Michou Kokodoko - Community Development Senior Project Manager
Published July 1, 2010 | July 2010 issue
The recent recession and its widespread job losses have hit millions of families hard. Yet even during the toughest period of the recession, new businesses and employment opportunities were created, often by entrepreneurs who launched small-scale enterprises. In other words, at a time when most people tightened their belts and took fewer financial risks, thousands of entrepreneurs across the country mustered their courage and decided to try business ownership. Their decision raises some interesting questions: What do these new businesses look like? How were they financed? Why start a business during an economic downturn? And how do businesses started in downturns fare?
To answer these questions, we reached out to our banking and community development partner organizations that assist entrepreneurs with technical expertise or funding. We asked the partner organizations to identify entrepreneurs who started new businesses in Minnesota in 2008 or 2009. We focused on Minnesota because among the six states in the Ninth Federal Reserve District, it has the highest concentration of community development financial institutions (CDFIs) that are involved in fostering entrepreneurship.1/ The entrepreneurs then completed a questionnaire about their new business enterprises and in some cases were interviewed by a Community Affairs representative. We gathered the information from January 9 to February 5, 2010. In the end, we surveyed about 20 entrepreneurs.
Although our survey was too small in scale to be considered a scientific sampling, it provides a useful snapshot of the challenges that newly minted entrepreneurs face in a difficult economic climate. What follows is a discussion of our survey group's experiences. In addition to information obtained during our conversations and other information gathering, the article relies on recent research and data on new business development and entrepreneurship.
Our survey reveals a number of similarities among the entrepreneurs and their businesses. Most of the entrepreneurs told us that they had thought about their business ideas for a long time. Only two indicated that they created their businesses on the fly. Also, the majority of the entrepreneurs have worked previously in the industry in which they started their business and have spent much of their lives in the towns where the businesses are located.
The main industry sectors represented by our survey respondents are finance and insurance, manufacturing, and real estate. Most of the entrepreneurs in our group are equipped with college degrees, which enable a select few to continue working at a job other than the new business in order to generate additional income or purchase adequate medical coverage.
The businesses in our survey are small, employing one to four people including the founder. Their size means they fit the commonly used definition of a microenterprise: a small business that employs five people or fewer. (For more on the definition of microenterprises, see the sidebar below.) In terms of their size, these new businesses are typical of start-ups in Minnesota. Of the 8,623 new employer firms started in an average year in Minnesota between 1977 and 2005,2/ only 15.5 percent were able to hire more than four employees. Similarly, total employment by new firms that were started in an average year during the same period was only 2.78 percent of total employment by all firms.3/ Various data sources also suggest that new businesses are small when measured by revenues.
More than half of the businesses in our survey needed $50,000 or less to begin operations. For most of the entrepreneurs, revenues had not exceeded expenses for more than 6 of the 12 months preceding our survey. Such was the case for Marilyn Schroeder, a licensed hearing instrument distributor and certified occupational hearing conservationist who founded Maris Hearing Center in Ivanhoe, Minn., in March 2009. At the time of our survey, Schroeder was relying on her husband's income to cover personal bills and household expenses while her business got off the ground. "I cannot take any draws from the business yet," she reported.
According to a 2010 Federal Reserve survey of senior loan officers, commercial banks generally ceased tightening their credit standards on many loan types in the fourth quarter of 2009 but have yet to reverse the considerable tightening that occurred over the preceding two years.4/ In a tight credit environment such as this, requests from new businesses might not be appealing to some credit providers. As an alternative, many new businesses turn to community banks, credit unions, and CDFIs, which all rely partly on personal relationships and knowledge of the local market to assess credit risks. Also, internal finance—that is, financing from the personal resources of business owners and their family members, friends, and business associates—can help compensate for a lack of access to capital and is crucial to both new and established small enterprises.5/
In fact, several studies show that the most common source of start-up capital for new businesses is the founders' personal savings. This was true in our survey group as well. Our small business owners indicated that their main source of start-up financing was their own savings. They did receive funding from sources such as community banks, credit unions, government agencies, CDFIs, family members, and friends, but only after using their personal savings to provide an initial equity injection.
Our new business owners also used personal credit to provide start-up funding. They used personal credit cards, relied on their personal credit histories to take out loans or lines of credit from banks and nonprofit lenders, and borrowed from friends and family members. Since the majority of the respondents are sole owners of their businesses, this indicates that they may have pledged personal assets to secure the financing. In other words, they were willing to provide personal guarantees for the debt of the new business.
On the surface, an economic downturn looks like an unwise time to launch a new business. But during periods of economic crisis, opportunities often emerge for prospective entrepreneurs. For example, when times are tough, customers will look for more cost-effective ways to get the products and services they need; they may be less likely to remain loyal even to longtime suppliers. By seizing opportunities like these, new firms can turn downturns to their advantage.
Financial difficulties resulting from job losses are another reason why people start new businesses in a tough economic environment. As people are pushed out of the job market by corporate downsizing and the outsourcing of jobs, they look for other ways to generate income. For example, Brad Peterson, one of our survey group members, started Channel Partners LLC in 2009 after losing his job at a Twin Cities-based employer. His start-up company helps advise and link businesses with financing agencies throughout the country that provide short-term working capital and cash advances.
Although it is impossible to determine how many new businesses have been founded by the newly unemployed, it is interesting to note that during our current economic downturn, an unusually high unemployment rate in Minnesota has coincided with an unusually high rate of new business filings. The preliminary statewide unemployment rate in Minnesota was 7.4 percent as of December 2009, compared to 4.9 percent two years earlier. According to the latest data available from the Minnesota Secretary of State's Office at the time of this writing, Minnesota was on pace to set a state record of more than 63,000 new business filings for the 2009 calendar year. That total represents a 15 percent increase over 2008 filings.
However, a historical analysis of the relationship between recessions and job creation reveals a mixed picture. Data from the U.S. Census Bureau Business Statistics database show that the rate of new firms formed per 1,000 people fell during the 1980 and 1981–1982 recessions (see Figure 1). The rate stabilized during the 1990–1991 recession and increased during the 2001 recession. Consequently, it is difficult to prove a direct link between periods of economic contraction and upsurges in entrepreneurial activity.
Being self-employed can bring substantial financial rewards. When a business survives the first few years, it tends to improve the income of the founder's household. One study shows that business-owning households make almost three times as much income, on average, as households without any business ownership.6/ The average net worth of a successful entrepreneur is much higher than the average net worth of a nonentrepreneur. And calculations based on census data indicate that the total personal income for self-employed people (including owners of incorporated and nonincorporated firms) averages $55,248, while the total personal income for people working for other private companies averages $40,518.7/ However, there are drawbacks to self-employment. Entrepreneurs tend to have much more variation in their income from month to month and year to year than persons who work for others,8/ and they fall in a higher income tax bracket than people who are not self-employed.
Generally speaking, new businesses struggle, whether they are started during a recession or an economic boom. In fact, most studies agree that the majority of new businesses fail. When we look at five-year survival rates for the new firms started in Minnesota in any given year during the period from 1982 through 2005, the pattern for each year's batch of new firms is the same: the survival rate drops sharply in years one and two and flattens in years three to five. For any given year, an average of 45.1 percent of new firms survives to age five. It is important to note that there are no significant differences between the survival rates of businesses started in recession years and businesses started in nonrecession years. In other words, companies founded during recessions are no more likely to fail than any other new company. (For a visual representation of the consistency among survival rates from year to year, see Figure 2.)
There is ample research to confirm this trend. For example, according to a study conducted by the Ewing Marion Kauffman Foundation, recessions do not appear to have a significantly negative impact on the formation and survival of new businesses.9/ In fact, many successful, well-known companies got their start during a recession. Examples include General Electric and AT&T. More than half of the companies on the 2009 Fortune 500 list (57 percent) and just under half of the 2008 Inc. list (48 percent) began during a recession. Also, the 2009 Inc. list of the fastest-growing companies includes 17 companies in Minnesota that were started during a recession. And of the 32 Minnesota-based companies included on the Fortune 1,000 list, well over half were started during tough economic times. Additional findings from the Kauffman Foundation study indicate that job creation from start-ups is much less volatile and sensitive to downturns than job creation in the economy as a whole.10/
For a start-up business to survive, it must find ways to innovate and overcome the challenges it encounters. One major challenge for new firms is establishing a competitive advantage. Generally speaking, if a new business has a patented technology, high-quality customer service, the ability to achieve economies of scale, and attractive financing terms, it can out-compete existing firms in the same industry. In a tumultuous time, the most successful companies never stop funding their critical competencies and maintaining their advantage. Unfortunately, some surveys indicate that many new businesses lack a competitive advantage. Preliminary data from a Kauffman Foundation survey reveal that more than one-third of new entrepreneurs believe that their companies do not have a competitive advantage.11/ Among the entrepreneurs we surveyed, almost half indicated that the products they offer are no different from those of their competitors.
Managing growth is another major challenge for business start-ups. Since many new businesses are one- or two-person operations, it can be hard for them to keep up if the demand for their services increases.
"It's a roller coaster," said Brad Peterson of Channel Partners LLC. "It's difficult focusing our efforts on originating new deals while working on the existing deals at the same time. Because of the size of our company, we don't have staff devoted solely to initiating deals. We get the deals, work on them, and then we go back and work on getting deals again." Marilyn Schroeder of Maris Hearing Center added, "I would love to hire a new staff person to help, but I can't do that yet. When I go visit neighboring communities or I'm with a patient, all I have is the answering machine. I'd like to be able to have someone here, so I could have more consistent hours for these people when they walk in the door."
Fortunately for business start-ups, overcoming challenges and surviving the first several years are not just matters of chance. Research suggests there are some factors under an entrepreneur's control that can increase the likelihood of success. One example is to choose an industry that is favorable to new companies. Another is to choose a business idea that aligns with one's prior career experience and existing business skills. As noted earlier, most of the entrepreneurs in our survey started their businesses in industries where they had previous experience. This choice not only affects the short-term survival of a new firm, but also its long-term growth and profitability.
All of our survey group members indicated that they believe the economic woes are not over yet. Still, they are optimistic about the future. In light of the sobering statistics concerning the survival rates of new businesses, such optimism might seem misplaced. However, the popular image of the successful firm that had its beginnings in someone's garage or basement is not merely an illusion. There is some truth to it. Even if they are founded during difficult economic times, some microenterprises can grow into small businesses, and small businesses can grow into large firms. At every stage of their development, successful businesses can provide economic independence and self-reliance for their founders, employment opportunities for the local community, and valued products and services for consumers.
The allure of creating a big success from small beginnings is what drives entrepreneurship. The individuals who participated in our small business survey are all hoping to beat the odds and achieve their entrepreneurial dreams. As we have seen, they have a number of things in common, and in some ways are typical of nascent entrepreneurs in Minnesota. Yet they also differ in some important respects, such as their industries of choice, levels of business skill, and competitive positions. Each entrepreneur brings a unique mix of traits, experiences, and circumstances that will determine whether he or she succeeds. While research can tell us much about trends, survival rates, and success factors among business start-ups, only time can tell us whether the new businesses in our survey will ultimately thrive.
"Small" vs. "micro"
Although they both refer to not-so-big business entities, the terms small business and microenterprise are not interchangeable. The U.S. Small Business Administration defines small businesses as firms with 500 or fewer employees and does not make further distinctions regarding the smallest businesses within that category. However, there is a nationwide industry of nonprofit small business lenders and development organizations that recognizes the smallest small businesses as a distinct category called microenterprises. The Association for Enterprise Opportunity, the national trade organization for microenterprise development groups, defines microenterprises as small businesses that have five or fewer employees. As noted in our article, all of the businesses that participated in our survey fit this definition.
1/ CDFIs are specialized entities that provide lending, investments, and other financial services in economically distressed communities. The CDFI industry includes banks, credit unions, loan funds, venture capital funds, and microenterprise development loan funds.
2/ A firm is the aggregation of all establishments owned by a parent company (within a geographic location and/or industry) that have some annual payroll. A firm may be located in one or more places.
3/ Sources: www.ces.census.gov/index.php/bds/bds_database_list and author's calculations.
5/ Douglas Holtz-Eakin, David Joulfaian, and Harvey S. Rosen, "Entrepreneurial Decisions and Liquidity Constraints,"RAND Journal of Economics, Volume 24, Summer 1994.
6/ M. Gutter and T. Saleem, "Financial Vulnerability of Small Business Owners," Financial Services Review, Volume 14, 2005.
7/ Author's calculations based on data from the U.S. Census Bureau's Integrated Public Use Microdata Series 2006–2008 American Community Survey three-year sample.
8/ W. Carrington, K. McCue, and B. Pierce, "The Role of Employer/Employee Interactions in Labor Market Cycles: Evidence from the Self-Employed," Journal of Economics, Volume 14, No. 4, 1996.
9/ Dane Stangler, The Economic Future Just Happened, Ewing Marion Kauffman Foundation, June 9, 2009.
11/ This survey is a national probability sample of new businesses founded in the United States in 2004.