Often one of these provisions discusses “drag along rights.” As Investopedia explains, these rights allow “a majority shareholder to force a minority shareholder to join in the sale of a company.”

The inclusion of drag along rights in VC agreements is becoming more common, according to data assembled by the law firm Cooley LLP. The figure below shows the share of venture capital agreements for which Cooley provided the legal work in which drag along rights were included. While the proportion of agreements with drag along rights never exceeded 50 percent before 2006, it has never fallen below 50 percent since then. And since the second quarter of 2009, it has exceeded 60 percent in every three month period measured.

Why the increased use of drag along rights? As venture capitalist Brad Feld explains in his blog, when the sale of a company occurs at a low price, common stockholders (who are often the founders) usually earn very little after they pay the venture capitalists’ liquidation preference. As a result, the entrepreneurs are often resistant to such sales. To ensure they can sell companies even when founders (or other shareholders) oppose the sale, venture capitalists put drag along rights into their financing agreements.

The greater use of drag along rights reflects a belief among investors that venture capital-backed companies may have to be sold relatively cheaply in the future.

Source: Created from data from the Cooley Venture Capital Report, various issues

From Small Business Trends

Drag Along Rights Are Now Commonplace

To see why requires an understanding of the difference between the stock of entrepreneurs and the flow into entrepreneurship. Think of entrepreneurship like a bathtub of water. The stock of entrepreneurs is akin to the level of water the in the tub. The flow into entrepreneurship is similar to the amount of water coming through the faucet. Unmeasured in this analogy is the flow out of entrepreneurship, which is like the amount of water going down the drain.

The GEM report indicates that America opened up the entrepreneurship valve on the faucet. Inflow increased by 60 percent from 2010 to 2011. But the Bureau of Labor Statistics (BLS) data says the amount of entrepreneurship in the tub went down. The government agency reported a 2 percent decline in the share of the labor force working for themselves from 2010 to 2011, following an 8.5 percent drop in the self-employment rate between 2006 and 2010.

There’s only one way to reconcile a big jump in the number of people going into business for themselves with a continued decline in the number of people in business for themselves. That’s an increase in the number of people who ran their own companies leaving self-employment. Like the bathtub, we can’t have more water flowing out of the faucet, but a lower water level in the tub, unless more water is going down the drain.

I don’t think we should celebrate the increase in the number of people entering entrepreneurship in 2011. This rise must have been accompanied by an even greater rise in the number of people exiting entrepreneurship.

Drain Photo via Shutterstock

From Small Business Trends

Did the Entrepreneurship Exit Rate Surge in 2011?

According to venture capitalist Brad Feld, pay-to-play provisions were rare in the 1990s. But after the Internet bubble popped in 2001, they became very common. New data show that investors have moved away from pay-to-play provisions in recent years.

The figure below shows data on the share of venture capital deals with pay-to-play provisions taken from the Venture Capital Report produced by law firm Cooley LLP. While the data only cover deals for which Cooley did the legal work, they show the frequency with which VCs are using pay-to-play provisions.

While the trend is imprecise, the pattern is clear. Pay-to-play provisions have become less common since the fourth quarter of 2003 when Cooley first began to track this measure.

What does this trend mean for venture capital? Pay-to-play provisions encourage investors to reinvest when the condition of a business isn’t encouraging. If fewer venture capital deals have pay-to-play provisions then VCs will be less likely to put additional money into start-ups in down rounds than they used to be.

Source: Created from data from the Cooley Venture Capital Report, various issues

From Small Business Trends

Pay-to-Play Becoming Less Common in Venture Capital

Now, many of you are young and can’t remember the 1990s, so let me tell you about this ritual. The founders of companies would sell shares of those businesses to the public and the businesses would be listed on the stock exchange.

This ritual, my children, is rarely used anymore. Like other ancient tools like the typewriter and the phonograph, the IPO-as-exit-vehicle has been replaced by a more modern tool: the acquisition.

Dow Jones VentureSource recently released its counts of the number of venture capital-backed companies that exited in 2011, and the numbers tell the story of the lost IPO-as-exit-vehicle. The data show a slight rise in the number of acquisitions of VC-backed companies to nearly record levels (there were 6 more acquisitions in 2004 than there were last year) and a slight decline (by one) in the number of initial public offerings of venture-capital funded businesses last year. Moreover, as the chart below shows, last year the number of exits by acquisitions exceeded the number of exits by IPO by the largest amount since 1992, when Dow Jones VentureSource first began to produce exit data.

For those of you interested in ancient history, this pattern is far different than in 1992, which saw 69 more IPOs of venture capital-backed companies than acquisitions of those businesses.

Source: Created from data from Dow Jones VentureSource

From Small Business Trends

A Bed Time Story Venture Capitalists Tell Their Children

However, the index indicates that small business employment still has not returned to pre-recession levels. Intuit’s estimates are that 700,000 fewer people worked at small businesses in December 2011 than did so in December 2007. Assuming we add the same number of small business jobs in 2012 as were added in 2011, we will first return to pre-recession levels of small business employment five years after the economic downturn began.

Moreover, employee compensation at small businesses remains below where it was in December 2007 when measured in inflation-adjusted terms. In the last month before the recession hit, the average employee earned $25.90 per hour in 2011 dollars. In December 2011, average employee hourly compensation was only $24.53.

While the trend in the small business employment market is positive, neither hiring nor compensation have returned to pre-recession levels four years after the Great Recession began.

Source: Intuit Small Business Employment Index

From Small Business Trends

Small Businesses Are Hiring Again, But…

It’s an important question. The share of small businesses and the fraction of small business income hit by tax increases are usually very different numbers.

The figure below presents data from the U.S. Treasury, on the share of businesses and business income belonging to companies at different annual income levels. The data show that less than one percent of businesses generate between $5 million and $10 million in annual earnings. However, these businesses account for 20 percent of small business income.

This means, of course, that concentrating tax increases only on the highest earning businesses affects relatively few companies. However, it impacts a lot of business income. For instance, numbers from the U.S. Treasury show that a tax increase on businesses earning more than $1 million per year would affect less than 7 percent of small companies but would hit 81 percent of small business income.

Cumulative Share of Small Business Income and Number of Small Businesses by Business’s Total Income:

Source: Created from data from the Office of Tax Analysis, U.S. Department of Treasury

From Small Business Trends

Less than a Tenth or More than Four Fifths?

His answer should have been: “They own businesses.”

The chart at the bottom of the page shows the probability that a taxpayer includes a partnership or S-Corp on his or her federal income tax return. As you can see, the odds of having business income increase substantially once adjusted gross income (AGI) exceeds $100,000. More than 40 percent percent of people with an AGI of $250,000 or more have one of these two types of businesses. More than 72 percent of the really wealthy – people who earn more than $1 million per year – have a partnership or S-Corp. And nine-in-ten of the super wealthy – people with an AGI in excess of $10 million – have one of these.

The correlation between AGI and the odds of having a partnership or S Corp isn’t just a curiosity. It also tells us something about who experiences collateral damage from recent criticism of the wealthy. Whether directed at business owners or not, any disparaging remarks made about the “top one percent” – people who earned more than $344,000 in 2009 – are negative statements about them. IRS data reveal that the majority of the “top one percent” has a partnership or S-Corp.

Source: Created from data from the IRS Statistics of Income

From Small Business Trends

The “Top One Percent” Own Businesses

Last year, the number of jobs in establishments less than one year old was only 60 percent of its 1994 level, according to Bureau of Labor Statistics (BLS) data. That translates to approximately 1.7 million fewer people working in new businesses in 2010 than did so back in the mid-1990s. Given the increase in the population since 1994, that’s quite a shift away from employment in new entities.

The decline in employment in new establishments isn’t just another problem generated by the Great Recession. While the worst recession since the Great Depression accelerated the decline in employment in these businesses, the fall in new establishment employment started well before the downturn began. As the figure below shows, employment in new establishments has been on a continuous decline since 1999, after rising 14 percent between 1994 and 1999.

The BLS will soon tell us if the downward trend reversed itself in 2011. While it’s possible, my money’s on a continued decline, albeit at a slower rate than in recent years.

Source: Created from data from the Bureau of Labor Statistics

From Small Business Trends

Slide in New Establishment Job Creation

Okay, perhaps that statement is not surprising. But the patterns across countries in how business founders are assessed are intriguing.

As the figure below indicates, a recent British Broadcasting Corporation survey of more than 24,000 adults in 24 nations showed that a paltry 25 percent of Egyptians believe that business founders are “highly valued” in that country, as compared with 75 percent of Indonesians.

I doubt it would surprise most of you that two-thirds of Americans believe that entrepreneurs are highly valued, putting the U.S. in the upper half of the nations surveyed. But it might surprise you to learn that entrepreneurs are more highly valued in several other countries. The comparison that shocked me the most was that the French are more likely than Americans to think that entrepreneurs are highly valued in their country.

There’s something oddly troubling to me about this statistic. The French are supposed to be the ones who hold artists and philosophers in high esteem; and we’re the ones who are supposed to respect business people.

I think I heard De Tocqueville turning over in his grave when the survey results were released:

Source: BBC World Service Survey Poll, May 25, 2011

From Small Business Trends

Where Entrepreneurs are Valued

While the the unpredictability of business income is something that makes people everywhere apprehensive about business ownership, how big this fear is varies a great deal across countries. A random survey of the population of 36 countries undertaken in 2009 indicated that only 19 percent of the population in South Korea but 59 percent in Lithuania saw an uncertain income as one of the two scariest aspects of starting a company (see below).

That’s nearly three times as many Lithuanians as Koreans consider the unpredictability of business earnings to be one of their greatest fears about entrepreneurship indicates that people from some countries are better able to deal with this fundamental difference between working for oneself and working for someone else.

As you might expect, Americans were not as likely to be apprehensive about the uncertainty of business income as people from other nations. The U.S. was tied with the Netherlands and Iceland for the seventh lowest percentage of the population identifying uncertain income as one of their two greatest fears about business formation across the 36 nations where the survey took place.

Share of the population reporting that fear of an uncertain income is a top apprehension about going into business for oneself:

From Small Business Trends

Where Entrepreneurs Fear an Uncertain Income