Fostering Entrepreneurship: Promoting Founding or Funding?

Everybody loves Silicon Valley. Imitations can be found worldwide: Silicon Forest (Oregon), Swamp (Florida), Gorge (UK), Glen (Scotland), Fjord (Norway), Wadi (Israel), Savannah (Kenya), and many more. Policy makers, in particular, are eager to foster entrepreneurial ecosystems by promoting entrepreneurship, with the hope to foster economic growth, employment, and innovation. However, very different approaches can be taken by governments to achieve these goals. The questions becomes how to foster entrepreneurship?

Some policy makers focus on encouraging more founding, facilitating entry into entrepreneurship, and promoting firm formation. Such policies come in a wide variety of forms, such as training, access to mentoring and expertise, or a reduction of bureaucratic red tape. In the US, the Small Business Administration (SBA) offers a large variety of training programs for entrepreneurs, and the I-Corps program of the National Science Foundation (NSF) provides entrepreneurship training for scientists and engineers. A very different set of policies focuses on supporting the funding of entrepreneurial ventures. These policies use a variety of methods to encourage investors to channel more funding into start-ups. In the US, the SBIC program supports the funding of early-stage start-ups, and according to the Angel Capital Association, more than half of all US states have some tax credits for angel investing.

In this paper we raise the fundamental question of how different entrepreneurship policies compare in terms of their impact on entrepreneurial ecosystems. We tackle this question with a formal theory model that derives and contrasts the equilibrium impact of different government policies. Specifically we ask how different policies promote entrepreneurial activity, distinguishing between (i) founding policies that affect what is often called the `demand-side', i.e., the number of entrepreneurs demanding capital, versus (ii) funding policies that affect the supply of funds to new ventures.

Our analysis acknowledges that the financing of entrepreneurial ventures is different from standard financial investments and requires `smart money'. Specifically it requires tacit knowledge about the entrepreneurial process that is mostly acquired by going through the entrepreneurial process itself. We view so-called `angel' investing as the natural process by which experienced entrepreneurs pass on their knowledge to the next generation of entrepreneurs. In practice, the first check of successful start-ups often comes from angel investors who were successful entrepreneurs before: think of Andy Bechtolsheim, co-founder of Sun Microsytems, who wrote the first check for Google, or Peter Thiel, co-founder of PayPal, who wrote the first check for Facebook. Our model therefore accounts for the accumulation of expertise in an entrepreneurial ecosystem. Early in their career entrepreneurs start new ventures that may succeed or fail. Successful entrepreneurs accumulate both the expertise and the wealth to then fund the next generation of entrepreneurs. This creates dynamic interlinkages between generations of entrepreneurs, where the supply of angel capital is a function of the number of past entrepreneurs and the wealth they accumulated.

Promoting entrepreneurship is not a short term endeavor. Silicon Valley took decades to become what it is today. Imitators had to learn how long it takes to create an entrepreneurial ecosystem. Our dynamic model allows us to examine both the short term and the long term impacts of entrepreneurial policies. We first establish several important benchmark results in a model without intergenerational linkages. Comparable levels of founding and funding subsidies generate the same increase in entrepreneurial activity. However, founding policies create a competitive dynamic where more entrepreneurs seek a limited supply of funds, resulting in less favorable investment terms for entrepreneurs, i.e., lower valuations. By contrast, funding policies create a more abundant supply of capital which results in more favorable investment terms for entrepreneurs, i.e. higher valuations. We then introduce intergenerational linkages and show that the differences in valuations have important dynamic implications. This is because the wealth created by one generation of entrepreneurs determines the supply of angel capital for the next generation of entrepreneurs. A central finding is that for increasing entrepreneurial activity, funding subsidies are more effective than founding subsidies.

Our model also generates some interesting predictions about the dynamic path of entrepreneurial ecosystems. While there is always a unique equilibrium in every period, the model with intergenerational linkages can have multiple steady state equilibria. In the low (high) steady state equilibrium the lack (abundance) of entrepreneurial activity prevents (enables) the formation of angel capital for future generations, thus perpetuating the low (high) level of entrepreneurial activity. We show that even in the high steady state equilibrium there is too little entrepreneurial activity relative to the first best outcome. This is because future entrepreneurs benefit from the wealth of earlier generations, but this intergenerational externality is not taken into account by investors when striking a deal with entrepreneurs. In the low equilibrium there is an additional rationale for government support, namely to provide temporary subsidies to lift the economy above a critical threshold, beyond which there is a self-sustaining dynamic path toward the high equilibrium.

We extensively discuss the implications from our model for entrepreneurship policies, looking first at how policies affect a single ecosystem in isolation, and then looking at `open economy' issues that allow for capital and labor mobility across ecosystems. It is also worth noting that our model suggests a societal benefit to having wealthy entrepreneurs, and a benefit of giving tax credits to `already-rich' angel investors. At first sight this argument runs contrary to Piketty's famous argument about the harms of wealth inequality. However, our model does not suggest a blanket tax-exemption for the rich. Instead our argument is to create effective channels for rich entrepreneurs to reinvest their wealth (and their expertise) into the next generation of poor entrepreneurs. As such our argument focuses on creating a channel for social mobility.