Startups Are Our Economic Future: So Why Aren’t We Funding Them?

Estimated reading time: 7 minute(s)

By Carter Williams, managing director of iSelect Fund

Most people think the key to job creation in their state or city is to attract relatively large, established companies. The facts say otherwise.

Photo courtesy of Carter Williams
Carter Williams of iSelect Fund

Small businesses (those with fewer than 20 employees), which represent 98% of all businesses, are critical to America’s overall economic strength and dynamism. Although all businesses create and destroy jobs, when it comes to job-creating power it is not the size of the business that matters, but its age. In fact, according to research from the Ewing Marion Kauffman Foundation:

  • “New businesses account for nearly all net new job creation and almost 20 percent of gross job creation…”
  • “Companies less than one year old have created an average of 1.5 million jobs per year over the past three decades.”
  • “…from 2006 to 2009, young and small firms (fewer than five years old and twenty employees) remained a positive source of net employment growth (8.6 percent), whereas older and larger firms shed more jobs than they created.”

Put simply, entrepreneurship is the wellspring of employment.

Perhaps more importantly, however, entrepreneurship plays a vital role in promoting innovation and productivity throughout the economy. New companies arise from insights into ways to do things better, whether it’s hailing a cab or renting a movie. Many of these insights fail to pan out, but the ones that succeed can reshape entire industries and turn into significant contributors to the economy. Just ask your local taxicab commission or Blockbuster franchisee.

Unfortunately, the news for startups is not all good. Contrary to popular belief, domestic startup activity is not as white-hot as it may seem. Americans started 27% fewer businesses in 2011 than they did five years earlier. In 1977, 17% of businesses were less than one year old; by 2011, that figure dropped to just 8%. In fact, according to a recent Brookings Institution report, every major industrial sector, every state, and nearly every large city has a lower rate of new business creation today than three decades ago.

No one is quite sure what’s causing the decline, but many are worried. The aging of the baby-boom generation may be part of the explanation, since young people are generally more likely to start businesses. Still others point to increasing licensure requirements, corporate tax rates, burdensome regulation and a broader decline in innovation and productivity growth as potential contributors. Whatever the reason, the decline in new business activity has troubling implications for the country’s long-term economic dynamism and growth. According to Brookings authors Ian Hathaway and Robert Litan, this decline in entrepreneurship “points to a U.S. economy that has steadily become less dynamic over time.”

As individuals, we have the power to reverse this troubling trend. Nobel Prize winning economist Robert Solow showed that savings and investment determine the size of the capital stock, and therefore the level of production. Said differently, investment drives growth. When individuals invest in private enterprise, entrepreneurs create new firms. New firms beget new ideas, new technology, and new jobs.

Funding New Firms

Funding a fledgling new business is challenging, especially when those funds come predominantly from personal savings. A 2014 Gallup survey found that 77% of small business owners cite personal savings as a primary source of funding, followed by a loan or line of credit (41%). Once personal savings are exhausted, entrepreneurs turn to friends, family, and angel investors, whose investments often provide the first external validation and initial risk capital to propel a fledgling startup forward.

Angels are accredited investors that invest their own money in startup companies in exchange for equity shares of the businesses. Accredited investors, as defined by the SEC, are legally allowed to invest in startups and include anyone who:

  • Earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year; or,
  • Has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence).

Angels invest in startups for any number of reasons: to gain a return on their money, to participate in the entrepreneurial process, and to give back to their communities by catalyzing economic growth. Angels make a return on their investment when the entrepreneur successfully grows the business and exits it, generally through a sale or merger. Often former entrepreneurs, angels add value to their investments via hands-on mentoring and quality advice. Sometimes, to cross-pollinate networks, diversify deal flow, pool investment, and share administrative burdens, angels will form angel groups, or formalized investment syndicates that invest in startups within a specific region or around a specific theme.

Angels are a critically important part of the startup landscape. In 2014, U.S. angels invested $24.1 billion in 73,400 startups, creating 264,200 new jobs. And they do well. The average angel investment return is 2.6x in 3.5 years, a 27% internal rate of return.

But while there are an estimated 12.4 million accredited investors in the U.S, only 300,000 make angel investments. That’s only 2.4% of potential angel investors. It means that 12.1 million potential angel investors are not investing in startups. Given the data discussed above, why is the investment rate so small?

For one thing, it isn’t easy…

While average angel returns compare favorably with other alternative investments, the distribution of returns is varied. Like venture capital, “average return” does not describe the performance of most angel investments: 7% of investments achieve returns of more than 10x the money invested (accounting for 75% of the total return), while 52% return less than the capital invested. This high-variance return distribution demonstrates that making successful angel investments is challenging and investing in only a few companies creates a high degree of risk. Diversification is therefore the key. To quote the Kauffman Foundation, “an investment approach across multiple companies can lead to attractive returns.”

Diversification holds for angel investing because historical results demonstrate that the majority of returns come from a small number of investments. Outcomes often follow a Power Law distribution, where a few winners far outweigh returns from all other startup investments in a portfolio combined. In theory, the more diversified a startup portfolio, the more likely an angel is to invest in a home run company, offsetting the losses on failed investments. In fact, a simulation of 1,137 startup investments from the Kauffman Foundation’s Angel Investor Performance Project dataset reveals that, for portfolios of only one or two investments, an investor’s chances of merely breaking even are 83%. Increase portfolio size to 20 investments, and investors have a nearly 99% chance of break even and a 67% chance of a greater than 3x return. At the extreme, a portfolio of 500 startups increases the likelihood of break even to a near certainty, and the chance of at least a 3x return to 96%. These conclusions align with the insights of successful angels and demonstrate how diversification can offset the losses of most startups with exposure to the winning few.
But diversification alone will not prevent a portfolio from performing poorly if the companies selected for it are fundamentally bad investments. It’s worth taking the time to sort good companies from bad – due diligence matters. In fact, spending time on due diligence is significantly related to better outcomes. Angels who spent less than 20 hours per investment on research experienced an overall investment multiple of 1.1x, while angels who spent more than 20 hours experienced a multiple of 5.9x. What’s more, exits where investors spent more than 40 hours performing due diligence (the top quartile) experienced a 7.1x multiple. Of course, due diligence can never completely eliminate risk, but it does help eliminate the companies for which there are clear problems that lead to failure: products without customers, Founders with integrity issues, or convoluted intellectual property ownership rights.

In sum, diversification and due diligence are critical components of risk management. But when the typical venture capital fund requires a seven figure minimum investment and when access to due diligence materials is difficult and most investors’ time is limited, how can investors reasonably expect to reap the rewards of a properly diversified angel portfolio? They do not have the ability to commit $1 million or more to traditional VC firms that perform the necessary due diligence, and crowdfunding platforms, which have lower minimum investment requirements, do not perform the robust due diligence review to weed out fundamentally bad investments.

iSelect’s Solution

iSelect solves the time and amount of investment problems through its low minimum investment requirements —$50,000 total investment and $5,000 per company—and by performing more than 100 hours of due diligence on each company that appears in the Fund.

iSelect is the first investment vehicle offered exclusively by financial advisors that affords accredited investors access to an evergreen portfolio of venture investment opportunities that have been thoroughly vetted by a committee of successful entrepreneurs, angel investors, and professional venture investors. iSelect allows accredited investors to realize the potential to earn venture capital returns via a product that is diversified and risk-managed.

Over time, iSelect’s low investment minimums allow an investor to diversify across a spectrum of startup companies. Each company is subjected to an extensive three-tiered due diligence regime, including review by a FINRA compliant broker-dealer.

Potential companies first undergo review by iSelect’s Venture Team. Less than 5% of the companies are determined by iSelect to merit the next stage of review by iSelect’s Selection Committee, which is composed of independent entrepreneurs, business executives, and accomplished venture investors. The committee seeks to answer certain fundamental questions about each company: (1) Is the venture commercially ready for business? (2) Does the venture have the ability to create the barriers of entry necessary for a sustainable competitive advantage? (3) Is the management team in place capable of growing the business responsibly? Ultimately, the committee must reach the consensus that the company’s management team, business revenue model, and investment thesis are worthy of further review by iSelect and its Investment Committee.

Assuming a company successfully passes through each stage of iSelect’s review process and is approved for the Fund by iSelect’s Investment Committee, the information gathered by iSelect during its review process is summarized and packaged in an extensive diligence file made available to investors and their financial advisors. iSelect allows investors, in conjunction with their financial advisor, to select which companies to invest in, and how much to invest (subject to the $5,000 per company minimum). Post-investment, iSelect requires companies to provide quarterly reports that are made available to investors so each investor can monitor the progress of their portfolio. All of this is designed to help accredited investors to more easily evaluate, understand, and manage their personalized series of early-stage venture securities.

The truth is, 97.6% of accredited investors do not make angel investments because they lack the time and expertise to adequately source, vet, diversify and monitor an angel portfolio and/or cannot meet traditional venture capital firms’ minimum investment requirements. As the first build-your-own venture fund offered through financial advisors, iSelect solves this problem by managing the diligence burden and significantly reducing the investment minimum. The result: more angels funding more entrepreneurs creating more jobs and helping to advance the U.S. economy.