• Regulations and Entrepreneurship… The Musical?

    Posted by gmadmin   |   June 5, 2012

    This morning I wrote an email to a friend to follow up on a discussion we had last night. I thought I’d share it here:
    Regarding risk and new ventures, the problem I found when I was looking into financing a movie is that a movie, like many ventures, is very risky, requires enormous capital investment, yet it has a very high potential upside. In theory an entrepreneur can finance such a venture by selling pieces of the upside to unload the risk. If it’s a good value, smart investors will buy. If it’s a bad value, smart investors won’t buy and the project won’t get financed. This is a good test for the entrepreneur, because if an enterprise can pass muster with investors that is a good sign that it is fit. Here we have a voluntary arrangement in which not only is the risk dispersed and the upside shared, but the things that kill most startups – bad business plan, poor management, and under-capitalization – are mitigated by the investors. Businesses formed this way ought to be on superior footing.

    But in reality, that kind of arrangement is largely prohibited by regulations that forbid entrepreneurs from connecting with investors. So instead entrepreneurs finance their ventures by incurring debt – either private debt from family or by securing a loan against a house or something. We end up with businesses that don’t have enough money to survive the dip, don’t have the benefit of investor oversight, and ultimately land the entrepreneur in bankruptcy or defaulting on a debt to family. That’s the profile of a typical small business, isn’t it?

    Even worse, the current regime is discriminatory. It’s one thing for a college graduate from Paradise Valley to get loans from family, or even to get investors because they can satisfy the pre-existing relationship requirements. But where does that leave the South Phoenix mechanic who wants to start a body shop but has no access to capital? In a free market, the mechanic can compete for investor dollars, and investors will reward her based on the soundness of her business plan and experience. But the government deems people too unsophisticated to make those decisions on their own. In the interest of protecting investors, it strangles entrepreneurship.

    I’m of the opinion that progress and prosperity are created by entrepreneurs. A competitive environment has a lot of natural friction for entrepreneurs to overcome in their bid for investor dollars; adding more friction comes at a great cost to society, I believe. Now of course we want to protect grannies from being defrauded, so some investor protections are necessary. But like in so many other things, we go way, way too far: we maximize investor protections without any regard to the costs to progress and development. What should be a small correction becomes the overriding principle. And the net actual effect is that there are whole dead zones in entrepreneurship. Middle and low-income communities, ventures that require moderate (say, between $100k and half a million) start-up capital, ventures that provide good returns but don’t scale up in the way that would attract venture capital… These areas are anemic when they should be the most dynamic. On the investor side, ordinary people don’t have the privilege of participating in the private equity market – where they can actually bring their intelligence to bear in finding good deals – and instead they are stuck competing on the public exchanges where they don’t stand a chance at outsmarting the professionals. Where we should have a market of small companies competing for investor dollars, instead we have none – all in the name of protecting grandma. And do the protections we have actually prevent the Bernie Madoffs and AIGs of the world? Of course not lol.

    I came across a parallel example recently talking with someone who works for Medtronic. He said the company is totally dysfunctional and everyone there knows it, but they have virtually no competition. The only companies he said that can make medical technology are Medtronic, Johnson and Johnson, and some other company. The reason is that nowadays companies have to spend literally upwards of a billion dollars on clinical trials in order to bring something to market. Well, consumer protections are important, and nowhere are they more important than in the medical field. But these things come at an invisible cost in innovation, prices, progress, and lives that could have been saved… A billion dollars is probably ten times too high a burden; what we should do is ask ourselves how much less safe we would be if the burden for bringing a medical product to market were a hundred million. Might that strike a more optimal balance between market competition / innovation and consumer protection? Might tort law pick up some of the slack? But unfortunately the world doesn’t work that way… The general interest of society is not represented as well as the special interests of J&J and Medtronic. I guess my point is that there is some validity to the general spirit of these laws – protecting the little guy from predators. But in everything there are trade-offs, even if the costs are the invisible counter-factual – the progress that could have been. And we should take seriously, on principle, the question of how much we want the government to impinge on our freedom to enter into voluntary arrangements in the spirit of protecting us from ourselves. It’s a bit like living under police rule because a small minority of people are criminals, in my opinion.

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