How to Become Smarter (49 page)

I
NVESTING IN
Y
OUR
O
WN
S
TARTUP
B
USINESS
.
Polls suggest that self-employed people (business owners) are the happiest segment of the employed population, on average [
513
]. They are happier on average than highly paid employees such as managers, doctors, and lawyers. At the same time, most owners of startup businesses make
less
money than they did when they worked for hire. These data suggest that financial independence is more likely to make you happy than a higher than average income. These observations also suggest that the aim of government policies should be an increase of the percentage of self-employed people (the self-employment rate). This will make the people freer and happier. Unfortunately, the current self-employment rate and the role of tiny companies in the economy are so small that it is unwise to recommend everyone to start their own business. In my view, most startups that have four or fewer employees will fail because they are unable to compete against larger enterprises, since smaller firms usually face higher production costs.

Although it is a bad idea to invest all your savings in a single stock, it is even worse to invest all your money in a startup company. Companies with publicly traded shares of stock are established businesses with significant sales and usually with substantial profits. On the other hand, startup companies often have no sales and no profits to speak of. Therefore, their future is more uncertain than that of a publicly traded company. It is not a good idea to use your savings to start your own business because most startups cease to exist after several years. It may be a good idea to invest in a large portfolio of startups, but investing all your money in a single startup is too risky.

There is no consensus on how we should calculate survival of startup companies: there is some controversy in this field [
514
]. In the U.S., one half of startup companies disappear within the first five years of operation. (This is based on the latest data from the U.S. Department of Commerce and Bureau of the Census, Business Dynamics Statistics.) These data suggest that about 70% of startups go under within 10 years. Earlier research indicates that about 60% of startup companies disappear after 6 years of operation [
514
,
515
]. The highest discontinuation rates are associated with low startup funds, absence of employees, and young age of the founder. Paradoxically, having no startup capital at all is a more favorable condition than having low startup funds (<$50,000) [
514
]. The low survival rate of startup firms does not mean that most of them go bankrupt. Bankruptcy represents a small percentage of the closures; most of them disappear because they require too much effort while providing too little income. This causes the owners to liquidate the company at a loss or to sell it to a larger company. According to a U.S. Census Bureau survey in the 1990s, seventy percent of the owners whose startup business ceased to exist admit that the venture was unsuccessful [
514
]. The low survival rate of small businesses by itself is not necessarily a bad thing. The low survival would be OK if the rate of self-employment in the population were high and there were a high turnover of business startups and discontinuations. This is not the case.

Polls suggest that the majority of current employees would prefer to be self-employed rather than work for hire [
516
]. Yet only about 8% of the employed population in the U.S. are self-employed [
517
]. (The figure is about 11% if we add the incorporated self-employed.) Very small companies, fewer than 20 employees, employ about 16% of all private sector workers [
518
]. Tiny companies, four people or fewer, the kind that you are likely to start, account for 5% of all private sector employees [
518
]. (The U.S. Small Business Administration defines the term small business as a company with fewer than 500 employees. The Russian government defines a small business as a company with 100 or fewer employees.) About two thirds of all private sector workers in the U.S. work for enterprises that have 100 or more employees. Conversely, about two thirds of all private sector employees work for companies that have 5,000 or
fewer
people on the payroll. These observations suggest that the current economic system is most favorable for companies that have between 100 and 5000 people on the payroll [
518
]. These data also suggest that the system is unfavorable for self-employment and for tiny companies (consisting of four people or fewer). You will have to struggle, take risks, and bend over backwards in order to become self-employed, while getting a job is much easier. Although the tiny companies constitute about 40% of all private enterprises if we count companies, they only account for about 5% of private sector employees. Thus, tiny companies represent a negligible part of the economy. The vast majority of people work either for the government or for companies that have more than 100 employees. Therefore, an aspiring entrepreneur will be shoveling sand against the tide if she starts a business under these conditions. There is a high probability that this person will not become her own boss (at least for long). The situation is similar in industrial countries other than the United States. There is one exception, which is the sector of the economy that includes agriculture, forestry, fishing, and hunting. Self-employment rates in this sector are as high as 40-44% [
517
] and there is a realistic chance to become your own boss in this field.

Investing in a startup business is a gamble and you will do well to leave this sort of investing to professionals, such as venture capitalists and commercial banks. These people usually know a successful business when they see one. They also diversify their investments such that a failure of one startup will not damage the performance of the whole portfolio of investments. On the other hand, a typical person who starts a business is less qualified to predict success or failure of a startup. On top of that, they are putting all their eggs in one basket. There are many variables that an aspiring entrepreneur cannot assess regarding the financial future of the startup. The tastes and preferences of consumers are hard to predict, as is your own ability to satisfy those tastes better than others can. Because most startups cannot afford focus groups and thorough market research, the aspiring entrepreneur cannot assess consumer tastes and preferences accurately. The talents of the aspiring entrepreneur are crucial for the success of the venture, but this variable is unquantifiable. Consequently, you could say that entrepreneurship is gambling and a successful startup is a lucky guess.

Suppose the founder of a startup business is a person with average net worth (i.e. with small starting funds). In this case, in order to survive, this business must generate an outsized return on capital during the first few years. This outsized return must be around 300 to 500% a year, such that the owner can make a living and stay in business at the same time. A person can achieve this sort of profitability only by chance. (Whether or not someone has an entrepreneurial talent is also a random factor [
530
].) If every startup could generate a 300% annual return, the U.S. economy would be growing at the rate of 300% per year or even faster, instead of the usual 2-5% a year. To sum up, the odds are against the aspiring entrepreneur and it is more reasonable to invest the savings in something safer.

Realistically speaking, the majority of people who are employees (about 90% of the labor force in the U.S.) cannot become self-employed entrepreneurs. For example, imagine what would happen to the U.S. economy if all people who are working for hire quit their jobs and tried to start their own businesses. It is naive to believe that anyone can become an entrepreneur if they really want to. It is statistically impossible. Does my advice mean that I am against innovation and entrepreneurship? No, this advice means that you can try to become an entrepreneur, but it would be a good idea to obtain the seed capital from people or institutions who can diversify their investments. These entities are also better qualified at evaluating business opportunities and risks: we are talking about venture capital firms, angel investors, and commercial banks (not subprime lenders). Obtaining seed capital from your family or friends is less instructive. These people most often are not experts at assessing business ventures and may invest money in a doomed startup.

In general, for people who do not have a self-employed parent and do not have an advanced academic degree (Ph.D., M.D., J.D., and others), there is a one in eight chance of successful self-employment outside the agricultural sector. About 61% of employees want to be self-employed [
516
], but only 7.5% are [
517
]. Therefore, betting all your savings or savings of your relatives on this kind of a long shot will not be a smart thing to do. You are rolling the dice and if you have to start a business, at least let the experts decide whether your venture is worth investing or not. As mentioned above, these statistics are different in the sector of the economy that includes agriculture, forestry, fishing, and hunting. The chances of successful self-employment for most people are over 5-fold higher in this field compared to other industries [
517
]. Even though this sector is “low-tech,” it is a smart choice of a self-employed occupation because it offers a lower risk of failure compared to high-tech industries.

In the United States, labor force in the private sector is approximately 120 million employees. Around 600,000 new companies are born each year and about the same number of companies disappear each year (a few percentage points fewer than the startups). Sixty one percent of those working for hire want to work for themselves, i.e. to run their own business. Looking at these numbers, fewer than 1% of those who want to be self-employed can start a business within a one-year period. If we assume that an average startup has two founders, then the figure is about 2%. The lifetime probability of starting a business is higher than this. Nonetheless, these data should give you some idea how difficult it is to start a business that provides sufficient income for the owners. If starting a small business were such an easy and profitable endeavor as some “success gurus” would have you believe, pretty soon we would have an economy that consists of single-person or two-person enterprises. The majority of people would gladly work for themselves [
516
]
if they could earn sufficient income
. The problem is that the majority of startups either lose money or yield negligible income, whereas a small minority goes on to earn outsized returns. If you invest in a single startup business, you are playing a lottery-type game: most lottery tickets will lose money and a few lucky ones will make tons of money.

The notion that entrepreneurs are rewarded for risk is a fallacy. The majority of aspiring entrepreneurs are not rewarded for risk and some of them are punished by bankruptcy. The minority of those who succeed are rewarded for luck. The success or failure of any given startup company is difficult to predict. Hard work does not guarantee success of an entrepreneur because most entrepreneurs work excessive hours. (According to statistics, Russia is one of the few countries in the world where self-employed people work fewer hours on average than employees; this is not the case in the United States.) A high IQ does not guarantee entrepreneurial success either because there is no correlation between self-employment and high IQ scores [
519
]. Nevertheless, high IQ scores do predict better job performance in a variety of occupations [
955
,
956
]. It is possible that high IQ scores correlate with self-employment in some fields such as high-tech. Relevant research is lacking. Even if being very smart did guarantee entrepreneurial success [
520
], this advantage would still be attributable to luck because people are not born with equal mental abilities [
987
]. Nonetheless, some factors can increase the odds of entrepreneurial success. Some of these factors are beyond your control and others are subject to choice. For example, having rich parents increases the probability of self-employment [
521
]; having a self-employed parent increases the probability of successful self-employment by two- or three-fold [
520
,
522
]. Having a doctoral degree (Ph.D., M.D., J.D., and others) will increase the chances of self-employment two-fold or more [
507
]. Having an MBA degree does not increase the chances of unincorporated self-employment [
507
], but may increase the probability of incorporated self-employment. Starting a business later in life will increase the chances of success [
507
,
514
]. In summary, the weight of evidence suggests that entrepreneurial success has a lot to do with luck. Excessive work hours, high IQ, and risk-taking will not guarantee success. Having an advanced academic degree and starting a business later in life do not guarantee but can increase the chances of entrepreneurial success.

If you wish to become your own boss, please keep in mind that many self-employed occupations provide low and unreliable income to the vast majority of participants (musicians, artists, and writers). Running a successful small business usually requires excessive work hours, although with effective delegation of responsibilities you may be able to balance work and life. Popular types of self-employment such as real estate and farming are not too profitable due to substantial competition. Real estate business often entails taking on large amounts of debt. Excessive amounts of debt can make you vulnerable to shocks in the economy (having an affordable mortgage on your own housing is not excessive debt). You need to consider all of the above when deciding on whether you want to become your own boss.