Clearly, creating typical start-ups isn’t the way to enhance economic growth and create jobs. So what is? It is pretty straightforward. Stop subsidizing the formation of the typical start-up and focus on the subset of businesses with growth potential. Getting economic growth and jobs creation from entrepreneurs is not a numbers game. It is about encouraging high quality, high growth companies to be founded.
The evidence on high-growth start-ups is consistent. A tiny sliver of companies accounts for the vast majority of the contribution to job creation and economic growth that comes from entrepreneurial activity. These gazelles more than make up for the lack of job and wealth creation of the typical start-up (Henrekson and Johansson 2009). Moreover, because many gazelles are fairly old and large at the time that they become major wealth and job creators, the story is even more extreme for start-ups. A very small number of new companies account for a disproportionately large amount of wealth and job creation.
These companies are very difficult to pick out ahead of time, making it hard to categorize them. However, one dimension on which they can be identified is their source of financing. According to data from the National Venture Capital Association, since 1970, U.S. venture capitalists have funded an average of 820 new companies per year. These 820 start-ups – out of the more than two million companies started in the United States every year – have enormous economic impact. A report posted on the Venture Impact website explains that, in 2003, companies that were backed by venture capitalists employed 10 million people, or 9.4 percent of the private sector labor force in the United States, and generated $1.8 trillion in sales, or 9.6 percent of business sales in this country (Venture Impact 2004). Moreover, in 2000, the 2,180 publicly companies that received venture-capital backing between 1972 and 2000 comprised 20 percent of all public companies in the United States, 11 percent of their sales, 13 percent of their profits, 6 percent of their employees, and one-third of their market value, a figure in excess of $2.7 trillion dollars (Gompers and Lerner 2001).
In short, the question is not whether having a large number of typical start-ups is better than having a small number of high-growth start-ups. The latter is clearly better.
This pattern has important implications for policy makers. Instead of just believing naively that all entrepreneurship is good and developing policies to increase the number of average or typical entrepreneurs, policy makers need to recognize that only a select few entrepreneurs will create the businesses that will take people out of poverty, encourage innovation, create jobs, reduce unemployment, make markets more competitive, and enhance economic growth. Therefore, as unfair as it might sound, policy makers need to “stop spreading the peanut butter so thin.”Footnote 2 They need to recognize that all entrepreneurs are not created equal. They need to think like venture capitalists and concentrate time and money on extraordinary entrepreneurs, and worry less about the typical ones. That means identifying the select few new businesses, out of the multitude of start-ups created each year, which are more productive than existing companies, and investing in them.
How? First, we need to reduce the incentives that we give marginal entrepreneurs to start businesses by reducing the transfer payments, loans, subsidies, regulatory exemptions, and tax benefits that encourage more and more people to start businesses. Because the average existing new firm is more productive than the average new firm, we would be better off economically if we got rid of policies that encouraged a lot of people to start businesses instead of taking jobs working for others.
Take, for example, the home office tax deduction in the United States. Half of all new businesses are home-based businesses. So people who start businesses that they operate out of their homes can deduct the costs of using part of their homes for their businesses – a deduction not available to them if they work for someone else – which gives people an incentive to start companies that do little to enhance economic growth or to create new jobs.
Alternatively, consider the active labor market policy in Germany, which seeks to turn unemployed people into entrepreneurs. The German government spends around $12 billion Euros per year on this program (Baumgartner and Caliendo 2007). This figure is not far off the $20 billion or so per year that U.S. venture capital firms invest in start-up companies. But what does the German government get for its investment? Certainly not companies that go public, grow their sales, and create jobs the way that the companies backed by U.S. venture capitalists do. Instead, what they get is marginal businesses that create few jobs and have high failure rates.
Or consider the situation in France. According to one web site (Justlanded.com 2008): “There are over 250 different grants and subsidies … available to individuals for starting up a personal enterprise or small business in France, particularly in rural areas. These include EU subsidies, central government grants, regional development grants, redeployment grants, and grants from departments and local communities.” What does the French government get for these 250 different programs, other than employment for a large number of government bureaucrats? It is difficult to know for sure since no study has been done on the companies backed by all of these grants and subsidies, but the lack of easy-to-identify, high growth, high employment-generating, post-IPO companies that have been backed by these programs, suggests that the returns have not been spectacular.
So what should policy makers be doing instead? They should reallocate resources to programs that support high growth companies. For instance, in the United States, policy makers could shift money into the Small Business Innovation Research Program, which requires federal government agencies to set aside a portion of their budgets to support commercially viable R&D projects at small companies. The recipients of these funds are much more likely than the typical start-up to contribute to economic growth and to create jobs.
In France, policy makers on the right track with the 50 percent R&D tax credit. Even when it is reduced to 30 percent in the third and subsequent years (InvestinFrance.org 2008), this R&D tax credit exceeds the on-again-off-again 20 percent tax credit for U.S.-based research and development expenditures. R&D tax credits offer an incentive for entrepreneurs to conduct research and development that they otherwise would not undertake. Those new companies that conduct R&D, and which would benefit from this credit, are more likely than the typical start-up to contribute to economic growth and job creation.
These are merely two few examples of policies we could change. The general principle is to shift resources from programs that support generic entrepreneurship efforts to those that support high potential businesses.
Some commentators argue that we cannot just focus on the small number of highly successful start-ups because we do not know which start-ups will become high growth businesses and which won’t. To these commentators, the answer is to throw mud against the wall and see what sticks.
This view may be politically appealing, but it is naïve. It assumes that we cannot identify the things that make new businesses more likely to survive, generate profits, increase sales, and hire people. Unless the beliefs of venture capitalists and sophisticated business angels are completely wrong, we know what criteria to focus on. Between the human capital of the founder and his motivations, the industries in which companies are founded, their business ideas and strategies, and their legal forms and capital structure, among other things, we have a lot of information on which to choose likely winners from likely losers.
In fact, most people know how to select the companies to bet on. Take, for example, following two businesses:
A personal cleaning business that is started by an unemployed high school drop out, that is pursuing the customers of another personal cleaning business, and is capitalized with $10,000 of the founder’s savings.
An Internet company that is started by a former SAP employee with fifteen years of experience in the software industry, an MBA and a master’s degree in computer science, that is pursuing the next generation of Internet search, and is capitalized with $250,000 in money from the founder and a group of business angels.
Which one would you put your resources behind? It’s obvious that the second business’ chances to contribute to economic growth and create jobs are far better than the first’s and that, on average, we would be better off putting our resources into businesses like it.
In fact, policy makers know how to make this choice too. Although skeptics often ask for examples of public programs in which policy makers choose companies to back and end up picking winners, thinking that there are no examples, it turns out that there are. Take the Small Business Investment Corporation program in the United States as an example. This program has used taxpayer dollars to support the following companies, among others: America OnLine; Amgen, Inc.; Apple Computer; Callaway Golf Company; Compaq, Inc.; Costco; Cray Research; DoubleClick.com; Duracraft Corporation; Evergreen Solar, Inc; Extreme Networks, Inc; Federal Express; Fusion Systems Corp; Gymboree Corporation; HealthSouth Rehabilitation; Intel Corp.; Jenny Craig, Inc.; Outback Steakhouse; Peoplesoft, Inc.; Radio One; Restoration Hardware, Inc.; Rock Bottom Restaurants; Staples; Sun Microsystems; Wellfleet Communications; and Wire Networks, Inc. (SBA.gov 2008). Most venture capitalists would be happy to have had these companies in their portfolios. So why are we encouraging and subsidizing the creation of marginal businesses instead of focusing government resources on the high potential ones?
The fix to our failing public policies toward entrepreneurship will take political will. There are many more voters that directly benefit from our current policies – they get subsidies and tax benefits from starting companies – than would directly benefit from a focus on high potential companies. The greater benefits from the better policies are diffuse and down the road because they come from having more high growth, job creating companies. So policy makers need to make a choice: do they want to pursue good policies or good politics?