The Costs of Entrepreneurial Job Creation

By Scott A. Shane
Do the Math

Based on the interest in my post about estimates of entrepreneurial job creation, I would like to explain how I calculate these numbers. My analysis is debatable, but I will outline the assumptions behind my figures so you can decide for yourself.

There are four key assumptions to calculate the job creation numbers: (1) the amount of money it takes to motivate someone to begin the entrepreneurial process, (2) the percentage of people that begin the entrepreneurial process who create a business, (3) the percentage of newly created businesses that employ anyone (employer firms), and (4) the number of employees in the average new employer firm.

Assumption No. 1
Surveys of entrepreneurs consistently reveal that the biggest deterrent to starting a company is lack of capital; and natural experiments in which people receive random financial windfalls from lottery winnings show that an unexpected capital infusion encourages people to start businesses. So, to get people to start the entrepreneurial process, we need to overcome their lack of capital.

A representative survey of new business start-up efforts in the United States indicates that the typical (median) entrepreneur needs $15,000 to pursue a new business idea and can provide $6,000. Therefore, we need to give the typical person $9,000 to overcome this capital gap so he or she can start a business.

Assumption No. 2
The same survey shows that about one-third of people who begin the process end up with an “up-and-running” business within six years.

Assumption No. 3
About one in five new businesses has employees. The survey indicated that 18.5 percent of the entrepreneurial efforts tracked had filed for state unemployment insurance and 19.2 percent had filed for Federal Insurance Contributions Act taxes, two indicators that a business is an employer firm.

These percentages are consistent with United States Census data, which indicate that, at a point in time, only 24 percent of businesses are employer firms. (Because employer firms are more likely than nonemployer firms to survive over time, one should have a slightly higher percentage of surviving firms that are employer firms.)

Assumption No. 4
Data from the Small Business Administration’s Web site reveal that the average number of employees in a new employer firm is 5.6.

(This is lower than the estimate that comes from the data on the Business Dynamics statistics Web site of the Census Department, which indicate that the average number of employees in a new establishment is 6.51. New establishments, however, don’t include only new firms; they also include new locations of existing businesses, like the addition of a new fast-food outlet.

Moreover, the Bureau of Labor Statistics’ estimate of the average number of employees per new establishment was 4.3 in the third quarter of 2008, putting the S.B.A. new employer firm number right in the middle of the two figures for new establishments.)

Creating an Employer Firm
Multiplying the percentage of people who start the entrepreneurial process and create a viable business by the percentage of new businesses that file for unemployment insurance or F.I.C.A., we find that it takes 15.8 to 16.4 people who begin the start-up process to get one new employer firm.

This estimate is similar to that of Paul Reynolds, the lead researcher on the study that generated these data, who says “it may take 15 active nascent entrepreneurs to generate one firm with employees.”

Cost Per Job
Multiplying the 5.6 employees in the average new employer firm by the average of the percentage of businesses that have filed for unemployment insurance and F.I.C.A. (18.9) and the percentage of start-up efforts that become businesses (33), we get an estimate of 0.35 jobs created per person who begins the start-up process. At a cost of $9,000 to encourage a person to begin the start-up process, we get a cost of $25,603 per job through efforts to encourage people to become entrepreneurs.

The S.B.A.’s estimate of 5.6 employees per new employer firm is higher than the estimate of 4.6 employees per new employer firm reported by the Kauffman Firm Survey. If we use that number of employees per new employer firm, we would get a cost per job of $31,169.

Returning to Prerecession Employment Levels
The United States economy is currently down 8.8 million jobs from the number necessary to have the prerecession rate of employment, given estimates of the number of jobs lost and job creation necessary to keep up with population growth (based on the Economic Policy Institute’s methodology for calculating these numbers). If we multiply the cost per job by the number of jobs we need, we get an estimate of $225.3 billion to get us back to prerecession employment levels by encouraging people to become entrepreneurs.

My estimates could be wrong. But I think that $225.3 billion is closer to the true cost of getting us back to prerecession employment levels by encouraging entrepreneurship than the $3.1 billion (or $3.3 billion if we include the June job loss numbers) that comes from other estimates.

Scott A. Shane is a professor of entrepreneurial studies at Case Western.

Comments are no longer being accepted.

Rob July 6, 2009 · 1:14 pm

Universal healthcare would remove a huge barrier to small businesses.

Ano July 6, 2009 · 1:45 pm

How many “up and running” businesses fail within the first six years?

Pierce Moffett July 6, 2009 · 1:46 pm

The author concludes that it would cost $225B to restore pre-recession employment by fostering entrepreneus. But there is a big missing piece here, which is how these jobs compare with pre-recession jobs. For example, we know that each job-creating entrepreneur creates an average of about 5 jobs. But how do these jobs compare with “average” pre-recession jobs in the workforce in general in terms of compensation, benefits, full/part status, etc. If these jobs are substantially below the pre-recession average in compensation and benefits (which I suspect they would be), then they have not fully closed the employment gap. For example, are we replacing a full-time factor worker at GM with a part-time bicycle messenger? To really try to close the employment gap through entrepreneurial job creation with jobs comparable to those that have been lost is probably going to cost a lot more than $225 billion.

mjb July 6, 2009 · 1:47 pm

Amen, #1 post, Rob. Universal healthcare is a very important answer…

joe July 6, 2009 · 1:48 pm

I second Rob.

Healy Jones July 6, 2009 · 1:52 pm

But does this mean we would need over 25 million entrepreneurs to try to start these businesses to try to create the 8.8 million jobs needed to get us to the pre-recession employment rate? (8.8 million jobs needed divided by 0.35 jobs created per person who begins the startup process)?

With only 14 million people unemployed there will need to be millions of current employees who have to leave their day jobs to create these startups. Some of these millions of entrepreneurs-in-waiting who are currently employed are probably very productive at their current jobs – losing them will hurt their current employers, thus probably increasing the “cost” of getting all these new jobs created.

David July 6, 2009 · 1:57 pm

Rob – Only if it didn’t impose substantial additional cost and legal hassle.

I run a small business (< 20 employees), and even though we fall under the state and federal size at which a great many regulations kick in, I have found that state (NY) and federal beaurocracy is one of the biggest obstacles to running and expanding my business. We provide healthcare, and the cost is about $400/month/employee, which pales in comparison to some of our other costs, such as workers comp, unemployment insurance, state taxes, city taxes, accounting fees to pay for the work to prepare all the taxes, etc. The best thing that could be done to encourage entrepreneurship would be to remove, or at least consolidate, the legal obstacles imposed by the government. When I started this process three years ago, I was no expert on starting and running a business, and I’ve had to discover most of the requirements as they came along. I’ve also spent literally weeks trying to get the state of NY to fix errors that they have made over the years.

Elizabeth Li July 6, 2009 · 1:58 pm

Whether a new firm is an employer firm is a function of the organizational forms that new business owners select. If the owners select the s-corp route, then the owner/shareholder must be treated as employee to receive payment. If the entrepreneur/owner chooses the LLC route- which is increasingly common nowadays, they would be treated either as sole proprietor or partners for tax purposes, and they would pay self employment tax on earnings when they file their own tax returns.

Each of these entities may hire additional workers- which I assume is what you are trying to determine, but S-corp owner are more likely to be listed as employees as they are required by law( though compliance rate has been low) and LLC members are not required to treat themselves as employees unless they elect to do so.

At this stage of the cycle, there are probably many individuals who establish their own consulting or engage in other temporary work arrangements withoug being an employee. But regardless, a proper analysis of job creation would need to come up with some estimates of the self-employed population ( which will include the large majority of entrepreneurs who adopted LLCs as an organizational forms)

JGNY July 6, 2009 · 2:01 pm

Universal HC will save nothing. It will cost more. Also, as a small business owner, taxes, withholding, fica, sui, fui, disability are the backbreakers. The witholding tax is the biggest fantasy, Employees do not really pay this tax, the employer has to generate the revenue to pay the salaries of the employes. If the revenue is not there, we cannot pay the tax and the employee. the greatest deterrant is Taxes. This does not count the sales tax, property tax, utility taxes, and all the rest. Governments do not want businesses to succeed. They only want your taxes to fund their freebie give away programs. This way the employers are forced to compete with the gov’t programs. You have less of a job pool to pick from.

Joe Mescher July 6, 2009 · 2:01 pm

$9,000 Stands Between us and New Jobs…?

The average cost being $9,000, I am curious about the possibility of fast tracking business models that require slightly less funding and/or are less capital intensive.

Your typical Online venture, for example, could be done for less than $9,000 total (in the start-up phase anyhow). eBay, YouTube, Twitter, Facebook…the list goes on with respect to Social Media sites that provide avenues for exposure.

I wonder if there’s any effort underway by folks like Bill Gates and Pierre Omidyar to fund start-ups using Micropayments?

CQP July 6, 2009 · 2:09 pm

This is a great example of the kind of silly reliance on statistics without understanding underlying reality that got us into this mess. Do we really think that every person out there, if given $9,000, is 33% likely to start a successful business? There’s an incredible amount of selection bias in the people who *do* go out and start successful businesses. Can’t imagine everyone else is equally likely to succeed. Getting capital is only on of the first of many seemingly impossible tasks a would-be entreupreneur must complete to get a business up and running….

jo July 6, 2009 · 2:21 pm

Your analysis is overly simplistic. If capital becomes more easily available (say the government hands out that 9K for free), the survival rates of new businesses will fall. Ergo, the marginal cost of creating the incremental job has risen. $225.3 billion is an underestimate of the costs: it could esily be five times as much.

JB in DC July 6, 2009 · 2:30 pm

Thanks for the analysis, Scott. Anyone who’s ever started a business knows that building something from scratch is hard. Your take on the numbers underscores that reality.

Further, I’d be willing to bet that encouraging entrepreneurship by closing the capital gap via direct transfers would actually lead to a more expensive endeavor than you suggest, as I’d expect to see a lower employer-firm success rate as more potential entrepreneurs take the plunge. But lower the initial capital gap by reducing the costs associated with incorporation, insurance, health care, payroll processing, etc., and we may be onto something.

jpgaskell July 6, 2009 · 2:44 pm

I can’t tell from your discussion:

A. If the only employee is the start-up person him(her)self, is the company considered to have employees?

B. Or do you only count as employees those who are non-principals?

I’m guessing that any company that can afford to pay anyone’s wage is in pretty good shape. But – to be truthful – I’m not sure how one method or the other would affect your conclusions.

PS: I second anyone who is promoting universal health care.

Charles July 6, 2009 · 3:07 pm

It’s no accident that the majority of new businesses fail. After 30+ years of starting and running successful businesses (with as little as $2000 in startup capital) I’m convinced that there are two basic types – employees and entrepreneurs. Entrepreneurs find the money to start businesses and do whatever it takes to succeed. Employee types often lack what it takes to start and run businesses, they tend to kill businesses they inherit.

The key difference between the two types is that entrepreneurs answer to themselves and employees need bosses to answer to.

Having watched too many employee types blow their savings trying to start businesses my best advise is for them to either avoid the risk or look into purchasing a viable franchise (which is the equivalent of buying themselves jobs) because the better franchises require the franchisees to answer to them.

George Fernandez July 6, 2009 · 3:28 pm

Hey Rob (#1),

Good point. Would be nice to see the payback period for those job creations, too. In other words, if the Feds spent this much to create new jobs, how loing would it take for the government to get the money back in taxes.

Just like Social Security, the money given , because of churn, continues in a value chain cycle, bringing monies back to the government, as this money is spent by other business supporting the new business.

The trick is to try and focus on business that have high economic value. Either creating new value or saving costs thereby preserving value.

George F.

George Fernandez July 6, 2009 · 3:32 pm

#3.

Its a crap-shoot. Like everthing else in life. What’s your point? That we shouldn’t try this. Its also possible that the new jobs would be more valuable, especially, if education in technology is included. Subsidized training for start-ups. This is already going on in smarter areas of the country, so far, successfully.

George F.

George Fernandez July 6, 2009 · 3:48 pm

#9
Give-aways are not the problem, and your response sounds a bit reactionary instead of reasoned.
Wasteful spending, sweetheart deals, cronyism, payroll padding, and political fiefdoms are the problem.
Do you think all politicians have as their sole aim, to give away moeny to the poor. Boy, you have a better view of them in general than I do.

#11
33% of the people not an individual 33% more likely.

#12
I don’t think Scott is selling it as anything else but a simple work through of numbers. The way we got into trouble, if indeed it was, was by making more of the numbers and possibilities than is warranted. There are no sure things but Death and Taxes. Didn’t you read the memo?

George F

Sean W July 8, 2009 · 4:14 pm

I think the $15,000 assumption is extremely low.

It would be more realistic to say that there are $15,000 in startup business expenses, PLUS the owner will need enough savings in his/her personal accounts to last a year without a salary.

The owner’s labor is never “free” – despite what some might imagine. Personal bills arrive in the business owner’s mailbox every month, and they need to be paid. There is tremendous opportunity cost associated with starting a new business – and opportunity cost is very, very real.

Ruth Hedges www.fundingroadmap.com July 9, 2009 · 10:44 pm

“There are 14 million people waiting for big business to save them,” said Hedges, citing the number of unemployed Americans. “In reality, they can save themselves.”
//www.lvrj.com/business/49923017.html

//www.fundingroadmap.com
Ruth Hedges

Jim February 24, 2010 · 9:24 am

I run a small business in Alabama. The largest hurdle…government. There are numerous government agencies lining up at the trough from the federal level to the local level. They all see that they cannot produce anything but they want a slice of the pie. They have the threat of government to take it.

There are some municipalities around here that have a larger profit margin than I do on some jobs yet they never visit the job site, they never take a measurement, they never make any calculations, they never purchase anything or manage the project. They take no risk but they take the largest profit. It reminds me of the government’s take at the gas pump. Look at the amount they take compared to the companies that take the risk to go into some of these hostile countries, explore, extract, refine and deliver the product to us for a margin far less than the governments.

The US is becoming a hostile environment for small business.