Scott Shane's White Paper on Economic Growth Through Business Formation2

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White Paper on Economic Growth Through Business Formation

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Scott Shane2966 Manchester RoadShaker Heights, OH 44122Tel: (216) 283-0533Email: scottashane@yahoo.com

Purpose

In recent years, Northeast Ohio (NEO) has seen a resurgence of high potentialentrepreneurial activity that is due, in no small part, to efforts by the foundationcommunity to stimulate it. However, this resurgence has not been complete, and thelevel of “attractive” entrepreneurial activity in the region remains below its peak.Moreover, the causes of this resurgence are not well understood. This lack of understanding is problematic because area philanthropists would like to target their efforts to encourage “attractive” entrepreneurial activity to make these efforts moreefficient and effective.To better understand the types of interventions that encourage “attractive” entrepreneurialactivity, the Fund for Our Economic Future (Fund) commissioned an effort to examinethe effectiveness of different types of interventions to encourage the development of “attractive” entrepreneurial activity in NEO. This white paper is the result of that effort.

Summary of the Effort

The white paper explains why foundations and policy makers who seek to encourageeconomic development through entrepreneurship need to do more than encourage thecreation of a large number of start-up companies. It also identifies four types of “attractive” entrepreneurial companies: venture capital-backed start-ups; companiesfinanced by angel groups; young businesses that receive external equity financing; andgazelle companies – businesses that grow at more than 20 percent per year. It examinesthe efficiency and effectiveness of seventeen categories of interventions to change theindustrial composition, human capital, financial capital, research and technology base,and government policies of the region. The white paper also recommends whether or notthe Fund should encourage these types of interventions in the 16 county region of NEO, basing its recommendation on whether there is evidence that the intervention increasesthe level of “attractive” entrepreneurial activity in an efficient and effective manner;whether the intervention can be initiated through the research, grant making, andconvening activities that are the domain of the Fund; and whether the intervention is of amagnitude that the Fund can support.The analysis conducted for this white paper led to a division of the types of interventionsinto four groups: (1) interventions for which there is no evidence of an effect on the levelof “attractive” entrepreneurial activity in a region; (2) interventions for which there is

2evidence of an effect, but which are more appropriate for other entities to conduct; (3)interventions that are appropriate for the Fund, but show relatively low potential returns;and (4) interventions that are appropriate for the Fund and show relatively high potentialreturns.

Caveats

Two important caveats need to be noted at the outset. First, the focus of this white paper is on interventions to increase the amount of “attractive” entrepreneurial activity in theregion. Effective interventions to increase the amount of this activity may not be thesame as those that help to achieve other goals, such as enhancing the quality of life in theregion; making the workforce more attractive to large employers; or making the regionmore inclusive. Because the scope of this white paper is limited to the goal of increasingthe amount of “attractive” entrepreneurial activity in the region, its recommendationsshould be read as being limited to that goal. The recommendations could easily have been different if the effects of interventions on other goals were being examined.Second, the white paper examines the types of interventions individually. Existing dataare insufficient to determine whether certain categories of interventions arecomplementary and should be undertaken together. The types of interventions notrecommended in this white paper might enhance the performance of the recommendedtypes of interventions. However, they might not. Because the cost and complexity of undertaking many types of interventions simultaneously is prohibitive, the choice wasmade to identify categories of interventions individually, given the absence of adequateinformation to figure out whether types of interventions are complementary or not.

Increasing the Aggregate Amount of Entrepreneurial Activity in NEO Should NotBe a Goal

The Fund should

not

seek to increase the amount of entrepreneurial activity that takes place in NEO. Contrary to much popular opinion on economic development, encouragingthe total amount of entrepreneurial activity in a region is not a worthwhile goal for philanthropists or policy makers. The typical new business does not generate mucheconomic value or create many jobs. The typical start-up is capitalized with about$25,000 of the founder’s savings and operates in the retail or personal services sectors of the economy, sectors prone to high failure rates and low rates of growth and new business profitability.

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The typical start-up only employs one person, and is a home-based business,

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founded by someone who aspires to generate only around $100,000 in revenuein five years.

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The typical new company is not very productive. A study by John Haltiwanger, JuliaLane, and James Speltzer, using data from the U.S. Census and other sources showed thatfirm productivity

increases

with firm age.

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This means that the average new firm makesworse use of resources than the average existing firm.Moreover, contrary to popular opinion, places that have high rates of new businesscreation and self-employment do not have high rates of firm growth. For instance, SanJose, California has one of the country’s lowest rates of self employment, yet is the

3epicenter of Silicon Valley.

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And the metro areas that mark Silicon Valley – SanFrancisco and San Jose – aren’t among the top places for new business start-ups,according data from the Census Bureau’s Longitudinal Enterprise and EstablishmentMicrodata file, the government’s best data source on the per capita number of new businesses created every year in different metro areas. In fact, these two metro areasaren’t anywhere close the number one metro area in terms of per capita firm formation.

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In fact, places that have a lot of self-employment and new firm formation actually have

lower

rates of high growth business activity. Examination of the data published by ZoltanAcs and his colleagues in a recent Small Business Administration working paper showthat the rate at which MSAs have high growth firms is

negatively

and significantlyassociated with the rate of new firm formation in an MSA.Furthermore, increasing the rate of new firm formation per se does not increase economicgrowth. Sociologists Dieter Bogenhold and Udo Staber reported that the correlation between real GNP growth rates and the rate of self-employment in France, WestGermany, and Italy between 1953 and 1987, and in Sweden between 1962 and 1987 is

negative

.

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Economist Danny Blanchflower found that the correlation is also negative between self-employment and economic growth in the 19 OECD countries for which dataare available from 1975 to 1996.

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New companies also account for a small proportion of high growth companies. In areport for the Small Business Administration, Zoltan Acs and his colleagues found thatless than three percent of “high impact” companies – businesses that increased their salestwo-fold or more over a four year period – were younger than five years old.

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“In factthe average age of a high impact firm is around 25.”

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The typical new firm also is

not

an important source of jobs. According to analysis byeconomists Zoltan Acs and Catherine Armington on data from the U.S. Census,companies with at least one employee that are less than two years old, account for only 1 percent of all employment in the United States. By contrast, companies with at least oneemployee that are more than ten years old, account for 60 percent of all employment inthis country.

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New businesses also create relatively few jobs. Data provided on its website by theBureau of Labor Statistics shows that 31,472,000 jobs were created in the United Statesin 2004.

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That year, 580,900 new firms with at least one employee were started, each of which had an average of 3.8 employees. Thus, in 2004, new firms created 2,207,420 jobs,or 7 percent of the total number of jobs created in that year.Estimates of net job creation by new firms are remarkably similar to the estimates of gross job creation. A study by economists Steven Davis and John Haltiwanger shows that,in manufacturing, one year old firms created 6.4 percent of the net new jobs – an estimatethat is consistent across industries, regions, firm size, and type of firm ownership.

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