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The Not-So-Rosy Reality of Startups

Matt Palmquist

Matt Palmquist is a freelance business journalist based in Oakland, Calif.

 

Bottom LineDespite being trumpeted as an economic engine, startups have struggled to consistently exhibit job and revenue growth. Managers of new firms should carefully balance their goals of expansion against the reality of cutbacks and downsizing.

When we think of successful startups, we usually picture a steady rise to prominence — firms such as eBay or Google that grow step by step, on an upward trajectory, from the time of their inception. But the reality is very different, according to a new study of more than 158,000 fledgling firms. Even at fast-developing companies, continuous growth — measured in terms of both revenue and job creation — is more the exception than the rule during the first several years of a startup’s existence, the authors found.

There’s plenty of emphasis on how early-stage companies contribute to the economy; President Obama even introduced his Startup America Partnership program by declaring that “companies less than five years old account for all of the net growth in our country between 1980 and 2005.” But far less attention is paid to the struggles small firms must endure in their attempts to break through in the marketplace — and the lack of attention is surprising, given that sustained growth, even in the short term, appears unattainable for the majority of nascent companies.

The authors analyzed 158,681 companies that launched between 1999 and 2004, tracking them for up to five years after their founding. The firms were headquartered in several countries and operated in a variety of business sectors, including construction, manufacturing, services, retail, and transportation. In particular, the authors focused on years two through five of the companies’ existence to track how early-stage firms experience both the creation and the destruction of jobs and revenue.

The good news: By year five, startups do indeed create net revenue and jobs in each of the countries studied, lending credence to the argument that new firms represent a valuable economic engine, even for well-established markets.

The bad news, however, is in the details. On an individual level, startups seem destined for a bumpy ride — much of their contribution to the economy depends on cannibalizing other emerging firms. For example, 65 percent of the jobs created by startups in year five are offset by the number of positions eliminated at other new ventures, removing some of the sheen attached to the idea that fledgling companies propel the economy. The same is true, to a lesser extent, of financial growth: About 34 percent of the revenue generated by new firms in year five comes at the expense of their competitors. (Think of the way Facebook grew to the detriment of the previously burgeoning MySpace.)

Much of a startup’s contribution to the economy depends on cannibalizing other emerging firms.

Indeed, although about 35 percent of the companies studied saw three straight years of revenue growth at some period during the study’s time frame, a mere 7.5 percent were able to increase their head count for three consecutive years. On a macro level, that means that stimulating the startup sector may not be the cure-all for unemployment woes and job losses that policymakers would have us believe.

Consistent growth remained a pipe dream for most companies in the study. More than half of the companies that had revenue growth in their third year experienced a dip in year four or year five (or both) and could not post three consecutive positive periods.

Most companies in the study started small and remained that way; of the 38 percent of firms that realized positive job growth in their third year, only 19 percent could say the same about the following two years. The most common sequence involved a cutback on jobs during a firm’s fourth or fifth year, which is perhaps not so surprising considering that promising startups are often acquired or funded on the basis of their potential rather than their current size. When Instagram was bought by Facebook for about US$1 billion in 2012, the authors note, Instagram had fewer than 20 people on the payroll.

External forces also play a significant role. Changes in government regulations, lawsuits over novel technologies, and global recessions all affected the mixed fortunes of startup firms, the authors found. Consider the cautionary tale of Solyndra, founded in 2005 and regarded as one of the leaders of solar panel manufacturing at that time. In 2010, the company had a workforce of more than 1,000 employees and revenues of $140 million. But soon solar panels, many of them made in China, became cheaper, and not even $500 million-plus in loans from the U.S. government could save the company. It filed for bankruptcy in 2011.

Clearly, managers of startups must differentiate between self-inflicted wounds and those caused by the vagaries of the ever-shifting global marketplace. But bearing in mind that steady growth is exceptionally difficult to achieve for most startups, they should steel themselves for the inevitable potholes. As the authors write, “Managing startup companies means not only managing expansion but also understanding how to manage downturns so as to increase the likelihood that the company will return to the growth path.”

Source: “The Rise and Fall of Startups: Creation and Destruction of Revenue and Jobs by Young Companies,” by Antonio Davila (University of Navara), George Foster (Stanford University), Xiaobin He (Fudan University), and Carlos Shimizu (Stanford University), Australian Journal of Management, Feb. 2015, vol. 40, no. 1

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The Not-So-Rosy Reality of Startups