An Alternative Theory of Startups

(This essay is an amalgam of two pieces originally posted to Hacker News.)

The idea that people in small and mobile organizations, who get paid directly for their performance, can be far more productive than people in huge, bureaucratic organizations is not new. In fact, it is one of the main underpinnings of all of Western civilization as we understand it. The commonly known name for it is “capitalism”. Many people get confused on this point, because of all the politics surrounding the word, but the essence of Adam Smithian capitalism is not a few big companies with an oligopoly. It’s small, individual businessmen and entrepreneurs competing amongst themselves, in an open and dynamic market where the best minds win. Capitalism allows people, through ownership of businesses that they found, to benefit when they make better and cheaper products, and that’s why it’s been so successful.

Capitalism came into existence (roughly) during the seventeenth century in Britain, and later on in America and Western Europe. However, during the 1930s, in the panic after the Great Depression, national governments in the US and Western Europe began to seize unprecedented amounts of power, instituting government welfare programs like the CCC, Social Security, a minimum wage, and unemployment insurance. These governments also passed tax laws that favored existing large companies over new entrepreneurs. Hence, we started to see large chain stores and restaurants replacing individual and family-owned shops. In 1900, it was extremely common for people to own their own businesses; all of the stores that we go to every day, the grocery store and the shoe store and the clothing store and the furniture store, were all owned by individual, small entrepreneurs. There are no widely known hard numbers, but at a guess, in 1900, maybe 10-20% of the population owned their own business. By 1960, it was more like 2-3%.

However, during the 70s and 80s, the government passed laws which started to favor individual entrepreneurs over large businesses again. For instance, the Reagan administration passed a lower capital gains tax to encourage business, broke up state-owned monopolies like Ma Bell, and removed large numbers of business-related government regulations. Hence, we started to see a revival in capitalism, especially in the technology sector. The computer boom had already begun by that time- but what differentiated it from, say, the jet travel boom or the TV boom, is that it was dominated by small companies like Apple and Microsoft, instead of large companies like IBM and Xerox. In many cases, these large companies actually did a lot of the technology development work themselves, but they still had their lunch eaten by small entrepreneurs, because they didn’t follow up on it.

What made the technology boom different from, say, the textiles boom or the automobile boom, was the extremely low capital cost required to enter the market. If you wanted to build a factory and sell cars, or textiles, or alarm clocks, you needed millions of dollars in capital. However, many technology startups, like Apple, Microsoft, Google, and Dell, were started with very little in the way of money. This allowed for extremely rapid progress in the technology sector, as competence in business became a more important factor than doing good deals with investors to get needed capital.

However, in the post-Bubble era, this sort of entrepreneurship and innovation is slowing down, as computer technology has largely become a mature market. In any industry, shortly after the industry begins, there is a feverish wave of entrepreneurship and innovation. Shortly afterwards, the number of competing companies gets smaller and smaller, through buyouts, mergers and failures- and eventually, after many decades, you have an effective oligopoly. For instance, shortly after the automobile was developed, there were a huge number of American car manufacturers, while by 1980 there were only three left. The computer technology industry has probably now reached the stage where we’ll see very few new big companies (Apples, Googles, Microsofts); most startups will be smaller, and will cash out by getting bought, instead of going public. There were at least a dozen billionaires created by technology companies founded from 1975-1985, and another dozen created by companies founded from 1995-2000, but only one who founded his company after 2000 (Mark Zuckerberg). Most of the new “Web 2.0” companies have been absorbed into existing companies, especially Google, rather than forming new big, public companies.

Now that the Bubble is over, many people are starting to realize that computer technology, because it is such an efficient and well-run industry, will always remain a relatively small percentage of the economy. This may sound counterintuitive, but the reasoning behind it is pretty simple. Suppose the average consumer wants two goods, A and B. As he gets more and more of A for a cheaper and cheaper price, his desire for A starts to be satisfied, and he’ll respond by spending less money on A and more on B. For instance, most of us nowadays spend very little money on spices, even though in 1500 spices were an extremely prized commodity, because our desire for tasty, spicy food has effectively been satiated, and we see little need to buy more. We have seen this pattern many times before. For instance, over the past two centuries, agriculture became extremely efficient, with the result that it is now a tiny percentage of the economy (2-3%), because our desire for food has been satisfied. The clothing industry also became extremely efficient, with the result that it’s now a small (less than 5%) percentage of the economy, because our desires have mostly been satisfied. On the other hand, health care and education, which are renowned for their inefficiency (due to bloated government bureaucracies and politicization), have grown very rapidly as a percentage of the economy.

We can try to calculate how large the computer technology startup industry will become using simple statistics. According to the BLS, there are 1.3 million “software engineers” and computer programmers in the United States. This number will go up over the next fifty years, but not by that much; the BLS’s projected growth rate is 2% annually. One could see this number increasing more rapidly if programmers are in so much demand that their salaries (either in the form of cash or startup equity) go up very fast, but we don’t see that happening; programmers nowadays don’t get paid that much more, in either dollars or equity, than programmers five or ten years ago.

Out of these 1.3 million people, of course, relatively few could start a successful company. To go through all of the barriers between working as a programmer, and entrepreneurship:

  • How many of these programmers have the skills needed to start a successful company? A reasonably optimistic figure would be 10%, which is above Paul Graham’s estimate (“The top 5% of programmers probably write 99% of the good software“).
  • Out of those, how many have the personality and determination needed to start a successful company? In the overall American population, this number is probably less than 5%, but the traits needed to become a good programmer, such as high energy, determination, and the ability to think well, probably correlate significantly with the traits needed to start a successful company. So, being optimistic again, call it 25%.
  • What’s the viable age window for programmers to start companies? At a guess, probably around age 22-37, so 15 years. Being optimistic again, let’s assume that all 1.3 million working programmers are within this age range.
  • How many founder-class programmers do you need to start a successful company? This number could probably range from one to five, but being optimistic again, we’ll say one.

So, dividing it out, the number of successful startups every year is bounded above by 1,300,000 * 0.1 * 0.25 / 15 = ~2,200, and this is almost certainly an overestimate. If each of these companies gets bought out for a mean of $10 million, (the median is probably somewhat less due to a long tail effect), this puts the total value of the startup industry at $22 billion a year, or around 0.15% of the US economy.

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