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.
* * * * *
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