A Fascinating Theory

December 9th, 2011 at 8:39 pm

One particular smart person in my orbit is my brother-in-law Clint Smith, a lawyer in Silicon Valley.  I was just visiting him and I hit him with a question that’s been plaguing me and…um…a bit more importantly, holding back the jobs recovery.  I found his response not only provocative, but it feels right.

Where are the startups?  More precisely, where are their jobs?

As I’ve written elsewhere, while the number of startups hasn’t fallen much, controlling for the business cycle, the number of jobs they create has fallen…a lot (see figures)   Yes, figure 1 shows that the number of startups fell sharply in the downturn, but so did everybody else.  What’s notable here is the difference in employment growth between the two expansions shown in figure 2.  Jobs in these firms fell by half in the 2000s.

This isn’t merely of passing interest.  Startups—the ones that survive, that is—play a disproportionate role in job creation coming out of downturns.   The question of why they’ve been MIA in terms of job creation seemed particularly germane in Silicon Valley.

Clint’s take is this: too many startups are getting absorbed by big firms and when they do, they’re stagnating.  He thinks it has something to do with the difficulty some of these small, dynamic firms have going public on their own.  That throws them into the world of quarterly targets, regulatory filings, SEC compliance, etc.

Wasn’t this always the case?, I asked.   His view, and I’m sure this is true, post-Enron/World.com, SarBox, etc. this kind of reporting has become a much bigger deal, especially for small firms.

OTE’ers know that I’ve got little sympathy for complaints about regulatory filing burdens—you trade publically, you need to honestly and transparently tell investors what you’re up to, and no, I don’t trust you to do that without oversight.  But Clint may well be right about the dynamics at play here.

So the small guys start to grow and Microsoft or Google or HP or Oracle comes along and offers them a clean gazillion or so.  It’s not that they die at that point—and this is all theoretical, if not anecdotal.  But he gave me lots of examples of firms that stopped growing, innovating, or adding many jobs once they were acquired by Big Tech.

While thinking about this, I ran by Skype, which was bought by Microsoft for $8.5 billion in cash a few months ago.  I’m sure I’m projecting—and we’re beyond even anecdote here, into impressionism.  But it seemed like a much more drab, little place than the dynamic innovator I envisioned.

Anyway, more to come on this, but it’s an important theory that deserves consideration and research.  He even offers an idea to solve it, which I don’t love: have a special category of equity markets for smaller, riskier ventures with many fewer reporting requirements.

 

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18 comments in reply to "A Fascinating Theory"

  1. mcarson says:

    Consider looking at this from another direction. There is all kinds of money looking for a place to be. Nobody is getting 12% or 20% or whatever they were during the recent round of ‘liars poker’. That game has been cashed out. But the same people are looking for stuff. And the big tech firms are like everyone else, they have money they don’t know what to do with. In the past they kept it liquid and made a little cash, but now it’s all Treasuries, all the time.

    So they start looking for new things to invest in. I’m willing to bet Skype, et all, did not go looking for Microsoft, and that Microsoft did not go looking for Skype. They were matched by a group of investor, lawyer, deal proposing guys who don’t get to bundle mortgages any more.

    And they’re getting stuck with the suits too early, and they’re not growing as fast as they would off on their own.

    You’d be surprised how much trouble the search for big payoffs and safe investments has destroyed America. That’s what did in the S&L’s, the Private Energy sector (Enron), the mortgage business, Tyco.

    It will take a while for the fast buck guys to stop knocking everyone over, but eventually we may get to the place where the big money is in actually DOING something, rather than financing it. Where talent and vision and luck and hard work pay better than just waiting for the interest payments to show up.


  2. Arun says:

    Another way of reading this is: The big firms hold an unprecedented amount of cash, which they use to buy and stifle or control potential competition, and to control possible game-changers. Perhaps there needs to be some tax policy that would shake loose the cash that the big firms hold.


    • markg8 says:

      Isn’t this the way it’s always worked in the biotech industry? NIH funds basic university drug research which get spun off to bio tech firms to come up with marketable drugs. Once they develop promising prototypes they get bought out by the big pharma boys with the manufacturing and marketing muscle to actually sell them.

      That said GOP house reps have recently set up hearings across the country, my rep Judy Biggert IL-13, just held one in Chicago to try to push the meme that Dodd Frank regulations are crippling small banks and small business lending. The only specific small business I read about at this hearing was a sign maker from Bolingbrook IL who said though he’s always paid his credit card bills on time, above the minimum payment, his bank recently lowered his credit limit based on the bad credit rating of the former owner from 2 years ago. Biggert sits on the Financial Services Committee and deregulation of any kind has been her hobbyhorse for quite some time. I’d like to see more evidence pro or con about Dodd Frank hamstringing lending. I can’t imagine it’s true because the CFPB didn’t even finished writing it’s regs til last summer, had plenty of input from the public including banks and doesn’t have a director yet and can’t enforce most of what it’s empowered to do until it does. I’ve heard a lot of stories about cc banks arbitrarily lowering credit limits for individuals and one story of Chase practically begging a doctor friend of mine (an excellent credit risk with an excellent credit rating) to take a new lower cost mortgage. When he pressed them about why they were essentially giving away money they admitted they needed to show they were modifying mortgages.


  3. marcel proust says:

    More a hypothesis than a theory, don’t you think?


  4. jo6pac says:

    If have a little time great read by someone that knows the silly valley well.Your close but here’s the truth on where the jobs went.
    http://www.businessweek.com/magazine/content/10_28/b4186048358596.htm


  5. Michael says:

    Arun has it; you’re burying the lede underneath the conservative obsession. The issue is anti-monopolistic behavior by leading firms, enabled by the vast gobs of cash we’re shipping their management.


  6. Michael says:

    Fundamentally, every major problem with the American economy traces back to the Class War. If you have a problem, and you’ve decided it’s major, then you’re not done understanding it until you’ve gotten to the Class War.


  7. The Raven says:

    Skype’s business model, if it can be called that, relies heavily on, ah, borrowing bandwidth from major sites. I don’t think they’re much of a job creator, either–how many people does it take to run a network service when most of the infrastructure already exists, after all?

    On Skype as a service:
    http://snapvoip.blogspot.com/2010/12/skype-supernode-outage-post-mortem-mega.html
    http://www-d0.fnal.gov/~schwier/msu/videoconf.html


  8. The Raven says:

    Creating jobs has to depend on having people do something in the physical world. It’s not clear to me what the USA has to offer in this area at this time, even once Chinese currency manipulations are stripped away. Capital that works has to be built up over time, and that can’t be done overnight.


  9. Tom in MN says:

    Do you blame increased regulation on the government or on the firms that did the wrongs in the first place that caused the need for regulations? We would have fewer laws and regulations if everyone tried to do the right thing, but instead there are those that see what they can get away with and drive the need for regulations. You can’t blame this on the rest of us for wanting to stop these behaviors, that typically also result in the companies (or the economy as a whole) blowing up. I used to think CEO’s cared if their companies self destructed. It’s not so clear to me anymore that they do. So we end up regulating them for their own good (and for the rest of the economy) and there are of course costs to this, but they are smaller than letting them have a free run.

    Plus there is also the good side of this, my (unofficial) bother in law got fed up with the management of the bio-tech firm he was in spending all their time watching their stock price instead of innovating. Going public is not necessarily that great a thing.


  10. David Fisher says:

    One thing I think you and your source are missing:

    The current structure of health care in the US is a large
    and rising cost to small companies. And one that rose tremendously
    during the period under consideration. It may not just be regulation,
    but other fixed costs that drive small to midsize companies to be happy
    to sell themselves off to large corporations.

    While regulatory costs might be having an effect, it seems possible that the
    cost of providing health insurance to employees could be just as big an issue.

    I know I’ve seen this point raised elsewhere.


  11. Th says:

    I think mcarson has it right. My take is that high end tax cuts + Japanese stagnation and third world depression after the 70’s oil shocks = megatrillions from around the world looking for an investment return. Watch the original Wall Street and note the deals they are working on. Use a company’s physical plant and pension fund as collateral for a leveraged buy-out, suck every dime you can out of the company and sell the carcass for salvage.

    The dot.bomb bust was the turning point in the jobs graph above. The real estate/mortgage boom was dominated by established players. The jobs situation will be all about where the next bubble is and how labor intensive it is.


  12. Comma1 says:

    Computers don’t create jobs, they eliminate them. After all, Skype produces nothing other than a software package, there is no low-skill, or even high-skill manufacturing jobs involved there. The jobs it does create are becoming harder to get. Jobs that paid middleclass wages for self taught programers 20-30 years ago, now require a masters degree. Furthermore, you are in competition from cheaper and cheaper foreigners.

    Startups are often formed with the goal of being “absorbed” by larger firms (aka, hitting the lottery) not for the long haul. This means larger firms are essentially, pushing r&d onto startups. This externalizes much of the cost of r&d. The other benefit to larger firms is that buying small firms is an easy way to crush competition. This is easy because investment banks are handing money to tech companies hand-over-fist. (100 billion Facebook IPO anyone?) (This also ignores the whole concept that most of the cash being created here is by investors with the privilege of investing pre-IPO, not after it).

    Furthermore, I’ve yet to hear anyone mention the economics of, what I call, “the last tool” or if you’ve seen the Lord of the Rings – the “one ring to rule them all.” All tools up to this point were generally unrelated to one another — a saw, a gun, and a hammer are fundamentally different. All tools after computers are, you guessed it, computers. The difference between skype on your mac and skype on your iphone is a difference in degree not a difference in kind. So is the difference between self checkout machines, netflix or gmail, because they are all computer based. This is a fundamental shift, for tools, for economics and for humanity, and I’ve yet to hear anyone discuss the ramifications of it.


  13. He Loved Big Brother says:

    Arun and Markg8 have it right. Large companies w lots of cash and reduced R&D spending (and also low productivity in R&D). I work in the pharma industry (big pharma) where R&D has been a spectacular bust for >10 years. These companies have tons of cash and are snapping up everything in sight that has a pulse (and quite a few that don’t). I would guess that other large companies that are also sitting on so may $$$ see this as a way to innovate on the cheap, and if this helps to stifle competition, so much the better.


  14. Bert Merder says:

    This is an interesting theory. But it also strikes me as something that large firm (and their lawyers) might be telling small firms. Or perhaps there’s a business opportunity for a firm to consult with these startups to take them public. Or finally, maybe the start-up guys (and gals) are completely happy taking the quick cash that large firms have in abundance.


  15. Jake Lopata says:

    Reading through some of the comments; I am surprised no one has mentioned anything about market demand for goods or how a large portion of wealth was wiped away by the recent recession, which makes for a deeper hole to climb out of.

    I am not an entrepreneur, but I am pretty sure you need to have money to start a business or even to get a loan. Small businesses are usually, sole proprietors, partnerships, or LLC’s which consist of one or a few investors. Perhaps entrepreneur wealth has been wiped away making it more difficult to participate in the market.

    The other thing is the demand for goods. Now I know consumption seems to be doing fine, but if you are thinking about starting a business and you pick up a newspaper everyday and ready something depressing about the economy like, an unsettled budget, shaky markets (here and in Europe), taxes going up, etc… You would be nervous starting a business…that is if you didn’t know better…

    People have been trying to stay afloat, when are they going to have time and money to start a business?


  16. really says:

    I say the following as someone who is intimately familiar with SEC filing requirements and SarbOx, someone who has been involved in SarbOx implementation at companies ranging in size from “I can count my accounting personnel on the fingers of one hand” to “Fortune 50 Ultralith,” and also as an investor who prefers to be well informed before taking the plunge:

    1. SarbOx requires a framework of very basic policies and procedures designed to ensure that financial statements are presented accurately. Things like “Are we recognizing/reporting revenue appropriately vs. pulling a number out of our @!*” and “Does the company incentivize risky behavior that could take down the company and erase shareholder wealth?”

    Accountability provisions in SarbOx (if enforced correctly, that’s another story) also theoretically invalidate Rumsfeldian “I do not recall/was not aware” defenses by upper Management when fraudulent activity occurs.

    These are boons to investors and employees alike. The cost of hiring an accounting firm to verify that the company is performing as described may negatively impact the executive bonus pool, but the alternative, self-regulation, has been…somewhat disappointing? Anecdotally I can say that almost all upper-management types in their calmer moments agree that SarbOx is “just good business practice” codified.

    2. SarbOx has been refined over the years to allow room for judgment on what is “in scope” and “out of scope” based on qualitative and quantitative factors.

    If Microsoft acquires a budding startup that brings in a fraction of the parent company’s annual revenue and typically doesn’t incur any exotic qualitative risks, the SarbOx requirements are commensurately reduced.

    If they acquire an $8 billion dollar company a la Skype, then I would certainly hope that all parties (MS, investors, etc.) would be interested in ensuring that Skype’s financial position is being presented correctly (see #1).


  17. Eric Titus says:

    It is very hard to get good number on job creation by the sorts of high-tech startups you are talking about. But these stats definitely don’t cut it.
    Internet and biotech startups are just the rounding error in those statistics, which include restaurants, grocery stores, laundromats, etc. And it takes more than a year for most tech startups to hire more than 5 people.

    What you are seeing here are trends in the creation of restaurants and the like. The reason there are fewer restaurants, bars, etc since the start of the recession is that there is less borrowing to start places, and less spending to support them. The reason those institutions have been declining for a decade is less clear. The decline of the middle class means fewer people founding their own businesses. Chains have continued becoming more widespread. People can’t risk starting their own businesses without a social safety net to fall back on. The legal and regulatory environment may appear daunting.


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