Yes, America Needs More Start-Ups, but Here's What Start-Ups Need

Thomas FriedmanThomas L. Friedman, The New York Times's op-editorialist extraordinaire, penned a Sunday column about a topic that could affect the future of the U.S. economy. But while his overall point is on target -- he misses the mark in a key way.

I agree with Friedman (pictured) on the main point, that a recovery depends on small companies creating jobs. However, his prescription -- increasing the number of what he calls "high-IQ risk-takers" in the U.S. -- won't do the trick. Instead, jobs will result when entrepreneurs can get the capital they need to start and build successful ventures. And getting that money takes more than just smart people.

Friedman's argument springs from what appears to be an interview with Craig Mundie, the chief research and strategy officer of Microsoft (MSFT). Although Microsoft has been a relative laggard technologically for at least the last decade, Friedman appears to be swept away by Mundie's viewpoint.

The Microsoft exec suggests that the problem with the U.S. economy is that so-called high-IQ risk-takers (a phrase that Friedman repeats eight times in his column) in business and government are being discouraged by "cutbacks in higher education, restrictions on immigration and a toxic public space that dissuades talented people from going into government." Moreover, Mundie argues that the common element that explains the "above-average returns as a country" for Singapore, Israel and America has been those high-IQ risk-takers.

An Important Flaw

I find it quite plausible when Friedman cites research from The Kauffman Foundation to conclude that most jobs come from small businesses. Kauffman's Robert Litan argues to Friedman that, "Between 1980 and 2005, virtually all net new jobs created in the U.S. were created by firms that were 5 years old or less. That is about 40 million jobs. That means the established firms created no new net jobs during that period."

With 8.4 million people out of work since the Great Recession began in December 2007, anyone looking for a job surely cares deeply about the source of new jobs. Why does it matter if Friedman is right or wrong? Friedman's effort to attribute small business jobs to high-IQ risk-takers is flawed. And that flaw is important because if policymakers follow the prescriptions that flow from his analysis, they won't create the new jobs that people want.

Friedman's analysis is off-base for three reasons:

  • Failure to define key terms or to explain how they create jobs. Friedman does not provide any evidence of what Mundie calls the "above-average returns as a country," when you have a "happy coincidence of high-I.Q. risk-takers in government and a society that is biased toward high-I.Q. risk-takers." Nor does he explain the linkage between the "high-IQ risk-takers" and those high returns. I would agree that smart entrepreneurs are an important ingredient for creating start-ups, but Friedman also argues that "In its heyday, our unique system also attracted a disproportionate share of high-I.Q. risk-takers to high government service." However, I disagree that high-IQ risk-taking among government policymakers has a significant effect on start-up activity. Politicians strive for election, and because risk-taking lowers their odds of winning, I question Friedman's premise.

  • The success of Singapore and Israel come from very different sources. Singapore is a city-state that sprang from Malaysia. It's clean, tightly run and has a high standard of living. But after visiting there several times (once to advise it on how to spur start-ups), I came away with the impression that its people do not like to take the risk of starting up new businesses. Instead they prefer the security of a job at a bank that will allow them to buy a condo in the right building and afford country club fees. Israel's success results in part from its many talented people. But it also springs from Israel's need to scratch a living from the desert after its neighbors declined to trade with it; from the common culture of universal army service; from its access to Silicon Valley venture capital; and from its ability to sell technology to customers around the world.

  • It excludes factors that are critical to entrepreneurial activity. In my forthcoming book, co-authored with Srini Rangan, Capital Rising: How Capital Flows Are Changing Business Ecosystems All Over the World, we argue that capital flows to countries that possess the best "Entrepreneurial Ecosystems" (EE). The EE includes smart people -- what we call human capital -- as well as a country's financial markets, its corporate governance patterns and its intellectual property (IP) regime. Friedman's neglect of these other factors weakens his argument.
In considering what the U.S. must do to encourage more start-up activity, Friedman's prescription of letting more smart immigrants into the U.S. seems fine. But many U.S. companies have found ways of tapping potential immigrants' talents by partnering with them in their home countries without them being U.S. citizens. To the extent that Friedman's focus on human capital has merit, it doesn't go nearly far enough.

Hedge Funds Have the Advantage Over Venture Capitalists

Previous waves of job-creating technological innovation came from business investment in technology. But too much capital in the last decade in the U.S. has flowed narrowly to consumer-focused technologies -- products such as the iPhone and social networks like Facebook. While these products and services have helped create jobs, greater employment growth depends on shifting capital flows to technological innovation that boosts business productivity and unleashes a wave of capital investment to that end.

Furthermore, I see a deep, unresolved problem with America's financial markets. Quite simply, in the last several years, too much capital has flowed to hedge funds that appear to prosper from very short-term trading bets made with the use of powerful computers. To wit, the top 25 hedge fund managers earned $25.3 billion in 2009, and the top 11 hedge funds managed a whopping $316.2 billion in assets that year.

This flow of capital suggests that venture capitalists (VCs) are at a significant disadvantage to hedge fund managers. That's because venture capital is much more risky, and the payoffs tend to be less, fewer and take far longer to reap than the rewards hedge funds generate. And that's despite the fact that VCs and hedge fund managers get paid in a similar fashion, a 2% management fee based on assets under management and 20% of the investment profits.

Moreover, thanks to the massive losses from the dot-com crash, which are still vivid in the memories of institutional investors, significant skepticism remains about the value of such start-up investments.

How Capital Flows Is the Key

I agree with Friedman's call for "thinking seriously and urgently about what are the ingredients that foster entrepreneurship -- how new businesses are catalyzed, inspired and enabled and how we enlist more people to do that." Unfortunately, I'd say the core of Friedman's argument seems to be that he really likes the phrase "high-IQ risk-takers," and if he repeats it enough, everyone else will like it as much as he does.

But if they're serious about creating new jobs, American policymakers should consider the EE framework as the core tool for encouraging such entrepreneurship. Friedman is right to push policymakers to focus on human capital. But as Rangan and I point out, doing so without also changing the other factors that determine capital flows -- financial markets, corporate governance and IP protection -- won't produce sufficient start-up activity.

And that could leave millions of aspiring workers out in the cold.
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