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Fertile Ground for Startups


History shows that a certain breed of entrepreneur feeds off adverse conditions, and this recession is no exception

Who needs job security? In June 2008, as the recession was moving from bad to worse, Caterina Fake gave up a comfortable, executive-level job at Yahoo! (YHOO) to launch a company. She left California and set up shop in New York City to co-found Hunch, a Web site that uses the experiences of others to help people make decisions. The 40-year-old, who had co-founded the photo-sharing site Flickr before it was acquired by Yahoo, couldn't resist the idea of creating something new, whatever the economic headwinds. "The entrepreneurial spirit really thrives in situations of adversity," says Fake. "The world is full of more possibility."

Fake isn't alone in betting on that. A crop of potentially groundbreaking companies is emerging from the wreckage of the Great Recession. No question, some will blow up, and others will fail to reach their potential. But the downturn has done little to dampen the entrepreneurial spirit. During the first half of this year, angel investors financed 24,500 new ventures, 6% more than during the same period last year, according to the Center for Venture Research. The overall amount of money going into startups has declined, but the figures suggest that this year will see the birth of roughly 50,000 companies with enough promise that someone is betting money on them. "It may be that this is the best time to start a company," says Carl Schramm, president of the Kauffman Foundation, an organization that promotes entrepreneurship.

"VAST AND UNTAPPED"

With that backdrop, BusinessWeek set out to find the world's most intriguing new companies. After much reporting and research, we've assembled a list that's a barometer of innovation trends in the global economy, with startups that are pioneering new markets in biotechnology, clean technology, health care, and Web computing. Hunch is just one of 25 that made the final cut. Other standouts include Epizyme, a Massachusetts outfit creating cancer-fighting drugs that attack errant proteins; China Water & Energy, a Hong Kong company developing massive wind-power farms in the Chinese countryside; and Driptech, a California startup engineering low-cost irrigation systems for poor farmers around the world. "The markets that we are addressing in India and China are vast and untapped," says Driptech's 26-year-old founder, Peter Frykman.

History shows that great companies are often built during bad times. In 1939, at the tail end of the Great Depression, two engineers started Hewlett-Packard (HPQ) in a garage in Northern California. Silicon Valley itself was largely created during the nasty recession of the mid-1970s. During that decade, entrepreneurs laid the groundwork for the boom of the 1980s, building companies that pioneered three new industries: Atari in the video game business, Apple (AAPL) in personal computers, and Genentech in biotechnology. "The only people who venture out in tough times are on a mission, which is what you need," says Michael Moritz, managing partner of Sequoia Capital, a venture capital firm that invested in Apple back in the '70s. "The people we are meeting are the genuine article, as opposed to the pretenders."

Entrepreneurs, financiers, and historians point to several other reasons for this phenomenon. For starters, everything is cheaper during a downturn, including the cost of labor, materials, and office space. There's less competition both from incumbents preoccupied with putting out their own fires or from other startups unable to raise money. Tighter money means stronger ideas edge out weaker ones. And the tough times force entrepreneurs to work on their business models earlier, so they end up reaching profitability more quickly than when money comes cheap. "[The years] 2010 and 2011 should be extremely good years for innovative small companies," says Jim Breyer, general partner of Accel Partners, a venture capital firm that has invested in Facebook. "We'll see dozens of very successful companies emerge."

SMALL DROPS, BIG SPLASH

Startups are playing an increasingly important role in American business, and they may play a central role in any recovery. As of the end of 2008, companies infused with venture capital were responsible for generating 12 million jobs and 20% of U.S. gross domestic product, according to a recent survey published by the National Venture Capital Assn. A previous NVCA survey found that venture-backed companies accounted for 10 million jobs and nearly 17% of GDP at the end of 2005.

Entrepreneurship is also becoming more global. China and India are leading the way, but Tarun Khanna, a Harvard Business School professor, sees pockets of innovation popping up in less obvious places, such as Brazil, South Korea, and Turkey; 5 of the 25 companies on BusinessWeek's list are based outside the U.S. "Now you are seeing traction in a handful of countries," says Khanna.

Still, recessions certainly present challenges for entrepreneurs. It's much harder to drum up business, take a company public, or raise money than during good times. In the third quarter of 2009, venture capitalists invested $4.8 billion in 637 companies, down from $7.2 billion and 994 companies in the year-earlier quarter, according to a report from PricewaterhouseCoopers and the NVCA.

Fake has some experience working her way through tough times. When she co-founded Flickr after the tech bust, Internet startups were shunned and the company couldn't raise capital from professional investors. So Fake hit up friends and family for money and scraped her way along until the company had built a popular photo-sharing site that foreshadowed the rise of Facebook and other social media Web sites.

Today, Fake is back to being careful with her cash. Last September, to stretch her bankroll, the company lowered salaries for all 10 employees. The group hasn't scaled back its ambitions, though. They believe Hunch can be a leader in a new kind of search technology, going beyond Google to deliver answers based on the wisdom of crowds. Type in "What magazine should I subscribe to?" for example, and Hunch will provide answers by matching responses from users with similar preferences. "The next phase in search is some mating of brute-force algorithms and user-generated content," says Fake.

So far, Hunch has built up to about 300,000 users and has been gathering information about those people by asking them 5 to 10 questions. Now Fake is preparing to move out of "learning mode" with a home page that doesn't require people to fill out a questionnaire. "It is actually time to expand and spend and start a new project," says Fake. "We love recessions."

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