Comparison of firms births in different countries
How they are funded and how the tax system affects funding

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Funding and firm creation

Tuesday 17 May 2011, by Bernard Zimmern

Companies created by necessity and companies created by opportunity

In order to create a company, you need cash to allow the company to survive at least for the sales to balance the expenditures.

That is why most of the companies are created without employee, with minimum fixed costs. But they create few or no jobs, managing, but not all, to feed their creator. Following a categorization given by the Global Entrepreneurship Monitor (GEM), one has to distinguish companies created by necessity – created to feed the entrepreneur and his family - from companies created by opportunity - those in which an entrepreneur sees opportunities for new product or service and creates the company ... and get rich!

For 40 years, France has played the card of the companies created by necessity, because it did not know how to create companies by opportunity. This was the bad behind government initiatives such as the creation of “universal service employment check” (CESU) (created by Jean-Louis Borloo) or the Association for the Right to Economic Initiative (ADIE) of Maria Nowack which is heavily subsidized (the last report by inspection of finance on microcredit concluded that the interest rate should have been of 32% to cover the costs of the ADIE, a little better than 10 years ago where an interest rate of 100% should have been necessary [1]).

The Government itself has promoted the employment of unemployed with ACCRE programs (aid to unemployed for creating of taking over a company) and NACRE (new support for creation and business take over) (costs in 2009: 15 million euros and 75 million euros respectively).

At the end, these programs are very expensive to the budget (90 million euros in 2009) but their effect on employment is highly questionable because the number of jobs created is limited, and many of those jobs replace legitimate jobs that existed beforehand. This is because we can’t grow indefinitely services to individuals in a society, services for which these individuals do not have an expansible budget, quite the contrary (this is to be distinguished from services to businesses that had a big boom in the last 50 years because they brought a significant improvement in productivity).

The best way, followed by Germany, England and United-States, as well as several Nordic countries like Sweden, was to encourage companies created by opportunity, based on the emergence of a new product or service and which bring with them the creation of new service jobs such as catering, maintenance...

Some companies by opportunity grow from companies created by necessity, but their number is low because once a new product or service emerges, there are many competitors who rush and it is therefore essential to have the (financial) means to go fast. This is the strategy followed by Apple in terms of product.

It is therefore important to identify which companies have the means to develop from birth. As well as the amounts that were invested in these companies.

It consists in measuring the importance of the “high growth firms”.

A study on the funding of the small enterprises as defined by the European Community, shows that the small enterprises having the higher capital stock per employee at their creation have the greatest chance to grow and to become a SME the year after, that is to say to move from the class of companies having less than 50 employees to the class of companies having between 50 and 250 employees.

Funding sources

There are several funding sources for companies, even for seed capital. The table below is a GEM table identifying the source of the initial capital of United Kingdom companies:

Table 1. Sources of finance for men and women in the UK 2005
(in %)
Source of finance used
Source of finance sought but attempt unsuccessful
MEN
WOMEN
MEN
WOMEN
Friend and family
23,0
17,8
2,2
2,4
Individual investors
9,1
6,6
2,8
2,1
Unsecured bank loan
18,0
10,3
4,6
1,7
Bank overdraft
32,5
23,5
5,4
3,0
Secured non bank loan
5,7
3,5
1,8
1,2
Secure bank loan
12,8
14,0
2,8
1,6
Equity
4,9
3,5
1,9
0,8
Government grant
8,0
9,5
4,6
3,6
Credit card
17,4
15,9
Source: Adult Population Survey (weighted sample of approximately 3764 individuals), GEM UK 2005, Page24

In some countries like Germany, it seems that the initial capital needed for business creation is largely provided by banks and especially corporate banks (including Raiffesen and Volksbank), but that contribution is possible because it exists a strong link between the banks and the local industrial base, including the Mittelstand, and an innovator supported by the Mittelstand is likely to be funded. This fact is also true for more developed businesses as the equity of German firms are proportionally much lower than that of French companies, the share of long-term debt on the balance sheet being much more important. The same phenomenon exists in Japan. This was also the case in the U.S.A. before condensation in the banking system that constrained or even eliminated the risk that local banks were taking to create long term customers while giving first loans to local entrepreneurs.

In Anglo-Saxon countries and France, it seems that funding at the creation and early development of the business is assured first by the informal capital and, only when the company exists and reached a certain size, the VC (venture capital) followed by initial public offerings or other tenders.

Informal capital consists of funds from the creator and his family: FFF (Family, Friends and Fools), but also by other investors who have no prior relationship with the business creator but who were attracted as much by the hope of a long-term profit than by the contribution they can have to the success of the investment made in providing advice to the creator and using their networks. The Business Angel, a term invented in the early 80s by Professor Wetzel from the University of New Hampshire, invests near his home, generally within 100 kilometers. Tax laws have encouraged their emergence in the USA and Great Britain but by limiting their participation in the firms they invest in by 30% of voting rights to avoid the systematic dispossession of the creator. Business Angels are not rich but wealthy people; 70% to 80% of them are already entrepreneurs who have invested in other innovations.

Venture capital, sometimes referred as investment capital, was born in the USA in the immediate post-war period, notably thanks to General Doriot, a French emigrant who founded the American Research Development Corporation, which made its first investment in Digital Equipment Corporation with such a financial success that the profession of Venture Capital is now well established. The U.S. Congress in 1958 realized that the venture capital accelerates the development of existing businesses, but very rarely at their creation. There was a need to forge a different tool, what the Congress did especially in the Small Business Investment Act in 1958 [2]]. Because the "venture capital" invests in "formal" money which is not the one of the managers who take the investment and management decisions - or not fully their - it must protect itself against failure and thus validate their decisions by a board of directors or an investment board. They need to bring expert reports not only about the market, the product or the company financials but also on the managerial capability of the creators to manage and grow the business. Therefore, it is rare that the "venture capital" invests below $2 million while the capital needed by a company to start is, for 95% of the companies, below $1 million. The Venture Capital does not invest in creation but in the development of the companies so entrepreneurs need another source of capital. At the seed stage, only the Business Angels and the U.S. SBIC are proved to be economically efficient.

The Small Business Investment Act of 1958 introduced two laws: the Sub-Chapter S and the SBIC which are largely responsible for the remarkable economic expansion of the USA.

England introduced in 1983 a tax incentive that had become, in 1994, the Enterprise Investment Scheme, EIS, also remarkably effective.

Comparison of funding sources in France and in Anglo-Saxon countries

A study of 2008 on funding sources suggests that France has an inverted pyramid of the funding sources and that it is one of the major cause of the lack of entrepreneurship and employment.

In summary, in the USA, the informal capital is about $100 billion invested annually in 500,000 companies, business angels investing $25 billion in 50,000 companies for $15 billion invested by venture capital in 1 500 companies: a pyramid if one goes from first to last. In France, in 2008, "venture capital" is around €10 billion invested annually and collected while the informal capital can be valued at less than €3 billion and invested by business angels represent less than a billion. Also, the lack of venture capital missed businesses to invest in and take refuge in the LBO or foreign investment.

This absence explains at least partly why France do not provide enough high growth firms and why the €10 billion of the venture capital firms, outside of €3 billion, have to take refuge in LBO and foreign investments.

Footnotes

[2[Do not confuse with the Small Business Act of 1953 creating the SBA (Small Business Administration)

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