Startups Are Finding the Sweet Spot in a Downturn

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Wharton’s Ethan Mollick talks with Wharton Business Daily on SiriusXM about the uptick in small business formation during the pandemic.

It’s counter-intuitive for people to start new businesses in an economic downturn, but startups are prying open new market opportunities that coronavirus pandemic lockdowns have created. New business applications, which is the Census Bureau’s tracker for startups, grew 38% in the week ending Oct. 24, compared with the same week a year ago. The increase is in line with an upward trend seen since late May. In fact, Census data shows a new high for that week since 2007. New business formations rose highest in Louisiana, which was up 77% over the same week last year, followed by Georgia, Nevada and Florida.

It is not immediately clear if those numbers are triggered by the government’s economic stimulus programs contained in the $2.2 trillion CARES Act of March, which built on measures by the Federal Reserve and two bills covering health care and paid leave. Notable among its features is the Paycheck Protection Program, or PPP, which gives out loans to help small businesses continue paying wages. The size of the program has grown from its original $320 billion to $670 billion, and efforts are underway to convert the loans into grants.

Even so, the startup boom is unexpected, if you ask Wharton management professor Ethan Mollick.

“A lot of the stimulus was aimed at supporting existing businesses rather than encouraging new startup growth,” Mollick said in a recent interview on the Wharton Business Daily radio show that airs on SiriusXM (Listen to the full podcast here). “So, I would have thought that might have pushed in the other direction.” The startups or new businesses include both high-growth businesses that are funded by venture capitalists, sole proprietorships and mom-and-pop establishments.

“We find that during college breaks, the number of startups launched goes way up because college students have idle time to launch companies.”

The Boom, Explained

The drivers of those new business formations are mixed. “In a normal recession, we see that business starts to drop,” but it’s different with the pandemic-induced lockdowns, Mollick said. Most people have been confined to their homes for long periods, and many would have thought of starting a side business, he noted. “People might have been moonlighting because of the disruption of the regular work, and maybe they’re ready to launch something. It’s also possible that people are being forced to start new businesses as their work shut down.”

For some others, the present times may be just right to act on a business idea they’ve had or unleash some latent creativity that hasn’t found a vent as yet. Those possibilities match some research by Mollick and his colleagues where they looked at the effect of winter breaks on launching new crowdfunding startups. “We find that during college breaks, the number of startups launched goes way up because college students have idle time to launch companies,” he said. “What’s surprised us the most is that the boom has been so quick.”

Rising from the Dumps

The current rush of new business formations is also running counter to the trend of low or negative growth rates over the past dozen years or so. For instance, new business applications fell 24% in 2008, 4% in 2011 and 6% in 2014, and grew just under 1% last year, Census data showed. One explanation for that is that large companies have been accounting for an increasingly larger share of the economy, said Mollick.

The long-term entrepreneurial ecosystem in the U.S. has been declining in recent years, Mollick noted. “Small businesses are responsible for most job growth in the U.S. and for huge amounts of innovation — and they were stagnating. This definitely shook things up. We just don’t know in what way at this stage.”

Some windows opened for small enterprises as the pandemic disrupted the businesses of large companies. “As we disrupt large companies, that creates opportunities for startups to move in nimbly and to take and create new markets,” he added. One example of that is startups springing up to offer remote work solutions. “So, there’s a chance for real disruption that might result in real innovation and a more dynamic underlying economy.”

Will They Succeed?

It may be boom time for startups, but how many will succeed? Mollick offered a data point: “Once a startup is underway, it’s survival rate is close to 50% in five years, but much higher if you consider the earlier stages of a company as well. [However], if the economy drops, startup failure rates will increase.” On the plus side, “startups can thrive on uncertainty because they can change direction and learn from the market more quickly,” he added.

Some historical trends are not helpful. “Typically, if you launch a company during a recession, your company does worse in the long term,” Mollick said. “There are exceptions to the rule, like Google, but most companies launched during a recession do worse than companies launched during good times. So, are these companies marked from birth by coronavirus?”

“As we disrupt large companies, that creates opportunities for startups to move in nimbly and to take and create new markets.”

How sustainable the small-business boom can be will depend on government policies in dealing with a second or third wave of the pandemic and the resulting economic fallout, said Mollick. While uncertainty over all that looms large, “the good news is that the damage to the entrepreneurial ecosystem is much less than we thought, and it actually seems to be providing opportunities.”

Meanwhile, dark clouds are gathering. Expectations have been running low of another stimulus bill (the fourth round) in the forthcoming lame-duck session of Congress (called so because many sitting members will not be in the next Congress). Also, the rise in COVID-19 cases will likely be met with a fresh round of lockdowns in the U.S., as in Europe. That could mean a return to the crippling lockdowns of April and May, Mollick noted.

A fresh round of economic stimulus will be critical for businesses to survive new lockdowns, if only to build on their recent momentum, said Mollick. “We’re entering a time period where businesses have already been buffeted by [the impact of the pandemic], the amount of reserves they have has dropped.” The coming holiday season is also “a very productive time” for businesses, he noted.

Tips to Succeed

Startups can ride out that uncertainty if they have the right approaches, and Mollick shared some tips. “The most successful founders are people who often start from an industry they already know,” he said. “You can think about your own company that you’re at, and what disruptions are happening there, and where is it failing. This is a great time to think about competition in a new world where we care a little bit less about being in the same location, and where e-commerce and remote work are more possible.”

E-commerce businesses are on a roll, and entry barriers for them have fallen dramatically. Mollick pointed out that from the late 1990s, “the cost of launching a web-based business has dropped by three orders of magnitude, or by 1,000 times.” He expects many businesses that are exploring e-commerce and web services apps in new ways “to try and bridge some of the gaps that have been exposed by COVID.”

Mollick also recommends startups avoid following a hot trend. “You probably don’t want to launch another video conferencing company. But if you know an industry, if you know a problem, that is the thing to go after.”

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