The Expectations of New Business Founders: The New Zealand Case

Abstract

The desire to develop one's own business is widespread. Reynolds (1995) estimates seven million U.S. adults are in the process of starting a business at any one time. This was confirmed by Dennis (1997), who surveyed 36,000 households and concluded at any given time, five percent of the U.S. adult population is in the process of starting a business. This phenomenon is not just confined to the U.S. The widespread extent of the high rate of new firm formation is evidenced by data from various countries provided by the OECD (1998). These figures show establishments in their first year made up between 11.2 and 16.8 percent of firms. The high failure rate of new firms has been clearly established in the literature. Pinfold (1997) found the level of new entrants into business in New Zealand was 5.75 times greater than the economy could sustain, and in doing so demonstrated the inevitability of a high business closure rate. The probability of failure for each firm will of course vary, depending on its individual survival characteristics. Not only are the risks high, but also the rewards in a firm's early years maybe lower than is generally imagined by business founders. Williams (1987) shows the profitability of new firms does not reach satisfactory levels until the fifth year and it takes eight years to achieve long-term levels. Biggadike (1979) found new ventures of U.S. corporations lost money for their first four years, taking 10 to 12 years to reach the same return on assets as mature businesses. Weiss (1981) conducted a follow-up study on businesses founded by individuals. Although he found they performed better, they still required an average of 3.5 years to reach profitability, and in the second year, the median return on investment was a negative 40 percent. The poor returns are not just confined to misconceived ventures. New ventures which pass the scrutiny of professional investors may generate only moderate returns. The European Venture Capital Association (1997) cites a median return of 4.5 percent per annum on the 1.5 billion Euros members invested in start-ups. It has been argued many, if not most, individuals who start their own businesses earn less than they would if they were in the employment of others. The U.S. Small Business Administration (1997) found one-sixth of self-employed individuals earn less than the minimum wage. New firms have few advantages, apart from entrepreneurial zeal, over their more established rivals, yet their disadvantages are manifest. Although some new ventures do extremely well, the evidence is many, perhaps the majority, do not produce satisfactory profitability. It seems probable when new ventures are viewed on an economy-wide basis, their owners on average obtain a very poor return on investment, particularly when risk is considered. Given the high risks and low returns, the eagerness of people to start a business would seem to imply they are either unaware of the statistics or believe the statistics only apply to others. Are business founders unduly optimistic about their own chances of success? Taylor and Brown (1988, p. 198) note that ... considerable research evidence suggests overly positive self evaluations, exaggerated perceptions of control or mastery, and unrealistic optimism are characteristics of normal human thought. Hoorens (1996) finds optimism is highest when events seem to be under a person's control, and running one's own business is certainly an activity where there is a large degree of personal control. In their model of business start-ups, De Meza and Southey (1996) postulate if entrepreneurs are risk-seekers, mean expected returns must be negative. These researchers found even when entrepreneurs are risk averse, only optimists become entrepreneurs, as the selection process ensures those with realistic expectations are unable or unwilling to fund the new venture. …