Small Businesses Hold on Despite Economy

Matthew Bandyk

Weak consumer spending and lack of credit take their toll on small-business owners, but many persevere

That conventional wisdom is mostly true when it comes to small businesses struggling in an economic recession. Small businesses drive the nation's economy -- more than 95 percent of all businesses in the United States have fewer than 500 employees -- so when the economy slows down, they take the brunt. Compared with large businesses, they have less of a cushion of capital to compensate for sales losses. Tight credit makes business expansion difficult -- expansions that can be the difference between life and death for some small businesses. And economic slowdowns can expose fundamental flaws in the business plans of newly established businesses, driving them out of the market.

But despite all these disadvantages, the number of small businesses as a whole seems to be recessionproof.

The Bureau of Labor Statistics and Census Bureau each month track the number of self-employed people in the workforce. This includes business owners and independent entrepreneurs. The rate of self-employment among nonagricultural workers has barely budged in the face of the recession. In fact, the rate has slightly increased recently. In January, the number stood at about 6.2 percent of all nonfarm workers; in June, the rate of self-employment was up to 6.6 percent, with 9.1 million self-employed people. By way of comparison, in 2006, before the recession, the average self-employment rate for the year was 6.7 percent.

Why hasn't the number of self-employed plunged? Part of the reason is that recessions often have the odd effect of encouraging people to go into entrepreneurship. People laid off from their jobs "often turn to self-employment as a last resort," says Robert Fairlie, a professor of economics at the University of California-Santa Cruz.

Indeed, in the most recent two recessions, more small businesses started up than closed down, according to data from the Small Business Administration. In the recession period from 1990 to 1992, 1,068,124 small businesses closed their doors. But 1,085,737 were created -- a net gain of 17,613 businesses. What about the recession in 2001? More businesses shut down than were created in 2001, but that trend was reversed in the following years despite the bad economy. From 2002 to 2003, there was a net gain of 54,498 small businesses. Data on small business "births" and "deaths" is not yet available for the most recent years.

There are more fundamental trends at work, too. It's easier than ever to start an enterprise, says Ridgeley Evers of Tapit Partners, an entrepreneur and venture capitalist who founded the software company Netbooks (now known as WorkingPoint). "As work becomes more intellectual and less physical, you can pull together a 'company' from all across the globe," says Evers.

But there's a flip side. Just as the barriers to entry are lower, the barriers to exit are lower, too. Competition is fierce, and consumer spending for small-business products is the weakest in decades, Evers says.

The chances of exiting can be higher depending on the industry. The financial analysis firm Sageworks collects data on privately held companies across the country. According to Sageworks's data, which comes from thousands of accounting firms, companies in the land subdivision industry -- closely related to construction -- have suffered the biggest percentage drop in net profits over the past year, at a loss of 45.9 percent. Other industries connected to housing or construction have suffered, too: Lumber wholesalers have lost 19 percent of their profits, and home furnishing stores have lost 17 percent. But industries far removed from the housing bubble also are struggling. Profits in the software company industry declined 23.4 percent -- the sixth-highest of all industries. Business support service profits fell by 19.8 percent.

The other major factor forcing small businesses and start-ups out of the market -- or preventing them from getting started in the first place -- is lack of capital. Sometimes, the demand-reducing effect of the recession can turn what would normally be a well-capitalized business to an undercapitalized one. That's what happened to Andy Lawrence, 27, who had an idea for a business that he thought would change the world of art collecting: applying the concept of fractional ownership to art. Lawrence left his job at a commercial supply company in Los Angeles in April 2008 to start Untitled Partners, which would sell shares of single art pieces to multiple collectors. He and his business partner, Jordan Cooper, had a big advantage over many other first-time entrepreneurs: outside investors. Cooper had connections to venture capital that Untitled Partners was able to tap. Lawrence also benefited from good timing. If he had waited a few months, the funding would have been much more difficult to obtain. "Now, the capital environment is a completely different ball game," he says.

Even with venture capital, Untitled Partners was not able to overcome a more significant problem: The recession was wiping out demand in the art market. Early this year, Lawrence began to fear he couldn't find enough clients. "The target customer no longer existed," he says. Lawrence realized that Untitled Partners wouldn't make money in the next few years, so he and Cooper are returning half of the capital they acquired and shutting down the business. "Given how hard fund-raising is, there was more opportunity to do what I'm good at -- leading a team -- at an existing operation," Lawrence says.

While this recession presents unique challenges to entrepreneurs like Lawrence, history might suggest that the current economy won't have a large effect on small-business and start-up ownership overall. Starting a business is a big gamble even in good economic times. "Forty percent of businesses don't make it through their first two years," says Evers. "That number has been remarkably constant for a very long period of time. It might go up a little higher now." But judging by the remarkable stability of the number of Americans who work for themselves, for many, that gamble is still worth taking.

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Small Businesses Hold on Despite Economy