There’s an excellent post from John Robertson of the Atlanta Fed on employment, new businesses, and how they finance themselves. The long and the short of it is that new businesses provide a remarkable proportion of the new employment, maintaining a “pipeline” of them is vital to the economy, and they tend not to finance themselves using bank credit.
The rate of new business formation has declined notably over the last twenty years. I suspect that’s due to some combination of a change in generational attitudes, large established firms tightening their hold on the economy, the closing or at least narrowing of the business frontiers, and general discouragement with the economic climate.
The lower rate of new business formation can’t be attributed solely to low demand. It’s been going on for at least three decades. Dr, Robertson’s post suggests that the most recent policy approaches, which have largely been concentrated on demand and financial strategies, are unlikely to be effective.
“they tend not to finance themselves using bank credit.”
I’d read that someplace else. Credit cards, savings, family, friends. It struck me that in most of those cases they began assuming that no bank would lend them money. In that I’d guess they were certainly right. That’s really what being an entrepreneur means, no? Just jump in and take a chance. And I’d not be surprised at all if the last thing on their minds was mean, old regulations. (BTW, on entrepreneurship, see, Moving to U.S. and Amassing a Fortune, No English Needed. The children, of course, are bilingual. )
Regulation may be more significant than you might think, sam. Registration, certification, licensing, patents, and copyrights all fall under the heading of regulation.
I didn’t mean to imply that there is no regulation, only that I’d bet for those folks, regulations didn’t figure into the go/no-go calculus. Didn’t count as an impediment.
The survey being described by the Atlanta Fed indicates that the younger, smaller firms are being denied access to credit:
“Firms under six years old submitted more applications
for credit on average, and applied to a larger
variety of lenders.”
“In the third quarter of 2011, 17 firms sought loans backed by the Small Business Administration. Of these, 16 were either denied or
the borrower refused the loan due to unattractive terms, and one firm received some of the credit requested.”
“One-fourth of applying firms received no credit, and 17 percent received substantially less than the amount requested over all their applications for credit. Firms in this group were much younger on
average than were firms who received most of or the full amount requested. Firms in this group were also likelier to say that their credit score, lack of equity in real estate, personal wealth/investment loss, or too few years in operation was affecting their ability to obtain credit.”
“The stricter credit standards prevalent in today’s lending market appear to be affecting the way startups are financed. Using personal savings for initial capital has become a much more common way to start a business in the past few years. Two-thirds of
firms less than six years old used personal credit to start their business compared with only half of mature firms.”
What’s the deal with the SBA? Small sample and all, its a tool that doesn’t appear to be working here.
Most start-ups are financed by equity, either the entrepreneur’s money or angel investors – the proverbial pass the hat. These businesses are just not creditworthy, or cash flow negative. Later they become candidates for asset based financing, generally with guarantees.
Interestingly, middle market LBO financing its as red hot as ever, with 3/4+ deals getting done all the time.
This is why the Entrepreneur Access to Capital Act is so important. As a “small time” investor (less than 1 million in investable assets outside of retirement accounts) I’m mostly limited to public companies. Good growth public companies are becoming shorter and shorter in supply because of the onerous rules involved in going public.
I know Drew is alluding to lowering income taxes on the likes of him, but I wonder if some simple changes to allow some of us “small timers” to get into the private investment world would be more beneficial. Lower personal income taxes that would probably just increase consumption among the rich since we’re talking capital gains on investment anyway.
link:
http://marginalrevolution.com/marginalrevolution/2011/11/all-hail-mike-mandel.html
There’s actually a new company that’s doing something that might present a creative alternative for doing this. Sort of an eBay for investors and companies. The traditional routes aren’t the only ones, maybe not even the best ones. One of the areas in which the Internet has the most promise is disintermediation.
However, I think this discussion has digressed a bit. What has changed over the period of the last 20-30 years that would result in a lower rate of new business formation? I don’t think it’s less access to capital.
Sam –
All of our prior funds have had a portion of the committed capital provided by individuals – so called “accredited investors.” Historically, private equity has operated under the 1940 investment advisors act.
Dodd Frank is now making this a much more difficult task, and it has nothing to do with tax rates. Instead, it creates SEC style disclosure provisions and the potential for disgruntled investors to make complaints that will retard PE firms from accepting individuals.
There are people, including some who comment here, who think Dodd Frank is just fine. But they don’t have a clue what they are talking about or what is in the regulations. Your lament is a classic example of how regulations – intended to punish the Big Guy – end up hurting The Little Guy. Yet I’m sure Mr. Dodd and Mr. Frank will have dinner at the Palm tonight while feeling good about themselves…………even as they have just hosed you.
“What has changed over the period of the last 20-30 years that would result in a lower rate of new business formation? I don’t think it’s less access to capital.”
I think that is directionally correct. At least through 2008 there was plenty of capital. Its tightened since, but not to the point of choking off businesses.
I know that my views on what has changed will not be generally accepted by commenters here. But regulatory burden and litigation concerns, as well as the cost to employ are very significant factors. I live it every day.
Those who deny this generally cite something like Facebook and state “I don’t think they cared about regulations….” That example is one in a million. But back in the real world, its become a terrible problem. Just as in my Dodd Frank citation above, you can deny it all you want, but its the Little Guy getting hosed.
I know I’ve said it before, but “The Millionaire Next Door” tells me that successful, growing businesses have owners that realize very little income as a percentage of their overall wealth – and most started out poor and grew a business out of necessity. Being very frugal is rare, but rarer still the more government subsidizes consumption. Combine this with less incentive to move out of the lowest income quintiles out of necessity and I think you have a good chunk of your answer.
Another distorting incentive is health care. If I were to leave my cushy, well paying job with government subsidized health insurance to start a business, I’d have to pony up over 12k a year for minimal family coverage while I built up my business income. I’ll stay in the cushy daytime gig, thanks.
I suspect ObamaCare’s official start will see more business start-ups, not less.
Prior to Dodd-Frank it was impossible for me to be an equity investor in any non-public company except the one I’m working for. After Dodd-Frank, it’s still true.
I know you’re talking about restricted access to “accredited investors” but I think a bigger problem is that private equity investment is limited to them in the first place.
I’m somewhere in the high 80s percentile for wealth, probably well into the 90’s for people my age, but I can’t invest in a private company?? Not even 30 bucks??
As a for instance, here in the Phoenix real estate market, houses are very cheap to buy, but rental prices are holding up fine.
The only problems are I don’t really want to spend the time looking for a fantastic deal, I have no interest in being a landlord, I’m debt averse, and while I could scrape together the cash to buy a 100k house, it’s not an amount I’m comfortable having all in one asset.
But I would gladly invest in someone, along with a bunch of other equity investors, who knew what they were doing to buy up and rent out 10 properties. Dodd-Frank or not, the Entrepreneur Access to Capital Act could make that a possibility.
Sam –
“Prior to Dodd-Frank it was impossible for me to be an equity investor in any non-public company except the one I’m working for. After Dodd-Frank, it’s still true.”
No, that’s not true. There have been any number of individual oriented “fund-of- funds” that had access to private equity. The usual concern about small private investors is that they are a pain in the ass. Big institutions who invest $10MM – $50MM have lawyers and a level of sophistication that minimizes administrative costs. What Dodd Frank has done is create a potential feast for disgruntled individual investor whistleblowers, who, well, are just not sophisticated investors.
In reading the thread above my first thoughts were the effects of the Dodd/Frank Banking Regulation Bill. It’s already been mentioned in above posts. However, here is an except from an article entitled Small businesses not celebrating Dodd-Franks Birthday.
While Sam appears to hold optimism for the effects of Obamacare, as it relates to startups….
I would tend to predict just the opposite.
Great question, especially given the social changes in the last 30 years. Women are more able to start businesses; people generally are marrying later and having fewer children. Both those would seem to make starting a business easier.
I suspect the reasons are those given in your post.
“The lower rate of new business formation can’t be attributed solely to low demand. It’s been going on for at least three decades.”
Two points:
1) Demand has been falling further and further behind for the last thirty years because wages have not kept pace with productivity growth. In fact the difference in wages and productivity is by definition a measure of economic underperformance.
2) An ever-worsening trade deficit has, all on its own, drained significant demand from our economy over that same period.
My suggestion: a massive tax cut across the board, but primarily focused on the middle class and poor. The increased budget deficit will accelerate the private sector’s healing process and lay the groundwork for increased demand once we climb out of this mess. Spending increases would accomplish the same thing, but I can’t see how it would be possible in this political climate.
“The rate of new business formation has declined notably over the last twenty years.”
Health care costs should be among the primary reasons. You take a real gamble when you leave a company to go out on your own if you have any kind of medical condition. You may not be able to get insurance or the cost may be prohibitive. The ACA should greatly reduce the cost for individual insurance and for businesses with less than 50 workers.
With wealth concentrated into the hands of fewer people, fewer people can finance their start up through family and friends. If we are going to concentrate income and wealth among a relatively few job creators, they had best be very good about creating those jobs. I think this also plays out in a cultural change. As kids fail to have role models who have been entrepreneurs, they no longer see themselves in that role.
Steve
That was something I was wondering about. If there are fewer entrepreneurs, then there are also fewer mentors.