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Entrepreneurship: What’s in a Name?

Wednesday, April 7, 2010

There is a long-running dispute over who constitute ‘real’ entrepreneurs. It is important we understand their importance.

At the University of Miami a few weeks ago, I had the opportunity to attend an entrepreneurship class with roughly 40 students. Most of them were juniors and seniors, joined by a small number of law students. The course had so far covered the theoretical literature on entrepreneurship, but on this particular day all the students wanted to talk about was their own futures.

Studying entrepreneurship in the midst of a severe recession and stumbling recovery, and in the months leading up to graduation, has made these students acutely aware that their own economic futures may not be entirely secure. Make no mistake: jobs are front and center in students’ minds. Both the Obama administration and the Federal Reserve expect the unemployment rate to remain at relatively high levels for the next few years, falling from the present 9.7 percent to around 8 percent by the end of 2012.

New companies create a vastly disproportionate share of new jobs in the United States and, according to William Baumol, also account for an outstanding share of breakthrough innovations.

The students, however, know that unemployment has not fallen uniformly across the American economy—particularly hard hit have been middle-aged men, young black men, and people in their 20s. The prospects for college and university graduates over the next few years are dimmer than they have been in years, and the number of job seekers will only grow, adding further pressure to the economic recovery. Over the past two years, institutions of higher education in the United States have welcomed the two largest matriculating classes in history, meaning that in four or five years, even as we return to positive rates of job creation, we will have a flood of new labor market entrants looking for jobs.

This is not all bad news, of course: the U.S. economy has a remarkable record of job creation, and new workers can be an important source of ideas and innovations for companies. Yet the current employment situation seems daunting: nearly 15 million Americans were unemployed in early 2010 and millions more are “underemployed,” meaning they are only marginally attached to the labor force or have been forced into part-time work for economic reasons. The broader underemployment rate, in fact, is at historically high levels of 17 percent. Add to this the steady stream of labor market entrants, and the economy needs to generate new jobs at a pace seen only a few times in American history.

Where will these jobs come from? Policy makers have been trying all sorts of ideas, from a payroll tax exemption for those companies that hire currently unemployed workers to more federal funding of things like highway construction. Only time will tell if such programs work, but these and other ideas fail to address what has always been the primary source of new American jobs: entrepreneurship. New companies have historically been the engine of economic growth, producing innovative products and services and accounting for nearly all net job creation.

The broader underemployment rate, in fact, is at historically high levels of 17 percent. Add to this the steady stream of labor market entrants, and the economy needs to generate new jobs at a pace seen only a few times in American history.

The importance of entrepreneurs is not lost on policy makers in Washington and state capitals, but too often people see “entrepreneurship” through the narrow lens of, on one hand, venture capital and, on the other, small business or self-employment. There is evidently some confusion as to what exactly an entrepreneur is and whether certain types of entrepreneurs are more or less important than others. This is not an obscure methodological dispute best left to academic seminars. For the large population of unemployed, for students soon to enter the labor market, and for lawmakers keen to craft job-creating policies, it is a critical imperative. If we cannot understand the phenomenon we are seeking to promote—entrepreneurship—we may end up doing more harm than good.

'Real' Entrepreneurs: Small Business? Self-Employed? Something Else?

The long-running dispute over what constitutes a “real” entrepreneur—and, consequently, how to measure the level of entrepreneurship—can swing from one extreme to the other. At one end stand those who confine entrepreneurship to the small fraction of companies that receive venture capital financing. So if 600,000 new firms start in a year, and if less than 1 percent of those receive venture capital, than we only saw a few thousand entrepreneurs come into existence. This insults hundreds of thousands of people starting new companies, as it basically sends a degrading message to the new coffee shop or boutique clothing store on the corner: you don’t matter to the economy.

There is evidently some confusion as to what exactly an entrepreneur is and whether certain types of entrepreneurs are more or less important than others.

At the other extreme, many analysts equate entrepreneurship with either small business or self-employment. While it’s true that all new firms start small, it’s not true that a new startup or two-year-old company will be equivalent to a 25-year-old company even though they have the same number of employees. As economist John Haltiwanger has pointed out, a more precise distinction in discussing entrepreneurship is one of age, rather than size.

Self-employment, too, can be a misleading proxy for entrepreneurship. The self-employed are clearly important to the economy because they represent individual attempts to shape personal futures and can be an important source of fluidity in allocating time and resources. Yet there are two problems in equating self-employment and entrepreneurship: the first is that self-employment generally does not establish businesses that grow in terms of adding jobs.

The second has to do with measurement: the data collected and reported for self-employment offer only a static picture. The government reports only the absolute number of self-employed people in any given year, so we have no sense of the inflows and outflows in this population. Using self-employment data, we can purport to find that “entrepreneurship” in the United States is on the wane, simply by dividing self-employment by population:

 Stangler1

According to this chart, entrepreneurship as self-employment fell steeply through the 1950s and 1960s, recovered somewhat over the next two decades, but has since resumed a general decline. Again, this provides no sense of the number of people moving in and out of self-employment—there is, in other words, no dimension of dynamism to this measurement. It also misses the large number of people who start new companies (“employer firms” in the data parlance) and so are classified as employees of their own company. Like the venture capital view, self-employment is a narrow proxy for entrepreneurship.

One way to resolve the tension between these two extreme and unsatisfactory views of entrepreneurship is to split the difference and look only at the number of actual new companies that are started each year. This has advantages and disadvantages. For one thing, when people speak generally about entrepreneurship, they usually have in their mind someone who has founded and built a firm: Bill Gates built Microsoft, Mark Zuckerberg built Facebook, Henry Ford built Ford Motor. Firms are at the heart of economic activity; they are the central mechanism by which resources (labor, capital, technology) are put to economically productive use. At the most basic level, then, entrepreneurship means firm formation.

Economist William Baumol has shown that even if the rate at which the United States generated innovations were to remain flat, the economy would actually continue to expand at a growing pace because of the very nature of innovation, in which each innovation makes subsequent innovations more effective, and the benefits of innovations leak away from their originators.

This is imperfect, of course. We probably all know individuals whom we could call entrepreneurs but who haven’t officially incorporated a business because it is currently their side project. Similarly, there is a large population of “nonemployer firms” in the United States, companies that have yet to hire anyone beyond the founder. The universe of nonemployer firms, in fact, is nearly four times as large as that of employer firms and, in any given year roughly one-third of new startups emerge from the world of nonemployers. As with self-employment, however, the data don’t allow us to see the in-and-out dynamism of these firms and, if we’re interested in new job creation, nonemployers by definition contribute only a fraction.

It should be apparent that one of the great difficulties in researching entrepreneurship and attempting to design policies to promote it is the frustrating lack of precise measurement and uneven comparability across datasets. There remains a great deal of research to be done not only on new companies but also on the interactions between employer firms, nonemployer firms, and the self-employed. But economists at the U.S. Census Bureau have recently done a heroic job of assembling a dataset, the Business Dynamics Statistics, that captures the annual number of new firms that enter the American economy. Again, this only captures officially founded new firms, but if we place firms at the heart of economic activity, then this is a good place to start in terms of looking for entrepreneurs.

Entrepreneurship Trends

Above we showed a chart that seemed to indicate declining entrepreneurship but, as noted, this captures only the fixed number of self-employed, not the number of newly self-employed per year. Self-employment, moreover, is only one dimension of the world of entrepreneurship. Let’s look instead at what the Census Bureau has found in terms of actual new firms. Here, for example, is the annual number of new firms created in the United States over nearly the past 30 years:

 Stangler2

Remarkably, the number of new firms started in the United States varies little from year to year. This, of course, is an absolute level, and says nothing about the pace at which new companies are created. Next, we’ll look at the creation rates for not only unique new firms (“startups”) but also establishments, which includes new firms as well as new locations of existing companies, such as a new Wal-Mart store. (For example, Wal-Mart Inc. is a firm. Each Wal-Mart store, however, is a separate establishment. So Wal-Mart is one firm with thousands of establishments. This often skews discussion, but the establishment-to-firm ratio in the United States is 1.26. It cannot fall below one, since every firm has at least one establishment; this means that for every 100 unique firms in the United States, there are 126 establishments, so most of the companies included in the establishment data below are unique companies.)

 Stangler3

Here we see that the rate at which new businesses are created fluctuates mildly—and while there does seem to have been a decrease from the 1980s to the 1990s, for the last 20 years new business creation rates have been mostly flat, neither increasing or decreasing much. These rates, however, may still tell an incomplete story if they aren’t measured against population growth (rather than the universe of existing companies). Since the self-employment per capita trend was downward, perhaps new business creation per capita is also declining?

 Stangler4

This chart includes both prior measures of new business creation (startups and establishments from the Census Bureau), as well as data on new establishments from the Bureau of Labor Statistics and employer firms from the Small Business Administration. Each line tracks the per capita level of new businesses over time. As we can see, rather than a steady downward (or upward) trend, entrepreneurship in the United States appears to be a relatively constant phenomenon.

Some may view this as bad news: if new firm formation in the United States is flat, then that must mean our economy is either standing still or moving backwards! If we’re not getting any more entrepreneurial, how will the economy continue to grow? Such constancy, however, is little cause for concern. Economist William Baumol has shown that even if the rate at which the United States generated innovations were to remain flat, the economy would actually continue to expand at a growing pace because of the very nature of innovation, in which each innovation makes subsequent innovations more effective, and the benefits of innovations leak away from their originators. If we assume that the constant level of firm formation implies some constant level of innovation (because a number of those entrepreneurs will either be bringing forth new innovations or instigating innovation in other companies), then we can be assured that flat entrepreneurship rates do not automatically suggest economic decline.

One indicator of this is the pace at which new companies create jobs:

 Stangler5

Without new companies, net job creation in the U.S. economy would be positive in only a handful of years! This is a bit redundant, of course, since new companies, when they come into existence, can only create, not destroy, jobs. This says nothing of their impact on other firms, but relative to the startup itself, jobs are added not subtracted. This dramatically reinforces the point that new companies are absolutely essential if job growth is to keep pace with labor force growth and the re-employment of unemployed workers. Importantly, too, this chart illustrates that while the absolute level of job creation from new firms is important, the pace at which they have created jobs has been steady.

Are Immigrants Entrepreneurial?

One of the most recent debates involving the future of American entrepreneurship has centered on the role of immigrants. While some research has found that immigrants contribute a disproportionate share of new companies and new jobs to the U.S. economy, other research has seemed to contradict this, finding that immigrants are no more likely to be self-employed than natives. We have already pointed out that self-employment cannot tell the entire story of entrepreneurship—in fact, measures of self-employment even disagree on the role of immigrants. Robert Fairlie, a professor at the University of California-Santa Cruz who conducts the Kauffman Index of Entrepreneurial Activity, has found a widening gap between the entrepreneurial activity of immigrant and native-born Americans, with immigrants having a rate nearly twice as high in 2008.

The debate, such as it is, around immigrant entrepreneurs cannot be resolved by glib comparisons using only self-employment data.

In a larger sense, however, we cannot understand the true economic role of immigrant entrepreneurs by simply comparing across-the-board rates of self-employment. This is because immigrants are not evenly distributed across the United States: some regions have a much higher population of foreign-born residents than others. In California, for example, more than one-quarter of the population is foreign-born; in New York City, it’s more than one-third. By contrast, in Montana and Iowa, the percentages are 2 and 4, respectively. And, because immigrants move to these regions for different reasons, we would expect economic activity to be similarly differentiated. There might be higher rates of immigrant entrepreneurship, for example, in areas with more immigrants than in places where a smaller number of immigrants are specifically recruited to work in large, existing companies.

The sectoral patterns of economic activity, too, are not uniform in terms of immigrants. Many immigrants come to the United States to study or work in high-skilled jobs—they will naturally tend to cluster in areas with universities and high-skilled sectors. A recent paper, in fact, finds that immigrant students are more likely to start companies than native-born students. Ongoing research led by Vivek Wadhwa, moreover, has found that immigrants accounted for one-quarter of all technology and engineering companies started in the United States between 1995 and 2005. In some regions, such as Silicon Valley, they accounted for half of such companies, and of the ten “tech centers” examined by Wadhwa’s team, immigrants had a higher-than-average startup rate in all but two.

Entrepreneurship remains a phenomenon not totally understood by economists and others and that remains largely resistant to generalizations.

None of this means that immigrant entrepreneurs are somehow “better” than native-born entrepreneurs, or that native-born entrepreneurs are any less important. Part of this is self-selection—those who immigrate to the United States, whether for work or study, have already selected themselves out of their country’s population and exhibited characteristics—ambition, drive—that may make them more likely to start a company. And in the science and engineering fields, foreign-born students now account for 40 percent of doctoral degrees at American universities. Because we see a good number of companies that emerge from our research universities, it makes sense that we would see a relatively sizeable percentage of immigrant entrepreneurs in these fields. What this does mean is that the debate, such as it is, around immigrant entrepreneurs cannot be resolved by glib comparisons using only self-employment data.

The Essential Entrepreneurs

Entrepreneurship remains a phenomenon not totally understood by economists and others and that remains largely resistant to generalizations. The self-employed, the nonemployer firms, and the employer firms all exhibit different characteristics in terms of their products and services and their ambitions for growth. Entrepreneurs also differ greatly by sector: a software entrepreneur will have different interests and incentives than a restaurant entrepreneur. Immigrant entrepreneurs are important, but this importance cannot be captured by overly broad measures.

Where we can generalize about entrepreneurs, however, is in their economic importance. New companies create a vastly disproportionate share of new jobs in the United States and, according to Baumol, also account for an outstanding share of breakthrough innovations. They do this, moreover, at a remarkably steady pace, seemingly impervious to the vagaries of recession and expansion. The message for policy makers at all levels of government seems crystal clear: for more new jobs, we need more entrepreneurs.

People across the country, including students, share deep concerns about the continuing capacity of the United States economy to offer them jobs and opportunities. Some of them, however, are not waiting around for Washington to act: by some (but not all) measures, new business creation rose in the first half of 2009. A handful of those students in Miami were already running their own businesses. We need to be sure that in our understandable haste to stimulate hiring in existing companies, we don’t unintentionally dampen the abilities or incentives to start new companies.

Dane Stangler is a senior analyst at the Kauffman Foundation.

FURTHER READING: Stangler last wrote “Old and in the Fray: The Coming Entrepreneurship Boom” for THE AMERICAN. Scott Shane discussed immigrant entrepreneurs in “Give Me Your Tired, Your Poor, Your Entrepreneurs” and “From Start-up to Stop: The Recession and Entrepreneurship.” The American Enterprise Institute’s Kevin Hassett said “'Manchurian’ Obama Tries Big Plans at Worst Time,” while Roger Bate and Greg Lindsay pleaded, “Protect Us from Protectionism.”

Image by Rob Green/Bergman Group.

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