Why Start-ups Matter 
Why Start-ups Matter

Spectacular Initial Public Offerings (IPOs) strike a media fireball of attention on start-ups -- defined here as companies that hire and have been around up to six years. But start-ups should be getting more attention for their contributions to employment. After all between 1977 and 2009 start-ups contributed nearly all the roughly two million to three million new jobs created every year. Big companies contributed no net new jobs.
Dane Stangler, a research manager at the Kauffman Foundation, explained his views on the importance of start-ups and provided the data to back them up in a June 24 interview. According to Stangler, there are about 500,000 new businesses created annually.

These new firms help maintain a total of two million start-ups -- at 30% there are more of them than any other type of company. And between 48% and 50% of start-ups survive to their fifth year. If you net out job turnover, those start-ups create about two net new jobs every year.

Stangler points out that there are good reasons why the start-ups produce most of the net new jobs. First of all, there are more of them. And secondly the larger and older businesses tend to hire lots of people during economic upturns and then terminate them during periods of economic contraction and expansion.
Stangler suggests that large companies and start-ups have different attitudes towards innovation. The large companies invest in incremental technologies that have more controllable risks -- and predictable returns. By contrast, start-ups invest in breakthrough innovation.

The different incentive structures for managers and investors help explain why. After all, even when a large company encourages risk-taking, there are limits to how much money a bet on innovation can lose before the person responsible for it pays a career price. Whereas for a start-up -- it is understood at the beginning that there is a one in 10 chance of hitting it big -- and if that happens, the reward will be a massive return on investment.
An interesting feature of start-ups is how they're financed. Stangler estimates that between 1% and 3% of the financing for start-ups comes from venture capital firms. And that comes later in their development. He pointed out that a 2009 study written by Paul Kedrosky, Right-Sizing the U.S. Venture Capital Industry, found that 16% of the 900 Inc. 100 companies between 1997 and 2007 took venture capital.
During a start-up's initial stages, the funds come from friends, family, and founders. As a start-up grows, the money comes from bank loans, credit cards, and before 2008, home equity. And only if the start-up has reached a further stage of development does it get equity investment.
Stangler believes that U.S. could boost job creation by letting more immigrants who study here stay to start new companies. Stangler pointed out that between 1995 and 2006, immigrants helped start 25% of all technology companies. And while they accounted for a mere 0.7% of the companies founded here, they created 10% of the new jobs.
Duke University researcher Vivek Wadhwa has surveyed thousands of students from China and India who returned home after getting their degrees in America. They ran into so much difficulty trying to stay here that they started their companies back home instead. And China is taking steps to encourage its natives to return home to start their businesses.
If the U.S. could make it easier for those job-creators to stay here, the number of start-ups and their net new jobs would rise.
The final reason start-ups matter is somewhat theoretical -- but quite interesting. According to Stangler, for a company or a society there are diminishing returns to complexity. Initially, investment in more complexity generates an attractive return. But eventually more complexity produces negative returns.
In Stangler's view, start-ups reset the complexity curve. Through breakthrough technological innovation, they extend the productivity frontier of companies and society. And they create new opportunities to make high-return investments in increased complexity before those diminishing returns again set in.
I find this argument very compelling -- but for now, I think people looking for work would settle for a policy change that lets more of those job creators start their companies here instead of China or India.