Incentives for Entrepreneurial Firms

Many economic development organizations (EDOs) have embraced the mission to support entrepreneurial firms in their communities. EDOs engage in their entrepreneurial ecosystems, in part, by providing resources, sometimes in the form of business incentives.

The purpose of this report is to provide practitioners and policymakers with insights regarding the use of these incentives and guidance for offering incentives to entrepreneurial firms. Researchers and policymakers use a wide range of definitions for “entrepreneurial firm” and “incentive,” making it difficult to categorize and describe the current state of entrepreneurial firm incentives. Multiple additional research challenges, including a lack of data on program outcomes, hinder the ability to draw definitive policy guidance from both program evaluations and academic research. This report strives to sort this tangle of material into a framework that is helpful for policymakers and economic development practitioners.

Typology

The most common types of state and local incentives for entrepreneurial firms are financial, fiscal, and services. Incentives for entrepreneurial firms are, for the most part, divided into two target categories: small business entrepreneurs and innovation- or technology-oriented entrepreneurs. New or young firms are rarely the defined target for state and local incentives.

State and local financial incentives are primarily intended to fill small business funding gaps and address the regional disparity in private equity investment. They may take the form of debt, equity investment, or grants. The most prominent type of fiscal incentive is a tax credit for angel investors, which is intended to address the funding gap by encouraging more private investment. Services incentives include, for example, business advice and training, technical assistance, professional services, access to innovation spaces and networks, and referrals.

State and local governments have increasingly recognized that incentives designed either for all small businesses or for only technology-oriented businesses with high growth potential leave out many types of entrepreneurial firms that contribute to community and economic development. In response, these governments are devising new approaches to support growth-oriented and second-stage small businesses, inclusive entrepreneurship and social enterprises, and microenterprises.

Entrepreneurial firm incentives in practice

Incentive program names, types, targets, and mechanisms tell only part of the story. Each location’s entrepreneurial ecosystem context and program implementation practices shape the impact of its entrepreneurial firm incentives. The following six implementation issues can influence incentive effectiveness.

• Incentives are only a minor component of the entrepreneurial ecosystem.
• Incentive program rules may inadvertently constrain access and limit participation.
• Awareness of and access to incentive programs remains a challenge without a consistent pathway for entrepreneurial firms to navigate offerings.
• Most individual incentive programs are very small, providing relatively small amounts of money and assisting a limited number of companies per year.
• BIPOC and women entrepreneurs, as well as entrepreneurs in rural communities and distressed urban locations all remain underserved. Existing programs, then, are primarily engaging a narrow segment of entrepreneurial firms. A new approach that serves all entrepreneurial firms is needed.
• Careful program design and active project management can improve effectiveness.

Outcomes

Research challenges limit the specific policy guidance that can be gleaned from academic studies, formal program evaluations, and annual reports. Many of the most robust studies examine federal programs rather than smaller, heterogeneous state and local incentive programs. Despite these limitations, a review of research resources has yielded some insights regarding best practices in the field of entrepreneurial incentives.

• Small business lending programs can be effective, but most stand-alone state and local small business loan programs are too small to have a substantial community- or firm level impact. The programs themselves may fill a gap in credit access, but they are still a minuscule segment of the small business credit universe. Good management practices, technical expertise, sustained outreach, and effective compliance procedures are necessary to ensure a chance for success – all of which are a challenge for programs that manage a small number of transactions per year.
• Research tends to highlight the risks associated with public funds for private equity investment, but this strategy remains popular. Even successful private equity investors generate few breakout successes and tolerate many company failures. State and local governments face an even greater challenge in achieving success because their goals are for firms receiving investments to create a substantial number of new jobs and remain in the state over the long term. Experienced managers and good management practices play an especially important role in equity programs.
• Grants appear to have positive firm-level effects, including employment and sales growth, that should yield community-level benefits, as well. The scale and scope of most grant programs, however, suggest that community-level outcomes would not be widely felt.
• Angel investor tax credits appear to have a positive but limited impact on the firm and community. Research in this area, however, is not definitive. Program design may mean that the tax credits disproportionately or unintentionally go to company insiders who may have made the investment even without the tax credit. Community-level benefits would not be widely felt except in the unusual case of a breakout company success.
• Tax incentives are not the best method of helping entrepreneurial firms. At best, they have indirect positive effects; at worst, they have a negative impact. Transaction costs can diminish the value of refundable or transferrable tax credits, diverting intended resources away from the entrepreneurial firm.
• Services to entrepreneurial firms appear to generate positive firm-level outcomes, but it is not clear which types of services are most valuable. Service offerings must be sufficiently staffed and funded to be effective.

Guidance and Conclusion

1. Design incentives to leverage other resources and boost the ecosystem.
2. Strengthen incentive management and implementation procedures to improve program effectiveness.
3. Establish data and research standards to help researchers and evaluators determine best practices.