Strength in Numbers: the Small Business Outlook

In the last couple of years, small business has been one of the great, underrated success stories behind the continued strength of our economy. But the party may be over.

Small businesses, defined as companies with fewer than 500 employees, have accounted for a massive share of hiring since the pandemic hit. According to Jefferies, nearly 80% of all job openings last year were driven by small businesses.

So what’s been driving this strength? The pandemic led to a surge in entrepreneurship, with many people starting their own businesses in response to surrounding economic challenges. New businesses emerged to meet changing demands, and we saw strong growth in areas like eCommerce, digital health, and education technology. Even the gig / freelance economy began to take off and is expected to reach $455B by the end of this year, doubling its market size from 2018 (Zippia).

The higher relative share of small business job openings in 2022 also stemmed from large companies retracting, particularly high-flying tech stocks. Share prices were slaughtered in a collapsing stock market, forcing many companies to cut costs and operate more efficiently. Granted, Big Tech does not represent the entire market, but it’s a reminder that there is a bust for every boom.

Many workers were fortunate to find jobs at small businesses during that period. Now in 2023, however, the economic backdrop is much different. The pain will increase as consumer savings deteriorate and the Fed hikes rates. And the entities that will be impacted most severely are the ones most sensitive to higher borrowing costs, expensive labor, and slowing end-price inflation - specifically, small businesses.

As pricing power deteriorates and wages catch up to inflation, small business profits will suffer. Large public companies can tap into the bond markets to raise money and weed out the storm. On the other hand, small businesses tend to borrow from banks, making them more vulnerable to interest rate hikes. The heightened exposure to floating rate debt could lead to financing costs doubling from 2021 levels, which will lead to layoffs. Starting to see the cycle?

This signals that the economy is headed towards a recession in the second half of this year, and it's a reminder that the Fed should not be complacent about the current state of the economy. We’re not at the finish line yet.

So what does this mean for early-stage startups? I think the landscape is even more difficult. Startups may not have established customer bases and revenue streams compared to small businesses. They are more susceptible to economic downturns, given their focus on emerging markets and technologies. And they rely heavily on external investment to fund their growth, which may be challenging to obtain as interest rates rise. Fewer investors are inclined to pour money into a cash-sucking startup when they can earn nearly 5% on risk-free bonds.

Don’t get me wrong, some of the best companies will emerge from this downturn. Square and Uber were founded in 2009, post-financial crisis. Groupon and Airbnb launched around the same time, as their founders looked for ways to save people money. Solutions that improve the bottom line should be similarly in demand this year, which bodes well for some FinTech and Enterprise SaaS startups. Opportunities still exist in a down market - companies must address the most relevant needs.

And it must be done efficiently. Although there’s a massive amount of dry powder on the sidelines, investors will be more mindful of valuations and “momentum” deals. One can argue investors have spoiled entrepreneurs in recent years, with rounds priced at 60x ARR and round-the-clock bridge financing. Founders will be forced to do more with less moving forward, and capital efficiency metrics will be closely watched. It’s a healthy reset, all things considered.

Cheers for reading.