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News : Innovation Last Updated: Apr 26, 2011 - 5:40 AM

US job creation is dependent on startups and young companies; Falling cost of entry likely will lower survival rate
By Michael Hennigan, Founder and Editor of Finfacts
Sep 23, 2010 - 4:00 AM

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In this illustration the economy begins with the entry of 500,000 new businesses; in Year Two, 394,600 from this initial batch have survived, joined by the second year’s round of incoming businesses, another 500,000. The economy now is populated by 894,600 businesses. If we continue this process over forty years, the organizational population of businesses classified by age looks as represented in Figure 3. After one decade, firms aged five and younger account for more than two-thirds of all businesses in the economy.

We have reported in recent times on how US job creation is dependent on start-ups and young companies and today we report on a study which highlights the falling cost of entry and likely lower survival rate in the sector.

The small business sector has been long viewed as the engine of job generation and in the US, data shows that two-thirds of net new jobs are created by companies with fewer than 500 employees, which is the US government’s definition of a small business.

But research published in August, shows that that once the age of the businesses is taken into account, there is no difference in the job-producing performance of small companies and big ones. Size simply does not matter. It's age that counts.

The Kauffman Foundation, which focuses on entrepreneurship, publishes useful research on startups in the US and for example a study that tracked technology and engineering startups from 1995 to 2005 found that one quarter of them had a foreign-born chief executive or head technologist; by 2005, the surviving companies generated $52bn in sales and employed 450,000 workers.

In a paper this month, published by the Kauffman Foundation, the authors say that once upon a time in economic thought, it was seemingly well-established that the economy either didn’t change much or had matured to a point at which change was no longer necessary. John Kenneth Galbraith, for example, excised the entrepreneur from economic progress in his 1967 book, The New Industrial State. No longer would new firms and innovations create waves in the economy; rather, the “technostructure” of big companies and big government successfully managed both demand and supply and, thereafter, innovations would emerge from that structure.

The paper says clearly, such an observation either never reflected economic reality (Intel was founded the year after Galbraith’s declaration of stasis) or was quickly overtaken by events. The most perceptive economist of the past century was Joseph Schumpeter, who observed: “Capitalism, then, is by nature a form or method of economic change and not only never is, but never can be, stationary.”

After one decade, firms aged five and younger account for more than two-thirds of all businesses in the economy.

While the extraordinary contribution of jobs from new and young firms often is treated as something unique to these firms, the study, Neutralism and Entrepreneurship: The Structural Dynamics of Startups, Young Firms and Job Creation, reveals some measure of structural order behind that reality. However, the study points out that forces creating this structure are subject to change. Recent shifts  --  including the declining cost of company creation in information technology and other sectors, and lower investment thresholds for seed-centric acceleration programs - - indicate that we could very well be on the cusp of one such change: an increase in new company creation in certain sectors of the economy.

"This study reveals an important structural context in which firm formation and job creation occur that helps explain why new and young companies dominate net job creation," Robert E. Litan, vice president of Research and Policy at the Kauffman Foundation. "We need to understand the structural features of entrepreneurial capitalism - - the why of firm formation and job creation - - so we can take steps that support and encourage those features and not unknowingly undermine them."

Because startup entry and survival rates have proven to be relatively constant over time, the number of firms populating the American economy grows annually, with companies five years of age or younger comprising the largest demographic sector each year. In part, this bloc's size alone results in the most net new jobs contributed to the economy, according to the report.

The study bases its findings on an analysis of a Business Dynamics Statistics (BDS) dataset broken out by firm age to determine how total employment in startups changes as those companies age. The BDS, a US government dataset compiled by the US Census Bureau. tracks the annual number of new businesses (startups and new locations) from 1977 to 2005, giving data on firms and their establishments according to firm age for each of the first five years after the birth year and in five-year blocks thereafter.

"While startups and young companies' status as the largest demographic category accounts, at least in part, for the fact that they add more net new jobs to the economy each year than older companies do, a study of various datasets from the past several decades seems to show that US firm formation has been remarkably consistent for the last 100 years," said Dane Stangler, research manager at the Kauffman Foundation and author of the study. "What this indicates is that the level of firm formation is largely neutral - - that is, rather than being a process of constant turmoil, as often is assumed, it follows a natural structural order."

Research into the BDS dataset shows that, once the economy reaches a point at which it includes firms older than age six, new and young companies account for between 30% and 40% of all firms in the economy. Over time, as these companies age, they decrease in number. But, for about the past 20 years, net job creation from those that survive has been greater than that from businesses that open and close. Thus, the large amount of net job creation from continuing companies also appears to reflect the structural dynamics of firm accumulation.

Few companies survive past age 40. Although four-fifths of the companies on the Fortune 500 list were founded before 1970 - - meaning that they have survived past age 40 - - they represent only a tiny percentage of the 6 million-plus US firms. Such long survival requires merging with and acquiring other companies – success factors for which new and young companies provide sustenance. In addition, firm entry likely stimulates older firms' demise, helping to account for the shrinking share of these companies.

The research also found:

  • The fact that so many companies on today's Fortune list were not there, say, 30 years ago, seems to evidence economic upheaval. However, churn cannot be analyzed apart from the structural perspective revealed by the BDS data. As long as older firms continue to decrease in number over time while new firms continue entering, the economy cannot help but experience constant turnover.
  • Substantial turnover is to be expected as a function of firm formation and accumulation. If, conversely, the pace of firm formation dwindled but survival expectations remained unchanged, older companies eventually would dominate the economic landscape. Such an economy might quickly lose any semblance of vitality.
  • Raising survival rates might or might not boost economic growth. From a policy standpoint, if barriers to firm entry were lowered, and new business creation increased as a result, lower survival rates might be required for the selection process to function commensurately and enhance productivity. In addition, a higher volume of new business entry might automatically lead to lower survival rates as a function of the "easy-to-start, easy-to-close" phenomenon identified by some studies.

The recession has sparked a surge in UK small-business entrepreneurs, with a rise of 175% over five years. "You would hope that we've got some of the engines for growth in the future," Charlotte Hogg from Experian told CNBC Thursday, Sept 16, 2010:

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