Tuesday, April 12, 2016

Entrepreneurial Leverage

Leverage is, "The ability to influence a system, or an environment, in a way that multiplies the outcome of one's efforts without a corresponding increase in the consumption of resources."- Business Dictionary

An entrepreneur in Israel Kirzner's broad sense is someone that is alert and then discovers and acts upon heretofore undiscovered opportunities.  Both Google and a new Chinese restaurant in an under served area are examples of entrepreneurship.

One produces significantly more results in terms of growth in revenue and profit for the entrepreneur and employment and contribution to its society than the other. Why? And How does the Entrepreneur pick projects?  Do they always pick high productivity projects?  If not, why not?  If growth of GDP (read prosperity of society) is driven in substantial part by these outcomes, can we, should we and how do we influence better outcomes as a society?

Entrepreneurs achieve more leverage with businesses that use a lot of new technology, ideas or business models.  In economic terms non-rivalrous inputs. These businesses have increasing returns to scale in the production function and create significant value when scaled.  The investment of entrepreneurial time and effort is leveraged relative to the same investment in businesses that are near replications of other existing business and offer near constant returns to increased scale in the business.  Each contributes to growth in the economy as a whole, but the former have out sized impact.

Entrepreneurs gain increased return when they can provide a level of excludability to their leveraged business. This can come from patent protection of the employed technology, copyright protection, trade secrets around the technology or business practices, exclusivity of resource acquisition, early acquisition of market share in markets with network effects or even speed.  In any given business there will be a varying amount of excludability.

This theory extends endogenous technological change growth theory (Romer 1990) to the entrepreneurial activity implied.  The model highlights important distinctions in entrepreneurial activity and implies potential advantaged public policies for economic development.

Businesses that employ new technology, ideas or business models have higher risk.  More experimentation, acquisition of knowledge produced by trial, is needed to employ new things and find a sustainable pattern of specialization and trade.  This takes time, patience, creativity and capital resources, all of which are expensive resources.  Little training is done in universities or corporations in managing the risks involved with this type of business building.  The literature, research and potential methods, often derived directly from experience and of varying quality, are passed down orally in business communities and only recently has there been an increased number of books and other publications with useful frameworks.

Entrepreneurs don't choose projects for leverage.  This theory is generally unknown to entrepreneurs specifically, and even with advanced, serial entrepreneurs often only vaguely felt, so they have no basis for differentiating potential projects in this way.  Most entrepreneurial projects are discovered, in Kirzner terms, alertly discovered, serially through the daily participation of the would be entrepreneur in an existing business or career.  They are not derived from a thinking exercise.  They thus appear sequentially to the entrepreneur, removing the ability to choose between several projects at once from easy consideration.

Capitalists, meaning venture capital firms, winnow this field to more leveragable projects by choosing to provide capital to firms with better business models.

Thus a poorly trained entrepreneur chooses a potentially poorly leveraged project with little training on how to maximize its chances of success.  It is no wonder that start up businesses fail frequently.
Accurate Reality:  Growth of GDP per person (read prosperity of society) is driven in substantial part by formation of new businesses - entrepreneurial activity.  Better trained entrepreneurs choosing leveraged projects with exclusion aided by better public policy would produce better outcomes.  These outcomes influence better outcomes - prosperity of society - for us all.

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