Founders, Family, Friends, and Fools
By William D. Bygrave
U.S. entrepreneurs are the engines that drive new companies -- and financing is the fuel that propels them. That's the findings of the most recent report of the Global Entrepreneurship Monitor (GEM), which shows a rise in U.S. entrepreneurial activity in 2003 after a two-year decline. New business startups increased from 10.5% in 2002 to 11.9% in 2003.
One of the most striking findings of the GEM report is the source of that fuel. Informal investors put up more money for startups and growing businesses than professional venture-capital firms. Indeed, informal investors are the lifeblood of U.S. entrepreneurship. If informal investors -- whom I call the 4Fs -- founders, family, friends, and foolhardy strangers -- dried up, entrepreneurship in the U.S. would wither.
PORTRAIT IN PROFILE.
In 2003, informal investors provided more than $100 billion to 3.5 million startups and small businesses. Formal venture capitalists invested only $304 million in seed and startup stage companies in 2002 -- the smallest amount invested in these types of companies since 1981. Most VC money went to expansion and later-stage businesses.
What else do we know about informal investors? GEM found that:
• Almost 5 in every 100 adults report that they have invested in someone else's private business in the last three years.
• Entrepreneurs and small-business owners are four times more likely than nonentrepreneurs/small-business owners to be informal investors.
• The more education that persons have, the more likely are they to be informal investors.
• Male informal investors are twice as prevalent as female informal investors, and they invest larger amounts of money.
• More than 50 % of all informal investments are made in relatives' businesses.
In the U.S. and most developed nations, venture capitalists receive a disproportionate amount of attention from policy makers, whereas informal investors are almost ignored. Governments at all levels need to work to provide an environment in which the entrepreneurial spirit may flourish.
THE TAX CURSE.
Money for informal investing comes from after-tax income and savings, which more often than not are accumulated from after-tax income.
Thus, it seems reasonable to hypothesize -- and the GEM findings confirm this -- that high tax rates inhibit informal investing. It's time that Washington paid as much attention to informal investors as it pays to venture capitalists. After all, if informal investment dried up, entrepreneurship would wither. However, as we have seen since the Internet crash of 2000, venture capital for seed-stage companies can slow to a trickle, but entrepreneurship still flourishes.
Note: The 2003 Global Entrepreneurship Monitor (GEM) was conducted by researchers at Babson College, who compiled the data from a study on entrepreneurial activity around the globe. The study was sponsored by the Ewing Marion Kauffman Foundation of Kansas City. A copy of the report is available at gemconsortium.org or www.kauffman.org
Bygrave is the Frederic C. Hamilton Chair for Free Enterprise Studies at Babson College, Wellesley, Mass. He was the 2003 GEM report's lead researcher.