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The startup version of the wealth gap

Entrepreneurship has never been easier, but entrepreneurship is on the decline. I first heard this surprising paradox a few months ago in a talk by MITs’s Andy McAfee. Digital technologies are inexpensive and ubiquitous, startups have access to all kind of cloud-based business services, and customers can now be easily reached and supported over mobile devices. It should be easier than ever, - as books and articles keep reminding us, - to become an entrepreneur and start your own company. But in fact, entrepreneurship has been in decline for years.

Most everyone I’ve mentioned this paradox to, - business colleagues, investors, journalists, - doesn’t quite believe it. But that’s what the data shows. In a recent paper, University of Maryland economist John Haltiwanger and collaborators used business data from the US Census Bureau to calculate the annual startup rates over the past several decades, - i.e., the number of new firms in each year divided by the total number of firms. The startup rate was 12.0% in the late 1980s, went down to 10.6% just before the 2007 Great Recession, and then fell sharply below 8%. Such sharp declines add up over time. In the late 1980s, 47% of all firms were 5 years or younger. The percentage of young firms declined to 39% in the mid 2000s, and has since continued its downward trend.

In another recent paper, economists Ian Hathaway and Robert Litan analyzed the same Census Bureau Data and showed that in addition to the continuing decline of new firm formations, failure rates have steadily increased for all companies under 16 years old, and they’ve been particularly high for early-stage firms.

Further evidence of this entrepreneurship decline is found in Where the Jobs Are: Entrepreneurship and the Soul of the American Economy, published in September of 2013 by John Dearie and Courtney Geduldig. Their book is primarily focused on the close link between entrepreneurship and job creation. It cites a 2009 study that shows that between 1980 and 2005, all net new job creation in the US came from young businesses less than 5 years old. They conclude that as a result of the decline in entrepreneurship, “the nation’s job creation engine - new business formation - has been breaking down in recent years.”

What’s going on? Why this perplexing paradox that many have so much trouble accepting because it runs counter to the stories of successful billion-dollar ventures we read so much about in the news? Last month I read an article in Newsweek by technology author and columnist Kevin Maney, Tech Bubble? No, It's a Startup Wealth Gap, that sheds considerable light on these questions.

It turns out that startups have their own version of the wealth gap between the rich and superrich, - the 1% and .1%, - and everyone else. The rising US wealth and income inequalities, - brought to light this past year by Thomas Piketty’s surprising best seller Capital in the Twenty-First Century, - is being repeated in the startup world.

“Everything goes to the top 1 percent,” writes Maney. “Below the top tier you’ll find a whole lot of striving and desperation - a burbling stew of stagnant companies, founder angst and money-losing investments… Losers get scraps. Tech is definitely red-hot, if you look only at the winners.”

Maney’s article is based on Time To Market Cap: The New Metric that Matters, a recent study by Play Bigger Advisors which he also co-authored. The study is focused on VC-backed US companies in the technology space founded since 2000. It analyzed data from over half a million private companies, as well as over 18,000 private investors, over 50,000 private M&A deals and another 50,000 VC funding rounds. It grouped companies into three distinct eras based on when they were founded, - 2000-2003; 2004-2008; and 2009-2013.

After extensive analysis, the study found a large and growing distinction between winners and losers. The winners, which they call Category Kings, are those companies that dominate the rest of their competitors in their particular market, - the Facebooks, Twitters and Ubers. Category Kings generally take over 70 percent of the total market value in their category, leaving everyone else to split the remaining 30 percent. Winners are winning at almost triple the speed since 2000, while losers are losing faster than ever. A company destined to reach a $1 billion dollar valuation, will do so now in one-third the time that it would have taken it just a dozen years ago, - 2.9 years in the 2009-2013 era versus 8.5 years in the 2000-2003 era.

“But this rising tide floats the yachts and sinks the dinghies,” writes Maney. “Only 80 companies started since 2000 have hit $1 billion in value. Those are the companies we read and cluck about. And in most cases, only such top-tier players get the explosive growth and searing envy.” Almost half of these billion-dollar companies are Category Kings.

A Category King is much more valuable than all other companies in its space combined. “The study found that a six-year-old startup that isn’t yet a Category King has almost zero chance of becoming one. Hundreds of companies are left to forever survive, like raccoons at a summer camp, on their category’s scraps.” Because winners and losers get sorted out in just a few years, there is little time to change course.

A similar dynamic was observed for both VC-backed consumer (B2C) and enterprise (B2B) companies. However, the Time To Market Cap is accelerating much faster for the consumer companies. “A typical venture backed consumer company is growing their market cap at more than $600 million per year compared to a typical venture backed enterprise company that is growing their market cap at $100 million per year.”

What’s driving this accelerating Time To Market Caps? After discussions with investors and CEOs, the study came up with a short list of causes, including:

“New products and services get discovered and adopted at a speed never seen before, driven by the networked economy and always-on rich communication.”

“The iPhone, launched in 2007, ignited a smart phone revolution, and now five billion people carry a connected device. Distribution is cheap and global at the same time.”

“Because of the fast spread of information, technology users come to understand that a problem (bad taxi service) can be solved with a new service (Uber). This creates a new category in consumers’ minds, while word quickly spreads about the leader who can address that category.”

“Business models have evolved from perpetual licenses to subscriptions. This has reduced the barrier of entry for users and buyers dramatically. As a result, adoption happens faster. Freemium models only drive the adoption curves even faster.”

“Services such as Amazon’s hosted web services have fundamentally changed the way companies create and deliver software applications. Start-ups no longer have to buy hardware or build data centers. The day Agile software development delivers a finished build, the product or service can go live to the world. That wasn’t true in the earliest part of this century. So fully-formed products and services can be globally launched and scaled faster than ever.”

“The cost of distribution has reduced dramatically, thanks to networks and the cloud. That’s contributed to an overall reduction in the capital requirements of start-ups. This means there is more capital available on a proportional basis.”

“CEOs have many more vehicles by which they can get funding well beyond the traditional venture capital circles, including super angels, angels, crowd funding, and accelerators. As more money from more sources has become available, start-ups have invested big and fast to define and develop a category as quickly as possible.”

“The emergence of the mega-round financing from crossover and hedge funds has created an abundance of available capital in the late stage market and enabled companies to delay their IPOs and continue to grow as private companies.”

The article cites a number of risks associated with this growing startup wealth gap, including: “Start-ups can emerge out of nowhere to redefine categories and markets. Companies can turn from being a meteoric star to a has-been overnight”; “Expectations have the potential to run away from reality for many investors and entrepreneurs… But Category Kings are rare”; and “The high-speed, high-investment race to become a Category King drives a great deal of stupid spending on marketing and sales in particular.” The rise of Category Kings and other young billion-dollar companies may both make it harder to start new companies under their shadow, as well as accelerate the failure rates of startups.

In the end, there is no paradox. We cannot judge the state of the startup economy by the success of the small fraction that make it really big any more than we can judge the overall economy by the success of the 1% and .1%. “The forces that drive this dynamic will only grow stronger,” concludes Maney. “Global networks and social media allow everyone to quickly find and adopt the best in any category and flock to the winners. There are about 3 billion people on those networks now, and that pool is growing 6.6 percent a year. In one category of business after another, the trend will continue to swing toward winner-take-most.”

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