On Friday, March 30th, I'll be speaking at the 2nd Annual Conference on Community Economic Development at the Western New England College School of Law.  The assigned topic is "Urban Entrepreneurship."  I offer my initial thoughts below.  I still have a couple of weeks to shape my remarks, so any comments, ideas or suggestions are welcome.

I want to make four points about Urban Entrepreneurship, which I understand to mean start-up  businesses that seek to operate in or serve economically-disadvantaged areas.

1.  The entrepreneurial spirit is universal; what varies from region to region are the challenges to raising capital. 

2.  Entrepreneurs seeking capital for projects in urban areas face a difficult challenge of showing a clear path to profitable exit.

3.  Traditional funding solutions include community networks and non-profits.  Each has its limitations.

4.  For-profit philanthropy offers a useful alternative model.

*    *    *

1.  The entrepreneurial spirit is universal.

There's plenty of evidence of the entrepreneurial spirit anywhere you look, from places we normally think of -- like Boulder and Silicon Valley -- to big cities like LA and NY, in rural areas, in Europe and Israel, in India and China, in Africa and Latin America.  Urban areas are no exception, of course. 

What varies from region to region are the barriers to raising capital.  Investors need a legal regime that makes them comfortable investing in a venture managed by someone else, and they need to be convinced that they can achieve a comfortable return on investment.  And investors and entrepreneurs have to be able to keep returns on investment, free from severe government corruption or confiscatory taxes.  The US has a legal regime that effectively supports entrepreneurship.  This isn't to say that the US system is perfect.  But the real challenge facing urban entrepreneurs is making investors feel comfortable that they'll get a return on investment.

Urban entrepreneurs face an enormous information barrier.  Many urban business model ideas don't fit what VCs have in mind.  Venture capital-backed entrepreneurship tends to focus on technology, where a successful investment can disrupt existing product markets and generate enormous returns.  It's these home run investments that can justify nosebleed valuations and allow investors to swallow the losses from the significant number of investments that will fail.  Many urban start-ups, by contrast, are looking for success on a smaller scale.  This doesn't diminish their importance, only their chances of finding traditional venture capital. 

2.  No clear path to cash.

This last point - the difficulty of fitting urban entrepreneurship into the VC-backed technology entrepreneurship model - is worth some elaboration. 

There are untapped product markets and underutilized labor markets in urban areas.  And it's possible for VC-backed entrepreneurs to reach a portion of this market.  There's no intrinsic barrier to funding; I don't think there's some conspiracy that makes profit-seeking VCs turn away from urban markets.  I recently saw a pitch by a company called gourban.net, which seeks to be an internet portal and on-line retailer for the urban market.  It's an interesting business model, and I suspect that particular company will find traditional VC funding ... if they can convince the VCs that the business is truly disruptive of existing product markets.

The challenge is for "slow growth" companies, like smaller retail companies, grocery stores, bakeries, laundromats, clothing stores, for-profit educators, and many service providers.  Many of these companies can provide incremental improvements over the status quo, but may not disrupt entire product markets.  The more logical source of capital here is from traditional corporations extending incrementally into new markets through franchises, or by opening stores into new areas, as companies like WalMart, Target, Starbucks, and Old Navy are trying to do. 

So now let's suppose there's an entrepreneur who wants to open a new clothing store on 125th St. in Harlem.  Should she go out and pitch traditional VCs?  Venture capital isn't likely to supply the needed capital to this market.  As with any other market, there's a huge information gap between the entrepreneur with the idea and the investors with the capital.  No matter how impressive the entrepreneur, there's a reason that VCs won't make the investment, and that's because the business model -- clothing retail -- isn't inherently disruptive.  Without the promise of a home run product, slow growth companies won't attract traditional venture capital. 

3.  Two traditional models used to overcome the problem are community networks and non-profits.  Each has its limitations.

By community networks I mean informal networks of friends and family financing that provide capital to small business owners, even where return on investment is quite uncertain.  These networks rely on non-contractual methods to guard against shirking and other moral hazard risks.  Historically, these networks have tended to be ethnically homogeneous, often but not always centered around immigrant groups.  In New York, for example, you've got -- just to name a few -- Korean grocers, Orthodox Jews in the diamond district, and African-American bakeries in Harlem.  But family and ethnic ties extend only so far, and the model becomes less useful as our urban communities become less homogeneous.  We cannot count on friends and family financing to generate the optimal level of economic activity.  We must look for other intermediaries to bridge the information gap between the capital markets and promising urban businesses.

Non-profits sometime serve this role.  Under the New Markets Tax Credit, for example, investors can receive a tax credit for up to 39% of their investment, over seven years, if the investment targets low-income communities and through a government-certified nonprofit intermediary.  While the scheme undoubtedly lowers the cost of capital for certain projects, it's difficult to assess whether the best projects are getting funded.  (For a discussion of government intervention in venture capital markets, see Ron Gilson, Engineering a Venture Capital Market.  For more information on the NMTC program, see this GAO report.)

And non-profits generally tend to suffer from a lack of accountability.  Non-profit managers are agents without principals - without the profit motive to guide behavior, there's a risk that non-profit managers choose suboptimal projects.  It's difficult for donor/investors to monitor what's going on, and accountability mechanisms are weak.   

4.  For profit philanthropy presents a useful alternative model.

For-profit philanthropy, as I use the term here, means an investment guided by traditional, for-profit principles of (1) accountability and (2) return on investment, but where the primary motivation for the investment is (3) altruistic.  These ventures might generate a profit, but that's just gravy.  Return on investment may include non-financial measures.  The real motivation is giving something back to the community; the philanthropic impulse allows the investor to stomach greater uncertainty and take on greater risk than she would otherwise take, given the expected returns. 

Three examples.

Angels

The first is angel investing.  Angel investors are normally thought of as for-profit investors, not philanthropists.  But when you talk to angels, it becomes clear that many see their mission as broader than that.  Many are former entrepreneurs, and they see angel investing as a method of giving the next generation a hand up.  Once in a while, of course, an angel investment turns into millions of dollars.  But it's become a method of providing both the capital and discipline of venture investing to a start-up that isn't yet ready to receive traditional venture capital. 

(But cf. Darian Ibrahim's work on angel investing, suggesting rational, non-philanthropic justifications for the structure of angel investing.)

Google

The second example is Google.org.  Google.org is the philanthropic arm of Google, investing in projects aimed at things like providing market-based solutions to global poverty and creating a better hybrid car.  By keeping the projects under the for-profit umbrella of Google, the Google founders and managers are likely to achieve better accountability than if they made a corporate charitable contribution to an outside non-profit. 

And it's worth noting that, counter-intuitively, they still get a pretty good tax break.  In For-Profit Charities, Eric Posner & Anup Malani suggest that we should allow for-profit entities engaging in 501(c)(3) activities to receive deductible contributions of capital and operate free from an entity-level tax.  (The mechanics are unclear from the early draft of the paper.)   But Google.org also achieves the same improvement in accountability and a similar tax break without creating the same sort of administrative nightmare.  When Google puts money into its Google.org subsidiary, and the subsidiary spends the money on things like R&D, the .org sub will generate operating losses.  Assuming the .org sub remains part of the consolidated return, the operating losses will soak up income from Google's normal profit-making activities.  Not all of the money contributed to the .org will generate immediate deductions - some investments will be capitalized, and some will later generate income.  But each dollar contributed to Google.org might generate, say, 20 or 25 cents of tax benefits to Google, vs. 35 cents, at most, for a corporate charitable contribution.  And Google.org can operate free from the income tax charitable deduction AGI limitations and free from the definitional constraints of 501(c)(3). 

(For more on the AGI limitations, see the smarter Prof. Fleischer on Why Limit Charity.)

Magic Johnson

The third example, returning to the urban context, is Johnson Development Corporation.  Magic Johnson's success is impressive, largely achieved through partnerships with Loews, Starbucks, TGI Fridays, and other traditional corporations.  These various arrangements demonstrate the discipline and accountability of for-profit ventures, and indeed these ventures have proven financially successful. 

But I'd be surprised if profit was Johnson's sole or even primary motivation when he first partnered with Sony Entertainment to build the Magic Johnson Theaters back in 1994.  Maybe it was, but I doubt it.  At the time, of course, there was extreme uncertainty about whether the business model would work.  Johnson stepped in not just as a founder and capital provider but as an intermediary, bridging the gap between the other capital providers and the urban community.  I think, like many successful entrepreneurs, Magic was looking to give something back to the community, and the for-profit model has made that gift more successful than a straight donation would have been.  For-profit philanthropy is the gift that keeps on giving.

In sum, urban entrepreneurs operate under conditions of great uncertainty that make it difficult to raise money from traditional sources.  And unlike technology entrepreneurs, who also operate under conditions of great uncertainty, they cannot tempt venture capital with the promise of disrupting entire product markets.  Rather than rely on friends and family, or try to squeeze more from traditional non-profits, or curse traditional venture capital, new institutions must develop to fill the gap.  I think the model of for-profit philanthropy will provide the most exciting new urban ventures in the 21st century.

Entrepreneurs

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