Innovation ‘Out of Necessity’: Entrepreneurship during a Downturn

During a recession with fast growing unemployment, looking for ways to incentivize entrepreneurial activity and enhance corporate liquidity has become a strategic focal point for Spanish companies. Ignacio de la Vega, director of the IE Business School’s Center for Entrepreneurial Management and president of the Global Entrepreneurship Monitor (GEM), which analyzes entrepreneurial conditions in 43 countries, spoke with Universia-Knowledge@Wharton about the current economic crisis and its impact on entrepreneurship. The GEM 2008 Global Report, which was recently released, is sponsored by the Ministry of Industry’s small and midsize business division and the Banesto Foundation for Society and Technology.

Universia-Knowledge@Wharton: What has been the impact of the global economic crisis on entrepreneurial activity in Spain? What differences are there compared with previous crises? In what ways will entrepreneurial activity evolve in 2009?

Ignacio de la Vega: Starting from 2000, we have measured the macro-climate and environment in Spain very carefully at our organization. We began with an entrepreneurial activity rate of 4.55% that year, and we see an extremely important turning point between 2000 and 2001, when the rate climbed to 7.78%. If we think about what was happening at that time in the market, we see that it was a period of boom, when the Internet bubble in Spain was at its decisive moment. There were lots of opportunities to start companies and, unlike the current situation, when entrepreneurial activity did not bear fruit it was not because of a shortage of work opportunities but purely because of the particular opportunity. In 2002, we practically returned to the levels of 2000, with a 24% drop in the rate of entrepreneurial activity, which is an accurate reflection of the overall economic climate. Then the Internet bubble burst, and there was a serious crisis in the technology sector — a sector crisis, not a systemic crisis like today — and there were the attacks of September 11 … and finally, optimism declined along with the rate of entrepreneurial activity.

Ever since then, we’ve been experiencing rising economic activity, until this year with some isolated declines, but that reflects the growth of our economy since 2000. Analysts began to notice the crisis in July 2007, but at that time it was a crisis in financial markets that had yet to spread into the real economy. In July 2008, at the time of our annual study, the financial crisis already had a very important impact on the real economy and we were expecting successive declines in the rate of economic activity in coming years. Given today’s challenging conditions, including the climate of pessimism, scarcity of financing and so forth, the rate [of entrepreneurial activity] will continue to drop. Nevertheless, we have been living through a new era ever since 2000, and an amazing drop-off in job opportunities — the unemployment rate is over 15%. Obviously, entrepreneurial projects are a very important source of development that takes place ‘out of necessity.’ For the same reason, the decline will not be as steep as in the 2000-2002 period because, since there are fewer job opportunities today, many unemployed people will have to look for refuge in self-employment.

UK@W: What barriers are today’s entrepreneurs facing?

I.D.V.: There are three fundamental barriers at the moment. The first is psychological. Given the problems in the market, starting a business appears to be very risky, especially in a country like ours, which has a culture where there is a clear fear of failure and risk. We find ourselves in a tense position, halfway between the need to find means for income and professional activity, and the psychological fear of failure and risk. In my view, the need [for income] will win out.

Once that barrier has been overcome, the second big barrier is [a shortage of] financial resources. Fewer financial resources are coming from the two principal sources for financing entrepreneurial activity: First, debt, which you get from financial institutions, and public support is not functioning at this time. Second, it’s not coming from informal investors, either; especially when it comes to the smaller companies we’re talking about, where [entrepreneurial] activity has fallen by 13%. The figure of the ‘business angel’ was already weak in Spain [before the crisis], and in the current situation, those people who are liquid expect to make money [on their investments], and those who have already invested [their funds] don’t have any more cash to invest. Our 2008 report already reflects this situation; it shows there has been a significant increase in the number of entrepreneurs who develop a business project and contribute 100% of the financing. Nowadays, given the rate of unemployment, a normative change is going to permit people to capitalize up to 60% of their unemployment subsidies and dedicate it to entrepreneurial activity. This will add some fuel to the system.

The third barrier is real demand. Demand has shrunk a great deal, and it is very hard to find [business] opportunities in many sectors. Competition between companies is already well established and, in an attempt to survive and grow, many companies are becoming more aggressive. That occasionally means lowering their prices, and taking competitive positions in the marketplace that make it hard for someone who does not have these competitive advantages to enter the market.

UK@W: How are people dealing with those obstacles? What concrete measures are they implementing, and what’s your assessment of them?

I.D.V: The solutions involve laying out public policies that are more efficient than those we have today; that includes making it a clear responsibility of financial institutions to get more involved in the system, and really bring to the market some of the rescue measures for small companies that have already begun as commitments by the communications media to develop some optimism within the system. As long as we do not see the light [at the end of the tunnel], we won’t be spending. When demand contracts in the ugly way it is contracting today, entrepreneurial activity becomes paralyzed. Companies leave the market, and it is very hard for others to enter it.

The Spanish government has limited resources. For example, its monetary policy is determined by the EU. However, there are some things it can do. It has tried to inject confidence in the market with its bank rescue plan, but it has had some mediocre results because many banks are not participating or are doing so only by dribs and drabs; that way, banks are not required to provide liquidity to the market. The problem is if the small companies don’t get any liquidity, and they turn off the flow of credit, and then even if they sell less and many of them don’t get paid when they do sell, they wind up not being able to take care of their [debt] obligations — not making nominal payments, payments to suppliers, and so forth. The vicious circle tightens, and it is very harmful. To remedy this situation, you create a rescue plan for small companies that basically consists of providing them with some 10 billion euros, but there is the problem of communication here. Financial aid is available through the ICO (the Ministry of Economics’ Official Credit Institute), but the catch is that this operates through financial institutions that have a maximum level of requirements when it comes to [providing] guarantees. As a result, small companies continue to lack access to that financing.

There is a need for more aggressive solutions such as if the government were to strongly guarantee help through the ICO for small companies that have a certain degree of insolvency. There are 3.5 million small companies, of which 80% have financing problems. On the other hand, you could jointly create a public bank to develop projects aimed at smaller companies, although that is also difficult to communicate given today’s community norms. The solution definitely involves injecting liquidity and confidence into the system. Some banks do that, but with complex criteria and in sectors of activity that are not subject to so much risk. In addition, the criteria for solvency are especially high, leaving out strong companies that could survive and that, at best, have a cash flow problem.

Starting from there, there are lots of other measures: A fiscal agreement for the serious reduction of taxes so that small companies can delay some tax payments — so that they can spread out payments of VAT (Value Added Taxes); and for social security liquidations, something that they can do now but which will have an extremely high cost when there is a bank guarantee.

UK@W: Experts talk a lot about innovation and exports as two good tools for getting around the crisis. Do you believe that the right policies for addressing those subjects are getting off the ground today?

I.D.V: Innovation is not just about developing innovative R&D in technology. That is just one sort of innovation that is possible for a very specific sort of company. Many small companies don’t fit in that category. The sort of innovation within reach of small companies often involves some technology but, especially, it involves an innovative business model. For example, a neighborhood supermarket faces a very trying situation such as declining revenues, higher costs for all sorts of things including logistics, and so forth. For this sort of entrepreneur, innovation could mean trying to generate additional value for customers with classic solutions such as discounting, or it could mean looking for more innovative products, since competing simply on the basis of price has become so difficult.

You have to invest in R&D and have a public policy [to support that], but people need to know this is about long-term investment. It doesn’t make sense to say that [R&D] is a [short-term] solution to the crisis. If we begin to invest seriously now and, for example, create a Ministry of Innovation, perhaps we can diversify the business model of the country in ten years. The reality is that the government’s R&D funding has been squandered; on occasion, it was used for buying new machinery and other initiatives that are not really R&D.

As for exports, diversified companies are more sustainable, according to the textbooks. But we are talking about small companies exporting and, at times, that is an oxymoron, a contradiction in terms. Ultimately, it is a problem of competitiveness. In order to export, you need to be competitive, and in this country we have a very troubling situation in that regard. At times, the origins of that problem are in public policy; we have trouble exporting because we have exhausted our options for exporting in many sectors. In addition, we start with an unfavorable scenario in many low-cost markets in that salaries in those countries are up to eight or 10 times lower than in Spain; absenteeism is practically zero there; quality control requirements are very lax, with no controls, etc. Things that we do not require of companies of [non-European] origin [such as China] are requirements for our companies [in the EU], and this makes our competitiveness deficit even a bit deeper. You have to start from the root of the problem: We need to educate our companies, provide them with resources so that they can be more competitive. And we all need to play with the same rules.

UK@W: The database for your report includes 50 countries. What is the profile of the typical Spanish entrepreneur? Has it changed a great deal in recent times? If so, why? How does it differ from that of neighboring countries?

I.D.V.: Our rate of entrepreneurial activity is a bit lower than in English-speaking countries, but higher than in the countries surrounding us. The profile of the entrepreneur is becoming more uniform, but the interesting thing is the change that has occurred in the last two or three years; the typical entrepreneur is maturing and aging. The average age has gone up by almost four years, and it is approaching forty [years of age]. These days, an entrepreneur coming into the market needs more professional baggage — more knowledge of the sector and so forth. This is very common among entrepreneurs older than fifty. This is related to the concept of becoming an entrepreneur ‘out of necessity’ — starting at that age because your professional career in Spain has come to an end even though that shouldn’t be the case. In addition, today’s entrepreneur has a higher level of training, and education now provides an additional competitive advantage. Today’s entrepreneur also invests more [in his or her business], and the average cost of an initial investment in a project has gone up. The entrepreneur contributes part of the funding from his own pocket, which means that there are fewer and fewer [external] sources of funding.

In times of crisis, the ratio between male and female entrepreneurs evens out. This is something positive, and it obscures a reality of our environment. In families where there are not workers, the woman often develops her entrepreneurial project on her own. This can even happen, at times, in traditionally masculine business sectors. Declining activity in sectors such as real estate, construction and automobiles means that male entrepreneurs are disappearing and female entrepreneurs are being created in the service sector. Traditionally, Spaniards invest in the service sector because it is more welcoming, and it has minimal risk. However, we also observe that over the past twelve months, there has been a significant increase in the industrial sector of renewable energy.

UK@W: Do you believe that the crisis will change business habits in Spain?

I.D.V.: For some years, you’ve already been seeing a certain change, but this is a little like R&D in that it is a long-term process. Nowadays, few Spanish college students want to become entrepreneurs. We need a profound change that begins with training, a change in values and society. So long as the communications media do not recognize the entrepreneur, rather than the speculator, as the person who generates value, things will go poorly for us. This change was beginning to occur before the crisis, building on the boom. Now we are moving in the right direction. In addition, the government is very interested because small and midsize companies generate more than 80% of all new jobs. The responsibility belongs to all of us — the people, the government, the business schools, the universities and so forth. What kind of country do we want to be in the future?

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