Symposium | Unfinished Business

Entrepreneurs: Spread the Start-Up Wealth Around

By Lenny Mendonca Laura Tyson

Tagged Affordable Care ActentrepreneurshipSilicon Valleystart-ups

To hear Republican critics tell it, President Obama has wreaked havoc on entrepreneurs through high taxes, stifling regulation, and, among many other alleged “job killers,” Obamacare.

The real surprise, however, is how resiliently entrepreneurs have rebounded from the worst economic slowdown since the Great Depression. The Kauffman Foundation’s Index of Startup Activity, an indicator of new business creation in the United States, plunged during and after the 2008-2009 recession but rebounded strongly in 2015, registering its biggest increase in the past two decades. Perhaps more encouraging, fewer of those new entrepreneurs were people who had previously been unemployed. Most were starting companies primarily because they saw opportunities rather than because they couldn’t find other jobs. In other words, entrepreneurship is being driven more by confidence than by necessity.

Meanwhile, venture capital investment reached $60 billion in 2015, the second highest year on record. “Angel” investing, in companies that are often still in the concept phase, totaled nearly $25 billion. Start-up accelerators, such as Y-Combinator and AngelPad, which offer financial and infrastructural support to new companies, have boomed as well. The Brookings Institution reports that the number of accelerators soared from 16 in 2008 to 172 in 2015 and invested in more than 5,000 start-ups. Those start-ups, Brookings estimates, went on to raise a total of $19.5 billion in funding.

On top of all that, the United States has experienced a remarkable boom in social entrepreneurship and impact investing supported by both nonprofit and for-profit enterprises that aim to tackle pressing social or environmental problems. Impact investing—investments made with the intention to generate social and environmental impact along with a financial return—attracted $10.6 billion in 2014.

To be sure, much of this resurgence simply reflects the broader economic recovery. But the Obama Administration also played a role through a series of initiatives aimed at boosting entrepreneurship. Among them:

  • The White House supported and pushed through Congress the Small Business Jobs Act, which provides some $12 billion in tax relief for small businesses. One particularly important provision, which greatly increases the investment appeal of start-ups, is a 100-percent tax exclusion on capital gains from the sale of stock in small companies. This targeted tax relief encourages more investment in risky start-ups by significantly increasing the expected after-tax rate of return.
  • Startup America, a bipartisan alliance launched by White House that includes private-sector leaders, universities, foundations and entrepreneurs, has organized a host of initiatives aimed at reducing barriers, accelerating the movement of new technologies from lab to market; and unleashing opportunities in clean energy, health care, and education. The alliance is dedicated to supporting and training at least a half million entrepreneurs in 1,000 cities around the country.
  • In a rare bipartisan legislative success, the President supported and signed the JOBS Act of 2012, which makes it far easier for start-ups to raise capital up to $1 million from qualified investors through crowd-funding and “mini-public offerings.”
  • The Small Business Administration, for its part, has launched a $1 billion investment initiative for very early-stage companies. The program offers loan guarantees of up to $50 million to Small Business Investment Companies that focus on early-stage companies.

Indeed, the much-criticized Affordable Care Act has itself been an important boost for start-ups and small businesses. Although the ACA requires employers to provide health insurance to their employees, it also provides generous subsidies for that health insurance to small businesses with fewer than 50 employees.

The ACA also liberates entrepreneurs by de-coupling insurance from employment and allowing individuals to buy insurance on the open market through health care exchanges—again, often with generous tax subsidies. These changes allow prospective entrepreneurs to forego jobs at more established companies without worrying about losing access to health insurance for themselves and their families.

Recent signs of strength in start-up activity and entrepreneurship are promising indicators of a sustained economic recovery. But there is much more work to be done. Despite a cyclical rebound in 2015, the rate of new business formation remains below its historical norm and has been on a gradual downward trend for several decades.

The United States can and should do better. The next President, in partnership with state and local governments, has many ways to boost start-up activity.

The University of Virginia’s Miller Center recently created a bipartisan commission (of which one of us, Lenny Mendonca, was a member) to identify strategies to support the creation of middle-class jobs through entrepreneurship. Providing access to capital for entrepreneurial ventures topped the commission’s list. Other recommendations included providing training and mentors for prospective entrepreneurs and startups, creating “ecosystems” of supporting infrastructure, and reducing regulatory barriers.

Venture capital and angel funding are now near record highs, but the funding boom is heavily concentrated in a few regions like Silicon Valley. The vast bulk of America remains on the sidelines. Fledgling entrepreneurs may be everywhere but innovation capital is not.

Let’s start with geographic diversity. Venture capital has a decidedly “clubby” nature: at the moment, 78 percent of venture capital flows into just three states—California, Massachusetts, and New York. The economist Richard Florida estimates that the San Francisco Bay Area alone accounts for an astounding 40 percent of all venture capital investment. For the other 47 states, it’s actually declined over the past 20 years.

The decision-makers in venture capital firms are hardly a model of diversity either. A full 95 percent of decision-makers are male, which is one reason that so few women are founding or leading high tech firms. Only 3 percent of venture capital partners are people of color. On “Main Street,” however, entrepreneurship is striking diverse. According to Kauffman, 37 percent of startups are founded by women, and 40 percent by non-whites. Indeed, the fastest growth is among Latinos, now 22 percent of new entrepreneurs.

A recent analysis of corporate boards at Silicon Valley’s 100 biggest tech firms provides striking evidence of how insular the Silicon Valley social network is. Men accounted for 87 percent of the directors and 97 percent of the, well, chairmen. Almost one-fifth of all the directors had undergraduate or graduate degrees from nearby Stanford University. Another 10 percent had gone to Harvard, with the University of California at Berkeley coming in third.

This isn’t simply an issue of fairness. It is also an issue of missed opportunities: almost any region and any industry is fertile ground for transformative innovations that foster productivity and prosperity. Indeed, some of the best start-up opportunities may well lie in the “fly-over” country of places and sectors that venture capitalists have ignored in their fixation on a handful of locations and technology fads.

Working with the Startup America alliance, the next President should highlight the venture opportunities in smaller cities and even rural communities. One important source of financing, especially for Main Street start-ups, is the Community Reinvestment Act (CRA). The CRA requires banks that gather deposits in low- or middle-income communities to reinvest some of that money in those communities. The CRA supports more than $60 billion in community finance, which is roughly equal to venture capital investing last year. Much of that investment has been in affordable housing, but it could easily be used to finance entrepreneurial start-ups and start-up accelerators in cities that are struggling to reinvent themselves.

A growing number of investment firms, drawing on CRA funding, are earning solid returns by focusing on local job creation and community revitalization. For good examples, look at the Bay Area Equity Fund in San Francisco, and Village Capital in Nashville.

Philanthropic foundations offer a second major new potential source of community-oriented venture capital. Philanthropies are required to donate 5 percent of their assets to charitable causes each year, and they did indeed channel $52 billion to such efforts in 2012. But the vast remaining bulk of their endowments go into traditional investments aimed at generating enough returns to expand their capital bases.

Fledging entrepreneurs may be everywhere but innovation capital is not.

The untapped opportunity here is in what are known as Program-Related Investments and Mission-Related Investments. These are investments that have a philanthropic purpose but also offer financial returns. The Obama administration has already helped, clarifying and broadening the definition of what the IRS will accept as a credible Program-Related investment. The next President could do considerably more, giving Program-Related Investments the same regulatory clarity that grants to nonprofits currently have. (A bipartisan bill proposing just this, the Philanthropic Facilitation Act, is currently on the House floor.)

The next President should also spur a broad re-examination of regulations, scouring them for intentional or unintentional biases that favor incumbents over new entrants. A number of states, including Utah and Virginia, as well as cities such as San Francisco and New York City, have taken a deep review of the challenge of starting new ventures in order to streamline their permitting and approval processes.

The next President should also help entrepreneurs take advantage of one of government’s biggest assets: data. With a more open data policy, government information—gathered with taxpayer dollars—in heavily regulated sectors like healthcare, education, government technology procurement, and permitting processes has huge potential for innovation and process redesign that could be enabled by open data. Governments at all levels in the United States procure $3 trillion a year from the private sector and utilizing that purchasing power for innovation is a huge lever. The federal government has taken major steps in the last several years to encourage more opening of data, but it can do much more to leverage its purchasing power to open up more state and local data and combining it in new ways, as it has most notably in GPS, opening satellite data to help enable products like Google Maps and Waze.

Let’s return briefly to health care. For many people, one of the biggest barriers to launching out as an entrepreneur—or as a self-employed contractor—is the loss of employer-based benefits. The Affordable Care Act made it easier for people to leave their employer and keep their access to health insurance. The next step is to further de-couple pension benefits from regular employment arrangements to ensure that people in “alternate work arrangements,”—including independent contractors and those working in the “gig economy,” such as drivers for Uber, or specialized service providers for TaskRabbit—can earn the same kinds of pension benefits as workers on standard employment contracts at least on a pro rata basis. Indeed, a broad array of business leaders and policy experts in both political parties recently came out in strong support for policies to encourage exactly this kind of benefit support to the growing number of Americans in the demand economy.

According to a recent study, during the last decade the increase in the number of Americans working in alternate work arrangements exceeded the increase in total employment—meaning that there was a net decline in the number of workers with conventional jobs.

In the United States, the social contract has long relied on conventional job arrangements in which, in exchange for workers’ labor, employers deliver unemployment insurance, disability insurance, pensions and retirement plans, worker’s compensation for job-related injuries, paid time off, and protections under the Fair Labor Standards Act. And even after the passage of the Affordable Care Act, most workers continue to receive health insurance through their employers. Under the next President, the social contract will have to be modernized both to foster more entrepreneurship on Main Street and to provide access to benefits to the growing number of workers earning their livelihoods in alternate work arrangements.

Finally, the next President should relentlessly reinforce the value of global openness access to markets and people. Fifty one percent of the fastest growing new ventures were founded by immigrants and 40 percent of science and engineerining PhDs in America’s top universities were born outside the United States.

The United States is the biggest beneficiary of an open global market, and we shouldn’t take it for granted. The backlash against trade and immigration is growing. To stem the backlash, the next President needs to address the dislocation costs of those disadvantaged by trade while reinforcing its net benefits to the country as a whole.

As the economic recovery continues, the opportunities for entrepreneurs are expanding. But overall the pace of start-up activity remains tepid. And support for entrepreneurs remains amazingly concentrated in a few geographies, sectors and demographic groups. Unleashing the next wave of entrepreneurial activity should be a priority for the new President; entrepreneurship is a key ingredient of the American dream.

From the Symposium

Unfinished Business

The economy's made halting progress, but the recovery's leaving too many behind. A series of contributors take stock of where we've come in one part of the economy, and what's left to be done. E.J. Dionne Jr. introduces the symposiumDavid Cay Johnston on TaxesMehrsa Baradaran on Banks Caroline Fredrickson on Families Lenny Mendonca & Laura Tyson on Entrepreneurs Adam Zurofsky on Corporations Amy B. Dean on Workers


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Read more about Affordable Care ActentrepreneurshipSilicon Valleystart-ups

Lenny Mendonca is a Senior Fellow at the Presidio Institute and a former director of McKinsey & Co.

Laura Tyson is a former chair of the President’s Council of Economic Advisors and a professor at the Haas School of Business at the University of California at Berkeley.

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