A quick scan of MSNBC.com’s business headlines for June 17 tells a nerve-wracking, but now-familiar, tale of America’s economic slowdown: “Fed Says Economy Remains Sluggish,” “Stocks Fall Once Again,” “Consumer Sentiment Edges Lower,” “Delta Airlines Expecting Loss,” “McDonald’s Lowers Estimates,” “U. S. Industrial Utilization Falls to a 17-Year Low,” “Brokerages Stuck in Profit Slump,” “The Layoff List.” How do headlines like these affect entrepreneurs who have recently been thinking about launching a new venture? Knowledge at Wharton consulted with several faculty members for their take on that all important economic climate. For
“Or, do I have something that’s truly a breakthrough,” continues Mittelstaedt, “in which case it’s always a good time to start a business.” He recently read about a company that received venture capital funding for a product which reduces plaque in human arteries without invasive surgery. The product creates bubbles inside the tissues of clogged arteries, then collapses the bubbles to reduce the plaque. “According to the article, these guys started this in their home. Now obviously they have scientific background and knowledge, but it is the kind of a product that, if it works, is such a breakthrough in the industry that any time is the right time to start.”
At the same time, Mittelstaedt acknowledges that the state of the economy may still make it more or less difficult to find the necessary capital.
The challenge of raising capital: Are investors ‘beyond conservative’?
Marketing professor
David Reibstein agrees. “Money is hard to come by now. If you went back 18 months to two years ago, there was such an upside for investors that they were looking at anything they could and throwing money at it. Many people were saying that the dot.coms and startups were busy spending a lot of money on advertising and growth because money was cheap. The situation today is that money is not cheap. Unfortunately, there aren’t many people out there willing to invest. In fact, I would characterize investors today as ‘beyond conservative.’”Reibstein notes also how today’s cost of capital affects valuations for new ventures. “In the past, people were given high valuations for the premise. Let’s say we wanted someone to invest a million dollars in our new business idea. What they would have said in the past was, ‘We think your business is worth nine million dollars. If we give you one million, the total’s going to be ten million, and we get 10% of your business.’ Today they would be much more conservative in estimating the up side. So rather than say it’s a nine million dollar business you have right now, they will say it’s a two million dollar business. They will contribute one million. That makes it a three million dollar business, so they get 33%, not 10%. So they are commanding much lower valuations for an idea, and hence a much larger percentage of the overall business.”
William Hamilton, professor of management and technology, paints a somewhat different picture. “I don’t think the economic climate is that fundamental to the startup process. Most startups begin fairly modestly and don’t require a great deal of capital, especially not when capital is tough. They often begin with money from friends and family. A small product-focused business can get going by subcontracting out manufacturing so they don’t have to build their own facility. A few years ago a couple of my students started a business with a hand-held electronic device that would provide very sophisticated remote TV and other remote device management. It was a small electronic device that could be produced by others; they didn’t have to make it.”It’s not the first stage of a venture, but later, when “you have got to get your second or third round of financing, that the current economic environment can be tough,” Hamilton says. He acknowledges, however, that certain types of startups do in fact require large influxes of cash from day one. “If it’s a capital-intensive business, then certainly the economic times will present challenges. For a small consulting business, you don’t need much capital. But for starting a biotechnology company, for example, you will need a lot of money from the very beginning because of the equipment, the scale of the science and the challenges of regulatory approvals.”
Peter Cappelli, management professor and director of Wharton’s Center for Human Resources, believes that it’s difficult for fledgling businesses to sustain themselves in the current economic climate, no matter what they are selling. “I would say economic timing is very important. What small businesses and startups don’t have is deep pockets, so they can’t weather bad times for long. You can’t make as much hay out of an upturn, either, as an established business could, and you can’t easily expand; you’re struggling just to get everything together. So you don’t have the same upside benefits, and you have considerably more downside risk.”Sectors to embrace, sectors to avoid
What industries look promising for entrepreneurs? “Not dot.coms,” was MacMillan’s straightforward prescription. “Everybody’s kicking dot.coms right now, and the market is very skittish about them.” Most of the faculty members echoed that sentiment, and agreed with Hamilton that dot.com startups are “easy in, easy out.” But MacMillan identified a related promising area: “The big opportunities now lie in helping existing companies use the Internet. There’s going to be a tremendous demand for people who can do that.” Reibstein agrees: “It’s particularly difficult to raise cash for a dot.com-only idea. Most of the dot.com activity now is going to happen in the bricks and mortar world – taking existing businesses and migrating them online. All those existing businesses need to figure out how to achieve the migration, and anybody who provides those services will be very valuable.”
Another strong area identified by Reibstein is mobile commerce. “Obviously communications appears hot right now. Entrepreneurs might look to m-commerce, which is thriving in Europe and Asia -basically everywhere but here. It offers all sorts of potential in the U.S. but really hasn’t reached us yet. I believe it will develop here as well.”
Mittelstaedt points to opportunities in business-to-consumer markets. “Despite what everybody has said about the slowdown, it’s largely been a slowdown in capital spending by large corporations, while consumer spending remains strong. So far consumers have not shown a willingness to be scared. Recently I saw in the New York Times that mega-homes – billion-dollar homes – are still selling at record levels. There are all kinds of opportunities out there that involve consumer expenditures, and consumers don’t seem to have cut back.”
What about sectors to avoid? “What used to be the panacea,” says Reibstein, “is now considered a very tough business to be in, and that’s computing. Computing tends not to be in good shape in part because there’s a large number of competitors; constant pressure for prices to go down (customers almost expect it); major requirements for investment in R & D; and a relatively short product life cycle so you have to get your returns quickly.” Adds Cappelli: “Don’t be where everybody else is. There are many unglamorous sectors where it’s probably easier to make money, things that aren’t electronic commerce. Traditional boring sorts of products probably have a better chance” of being successful.
Reibstein cautions that entrepreneurs preparing to make the leap into any particular sector should first assess its habitual competitive marketing strategies. “As a startup, one of your questions should be, how are the existing competitors going to react? If you’re moving into an environment that’s extremely hostile and aggressive, their natural reaction might be to cut prices, do everything they can to thwart the new entrant, and then after they have squashed you, raise their prices again. Obviously that type of environment would be much less attractive to go into, as compared to an industry that’s more passive.”
Finding the right people: Profit from another company’s loss
The faculty members agree that since many businesses – especially in the dot.com sector – have failed, entrepreneurs at least have the advantage of a greater wealth of talent to recruit from. “There’s an employee pool that didn’t exist before that’s worth thinking about,” says Reibstein. “Some of these very talented individuals have even made some money, so immediate wealth isn’t necessary for them. And they have maybe seen the dark side at someone else’s expense. They have got the kind of experience you would love for people to have.”
“The team is every bit or more important than the product, because often businesses don’t end up producing what they called for in their business plan,” adds Hamilton, who also sees the advantages of today’s broader talent pool. “Commonly, businesses end up having to react to the realities of competition, changing technology, and misreads of the market, and have to modify what they do. There’s an old saw in the venture capital field: You would rather have a grade A team with a grade B idea, than a grade B team with a grade A idea. The grade A team is going to find a way to make it work.” “The frenzy of job offers is way back, so it’s easier to find key people,” comments Cappelli. He also focuses on a nuts-and-bolts advantage: New ventures these days can get faster help setting up their infrastructure needs, such as phone systems and computers, because not as many people are starting businesses.
Meanwhile, entrepreneurs who want to look on the sunny side of startups can focus on Mittelstaedt’s parting comment: “In an economy this big, there’s always money out there.”
