Monthly Archives: February 2012

Is the secret to national prosperity large corporations or start-ups?

Harvard Business School professor James Heskett, writing in the February 1 Working Knowledge, begins an online forum with the question: “Is Support for Small Business Misplaced?”  Citing recent research, he posits that perhaps a better national economic strategy would target large multinational corporations:

Consider the conclusions from some recent research: Small businesses may not be a strong source of prosperity. Not only are they less productive than their larger counterparts, they have, according to a World Bank study, a lower rate of productivity growth because they invest only a small proportion of total R&D money. They therefore charge higher prices and pay lower average wages.

An analysis of census data by economists Erik Hurst and Benjamin Pugsley found that companies employing fewer than 20 people made up 90 percent of the six million businesses with one or more employees in the US in 2007. Most were small entrepreneurs creating what might be considered “lifestyle” jobs for themselves, intending to stay small and avoid employing many others. Eighty percent that were studied in detail didn’t create a single job between the years of 2000 and 2003. Another study, The Illusions of Entrepreneurship: The Costly Myths That Entrepreneurs, Investors, and Policy Makers Live By, by Scott Shane, found that while small businesses create more jobs than their larger counterparts, they also destroy more jobs. While they created jobs in the year of their founding, they netted out destroying jobs in years two through five as most of them failed, suggesting less job security than in larger organizations.

At the international level, economists Rafael La Porta and Andrei Schleifer conclude that a nation’s wealth is inversely proportional to the share of jobs provided by small businesses. Again, this is due in part to the lower productivity of such jobs.

We believe this argument is based on a category error:  the misconception that lumps together “lifestyle” companies and high-growth start-ups.  Job growth comes mostly from new businesses which grow rapidly, not the more common short-hand of “small businesses.”  The jobs created by high-growth companies, busy inventing products and services (and sometimes industries), dwarf those lost in the ongoing employment churn experienced by small businesses.  The net result is remarkably stable cumulative job creation from start-ups despite their high failure rate.  The aforementioned study by Scott Shane may be correct that small businesses “destroy” jobs in years two through five as they fail – but by that fifth year the surviving firms still employ 78% of the jobs created, and the additional start-ups created in those intervening years more than make up for the lost 22%.

Remember this about those large companies:  they all have birthdays, either as start-ups themselves or as spin-offs from other companies who once were start-ups.  Over half the companies on the F500 were started during a recession or bear marketThe patents for the Television, Jukebox, and Nylon were granted during the greatest period of job destruction in our history:  The Great Depression.  (Although we can’t confirm any patent information on the chocolate chip cookie, it too was invented at the same time.)  This is precisely the creative destruction that makes our economy an engine of innovation and wealth creation.

At the international level, the 2008 study by La Porta and Schleifer contemplates the “informal” firms operating in gray or black markets, who intentionally avoid scale in order to avoid detection, and therefore lag in productivity gains, have trouble financing growth, and seldom mature into larger firms.  For those countries, larger – i.e., formal – is better, but obviously these reasons don’t apply to the U.S. economy.  We also suspect that in many of those countries, national wealth is skewed by the large (often government-run) operations who extract natural resources.   Any nation that favors its large corporations will indeed see less wealth created by its small businesses.  Over the long term it will see less wealth created, period.

Anyone who’s worked for a large corporation – especially in an R&D department – would not rely primarily on that model for innovation.

Anyone who’s worked for a large corporation – especially in a dying industry – would not rely primarily on that model for job growth.

Yes, start-ups lack the economies of scale and R&D budgets of larger firms; but that’s the support venture capital provides.  Those start-ups that do gain traction are able to raise capital, and, with hard work and a little luck, become large companies.  With early-stage activity at its lowest level since 1977, it’d be a good time to help restore a favorable and predictable environment for new business formation – for entrepreneurs and their sources of capital.

Derek Thompson, senior editor at The Atlantic, makes the case in The Entrepreneur State: Safety Nets for Startups, Capitalism for Corporations.”  He starts from a different question: “What if the law were biased, not toward the oil and gas industry or the cotton farmers, but to the creative, the self-employed, and the entrepreneurs?” 

The broadest debate in Washington, and on the primary trail, is about whether government needs to step up to create jobs or step back to allow the market to work by itself. But what if we need both: A stronger safety net to lessen risk for wannabe-startups and purer free market approach for established corporations?  …

This isn’t industrial planning. It’s not about picking winners. It’s making rules that increase the odds that entrepreneurs play the game in the hope that many of them will win.

As a general rule, entrepreneurs don’t win. They mostly fail. Trying to start a company is like playing a high-risk casino game with your career. It’s roulette, except thousands of dollars, thousands of hours, and unquantifiable sacrifices are on the table. If we want more people to play startup roulette, we shouldn’t focus on how much to tax them if they win $200,000. We should focus on minimizing the downside of losing so that startup roulette feels less risky. After all, startups shouldn’t just be for rich kids who can afford to take a chance on a big idea.

You can build a stronger safety net stitch by little stitch, by creating new tax deductions for startups or making long-term venture capital gains totally tax free. Or you can focus on the whole net…  We could fortify welfare for startups as we disassembled the welfare state for corporations. The corporate tax code is more holes than Swiss cheese, which distorts business decisions and forces us to keep one of the highest marginal tax rates in the world. Reducing both the rate and the exemptions would raise taxes on some companies and cut taxes for others, but it might also level the playing field, attract more investment, and even raise more money for the government. Combined with our bloated, if well-intentioned, regulatory system, corporate welfare saps the market of competitiveness and makes voters angry by what they perceive as favoritism among elites.

It would be naive to think we can cleanse the law of all biases. But what if the law were biased, not toward the oil and gas industry or the cotton farmers, but toward the creative, the self-employed, and the entrepreneurs? What if we combined a liberal approach toward mitigating risk for startups with a conservative approach toward taxing and regulating established corporations? The result might be more people playing the entrepreneur’s game, more entrepreneurs winning the game and ramping up their companies, and more companies to hire more workers.

Good boards don’t mistake process for purpose

Most research and literature about good governance is developed with public boards in mind, and although the context is a little different than in our business, many of the same lessons do still apply.  Since our long term reward depends heavily on whether or not the value of our portfolio company appreciates, we tend to have a more personal ownership mindset – over and above the legal and fiduciary responsibilities – than public company directors.

Here are two interesting reports on good governance which echo our own thoughts on how to ensure a strong board.  While processes and best practices may be important, great boards rely on ‘robust social systems’ among its members to ensure that they function properly.

First, from Spencer Stuart’s Point of View 2012.  When helping to assemble a board, consider executives who:

…combine integrity with the right mix of knowledge, experience and vision to perform the board’s defined roles with excellence.  Beyond even these considerations, qualities such as judgment, engagement and strong communication skills are critical attributes for every director.  And, just as it is a component in any high-functioning team, interpersonal chemistry also plays a role in every effective board.

And this, from Bridging Board Gaps, by the Study Group on Corporate Boards – a joint effort by Columbia Business School and the John L. Weinberg Center for corporate Governance at the University of Delaware:

Recent institutional failures, surrounded by general economic turmoil, once again sparked the familiar question:  Where were the boards?”  …  But the new rules (e.g. Dodd-Frank) for public company boards are focused on board process.  In addition, boards need a renewed focus on their aspirational purpose and guidance for achieving it… never mistake process for purpose.

That purpose (for public company boards) is stated as “creat(ing) sustainable long-term value for shareholders.”  One Study Group member summed up the report’s conclusions this way:  “Maybe we should rename directors ‘shareholder representatives’ – then they would pull up to the table in the right mindset.”

Naturally this mindset comes a bit more naturally in our field since we are literally a shareholder representative – alongside the entrepreneur and any fellow investors.  (There are also far fewer investors than in a publicly traded company so owners are more meaningfully engaged.)

Owners of private companies get to pick both their investors and their board members.  If entrepreneurs pick great partners (broadly defined) to fund their business and make sure both financial incentives and long term goals are aligned, they will have achieved high performance corporate governance that will contribute substantially to their eventual success.

The love of taxes is the root of unhappiness: update

The Tax Foundation has issued its 2012 State Business Tax Climate Index, which once again confirms that the love of taxes is the root of unhappiness.

We remain… happy.  And happy to report that’s true for our region as well.

When confronted with the argument that higher taxes = unhappiness, we wonder, even while remaining sympathetic to the point of view, whether or not it runs vice-versa, or at least cuts both ways:  unhappy people like to raise taxes.

This is just the most recent study – see also herehere, here, here, here, here, and here – to confirm the country is experiencing the rise of the high-tech South.

Another factor in the Southeast’s attractive growth potential – and one clearly related to taxes – is lower state debt burdens.  Some state governments, when faced with crushing budget deficits, respond with growth-stalling tax increases on the businesses that operate in their states.  (The problem worsens dramatically when one considers many states’ unfunded pension liabilities.)

Two states whose budget woes have garnered recent headlines include Illinois, which pushed through a 45% increase in corporate taxes – apparently triggering an exodus; and California, which is on the verge of running out of money – again.

Some states, like the aforementioned California, respond in other “desperate ways” which further undermine investor confidence and entrepreneurial spirits:  accounting gimmicks, delayed payments, issuing IOUs, or even more borrowing.  As we’ve written before, only one non-Southeastern state – Nebraska – has a lower debt-to-GDP ratio than FL (5th), GA (4th), TN (2nd), NC (3rd), TX and VA (tied for 6th).

State debt-to-GDP ratio (Source: AEI)








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