeds the economy—either VC or banking model. And they should be prepared to find ways to do it on their own. Not easy, but don’t feel pressured to go into either of them.”

This is why Hwang talks about the Right to Start: because right now, it’s a right most people don’t have. Without your own capital, your mom’s garage, or a high credit limit, the choice to keep working for a boss, rather than setting out on your own, isn’t really a choice.

Until these issues of what amount to financial infrastructure are fixed, and our creaky, outdated systems replaced by a paradigm that treats the ability to start a business as a human right, our system will keep tending toward stasis and sclerosis: an economy where big business stocks can soar while a third of Americans worry about putting food on the table.

“You even listen to President Biden’s comments,” Hwang said. “He’s still talking about employers versus workers. That’s still the fundamental lens of how they view the economy. But that’s not how it works anymore, or how people want it to, Everyone is a worker; everyone can be a company. Everyone can pick and control their own economic lives; they can decide whether to work for themselves or start their own thing.”

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