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U.S. Entrepreneurship and Venture Capital

Author: Steven J. Markovich, Contributing Editor
June 5, 2012
This publication is now archived.

Introduction

Since the start of 2009, the U.S. unemployment rate has remained above 8 percent. Policymakers have proposed addressing this persistent joblessness through measures such as tax reform, increased infrastructure spending, and the recently enacted JOBS Act. Proponents argue the JOBS Act will encourage entrepreneurship by reducing regulations for young firms and expanding their financing options, while others are wary of potential harm to investors.

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Entrepreneurship is a primary contributor to job creation and sustainable economic growth, and policies affecting innovation and startup financing have wide ramifications. New firms are often responsible for disruptive products and services that launch entirely new markets and spur employment in high wage industries such as biotech and IT. High-tech startups benefit from innovation clusters such as Silicon Valley, which bring together leading firms, institutions, and venture capitalists, and accelerate job growth in these regions.

How Does Entrepreneurship Drive Job Growth?

Entrepreneurship has been the primary engine of U.S. job growth over the past thirty years. Historically, job growth from startups is fairly consistent, even in years that included recessions.

U.S. Entrepreneurship Chart

Jobs created by startups are volatile; roughly half of the startups founded in a given year will be gone after five years. The young firms that survive often increase their employment, partially compensating for the loss of other firms. While small businesses--under five hundred employees--usually attract the attention of policymakers, age matters more because even among small companies, young firms are more likely to grow employment.

Not all businesses have high job growth potential. Many successful firms start small and, by nature, will stay small: a corner diner may have a dozen employees, but will never employ thousands. Few firms will scale up to the size of Apple, Ford, and McDonald's.

High-tech industries like IT and biotech are of special interest to policymakers and venture capitalists alike. Innovations in these sectors have the potential to spawn the companies capable of scaling to billions of dollars in revenue and employing the next generation of high wage earners. These sectors, unsurprisingly, attract the majority of venture capital (VC) for this reason; more than 80 percent of startups receiving their initial VC investments in 2011 were high-tech startups.

How do High-Tech Startups Launch?

Startups that have the potential to become high-growth companies begin with an idea. Ideas can come from anywhere: university research, market failures, product and/or process improvements, or even common annoyances. CEO and co-Founder of Bump Technologies David Lieb came up with the idea for his mobile app, which exchanges contact information and photos by simply "bumping" phones , from his irritation at having to type this information in manually. After a year as a side project, he and two co-founders launched the Bump app, and went to Y Combinator--a Silicon Valley incubator.

Most U.S incubators are non-profits and approximately 40 percent specialize in emerging technologies such as biotech, IT, and alternative energy. Incubators help startups by providing subsidized space, tailored business services, and access to funding, talent, and contacts. According to preliminary survey data from the National Business Incubation Association (NBIA), roughly 4 percent of startups are in incubator programs. The NBIA-funded research indicates that startups at incubators have nearly double the survival rate, but other research casts doubt on incubators' effectiveness. While no general consensus has emerged among experts, the selectiveness of the program is likely to correlate with the success of its startups because the more prestigious incubators are most likely to have their pick of the "hot" startups.

After three months, Bump reached more than 4 million downloads, received $3 million in VC investment, and left Y Combinator. Bump elected to remain in northern California, as Lieb explained: "Silicon Valley is the place to be. All of the talent and investors are here. The people who know how to do startups are here. If you're trying to build a tech company like we were, this is the place to do it."

Silicon Valley is an "innovation cluster," a regional grouping of firms and institutions in a particular field whose interactions enhance competitiveness. Universities and research centers drive innovation clusters through cutting-edge research. John Doerr, partner of leading VC firm Kleiner Perkins Caufield & Byers said that he "can't imagine Silicon Valley without Stanford University." More than five thousand companies trace their origins to ideas or people from Stanford, which has licensed eight thousand patents generating $1.3 billion in royalties (New Yorker).

While innovation clusters propel economic growth, the Brookings Institution advised policymakers against attempting to create new clusters. They suggest that since clusters require deep, complex interactions among a variety of firms and institutions, policymakers would be better off supporting existing clusters that have passed the market test, but are lacking in some capacity.

Experts regard Silicon Valley as the most successful innovation cluster; it creates the most startups and receives more than one-third of all U.S. VC investment. Its strengths include: technical talent, experienced entrepreneurs, deep sources of capital, noted research universities, startup incubators and accelerators, and specialized business support. (Startup accelerators are similar to incubators but provide more extensive support.) These strengths compound over time; those involved with successful startups often found or fund new ones (NYT). For instance, among Paypal's founders were Peter Thiel, one of Facebook's first investors, and Elon Musk, who later founded SpaceX and Tesla Motors.

Beyond Silicon Valley, startup hotspots include New York, Boston, Chicago and Los Angeles. The map below shows state-level data for venture financing for the United States. (Click on a state to view its statistics.)

U.S. Entrepreneurship Map Legend

How Does Venture Capital Financing Operate?

Founders typically supply their startup's initial investment, often with support from family, friends, and angel investors. As their needs grow, many turn to venture capitalists who find, fund, and mentor promising startups. From 2000 to 2011, 52 percent of firms that held an initial public offering (IPO) were prior recipients of VC investment.

Venture capitalists are long-term, hands-on investors with access to deep pockets. The venture capitalists who manage the investments are referred to as "general partners." They charge fees of 1 to 2 percent per year of the invested total, plus "carried interest," typically a 20 percent share of investment profits. Most of the invested money comes from institutional investors such as mutual funds and pensions, and wealthy individuals. These silent, "limited partners" expect annual returns that outperform major equity markets, such as the New York Stock Exchange.

General partners often specialize in specific industries and/or stages of development and usually prefer startups with large growth potential and low capital requirements--such as mobile, Internet and biotechnology firms. While this model has been in place for decades, research shows that limited partners have received average returns below major equity markets for more than a decade. A glut of investment has led VC funds to invest in less attractive startups as the relatively few "hot" firms are taken, analysts say.

How does Venture Capital Backing Lead to an IPO or Acquisition?

VC investments fund growth, but there are benefits beyond money. Lieb said venture capitalists supported Bump's recruiting and business development, and gave him personal mentorship: "Two VC partners sit on Bump's board of directors. They give us strategic advice, operational advice and emotional support."

Even with this assistance, many startups fail or just break even. To generate the large returns demanded by limited partners, one or two of every ten VC-backed startups must end in either an IPO or a lucrative acquisition by a large firm like Google. In an acquisition, the entrepreneur typically surrenders control, while IPOs secure profits and raise funds from public equity markets for expansion.

Historically, control was also lost after an IPO, but in the past decade dual-class share structures have been used more frequently to retain founder control (Bloomberg). Facebook's IPO was of "A" class shares with one vote each, while CEO Mark Zuckerberg and fellow insiders got "B" shares with ten votes each. Zuckerberg retained majority control and can steer Facebook without bowing to shareholder pressure, despite only owning 28 percent (NYT).

From 2001 to 2011, the average number of IPOs was 80 percent lower than in the prior two decades; many entrepreneurs opt to be acquired to secure profits and avoid the cumbersome regulations (Economist) inspired by past crises, such as arcane accounting rules and detailed disclosure requirements.

What is the JOBS Act?

The Jumpstart Our Business Startups Act--enacted in April 2012--is a set of new rules designed to increase financing flexibility while decreasing regulatory burdens for young, growing firms. Proponents argue these measures will increase IPOs, entrepreneurship, and job growth. Critics, such as SEC Commissioner Luis Aguilar, say the provisions could encourage fraud and abuse.

This debate is largely over which effect is greater: benefit from stimulating growth through reduced regulatory burdens or harm to investors from weaker safeguards. Martin Neil Baily and Robert E. Litan at the Brookings Institution believe the JOBS Act will have a net positive--though unquantifiable--effect on job growth.

Accounting Regulations

The JOBS Act waives some Sarbanes-Oxley (SOX) reporting and auditing requirements for "emerging growth companies," those firms with under $1 billion in revenue which have been public for less than five years. SOX was passed in 2002 in response to major accounting scandals, including Enron. Major provisions included mandating internal financial controls, reinforcing auditor independence, and disclosing off-balance sheet items.

Steven N. Kaplan, professor of entrepreneurship and finance at Chicago Booth, says the relaxed regulatory burden will help grow new firms: "On the whole, the [JOBS Act] provisions make it easier to be a successful growth company and to go public. As a result, the provisions also will marginally increase the number of startups." Regarding the risk of fraud as SOX rules are rolled back, Kaplan added that the JOBS Act will likely have "a modest if not minimal effect…because a misstep once you are public is very costly." Groupon's accounting problems and stock price decline in early 2012 provides an illustrative and cautionary tale (NYT).

Richard Waters of the Financial Times argued that relaxed regulations will decrease IPO quality. Citing the rise of subprime mortgages, he wrote: "If the hurdles for accessing a market are lowered, then the credit and investment quality of the people and companies raising money goes down."

Crowdfunding

The JOBS Act also legalized "crowdfunding," the solicitation of equity financing from a broad range of unaccredited investors. While this opens up venture investing to a broader swath of the population, it also creates the opportunity for uninformed investors to unknowingly enter risky positions. The JOBS Act limits investment to the greater of $2,000 or 5 percent of an unaccredited investor's annual income or net worth.

Experts are uncertain of how widespread crowdfunding will become. Yale University economist Robert Shiller believes crowdfunding is an important tool to democratize financial innovation, and compared it to the 1811 law that stoked investment by restricting investors' money at risk to their initial investment. Meanwhile, Kaplan linked crowdfunding to adverse selection, arguing that strong companies will get VC funding, while firms with poorer growth prospects will resort to crowdfunding.

What Other Government Policies and Programs Affect Entrepreneurs?

The federal government encourages entrepreneurship in a number of ways: loan and investment programs, research funding, and tax incentives. The Small Business Administration (SBA) is Washington's lead agency for assisting entrepreneurs. SBA helps small business owners obtain financing from private institutions and provides educational and technical support. In addition, the agency's Small Business Innovation Research program coordinates R&D partnerships between qualified firms and federal agencies such as the National Science Foundation and the National Institutes of Health.

Several tax incentives are designed to support entrepreneurship by encouraging investment in innovation. The Research and Experiment tax credit, which expired in January 2012--but is likely to be renewed--is the most prominent example. Other tax credits are more targeted, such as the investment and production tax credits that encourage renewable energy. VC general partners also benefit from IRS rules that regard carried interest as a long-term capital gain, which is taxed at 15 percent, significantly less than the top ordinary income tax rate of 35 percent.

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