In a recent post, Anita Campbell puzzled over the seeming contradiction between two recent publications – The Kauffman Foundation’s paper Exploring Firm Formation: Why Is the Number of New Firms Constant? (PDF) and the SBA’s paper Nonemployer Start-up Puzzle (PDF) — about whether recessions lead more start-ups. The SBA report showed that the employer business start-up rate is higher in states with greater economic growth, while the Kauffman Foundation study showed that the number of new firms created annually is largely constant over time. So, Anita was left wondering whether the economic environment influences start-up rates.
Some readers left comments on the site highlighting the fact that the studies contradict less than they appear to at first glance. As the readers pointed out, the studies’ results differ in large part because of differences in their data. But none of the readers explained how these studies are less comparable than would first appear. I don’t fault any readers for that – you need to look very carefully at the two studies to understand what they are doing before you can really understand their conclusions. So I am going to explain what I think are the differences between the two studies that account for their different results.
Rates Versus Levels
The SBA study measures rates of new business formation. The authors divide the number of firms started by the size of the labor force. In contrast, the Kauffman Foundation study just measures the number of firms started. This difference is important because the labor force has tended to grow over time. And if the number of new businesses created annually stays constant and the labor force (and population) tends to grow, then the share of Americans who are starting businesses every year will decline over time.
In an earlier column I wrote on the New York Times small business page, I highlighted the fact that rates of entrepreneurship in the United States have been declining over time. As the charts in that article show, if you take several of the measures of new firm creation shown in the Kauffman Foundation study and divide them by the U.S. population, you will observe a declining rate of new firm formation. That is, over time a declining share of the population is starting businesses.
It appears that the authors of the Kauffman Foundation study actually know this, but for some reason chose not to make that clear in their paper. Buried in footnote 34 on page 17, they write “Of course over this period of time, we’ve seen a declining rate of entrepreneurship, a phenomenon we will explore in a forthcoming paper.” So basically, the Kauffman Foundation research shows that rate of entrepreneurship is declining over time because the number of new firms is constant and the population and labor force are growing.
Employer Versus Non-Employer Firms
The other big difference between the two studies is what they measure. The SBA study looks at both employer and nonemployer firms, while the Kauffman Foundation study focuses on employer firms. (Non-employers are companies with at least $1,000 in revenues but have no employees other than the owner.) However, non-employer firms tend to be smaller than employer firms, but they make up three quarters of all firms in the economy and close to 80 percent of all start-ups.
In another New York Times column, I highlighted the fact that trends in the rate of creation of employer and non-employer firms are very different. The rate of non-employer firm formation has been increasing in recent years, while the rate of employer firm creation has been decreasing. These different patterns suggest that external economic conditions might affect the formation of the two types of firms very differently.
Moreover, the two types of firms appear to be different kinds of companies, rather than different stages in the lives of businesses. Few non-employer firms “grow up” to become employer businesses. In a paper entitled, “Measuring the Dynamics of Young and Small Businesses: Integrating the Employer and Nonemployer Universes,” Steven Davis and his colleagues found that only three percent of non-employer businesses transition to employer businesses when observed over a three year period, and these businesses only account for 28 percent of young employer firms. Thus, Davis and his colleagues conclude, “It is tempting to think of the nonemployer business universe as a vast nursery for employer businesses [from which] many nonemployers evolve into employers and a few eventually grow into giant corporations that generate thousands of jobs. However, as our results confirm, most nonemployer business are quite small and never become employers.”
Other research also shows that employer and non-employer firms are very different. Analysis by Rick Boden and Al Nucci, for instance, show that 85 to 90 percent of all new non-employer firms are sole proprietorships, a much higher percentage than the share of employer firms. In fact, Davis and crew write in their paper, “Indeed, it is misleading to think of all records in the nonemployer universe as ‘businesses’ in the usual sense. Many nonemployer records reflect side jobs, hobby businesses or occasional consulting engagements that generate extra income for households that depend primarily on wages.”
This leads to another important difference between employer and non-employer firms, which is directly relevant to the comparison of the SBA and Kauffman Foundation studies. People might be more likely to start employer firms to pursue business opportunities, while they might be more likely to found non-employer firms as a reaction to bad economic alternatives. Examining the differences in the rate of formation of employer and non-employer firms across states, the authors of the SBA study found that employer start-up rates are positively correlated with real GDP growth, while nonemployer start-up rates are not related to economic growth.
There are also some other differences between the studies that might affect their findings. The Kauffman study doesn’t conduct any statistical analysis to net out the effect of forces other than economic conditions on start-up activity, while the SBA study controls for these other effects. The SBA study looks at differences between states at a point in time, whereas the Kauffman study looks at differences in the country over time.
In short, the two studies don’t tell a different story about what happens to entrepreneurship in response to different economic conditions as much as they explain the difference between employer and non-employer firms, and the difference between rates and levels of entrepreneurship.