10 Mar 2008  Research & Ideas

Encouraging Entrepreneurs: Lessons for Government Policy

Who you know and how much money is in your pocket have always been significant contributors to entrepreneurial success. New research by Harvard Business School professor Ramana Nanda explores new wrinkles in this age-old formula—and how government policy may impact entrepreneurship. Key concepts include:

  • Policymakers can benefit from understanding how peer networks and the financing environment impact the kinds of people who become entrepreneurs.
  • People with a higher fraction of co-workers who have been entrepreneurs are more likely to try it themselves. Moreover, peer effects substitute for an individual's own background—those whose parents have been entrepreneurs benefit less from exposure to entrepreneurial peers.
  • Not everyone who wants money to start a new business necessarily deserves it. Wealthy people are often able to start inadvisable businesses because they don't need to undergo the reality check of an investor's approval for funding.

 

It's common wisdom: When it comes to starting a new business, it matters who you know and how much money you have.

But research into the inspiration and success of entrepreneurs has not delved very deeply into why this is so. Does it matter whether who you know are themselves entrepreneurs? Does it matter where and at what price the money to fund an entrepreneurial venture comes from?

The answer, it turns out, is that it does matter—a fact that policymakers may benefit from

understanding as they look at ways to generate more entrepreneurial activity that boosts the economy and increases local, regional, and national competitiveness.

"Former entrepreneurs offer a positive impression of what it's like to own your own business."

In recent research, Harvard Business School professor Ramana Nanda analyzes these deeper layers of entrepreneurship. In "Peer Effects and Entrepreneurship," a working paper coauthored with Jesper B. Sørensen of Stanford University's Graduate School of Business, Nanda examines the question of whether a person is more likely to pursue an entrepreneurial activity if some of his or her coworkers have experience as entrepreneurs.

In a second working paper, "Cost of External Finance and Selection into Entrepreneurship," Nanda looks at how entrepreneurial activity is affected across various groups of individuals when a tax reform increases the cost of financing a business.

The tug of entrepreneurs

The research on peer effects emerged from a growing academic interest in the influence of social networks on entrepreneurial successes and failures, Nanda says. As an example, he cites Regional Advantage: Culture and Competition in Silicon Valley and Route 128, a 1994 book by AnnaLee Saxenian that examines contributing factors behind the differing results of high-tech companies started in Silicon Valley and Boston's Route 128 loop.

What is different about Nanda's work is that it's some of the first research to go beyond the regional level to consider peer effects within a firm.

Using a rich dataset that monitors individuals in the Danish labor market across time (the data tracks when a person enters a company and when he or she moves between periods of employment and self-employment), Nanda and Sørensen found that rates of entrepreneurship are higher in organizations where a greater number of coworkers are former entrepreneurs.

"A certain efficiency exists in the market when it comes to which businesses get off the ground."

"Thanks to this unusually detailed data, we can determine for each individual what fraction of their colleagues were entrepreneurs in the past," says Nanda, adding that Denmark was also an ideal choice for the study because its labor market shares many of the same characteristics as those found in the United States and the United Kingdom.

"Aside from being a source of ideas and opportunities, these former entrepreneurs offer a positive impression of what it's like to own your own business—even if that business may have failed."

Nanda and Sørensen control for the possibility that former and aspiring entrepreneurs are more likely to cluster together at a company with an entrepreneurial culture, demonstrating that the positive association between the number of former entrepreneurs and the higher levels of entrepreneurial activity continues to hold.

"A peer's experience can substitute for a worker's own past," Nanda says. "We find that this influence is diminished, however, when a person has been exposed to entrepreneurship because one or both of their parents owned a business when they were growing up. So we can see that there's an influencing mechanism at play here, and that there's a substitute for it as well."

Follow the money

The distinctions are a bit more subtle when considering the effects of external finance on who starts a business and who doesn't.

Nanda also uses Danish data for his second working paper, exploring a tax reform introduced in 1987 that made the cost of external finance significantly more expensive for entrepreneurs in the middle- to higher-level tax brackets (previous studies showed that in developed countries, wealthier individuals are more likely to become entrepreneurs).

As one would expect, the entry rates into entrepreneurship fell for those individuals who faced an increase in the cost of external finance. Digging down another level, however, produced some surprising findings: The highest number (50 percent) of people adversely affected by the tax reform were high wealth individuals who had low levels of human capital. In other words, these would-be entrepreneurs lacked the skills, experience, and people power so essential to the launch of a successful business.

"Not everyone who wants the money to start a business necessarily deserves it."

The second-largest adversely affected group, at 40 percent, were low wealth, low human capital individuals. Least affected, at 10 percent, were underfunded individuals with high levels of human capital. (High wealth, high human capital individuals were virtually unaffected.)

These numbers should be of interest to policymakers in developed countries, Nanda says.

"This goes against the conventional wisdom held in government policy circles and elsewhere that there are a large number of talented people lacking in personal wealth who can't start a new business because they don't have access to capital," says Nanda.

"Yes, it's a real problem that we do in fact have this 10 percent of low wealth, high human capital individuals who are unable to launch a new venture," he continues. "That's the group the Small Business Administration should be targeting with subsidies.

"My point is that not everyone who wants the money to start a business necessarily deserves it; and that wealthy people are often able to start inadvisable businesses because they don't need to undergo the reality check of a bank's approval for funding. The natural experiment created by this tax reform shows that, contrary to popular belief, a certain efficiency exists in the market when it comes to which businesses get off the ground and which don't."

Examining government policy

Nanda notes that much of his work is broadly connected to government policy in relation to economic development and entrepreneurial activity.

"In the peer effects paper, we see that policies that may encourage one person to become an entrepreneur have knock-on effects that go beyond that one individual, which in turn can influence overall economic activity," he says.

Meanwhile, the finance paper shows that a straightforward government policy of providing cheap credit for any and all new ventures may not be the most efficient use of taxpayer dollars.

"There are different ways that governments can try to spur entrepreneurial activity," Nanda remarks. "Each approach has its own costs and benefits, whether it's a direct subsidy, a loan guarantee program, or a venture capital model where the government is a direct investor."

In the future, Nanda hopes to find a situation where a government would randomize its funding of businesses so that he could study the outcome. "That's truly how to find out what does and does not work in a given environment," he says.

Julia Hanna is associate editor of the HBS Alumni Bulletin.