Fostering Entrepreneurship: Promote Founding or Funding?

Policymakers would be wise to create effective channels for angel investors to reinvest their wealth and prime the next generation of entrepreneurs
Fostering Entrepreneurship: Promote Founding or Funding?

By Thomas Hellmann and Veikko Thiele

Everyone 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. Policymakers, in particular, are eager to prime entrepreneurial ecosystems in the hope of fostering economic growth, employment, and innovation. But very different approaches can be taken by governments to achieve these goals. What’s at issue is how to foster entrepreneurship.

Some policymakers focus on encouraging more founding by 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 U.S., the Small Business Administration offers a large variety of training programs for entrepreneurs while the I-Corps program of the National Science Foundation provides entrepreneurship training for scientists and engineers.

A different set of policies supports the funding of entrepreneurial ventures. These policies use a variety of methods to encourage investors to channel more funding into start-ups. In the U.S., the Small Business Investment Company program supports early-stage ventures. As well, more than half of all U.S. states offer tax credits for angel investing, according to the Angel Capital Association.

Policy Impacts

In this article, 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 founding policies that affect what is often called the demand side (the number of entrepreneurs demanding capital) versus 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.” It requires tacit knowledge about the entrepreneurial process that is mostly acquired by going through the entrepreneurial process itself. We view 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 Microsystems, 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 careers, 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.

A central finding is that for increasing entrepreneurial activity, funding subsidies are more effective than founding subsidies

Promoting entrepreneurship is not a short-term endeavour. Silicon Valley took decades to become what it is today. Imitators had to learn how long it took to create an entrepreneurial ecosystem. Our dynamic model allows us to examine both the short-term and 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. Founding policies, however, create a competitive dynamic where more entrepreneurs seek a limited supply of funds, resulting in less favourable investment terms for entrepreneurs (lower valuations). By contrast, funding policies create a more abundant supply of capital which results in better investment terms for entrepreneurs (higher valuations).

We then introduce intergenerational linkages and show that the differences in valuations have important dynamic implications. This is because wealth created by one generation of entrepreneurs determines the supply of angel capital for the next generation. A central finding is that for increasing entrepreneurial activity, funding subsidies are more effective than founding subsidies.

Channel for Social Mobility

Our model also generates 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 equilibriums. In low steady-state equilibrium, the lack of entrepreneurial activity prevents the formation of angel capital for future generations, thus perpetuating the low level of entrepreneurial activity. The opposite is true in high steady-state equilibrium: abundant entrepreneurial activity enables the formation of angel capital for future entrepreneurs and perpetuates lots  of entrepreneurial activity.

We show that even in high steady-state equilibrium, there is too little entrepreneurial activity relative to the first-best outcome. Future entrepreneurs benefit from the wealth of earlier generations but this intergenerational externality is not accounted for by investors when striking a deal with entrepreneurs. In 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 high equilibrium.

It is 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 counter to Thomas Piketty’s famous argument about the damage caused by wealth inequality. Our model, however, does not suggest a blanket tax exemption for the rich. Instead, we argue for the creation of effective channels for rich entrepreneurs to reinvest their wealth — and their expertise — into the next generation of poor entrepreneurs. Doing so would create a channel for social mobility.


Thomas Hellmann is Academic Director of the Entrepreneurship Centre at Saïd Business School, University of Oxford. Veikko Thiele is an associate professor and Distinguished Faculty Fellow of Business Economics at Smith School of Business.

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