Special Report: State of the Entrepreneurial Economy

In past recessions, growth companies have absorbed shocks to the economy. A new survey of Inc 500 CEOs suggests that might not happen this time around.

Recession, downturn -- whatever you call it, the economic slowdown of the past year may be one of the most confusing in recent memory. It didn't start for the usual reasons, and it isn't obeying customary dynamics. Particularly for growth companies, the signs and portents were mixed even prior to the attacks on September 11, and since then they've grown only murkier. Even seasoned company builders are having a tough time reading the omens -- and determining how the downturn will affect their businesses.

Take Phillip Mosely, who founded his IT company, OnSphere, in 1988 and managed it through the recession of the early 1990s. Then, says Mosely, "it seemed like there was an end in sight. It wasn't depending on whether someone was going to blow something else up or not." Not so today, he says. "Now, primarily because of the events of 9/11, there's still not a sense of when we're going to come back out."

Another source of confusion is the employment picture. Well before September, job cuts at large companies had been announced in record numbers. Add in the postattack layoffs, and the total number of job cuts announced through the third quarter of this year came to nearly 1.4 million, more than twice as many as in any full year in the past decade. (See chart, below.)

Announced Job Cuts, 1989-2001
Dispatch Chart

A Shock to the System?
JOB LOSSES MULTIPLY: By the end of the third quarter, U.S. companies had announced record job cuts -- more than twice as many as those announced in any full year in the past decade.

* Through August 31.
Source: Challenger, Gray and Christmas.

Cutbacks of that magnitude ripple through the economy, sapping confidence and ultimately eating into spending. The unemployment rate, however -- at near-historic lows for the past few years -- has been creeping upward only slowly and is still well below the levels traditionally associated with a recession. That suggests either that most of the big-company cuts haven't gone into effect yet or that entrepreneurial businesses are picking up the slack.

The latter hypothesis fits with past experience. "Keep in mind that in the early 1980s [recession] and again in '91, the small-company share of job generation was 100%," says David Birch, president of Cognetics, perhaps the world's leading authority on small-business demographics. "This population of small growing companies acts as a shock absorber for the economy as a whole." The trouble is, right now the entrepreneurial sector may not be exhibiting the resilience you'd expect. Indeed, the signs from growth companies are as perplexing as those coming from any other sector. For example:

  • Birch maintains a database of what he calls "gazelles," companies that have grown at least 20% annually for four straight years. In 2001 the population of gazelles shrank substantially, dropping 12%. The drop can't be ascribed to the dot-com collapse: Internet companies as a group were never more than a blip in a database comprising more than 300,000 businesses. Says Birch: this 12% drop is "very significant."
  • Inc recently conducted an online survey of the last two "classes" of Inc 500 CEOs, who constitute a sizable chunk of the people who own and run the fastest-growing privately held companies in America. At least one statistic from the survey bears out Birch's view: 39% of respondents reported flat or declining sales in 2001, meaning that they were no longer running growth companies. More than one in six respondents even acknowledged that they had "serious concerns" about the viability of their companies. (See chart below.) And yet, on the plus side, 61% reported growth this year (see chart below), and even after September 11, 69% were forecasting growth for next year.
  • PricewaterhouseCoopers has tracked the attitudes and plans of 400-plus CEOs of growing companies for the past decade. As far back as the fourth quarter of last year, the CEOs had begun to cut back on their capital-investment and hiring plans, and they scaled back further after September 11. However, even after the attacks, 72% were projecting double-digit growth for the next 12 months, and more than half were planning to hire.

So nobody knows quite what to expect from this recession, particularly since it isn't following any recent scripts.

Falling Off the Fast-Growth Track
SLOWING SALES: Even before September 11, more than a third of Inc 500 CEOs were experiencing flat or declining sales. (NOTE: Figures compare sales from January through August with those for the same period in 2000.)
How Growth Companies' Sales
Fared in the First Three Quarters of 2001
Percentage of respondents
Sales up in '01 vs. '00 61%
Sales down in '01 vs. '00 33%
Sales flat 6%
Source: October 2001 Inc survey of 764 CEOs whose companies
had made the Inc 500 in 1999 and 2000; Inc received 202 complete responses.
Who's Worried?
CONFIDENCE WANING: 18% of Inc 500 CEOs surveyed this past fall said they had "serious concerns" about the viability of their companies. Historically, Inc 500 companies have an annual failure rate of approximately 2%.

Do you have serious concerns about the viability of your company?
No: 77%
Yes: 18%
Don't know: 5%

Source: September 2001 Inc survey.

Recession: More Than Numbers

In ordinary usage, the R word refers to a drop in gross domestic product over two successive quarters. The National Bureau of Economic Research uses a slightly different definition: a "significant decline" in key economic indicators lasting at least six months and affecting many sectors of the economy. However you define it, only three recessions have occurred in the past 30 years. Working backward:

The 1990s. The most recent recession took place from July 1990 to March 1991 -- but don't interpret those dates too strictly. In any recession, businesses typically feel a pinch at some time before and some time after the officially recorded slowdown, and indicators such as unemployment may not peak until the economy has actually begun to recover. The immediate cause of the early '90s slowdown was, as it often is, the Federal Reserve. Fearing inflation from the 1980s boom, Alan Greenspan and his colleagues slowly tightened the screws on interest rates. Finally, the prime lending rate topped 10%, GDP began to decline, and unemployment rose (hitting 7.5% in 1992). The brief Gulf War, in early 1991, didn't help matters -- consumers and businesses held back on spending until the tension in the Middle East eased -- but neither did it provoke a sustained slump.

Why not? One reason: a huge new technology -- the personal computer and its many spin-offs -- was waiting in the wings. PCs had become wildly popular in the previous decade, yet their potential had only begun to be realized. (How many people had even heard of the Internet in 1990?) The next nine years witnessed a boom in information-technology and telecommunications investment, opening up huge opportunities for entrepreneurs and helping spark the longest economic expansion in history.

The 1980s. The double-dip recession of the early 1980s -- January to July 1980 and then July 1981 to November 1982 -- was also touched off by Fed policy. In 1979 inflation was the highest it had been since 1946, and Fed chairman Paul Volcker fought back with brutally high interest rates. You'll remember those rates if you were in a credit-sensitive industry such as real estate: the prime neared 19% in 1981. With credit virtually collapsing, the GDP plunged a full 2% in 1982, while unemployment hit nearly 10%. But the painful medicine worked. Inflation soon fell to reasonable levels, confidence returned, and the economy embarked on the 1980s expansion.

One force driving the expansion was a dramatic restructuring of large corporations. Buffeted by economic conditions and new overseas competitors, big companies slashed payrolls by the thousands. They got rid of their cafeterias, shucked their travel offices, and reduced their human-resources staffs. Manufacturers bought parts instead of making them. Service firms farmed out work they had once done themselves. All that outsourcing spelled opportunity for young growth companies -- opportunity reflected in the fact that "business services" became one of the fastest-growing sectors in the economy. A second engine of expansion: deregulation. By the early '80s the airline, trucking, telecommunications, and banking industries were all open to new entrants, and entrepreneurs jumped in.

The differences between the previous recessions and the present one are striking. Inflation now is quiescent, and unemployment is still relatively mild. The Fed never did raise interest rates very high before this recession started, and the cost of borrowing is about as low as it can get. But there's one more period worth examining because it sheds light on the aspect of a recession that may trouble us the most today: the psychological. If you're old enough, you'll remember those bleakest of modern times:

The 1970s. The official recession of the '70s lasted a full 17 months, from November 1973 to March 1975. The GDP fell a little in both 1974 and 1975. Unemployment reached 8.5%. But the numbers alone aren't the story of the decade. In 1973, incensed by U.S. support for Israel in the Yom Kippur war, Arab members of the Organization of Petroleum Exporting Countries (OPEC) declared an embargo on oil exports to America. Energy prices shot upward. Gas stations were suddenly short on supplies; panicky drivers lined up for blocks to fill up their tanks. Companies with big energy bills found themselves struggling to stay in business. The crisis gradually eased, but then a revolution in Iran in early 1979 interrupted the flow of oil from that country, bringing the gas lines back and shoving prices skyward once again. Both events and their aftereffects seemed like symbols of a new kind of war, a war that we didn't know how to fight, that we weren't sure we could win, and that could drag on for years rather than months. When the Iranian revolutionaries took U.S. embassy personnel hostage, later in 1979, the horror seemed almost predictable: Americans felt they had been held hostage most of the decade.

The psychological effects were stark. Gloomy prognosticators declared that the world was running out of oil -- and probably many other resources as well. Corporate executives even worried that the government would have to run more of the economy. "Among business leaders, fear is developing that a gathering crisis will turn the nation decisively toward socialist patterns," said U.S. News and World Report. Technically, the economy was in recovery after 1975, but the mood was anything but ebullient. Growth was sluggish. Inflation and unemployment both remained high, a phenomenon that came to be known as "stagflation." The resulting unease and uncertainty plagued businesses and consumers alike, making both groups reluctant to spend or invest. Had there been a large population of growth-oriented entrepreneurs in those days, they might have felt as perplexed about the future as today's entrepreneurs feel now.

Test of a Resilient Group

Tote up all the historical parallels and what do you get? On one side of the ledger, the economic environment is every bit as enervating as that of the '70s, particularly in regard to the uncertain threats facing the United States from abroad. Worse, no obvious engine of growth is waiting for entrepreneurial fuel, as it was in both the early '80s and the early '90s. Such factors suggest a lengthy, stubborn downturn. "I'm sure we are in a recession, probably a relatively deep and extended one," legendary investor Warren Buffett told his managers at the end of the last quarter. Many leaders of growth companies agree. Close to half of the Inc 500 CEOs who responded to our survey expect the downturn to last a year or more, and 66% expect it to be moderate or severe in intensity. (See chart below.) Given such grim prospects, political leaders may soon be debating the possibility of judicious public support for growing companies. (See " Bridging the Capital Gap.")

Long Haul
LOOKING AHEAD: A majority of Inc 500 leaders believe that this recession will be moderate to severe and will last between nine months and a year.
How long do you think the recession will be?
Percentage of CEOs
Six months 23%
Nine months 29%
One year 34%
Two years 14%
Other 1%
Source: September 2001 Inc survey.

On the other side of the ledger, economic conditions aren't nearly as grim as they were in times past. And unlike in the 1970s, the U.S. economy now includes a large group of entrepreneurial companies run by seasoned CEOs, and many of those company builders are optimistic about their ability to create growth even in the midst of a recession. Whistling past the graveyard? Maybe. But even in a downturn like this one, Inc 500 CEOs largely outperform the economy. For the first half of this year, Inc 500 companies grew by 16% over the first half of last year -- four times the growth rate of the gross national product. And both the distressed companies and those that are still healthy have already begun taking steps calculated to regain (or preserve) their momentum.

CEOs of distressed companies, for instance, have embarked on sharp programs of cost control. They have laid off staff and renegotiated fixed costs, from lease payments to Internet access. They've eliminated perks and slashed their own salaries. "We put everything into two buckets, the 'have to have' bucket and the 'nice to have' bucket -- and we really cut that," says Jim Nall, president and CEO of Paladin Data Systems, a $10-million software-development company in the Seattle area. Expense cuts plus a 20% layoff will save Paladin nearly $3 million this year, a whopping 50% of its overhead. Paladin has also renewed its emphasis on that most basic of business activities: making a sale. "I'm full-time sales again," says Nall. "We couldn't afford to have the founders sitting around in offices making strategic-vision decisions."

The real trick for any company, of course, is to tighten up for a worst-case scenario, push for increased sales, and develop new opportunities, all at the same time. Tom Dodge, CEO of Advanced System Integration, an Austin company that develops factory-automation systems, has slashed payroll from 100 to 62 and is quoting jobs tighter because the semiconductor and telecom plants he once serviced aren't buying as much as they used to. But he's also increasing his visibility in the not-so-hard-hit food and pharmaceutical industries, hoping to generate new revenues there.

As for healthy companies, some are healthy precisely because they have carved out niches that are somehow protected from a downturn -- always a shrewd entrepreneurial strategy. U.S. Energy Services, in Wayzata, Minn., analyzes customers' energy use and finds ways for them to save money. "In good times we come in and say we can offer about $200,000 in cost savings, and they say, 'We don't have time to focus on that," says CEO and president Bill Bathe. "But in a slowdown, $200,000 gets their attention."

And many healthy companies have benefited from good old-fashioned smart management, opting for astute diversification, avoiding overextension, and conserving cash. Arthur Bedrosian, president of Zephyr Environmental Corp., in Austin, describes his job as recession-proofing his company. He has deliberately set out to serve customers in markets as diverse as consumer goods and energy production. "When one is down, the other is often up," he says of the two sectors. Bathe believes every company should have at least a few months' worth of cash readily available. "Just-in-time inventory for auto parts is fine," he says. "Just-in-time cash is not."

Small steps, no doubt. But the big economic picture is made up of a thousand little ones. And when the slowdown ends, as they all do, growth will go to those who have prepared themselves well. "What should you be doing in running your business?" asked Warren Buffett of his "all-star" managers in late September. "Just what you always do: widen the moat, build enduring competitive advantage, delight your customers, and relentlessly fight costs. With the exception of insurance pricing and coverages, almost all operating decisions that made sense [before September 11] make sense today."

Inc staffers who worked on this special report include contributor John Case, senior editor Elaine Appleton Grant, senior writer Susan Greco, reporters Jill Hecht Maxwell and Kate O'Sullivan, senior staff writer Mike Hofman, Inc Technology executive editor Christopher Caggiano, senior editor Susan Hansen, senior staff writer Emily Barker, and associate editor Thea Singer. The survey data were collected over the Internet using Inquisite by Catapult Systems ( www.inquisite.com). Send your E-mail to editors@inc.com.