Senator Amy Klobuchar, shown here campaigning in Virginia in February, has led introduction of the … [+]
As I discussed earlier this week, small businesses are hurting everywhere and the pain is only going to intensify. What about new businesses? Will anyone start a new company during the COVID-19 crisis and emerging recession?
History says yes: several years ago we did an analysis at the Kauffman Foundation that found that over half the companies on the Fortune 500 list had been founded during a recession or bear market. We updated those numbers a few times and the finding was consistent.
There’s a caveat, of course: with one exception, those prior recessions and bear markets didn’t occur during a pandemic. (There was a recession from August 1918 to March 1919, overlapping with the Spanish flu.) So maybe this time is different.
When the COVID-19 crisis eventually passes and the economic contraction abates, there will be a surge of economic activity. The economic shape of disasters tends to be V-shaped, with steep declines and sharp rebounds. Again, this time really could be different—some changes to daily life from shutdowns might prove to be unalterable.
No matter how long the pandemic and recession last or how difficult the recovery, it is certain that we will need new businesses to be started. Importantly, we’ll need them in every part of the country. Yet there is a problem.
The United States is in the midst of not only a long-term slowdown in business creation but also a geographic divergence in entrepreneurship and risk capital. Eighty percent of venture capital in this country goes to just three metro area, according to the Center for American Entrepreneurship (CAE). Venture capital represents a small sliver of entrepreneurial finance available to new businesses, but it is representative of broader financing gaps.
This week, a bipartisan group of senators, led by Sen. Amy Klobuchar, took action to try to make sure that entrepreneurs everywhere can get the financing they need. They introduced the New Business Preservation Act as part of the economic stimulus. The bill is endorsed by CAE, the Progressive Policy Institute, the Economic Innovation Group, Small Business Majority, and others.
If enacted, the New Business Preservation Act would aim to inject about $2 billion of federal money into the states to support the funding of public-private investment vehicles. It would do this through establishment of the Innovation and Startups Equity Program at the Treasury Department. (Let’s just shorten that to ISEIP.) Those vehicles, in turn, would match private investment into startup companies. The overall goal is to reverse the geographic concentration of venture capital—today’s 80 percent concentration in three metros is a one-third increase in the last decade.
Attention and support for the bill has focused, understandably, on the financial side. Yet that’s not why it could be helpful in supporting new businesses.
Building on Prior Efforts
Some investors will tell you that the clustering of VC money is natural, that it follows the clustering of investable startups, and that venture capital operates just like any other sector, where density enhances efficiency. This is a way of claiming that there just aren’t many good deals in most parts of the country. Yet the bill’s goal isn’t to equalize venture capital by population or anything else. As one person involved told me, capital will “naturally cluster.” But in most parts of the country, startups and their surrounding ecosystems are being deprived of even the chance to start because of the absence of equity investment in their communities.
The distribution of ISEIP funds would itself have a slight geographic bias—after all, the goal is to expand VC investments beyond the Bay Area, Boston, and New York City. So those areas’ states would be on the short end of calculations that would favor the Midwest, Southeast, and Southwest. In addition to being geographically concentrated, venture capital is also demographically concentrated—to the detriment of women and minority entrepreneurs. The presumption is that encouraging more equity investment around the country will help widen the inclusiveness of entrepreneurial ecosystems. The new program would give “special consideration to businesses created by women and persons of color.”
Encouragingly, ISEIP funding activity would build on and draw lessons from the State Small Business Credit Initiative (SSBCI). Created as part of the Small Business Jobs Act of 2010, SSBCI was run by the Treasury Department and distributed $1.5 billion to states for small business finance around the country. Nearly one-third of that was used by states for VC programs—and leveraged by a factor of 11 in attracting new VC dollars.
Likewise, ISEIP would align with the development of Opportunity Zones (OZs), which were created in the 2017 tax reform bill. One of the hurdles that OZ development has hit is lack of a clear way to support actual operating companies. It’s conceivable that the equity investment sparked by this legislation could help surmount that.
Venture capital is not the whole ballgame, of course—far from it. Only a small fraction of new businesses each year receive VC investments; and only a slightly larger fraction would be considered VC candidates. Most new businesses—even those that end up as high-growth companies—use some form of debt. Most of the SSBCI money went into credit support programs for that reason. Yet the skewed distribution of venture money and its outsized role in startup ecosystems mean it’s a fine place to focus.
Overcoming a Poor Track Record By Fostering Experience
Government schemes to promote venture capital investment into startups should, however, always generate skepticism. Their track record, as documented by Josh Lerner, is less than stellar. For the most part, that’s due to design flaws like allowing policymakers to have a say in the investments that are made. Sen. Klobuchar seeks to avoid this by trying to get money as quickly as possible to private investors, and directing that public money will only follow, not lead, investment decisions.
Yet here is the key point. The New Business Preservation Act is very much about helping generate a wider and deeper level of experience in entrepreneurial ecosystems. Research has empirically established the importance of startup experience for ecosystem development—the extent to which individuals have experience at startups, fast-growing scaleups, or with some sort of exit event (such as an acquisition). The more people there are in a place with those experiences, the deeper the pool of knowledge and wisdom that gets passed on to others. This is an important reason why we see path dependence in startup ecosystems, with entrepreneurial genealogies building over time and feeding future growth.
While experience among founders and employees is important, just as crucial is investor experience. Entrepreneurial ecosystems need investors who understand investments in early-stage companies and are comfortable with its risks. In regions without an extensive history of this, most of the money for supporting new businesses will come from individuals who do not necessarily have that experience. What often ends up happening is a mismatch between angel and seed investors who made their money in one sector (e.g. real estate) and the entrepreneurs in another sector (e.g. software) they’re trying to support.
One of the objectives of ISEIP is to help cultivate that investor experience in places that have little of it. The effects of the bill would thus presumably be enhanced in those places where SSBCI left behind a cadre of investors who understand startup investment. There will be bad deals, to be sure. That’s the nature of investing in entrepreneurial companies. But bad deals build experience and knowledge as much, if not more, as good deals. By ensuring that there are simply more deals done—and more early-stage capital across the entire country—the Act could help catalyze more ecosystems.