Failure to Launch?

Conventional wisdom holds that recessions are hotbeds of entrepreneurial activity, but will this time be different?
Kate O'SullivanOctober 1, 2009

American economic history brims with big-name companies that can trace their beginnings to a recession. Coors was founded during the recession of 1873. Bill Hewlett and Dave Packard cobbled together the prototypical garage start-up at the end of the Great Depression. Bill Gates, undeterred by stagflation, founded Microsoft in 1975. According to a recent report by the Ewing Marion Kauffman Foundation, an organization devoted to the study and promotion of entrepreneurship, more than half of the companies on the 2009 Fortune 500 list were founded during a recession or bear market, as were nearly half of the businesses on the 2008 Inc. 500 list of the fastest-growing companies in the United States.

While an economic downturn may seem an inauspicious moment to start a company, several factors often combine to produce opportunity. “The best time to start a business is when it’s hard to start a business,” says William Sahlman, a professor at Harvard Business School. In a recession, competition lessens as established companies struggle and fold, leaving room for new entrants. “You can make more progress during such periods and build a stronger position, without being competed to death by well-funded competitors,” says Sahlman. Rents tend to be lower, and high-quality talent is plentiful.

In addition, so-called opportunity entrepreneurs — people who have a new idea and try to capitalize on it — are joined by “necessity” entrepreneurs, says Dennis Ceru, an adjunct professor at Babson College. Finding themselves unemployed, some people who harbored an entrepreneurial dream but feared leaving the security of a full-time job may join with other laid-off workers who simply need to generate income.

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But as would-be entrepreneurs face the Great Recession of 2008–2009, are the odds too heavily stacked against them? The credit and capital markets are at the epicenter of this downturn, limiting access to capital even for larger companies. Will great ideas remain just that, rather than blossoming into great companies? Or will those who would be kingpins simply have to be more creative and resourceful than before?

Dialing for Dollars

By all accounts, raising funds for a new business today is harder than it has been in decades. “There are no bank loans right now,” says Louis Katz, a partner with law firm Ruberto, Israel & Weiner and a former CPA who works with small and midsize businesses. “The SBA is starting to free up some money for new businesses, but that’s about the only place you see it. Private-equity firms are shoring up their existing companies rather than going out to find new businesses to finance.”

Sahlman agrees that “anything that requires bank financing is problematic,” but adds that he’s seen increased availability of equity capital in recent months. “It would be hard to start a $100 million project today, but there are lots of people funding things on the Web where it costs $250,000 to figure out if an idea is going to work, and if it works, it might be the next Facebook,” he says.

Lack of capital is nothing new for entrepreneurs, more than 90% of whom never receive a dime from angel investors or venture-capital firms even in the best of times. Gregg Fairbrothers, founder of the Dartmouth Entrepreneurial Network and an adjunct professor at the Tuck School of Business at Dartmouth, says, “At the very seed stage of a business, there’s no money at good times or bad times. Most small companies just are not going to get money from banks or investors at any time.”

Instead, they turn to sources of capital affectionately known in start-up circles as the “three F’s”: friends, family, and fools. But in the wake of the stock market’s plunge, wealthy relatives and successful college roommates may be more cautious than in the past.

While angel investors have also watched their net worth decline, Fairbrothers says a surprising amount of angel money continues to flow to start-ups. “We’ve closed as many seed fundings in the past 12 months as in any period I can remember,” he says.

One explanation may be that many investors are unsure about where to put their money, and have found that more-traditional investments — in, say, mutual funds — were riskier than they thought. They may be more comfortable investing directly in a company, where at least they can feel some sense of connection with the management team. Plus, “for people who do have money, this is the best time to invest because valuations are lower,” says Fairbrothers.

Dave O’Brien, a former CFO who is now chief executive of Business Catapult, a software and services firm that helps create and manage online communities of entrepreneurs and investors, says investors are more selective than they have been in the past. They are also trying to limit their risk as much as they can. “I see more people interested in investing one stage later than they used to,” he says. “Someone who in the past might have funded a concept at a prerevenue company is now looking instead at a company with revenue that needs capital to grow.”

America’s Got Talent

While money is tighter than in recessions of the recent past, another economic condition could offset that constraint: namely, unemployment. By August, about 7.4 million people had lost their jobs since the beginning of the recession, yielding an unemployment rate of nearly 10% nationally and into double digits in many spots. The average length of unemployment has grown to more than six months, the longest period of time since the government began tracking the data in 1948. Such lengthy stretches leave workers with plenty of time to hone business plans — and indicate a dearth of other options.

“If you’ve been unemployed for many months and there are no companies hiring, you may feel compelled to give that business idea you’ve had a try. What do you have to lose?” says entrepreneur Geri Westphal, who founded and runs a day spa while continuing to work as an assistant treasurer at an engineering firm (see “A Calculated Risk” at the end of this article). As Robert Litan, vice president of research and policy at the Kauffman Foundation, puts it, “You see a lot of people in a recession saying, ‘To hell with the job market.’”

Many of those who are currently jobless are highly educated, highly skilled workers: the professional and business-services sector, which includes accountants, lawyers, and consultants of all stripes, has lost 1.5 million jobs since the recession began, according to the Bureau of Labor Statistics. “When an accounting firm or a law firm lays off 20% of its workforce, those are very well-trained people they’re letting go. They’re either going to get another job or open up their own business,” says Louis Katz.

Service businesses also require little start-up capital beyond the cost of a phone line and a laptop, making them well suited to today’s market. Katz has noticed start-up activity in the financial-services sector, as newly unemployed investment bankers launch financial-advisory businesses. O’Brien says he’s seeing a lot of management consultants trying to start their own practices.

At Harvard Business School, Sahlman says some 50 members of the class of 2009 are involved with start-ups. “If you were working at Bain or McKinsey or a financial firm [and left to pursue an MBA], they might say, ‘We can’t use you now; come [back] in January or March.’ A lot of those people are working on business plans or with buddies who are starting companies,” he says. “There’s a surfeit of talent out there.” Of 889 June graduates, just 83% of those who sought employment got a job offer, compared with 95% in 2008.

Ready to Pitch

It’s too soon to tell whether the pool of available talent will overcome the lack of capital to produce lots of new businesses. Start-ups are notoriously hard to track, given that many companies may not leave any paper trail of permit applications, tax returns, or other corporate filings in their earliest stages.

“The good news is that, in the deepest recession that we’ve had in my lifetime, so far the pattern of business creation hasn’t been broken,” says Litan. The Kauffman Foundation found that entrepreneurship rose modestly in 2008, the latest full year of data. Recent numbers from the Bureau of Labor Statistics show that the rate of self-employment has increased slightly, to 6.6% of the population in June, up from 6.2% in January.

Anecdotally, there are some promising signs of new business formation. “We see lots of evidence among our graduates that the level of early entrepreneurship is up substantially,” says Sahlman, adding that 150 people entered HBS’s business-plan competition this year, a marked increase from 2008. When O’Brien’s Business Catapult helped sponsor the annual Colorado Capital Conference in May, it had more than twice as many entrants as in the previous year. The 90 entrepreneurs who applied also submitted stronger business plans than in the past, says O’Brien.

In fact, it may be an ideal time for someone with finance skills to bring his or her experience to a nascent business. “Companies are putting together plans that say they understand we’re in a recession,” O’Brien says. “The amounts they’re asking for are a little bit less, and their pitches are sharper.”

He has also noticed that companies looking for money today have already proved their concept or have lined up a customer. “They’re showing investors that they’re trying to mitigate their risk,” he says.

Some of these businesses will make it — and maybe prove stronger and better managed for having grown up in a particularly challenging recession. Some, according to Kauffman’s research, will eventually end up on the Fortune 500. Launching a business in a recession, in fact, may be one form of market timing that you can truly bank on, even if banks don’t think so.

Kate O’Sullivan is a senior writer at CFO.

A Calculated Risk

One aspiring entrepreneur anticipated almost everything — except the Great Recession.

After a 20-year career in treasury at big companies including Oracle, Geri Westphal decided to launch her own small business last year because she wanted to build something with her family. “I wanted to ensure that we would always have a place to work. I wanted a business that my whole family could grow together,” she says. “This decision was made well before the economic meltdown, and not because I saw anything dangerous on the horizon.”

With her daughter graduating from cosmetology school, Westphal drew up a business plan for a day spa in Littleton, Colorado, where she continues to work full-time as an assistant treasurer at CH2M Hill, an engineering firm. She researched the industry, studied local demographics, and secured a prime location, financing the start-up phase with personal savings. “As a finance person, I felt confident that we had done the proper homework to launch a business that had a very good chance of survival,” says Westphal. “We worked hard on our business plan, but the unknown ended up taking over.” Ciao Bella Day Spa opened its doors on September 1, 2008, just weeks before the financial markets collapsed.

In talking with fellow spa owners, Westphal learned that many were seeing business decline by 40 to 50%. She slashed her forecasts and, in order to meet working-capital needs, drew on more of the family’s savings than originally budgeted. The business survived the first year — a perilous proposition for any company and a particular challenge in the current climate — and Westphal, showing the characteristic optimism of the entrepreneur, says things are looking up. “We’re seeing good growth entering the holiday season. We’re a year old and people know we’re here. I’m feeling really good about 2010.” — K.O’S.