September 30, 2014

A Mistake That Policy Makers Make in Encouraging High Growth Start-ups

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In Northeast Ohio, where I live, there is an entity called JumpStart, which takes money from the government and foundations to provide seed capital to start-ups. The premise behind JumpStart, and similar entities around the world, is a good one. Investing in high potential technology companies will yield some high growth companies that spur economic development. Unfortunately, policy makers consistently make the same mistake in setting up these entities; they underfund them.

Underfunding entities providing seed capital is problematic because it leads success to depend too much on luck. The kinds of start-ups that can transform a region by generating jobs and spurring economic growth are the gazelles. But relatively few start-ups, even in high tech, become gazelles.

Data from the U.S. Census on the sales of companies in high tech industries in their sixth year after founding. Even in high tech industries (which are the ones with the most high growth companies), only 1.34 percent of the companies founded every year generate more than $10 million in sales in their sixth year of operations.

This is where the luck problem kicks in. The seed funding entities don’t have the money to fund enough companies to have a good likelihood of success. For instance, JumpStart has been given a goal of investing in 60 companies by 2011. Given the average performance of high tech start-ups, this means that, on average, JumpStart should have an investment in 0.8 six-year-old companies with greater than $10 million in sales.

Unfortunately, it’s pretty easy to be unlucky and not get a winner with this small a number of investments.

But at triple the number of investments, JumpStart would expect to have investments in 2.4 companies with more than $10 million in sales in their sixth year of operation. Thus, the odds that JumpStart invests in no high fliers go down dramatically as the size of their portfolio goes up.

In short, policy makers reduce the degree that they need to be lucky to have success from investments in start-ups by making the scale of their seed funding entities larger. And they should take luck out of the equation. If policy makers want to rely on luck to promote economic development, they should take their money to Las Vegas instead of investing it in start-ups.

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About the Author: Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of seven books, including Illusions of Entrepreneurship: The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By and Finding Fertile Ground: Identifying Extraordinary Opportunities for New Ventures

5 Comments ▼

Scott Shane


Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.

5 Reactions

  1. I just want to point out that Laura Bennett’s Embrace Pet Insurance managed to get some early stage funding through JumpStart. It couldn’t have happened to a better group and I am very very happy for Laura and Alex and their company/employees.

    Laura has contributed articles here for the past 3 years on pet industry trends.

  2. I don’t know which government program JumpStart participates in but most programs that provide investment dollars to entities for private investment have some sort of matching-fund provision. Entities are required to raise $1 for ever federal dollar they get. Those entities are not limited to raising just $1, they can leverage the federal dollars for more funding if they can pull it off.

    In other words, the money provided by the government for this kind of investing is not intended to be the sole source of investment capital for a company like JumpStart. Some might argue (and do) that the government shouldn’t be funding investment capital at all, that such should be left to the private equity markets.

    Besides, right now, the government is kind of broke. Nobody wants to raise taxes and nobody wants to cut funding to stuff like roads or police or schools or health care or defense spending, in order to spend more money on investment companies. Just take a look at the budget battles between Congress and the White House over SBA funding over the last several years!

  3. Hi Dawn, I’m not a fan of the Federal government getting involved in venture capital through their SBIC program. It’s too hard to see a connection between taxpayer money and benefit back to the community.

    However, I am much more favorably inclined when it comes to local (state and regional) government funding. The reason? There is much more accountability when it’s local money that goes back to local companies. You see the benefits that come back to the local community, which in turn makes for a more vibrant local economy.

    Reports like the following demonstrate to me that there is strong accountability and a direct link to a local economy that comes from funding an organization like JumpStart:

    http://www.jumpstartinc.org/Docs/2007_VentCapReport_web.pdf

    I’m actually on the Board of a local economic development organization called NorTech (an unpaid position). NorTech helps determine where to distribute funds earmarked from the State of Ohio and other sources, and a large chunk of those local funds go to JumpStart. (I’m not authorized to speak on either organization’s behalf, so I will leave my comments as above and add that they represent my own personal opinion.)

    Best,
    Anita

  4. Supporting the so called gazelles is a much loved approach among policy makers everywhere, and it is usually done in a manner that concentrates support in the “few” rather than the “many”, and in high-tech rather than more mundane businesses. Policy makers like to show how prudent they are by concentrating their funding on the would-be winners. Such an approach is above criticism – it’s in the motherhood and apple pie category.
    The problem about concentrating seed funding on start-ups that are judged to have the potential to become gazelles is that nobody can really know at the start-up stage which businesses will become the gazelles. The market will decide that – but well down the line.
    A more productive approach might well be to spread the funding over more start-ups and not just the high-tech ones. Then, when growth potential is more obvious, public funding of the growth businesses could give the same overall economic return to local communities.

  5. Frank,

    I’d urge you to read my book, Illusions of Entrepreneurship. There is lots of evidence that we can identify firms at the seed stage that will almost certainly not be gazelles and ones which have favorable odds. It turns out that a small number of high growth businesses tend to account for a very large portion of the job growth and other economic benefits. So concentrating resources on high potential businesses, particularly in high tech, turns out to be one of the best strategies for generating economic growth through entrepreneurship.

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