Quarter 2, 2001
by Richard E. Caves

The Origin and Evolution of New Businesses
Amar V. Bhidé
Oxford University Press 2000

A vital force behind an industry’s productivity growth and efficiency is the turnover of firms—a Darwinian process in which units with high or rising productivity flourish, while those with low or falling productivity wither. This turnover occurs in two forms—the entry of new competitors and exit by the faltering and unsuccessful, and the expansion of incumbent winners and contraction of the losers. Economists have recently learned much about these processes by analyzing data from government industrial censuses and similar registers. Another piece of this knowledge falls into place in Amar V. Bhidé’s book, The Origin and Evolution of New Businesses.

Bhidé’s data source is not census records, but a set of intensive interviews and case studies focused on a class of winning entrants—Inc. magazine’s annual list of the 500 fastest-growing, privately held companies in the United States. Bhidé, formerly of Harvard Business School and now Glaubinger Professor of Business at Columbia University, interviewed the founders of 100 firms taken from Inc.’s 1989 list that had been started in the preceding eight years.

Were these founders the far-sighted entrepreneurs of capitalist lore, burning with a crystalline vision of some breathtakingly new product, service, or venture? Bhidé’s answer is a blunt negative. They were persons of limited industrial experience and moderate human capital (81 percent had college degrees, but only 10 MBAs), although with ample self-confidence and ambition, who simply muddled through on personal savings, second mortgages, and maxed-out credit cards until success came their way. Their ventures did not spring from clearly conceived innovations but from replicated or modified ideas encountered in previous employment. A magazine editor, for example, tired of his job, got the idea for a successful publication of crafters’ ads from his wife’s craft work. Only 6 percent claimed to have begun with a unique product or service. Forty-one percent started out with no business plan (26 percent with a rudimentary one), and only 5 percent enjoyed venture capital support. And they set sail with astonishingly little capital: the typical Inc. 500 firm starts with less than $30,000.

What, then, were the sources of these entrepreneurs’ success, beyond dumb luck? They turned out, finds Bhidé, to be successful at face-to-face selling (only 10 percent sold through intermediaries). They were also skillful at adapting their plans and improvising along the way; more than one-third significantly altered their initial concepts at least once. These startup firms’ distinctive competencies were closely bound up with the entrepreneur’s skills and abilities. They rested, however, not simply on the personal services of a crackerjack tailor or hairdresser, but on skills with a major intangible component that could be replicated without every sale demanding the entrepreneur’s direct labor. Finally, these entrepreneurs were not exactly risk-lovers gambling for a big win. What they had, Bhidé argues, is a high tolerance for ambiguity and missing information, and ample capacity to infer causes correctly and change course on short notice when new information and feedback emerged.

Bhidé’s winning startups were by no means randomly sprinkled across the spectrum of industries in the American economy. More than one-fourth were computer-related businesses—four times the representation of this sector in U.S. industrial activity overall. Few took root in sectors such as widely advertised consumer goods, whose technology and demand conditions made such small-scale, improvisatory entry infeasible. This brings us to the other principal contribution of Bhidé’s book—to identify in the population of new firms the traits and functions that distinguish these startups from new companies backed by venture capitalists or those created by established enterprises.

The advantages of bureaucracy

New businesses started by established firms, like other major investments by big firms, undergo a process of rational bureaucratic investigation, planning, and assessment. These planning processes represent costly services performed by skilled staff within the firm, a fact that carries two implications. First, the corporation’s planning staff has a certain fixed capacity in terms of the number of projects it can vet each year. Second, a project must exceed a certain threshold in terms of its likely future cash flow in order to warrant incurring the cost of this planning process. This bureaucratic procedure exists not for its own sake, but to satisfy the suppliers of resources to the corporation—the lenders of funds, the skilled employees with excellent job prospects elsewhere, and the suppliers asked to invest in the capacity to provide specialized inputs. This nexus of rational planning runs squarely opposite to the startup entrepreneur’s low-budget improvisation, which is viable exactly because financial market support is not required, and the employees picked up by the infant firm often lack the glittering resumés of big-business high-fliers.

While Bhidé does not pursue this line of inquiry, it seems clear that industrial markets divide quite sharply between those whose entrants are typically new startups and those that come from firms established elsewhere. The latter select markets where uncertainty is low and information (grist for the planning process) relatively abundant. They serve markets that require big-ticket initial investments and that offer scope for synergistic use of the enterprise’s accumulated resources. In between the migrating corporation and the entrepreneurial startup venture comes the new firm backed by venture capital (VC). Whereas the startup’s entrepreneur lacks a fully articulated plan, the VC supplier demands exceptional ideas or qualifications of the firm’s founders and avoids businesses narrowly reliant on entrepreneurial talent or “hustle.” When the VC deal is done, the firm gains access to $2 million to $5 million, generally with the expectation that losses will persist for several years—a marked contrast to the personally financed entrepreneurial startup that must fold or regroup if its cash flow does not soon turn positive. (These differences shed oblique light on the selection performed by Inc.’s list of fastest-growing companies; growing rapidly may be easier if you start out tiny.)

The credibility of these conclusions gains from the consistency of Bhidé’s findings with research based on census data. Each industry has its own stable pattern in the size distribution of entrant firms, reflecting its natural selection among Bhidé’s three functional entrant types. For example, new products in the men’s shaving market come from established firms that can fund large development and marketing investments. Firms backed by venture capitalists dominate the disk-drive industry and other such computer components.

Don’t discount luck

Bhidé’s research strategy suffers a limitation common to studies in business administration in its reliance on a nonrandom sample of ex post winners. Can the average traits of these winners be used directly to infer their average differences from the many losers among startups?

Consider two extreme possibilities. First, the losers might be the opposite of the winners in all respects—rigorous planners rather than improvisers, well financed externally, well equipped with previous industrial experience. Second, the losers might be indistinguishable from the winners in all respects other than the random strokes of fortune that smiled on the winners and sent the losers to their commercial graves. The second pattern sounds a priori a good deal more likely than the first, yet it leaves us adrift for formulating either business or public policy, with no way to advise entrepreneurs about decisions that will affect their chances (business policy) or to counsel governments about actions that might reduce the social cost of unsuccessful bets (public policy). Such a state of ignorance would be unwelcome, but it might better represent the state of our knowledge than the conclusion that the average traits of Bhidé’s winners predictably differentiate them from losers.

Bhidé’s study continues with an attempt to analyze the growth process that ultimately transforms entrepreneurial startups into orderly bureaucratic organizations. Here, the book rather loses focus. It relies heavily on case studies of a smaller number of industrial successes—the Microsofts and Wal-Marts. It lacks any clearly defined set of measurements or working hypotheses for studying the difficult problem of how the entrepreneur of a successful startup goes from being a one-man band to the head of an orderly and rational organization of collaborating specialists. The case studies provide food for thought but not much leverage for generalization. Also, the book becomes entangled with the complex issues of the nature of innovation and the type of organization best suited to achieve it—issues that have been extensively studied and prove resistant to casual scholarly contributions.

Plenty of room remains, though, for careful research designs that (for example) might compare the subsequent changes in organization and performance of a sample of initially successful startups. In the meantime, Professor Bhidé’s analysis of industrial entrants should advance both managers’ and scholars’ ability to understand the factors that account for wins and losses among new businesses.