Careful what you wish for: Entrepreneurial policies and startups

WSJ had a nice section recently on understanding entrepreneurs, Why Washington Has It Wrong on Small Business. In it, Professor Aaron Chatterji from Duke talks about how job growth comes from high-growth, not low-growth startups (companies younger than 5 years old). This insight mistakes hindsight for foresight but, more importantly, it puts the entrepreneurial cart before the horse.

It’s a well-established statistical truth that only a few startups grow larger than a handful of employees. Most small businesses stay that way (salons, contractors, restaurants, hardware stores), but those that do grow rapidly are ultimately responsible for almost all net new jobs in the U.S. In fact, it was a public policy debate from the 1930s through to the 1960’s, and my colleague Martin Kenney has done a terrific job recounting that in his history of venture capital.

Professor Chatterji offers the same policy advice now for dealing with the difference between these two types of startups. Fund the ones that grow fast, not the ones that don’t. The same advice that was arrived at a half-century ago.

That said, it’s a conversation worth having again and he does it well.

Mistaking hindsight for foresight

The problem is not in recognizing that high-growth startups contribute the most jobs, but rather in learning how to identify which startups are “high-growth.” Consider the following:

  • Home Depot began small (with two stores) but with high aspirations — going public within the first 3 years — and they now employ 330,000 people. But not all major retailers began with the dream of high-growth.

  • Wal-Mart employs more americans (1.4 million in the U.S.; 2.2 million globally) than any other private company. But it began as a single store, Walton’s 5 & 10, in Bentonville, Arkansas (few people with aspirations for global dominance open in a town with 2,900 residents). It would be another 12 years before Sam Walton tweaked his formula, opening a new discount store and calling it Wal-Mart. Then, in the next five years, the company began its rapid growth.

  • Starbucks opened in Seattle, Washington in 1971. It began as a single shop selling beans and equipment, with no higher aspirations. And it would be another ten years before their “high-growth” strategy came, in the form of new ownership. When their Director of Retail Operations, Howard Schultz, left after failing to convince them to sell coffee drinks instead of just beans, he started his own chain of coffee bars and returned to buy out Starbucks, rename his existing stores, and begin the phase of rapid growth and expansion. It now employs 111,000 people in the U.S.

  • Heck, even Microsoft started as a small software firm in 1975 and stayed that way for five years. Things changed only when they got the IBM MS-DOS contract in 1980. It now employs 94,000 people. World domination was not in their original business plan either.

Growth doesn’t necessarily happen in the first few years, nor is it necessarily in the original plan.

In fact, the very question is wrong. Small firms are neither high-growth or not until they grow or not. Until then, they may have aspirations to be one or the other — but we should not be betting on aspirations.

Asking policy makers to to favor only “high-growth” startups can and will lead to all sorts of hubris, turning government bureaucrats into venture capitalists at a time when venture capital has proven its own difficulties identifyng high-growth businesses with any success. For a review, see “Rightsizing the Venture Capital Industry”, as well as a Kauffman Foundation review of its own investments in venture capital, in which “the majority of funds—sixty-two out of 100—failed to exceed returns available from the public markets, after fees and carry were paid.”

And remember, if our objective is employment, the recent internet boom is not the best place to look for role models. Companies like Facebook and Instagram can, by relying on the existing IT infrastructure, now grow quickly without taking on many employees at all. Facebook went public with just over 3,000 employees. Instagram sold for a billion dollars after only 2 years, and with only 12 employees. Someone made money, but it wasn’t shared broadly.

Mistaking growth for good.

A second problem comes with presuming we should focus on high-growth businesses. This is the problem of rapid growth versus sustained performance. Weeds grow fast, but they tend not to stick around. If the goal is fostering long term growth in order to have firms that become and remain contributing members of society, perhaps the better path is patient growth. Find a real problem and build a lasting solution. If you get that right, growth will follow.

That’s because putting the growth cart before the horse can have a couple adverse effects.

First, it forces companies to develop solutions that are relatively easy to build, sell, and for customers to adopt. This is why Google, Facebook, and Instagram are the poster-children of rapid growth in today’s startups. And this is why venture capital failed miserably in growing clean energy startups, where most solutions are complex (matching the problems), difficult to sell, and hard to adopt.

Second, pressuring companies to grow fast changes their nature. The best path to growth comes from outsourcing as much as you can — of the technology stack, of manufacturing operations, of logistics, design, sales, etc… until we are left with high-growth companies with no there there. And it’s not just creating smaller businesses, it also creating more mercenary businesses, where growth — and the perpetual pivot toward more promising pastures — becomes more important than the original purpose and passion of the company’s founders.

Finally, as Paul Hudnut points out in Small Batch Madness, the emphasis on “getting to scale” invokes its own diseconomies of scale — by preventing many small experiments from happening and the evolutionary variation that produces inside and across companies.

Where there were passionate entrepreneurs, there are now far more professional entrepreneurs (jeans, vans, and hoodies do not hide this new feature). Funding for growth, in this way, runs the risk of creating startups that are born old, with all the heart and soul of corporate bureaucracies.