Solomon’s Knot, a book by Robert D. Cooter and Hans-Bernd Schäfer and published by Princeton University Press, is the newest release in the Kauffman Foundation Book Series on Innovation and Entrepreneurship. Authors Cooter and Schäfer propose a legal theory of economic growth that details how effective property, contract, and business laws help to unite capital and ideas. They also demonstrate why ineffective private and business laws are the root cause of the poverty of nations in today’s world. Without the legal institutions that allow innovation and entrepreneurship to thrive, other attempts to spur economic growth are destined to fail.

The authors explain that sustained growth depends on innovation, whether it’s cutting-edge software from Silicon Valley, an improved assembly line in Sichuan, or a new export market for Swaziland’s leather. Developing a new idea requires money, which poses a problem of trust. The innovator must trust the investor with his idea and the investor must trust the innovator with her money. Cooter and Schäfer call this the “double trust dilemma of development.” Nowhere is this problem more acute than in poorer nations, where the failure to solve it results in stagnant economies.

Cooter and Schäfer propose a legal theory of economic growth that details how effective property, contract, and business laws help to unite capital and ideas. They also demonstrate why ineffective private and business laws are the root cause of the poverty of nations in today’s world. Without the legal institutions that allow innovation and entrepreneurship to thrive, other attempts to spur economic growth are destined to fail.

Robert D. Cooter is the Herman F. Selvin Professor of Law at the University of California, Berkeley. His books include The Strategic Constitution (Princeton). Hans-Bernd Schäfer is professor of law and economics at the Bucerius Law School in Hamburg, Germany, and professor emeritus at the University of Hamburg. His books include The Economic Analysis of Civil Law.

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SOURCE: Princeton University Press, Kauffman Foundation

Jack Kemp, who died May 02, 2009, was remembered for his commitment to free-market principles, known as entrepreneurial capitalism, that transformed the world in the 1980s.

entrepreneurial capitalism: private capital, investing in private start-ups, with potential for a viable harvest

Kemp: “Does government create jobs, or do entrepreneurs? Does government spending spur growth, or do lower taxes, less regulation, and spending limits? Can government direct investment better than the private sector? The answers to these questions provide the keys to designing a strategy for long-term growth in America.”

The quarterback-turned-politician died of cancer at age 73. Mr. Kemp was an early influence, along with economist Arthur Laffer and President Ronald Reagan, in getting the Republican Party to embrace the philosophy of tax cuts. Republican Sen. Robert Dole’s selection of Mr. Kemp as his running mate in the 1996 presidential election reaffirmed Mr. Kemp’s imprint on GOP economic policy.

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Special Backstory: Entrepreneurs, Low Taxes, Create Economic Growth

For nearly every entrepreneur, access to private equity capital, or risk capital, is a key ingredient to successful business growth.

Entrepreneurship, combined with support from venture capital, is a major force driving economic growth in the United States. Thomas McConnell of New Enterprise Associates said, “Venture capital investment is a national phenomenon that helps set the U.S. economy apart from others in the world.” Venture capital financed groundbreaking research and untold improvements in infrastructure and technology. The average venture-backed company employs nearly 100 workers within five years and creates almost twice as many jobs as their nonventure-backed competitors.

Venture capital, risk capital, was perfected in the Reagan era with the help from Jack Kemp. Things changed with President Ronald Reagan’s election in 1980, when the business environment shifted from President Carter’s “Days of Malaise” as the Republicans produced political leaders committed to entrepreneurial capitalism. Their thrust took shape under “supply-side economics,” which was first envisioned by economic adviser Dr. Arthur Laffer. His winning thesis was simply this: Lower the marginal tax rates. He believed that individuals should keep more of their hard-earned money, which would encourage them to make more.

In August 1981, less than seven months after being sworn in, President Reagan signed the Kemp-Roth bill into law. It was the cornerstone of what would become the most successful economic policy for new business venturing in U.S. history. The bill’s treatment of capital gains, a lowering of the top capital gains tax rate from 28 percent to 20 percent, made high risk investments even more attractive, causing a twofold increase in commitments to venture capital funds in 1981.

Entrepreneurs then launched a boom that would last, except for a brief eight months following the Gulf War in 1991, until the end of the twentieth century. It was the longest period of economic expansion in the nation’s history. Between 1983 and 2003, the Dow Jones Industrial average provided an annual return of 11 percent. For comparison, between 1965 and 1983 its annual return was 1 percent.

According to the U.S. Department of Labor Non-Farm Employment Data, the American economy generated over 27 million new jobs between 1980 and 1995. Over 24 million of these new jobs were created by small- and medium-size entrepreneurs operating high-growth ventures. As Dr. Laffer predicted, even Washington, D.C., prospered well, with the U.S. Treasury revenues increasing 28 percent to more than $1 trillion in 1990.

At the closing of the last century, MIT economist Lester Thurow had this to say: “In what will come to be seen as the third industrial revolution, new technological opportunities are creating fortunes faster than ever before. The United States has created more billionaires in the past fifteen years than in its previous history—even correcting for inflation and changes in average per capita gross domestic product.”

>>Read More at Wall Street Journal

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“Other than President Ronald Reagan himself, few people in the political world have had more influence on the last quarter century of wealth creation and rising levels of entrepreneurial business expansion than Jack F. Kemp.”
- Steve Forbes

The Second American Revolution: Reaganomics
When Ronald Reagan took the oath of office as America’s 40th President on January 20, 1981, the country was experiencing some of bleakest economic times since the Depression. Taxes were high, unemployment was high, interest rates were high and the national spirit was low. The American dream had been restored with the help from Mr. Jack Kemp.
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>>Wall Street Journal: Jack Kemp

>>Heritage Foundation Mourns Loss of Jack Kemp, Fighter and Leader

>>Capitalist for the Common Man

>>Jack Kemp: It’s Time to Think Big on Tax Cuts

>>Should the GOP Forget Reagan?

>>He Had the Power of the Happy Man

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Jack Kemp in His Own Words
“It was this economy, triggered by President Reagan’s supply-side revolution of tax cuts in 1981 that generated 21.5 million new jobs, more than four million new businesses, relatively low inflation and higher standards of living for most people. This economy has created more jobs in the past decade than all of Europe, Canada and Japan combined. And according to the U.S. Treasury, federal income taxes paid by the top 1% of taxpayers has surged by more than 80% to $92 billion in 1987 from $51 billion in 1981.”

“In my opinion, people of all colors and income levels don’t hate the rich. They want to get rich. They’re more interested in generating wealth than they are in redistributing wealth. They want to own property, educate their children and build a nest egg that can be passed on to their heirs. Unfortunately, some aren’t able to access the same ladder of opportunity that is so readily available to the majority. . . .”

“By giving people access to capital and allowing them to take ownership of assets, entrepreneurship will be encouraged and the cycle of poverty can begin to be broken. All persons should have the opportunity to go as high as their merit and determination can carry them.

My favorite quote is from Abraham Lincoln, who said, ‘I don’t believe in a law to prevent a man from getting rich; it would do more harm than good. So while we do not propose any war upon capital, we do wish to allow the humblest man an equal chance to get rich with everybody else.’ Lincoln’s definition of entrepreneurial capitalism is the best I have ever heard.”

>>Read More

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>>A Tenth Anniversary Celebration of the Kemp-Roth Tax Cuts: The Importance of America’s Victory Over Washington, October 20, 1991 

>>Heritage Foundation: Corporate Tax rates 

>>Jack Kemp

>>Kemp Roth Tax Bill, 08-15-81

>>Jack F. Kemp Institute for Political Economy, Pepperdine University

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Origins of Entrepreneurial Capitalism

entrepreneurial capitalism: private capital, investing in private start-ups, with potential for a viable harvest

To better understand entrepreneurship, it is useful to look back to the early development of capitalism. Capitalism depends on harnessing private motives to produce the goods and services that the public wants as efficiently as possible. Historian Charles Van Doren leads us to the early roots of “primitive capitalism” in his book A History of Knowledge: Past, Present, and Future. He provides insight to the ancient Egyptians, economic life before the peasant, the introduction of the merchant, the king, the rise of the labor markets.

Defined today, capitalism is a political, social, and economic system. It is characterized by the private ownership of property—not only of land and buildings but of patents, know-how, and processes that are used by entrepreneurs to create profits for themselves.

Capitalism sharply contrasts with other economic systems, like feudalism and socialism. In capitalism, entrepreneurs are responsible for such economic decisions as what to produce, how much to produce, and what method of production to adopt.

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SOURCE: SoftwareAdvice.com

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SOURCE: Fox Business News

Marc Andreessen, co-founder of Netscape, vividly describes an insider’s view to the venture capital industry’s food chain: The best venture capitalists (VCs) can see ahead and are willing to think they can fix things, put the management team together, do all this stuff. Any huge success story like Netscape or Apple is like a sausage factory. Everybody likes to eat sausage; no one likes to see how it gets made. These things are all sausage factories inside.

In their influential book, Venture Capital at the Crossroads, Bygrave and Timmons tell us that the lifeblood of the venture capital process consists of three essential components: entrepreneurial deals, money to invest in those deals, and a return on the money invested in them.

Depending on the investment focus and strategy of the venture capital firm, it will seek a liquidity event to exit the investment in the entrepreneur’s venture within three to seven years of the initial investment. While the initial public offering (IPO) may be the most glamorous and heralded type of exit for the venture capitalists and founders of the venture, most successful exits of venture investments occur through a merger or acquisition (M&A). In the case of an M&A, the venture firm will receive stock or cash from the acquiring company, and the proceeds of the sale will be returned to its limited partners.

Just like the entrepreneurs they finance, venture capitalists have to go out and raise money too. They get the majority of their funds from outside the partners of the firms. Most VCs raise their funds from institutional investors, such as pension funds, insurance companies, endowments, foundations, and high net-worth individuals. These investors who invest in venture capital funds are referred to as limited partners. Venture capitalists, who manage the fund, are referred to as general partners. Each year, a venture firm will set out prospecting for investors with a target fund size. It will distribute a prospectus to potential investors and may take from several weeks to several months to raise the requisite capital.

The commitments of capital are raised from the investors during the formation of the fund. In 2001 a total of $40 billion was committed to 299 venture capital funds. Private and public pension funds continued to dominate as limited partners, as 42 percent of the capital committed to venture capitalists came from them, 25 percent from financial and insurance organizations, 22 percent from endowments and foundations, and 9 percent from individuals and families; corporations committed the remaining 3 percent.

As an investment manager, the venture capital firm will typically charge a management fee to cover the costs of managing the committed capital. This fee ranges between 2 percent to 2.5 percent of the money they manage and will usually be paid quarterly for the life of the fund. This is most often negotiated with investors upon formation of the fund in the terms and conditions of the investment. “Carried interest” is the term used to denote the profit split of proceeds generated from a liquidity event between the VC firm and its limited partners. This carry is commonly paid to the VC firm only after investors have recovered their investment.

Not all venture capitalists invest in start-ups and early-stage ventures. Venture capital firms have different preferences and practices, including how much money they will provide, where in the entrepreneurial life cycle they prefer to invest, and the cost of capital or expected annual rate of return they are seeking. The sources of capital change dramatically for entrepreneurs at different stages of development and rates of growth. According to Dan Bassett, a partner at InnoCal Partners based in Costa Mesa, California, “The number one piece of advice for entrepreneurs is to know where you are on the food chain. If you don’t know, seek advice and make use of the very high quality people in your environment.”

Stage Definitions used in the Venture Capital Industry
The five stages in the food chain of the venture capital industry are described in more detail below.

1. Seed-Stage Financing
The venture is in the gestation, or idea formation stage, as the product is not fully developed. A relatively small amount of capital is usually provided to an inventor or entrepreneur to prove a concept. This may involve product development and pre-marketing activities like market research, as well as building a venture team and completing a business plan.

2. Early Stage Financing
Early Stage or Start-Up Financing is used for completing product development and may include initial marketing efforts. Ventures eligible for this type of financing may be in the process of organizing, or they may already be in business for two years or less, but have not sold their product commercially. Investors want to see entrepreneurs that have conducted market studies, assembled the key players on their venture team, developed a business plan, and are ready to launch. Once launched, this opens the door to institutional investors, as the networking capabilities of the venture capitalists are used more here than in more advanced stages.

3. Development and Expansion-Stage Financing
Ventures here are usually more than three years old, demonstrating significant growth in revenues, and may or may not be showing a profit. Some of the uses of capital may include expansion of production capabilities, marketing, new product development, or developing new markets for the existing product line. The venture capitalists’ role in this stage evolves from a supportive role to a more strategic role, often bringing in more institutional investors along with initial investors from previous rounds.

4. Later-Stage and Bridge Financing
Investors provide capital for ventures in this stage that have reached a fairly stable growth rate and have either stable streams of profitable earnings, or highly predictable streams of top line revenues. VCs will provide bridge financing when a venture plans to go public within a year or so. This can be structured so that it gets repaid from the proceeds of a public underwriting. It can also involve the restructuring of major stockholders/early investors who want to reduce or liquidate their positions, or if management has changed and the stockholdings of the former management, their relative and associates are being bought out.

5. Acquisition and Leverage Buyout Financing
Investors provide funds to finance the acquisition of another private venture or public company. This includes money for mezzanine financing using subordinated debt, and bridge loans which are used to finance Leveraged Buyouts (LBOs), and recapitalizations. Financing for a Management Buyout (MBO) enables a group to acquire a product line or business, at any stage of development, from either a public company or a closely-held private venture. An MBO usually involves the revitalization, or a “turnaround” of an operation, where an entrepreneurial management team acquires a significant equity interest in exchange for improving the venture’s performance.

Understanding the Types of Securities
There are two types of financial offerings available to entrepreneurs, equity and debt. In exchange for private equity investments, the venture issues equity securities. There are three basic types of securities.

 - Common shares are most often issued to those who manage the corporation, bear the major risks of the venture, and yet stand to profit the most if it is successful.

 - Preferred shares have liquidation and dividend preferences over common shares and may be converted into another class of shares, usually common shares.

 - Debentures are long-term, unsecured debt securities.

Debt financing is a method involving an interest-bearing instrument, usually thought of as a loan, and it requires that some asset be used as collateral. Debt requires the venture to pay back the amount of the borrowed funds as well as a fee for the use of the money for the time it was loaned out, which is called interest.

All entrepreneurs interested in raising capital must decide which vehicle is most appropriate for their situation. An equity offering will give share ownership and some level of control to others. Also, with an equity offering, working capital and financial leverage of the venture improves, as interest costs and debt service in future years are avoided. On the other hand, debt financing has the distinct advantage that it does not dilute the existing shareholder value. While the main focus of this book is on private equity financings, the process and information required—like the business plan, marketing plan, and financials—are very similar to what is required for debt financings.

What Are Typical Returns on the Investments?
Entrepreneurs are the source of consistent high-performance returns on investments. Performance for the venture capital industry is traditionally measured by the internal rate of return (IRR). The IRR considers “cash-on-cash” returns from the sale of shares and disbursements from the liquidity events back to investors, such as dividends. It is calculated by taking inflows of cash as negative cash flows, and distributions of cash and stock to investors as positive cash flows.

Venture capitalists have to have a good idea of the percentage returns they anticipate on their investments. Their limited partner investors—the “limiteds”—are IRR-driven, hence so are the VC’s practices of investing. Because VCs focus on delivering an average of 30 percent-plus back to their limiteds, they target for around 50 percent-plus on each investment. Private equity returns are derived from distributions back to investors and interim portfolio company valuations.

The venture funds have lives on average of ten to twelve years. Their performance during the first three years of investment activity are volatile and difficult to measure. A typical VC investment might have one of five potential outcomes: “Bad,” “Alive,” “Okay,” “Good,” and “Great.” The Bad, a complete “wipe-out,” does not return anything; the Alive returns maybe 1x the money invested; Okay returns 5x; Good returns 10x; and Great returns are 20x or higher.

On the average, the gross returns on each $1,000 invested would be $4,400, and the net, less the Bad, would be $3,400. For longer periods of time, returns on venture capital investments outpace all others. For comparison, by the end of 2001, the five-year rolling averages were 38 percent for venture capital, 17 percent for NASDAQ, and 14 percent for the S&P 500.

Understanding the Selection Process
Venture capitalists mitigate the risk of venture investing by developing a portfolio of companies in a single venture fund. They invest in a small percentage of the business plans that get placed and reviewed at their firms. When considering an investment, they carefully screen the technical and business merits of the deal before them. Jesse Reyes, vice president for Thompson Venture Economics, a New York-based venture capital research firm, says, “The key to this new environment, though, is that the venture investors can afford to be choosy about what deals they do, and they’re exercising that right.” Therefore, the selection process can be quite comprehensive. We continue this discussion in Financing The Emerging Growth Venture.

How A Venture Capital Firm Screens Its Deals

1. Placement of Completed Business Plan, through appropriate “warm” referrals.

2. Quickview and Routing, the plan is directed to the most appropriate reviewer based on partner’s domain expertise.

3. Business Plan Review, one or more partners will review the plan and evaluate it based on a number of factors related to the firm’s current area of focus. Based on the outcome of the review process, the entrepreneur will be contacted and informed of the next steps.

4. Informal Dialogue, whereby additional details are requested from the entrepreneur through email and phone calls. If there is significant interest, the entrepreneur and team will be invited to present before the firm’s investment professionals.

5. Initial Pre-Screening Meeting, much like an interview process, provides opportunity for the interested partners to be introduced to the entrepreneur and team and see them in action with the presentation. They discuss the next steps in the funding process, and how the firm can assist the entrepreneur and team.

6. Informal Due Diligence, a step for pre-investment analysis, typically it can be conducted in about a week but sometimes takes as much as three weeks. The investment committee, which is made up of all the partners in the firm, reviews and discusses the due diligence that has been conducted up to that point.

7. Formal Presentation, if a decision is made to continue, they will ask the entrepreneur to formally present before senior partners. After the presentation, the investment committee would then make a decision whether or not to make an offer for investment.

8. Investment Decision, during the initial phase of either the informal and/or formal due diligence process, the investors will present and finalize details of a “Term Sheet.” The Term Sheet will outline the general attributes of the relationship between the entrepreneur and the VC firm.

9. Formal Due Diligence, a full firm-wide effort is applied to the in-depth investment review process. Generally, one of the partners will take the lead in this extensive analysis. This process includes additional reference checks of the entrepreneur and team, dialogue with industry and customer references, and interviews with independent subject matter experts.

10. Closing Documents, a collaborative effort between the attorneys of the venture firm and the entrepreneur that will define the legal framework relationship between the venture and the investors.

11. Investment, provided that all reach an agreement, the VC then provides the funding and the two parties begin working together and creating sustainable value.

IRS will not require reconciliation of gross receipts and merchant card transactions on business tax returns

On February 10,2012 the Internal Revenue Service (IRS) amended its informational webpage on credit card reporting requirements to announce that the IRS will not require reconciliation of gross receipts and merchant card transactions on Forms 1120, “U.S. Corporate Income Tax Return,” and other business income tax forms. The Housing Assistance Tax Act of 2008 requires credit card companies to report merchants’ annual gross credit, debit, and third party network payment card transactions to the IRS using Form 1099K. Small businesses had expressed concern about the burdens and costs associated with reconciling discrepancies between their own sales records and the Forms 1099K issued by credit card processors. The February 10th IRS announcement directly addresses these small business concerns.

>>Learn More: IRS FAQs on New Payment Card Reporting Requirements

This article describes some stylized facts about expropriation of Foreign Direct Investment (FDI) and develop a theory that relates direct and indirect forms of expropriation to the degree of political instability (the frequency at which groups alternate in power) and concentration of power (the number of powerful groups affecting policy).

Lack of commitment of a government that cannot write binding contracts with multinational corporations, together with the existence of redistributive uncertainty of the amount expropriated, result in excessive expropriation. We find that, consistent with empirical work, countries that are politically stable attract more FDI because foreign investors expect lower expropriation rates. Interestingly, this result holds as long as power is concentrated between a few number of influential groups.

NOTE: This is an Adobe PDF file. Download the Article in PDF

>>Read More at NY Times

Hello City Planner!
Watch this video and learn how government policies and regulations hurt entrepreneurs who want to launch a new business.

It was once assumed that college graduates would go to work for a Fortune 500 firm and that is often true; what is also true is that more students see entrepreneurship as a viable option for their careers. This study examines the relationship between education and the choice to become an entrepreneur, building on previous research and using the Panel Study of Income Dynamics (PSID) to analyze the characteristics of the self-employed compared with individuals employed by others.

The study finds that educational attainment is an important determinant of self-employment: individuals with more schooling are more likely to start their own business, particularly in certain industries.

NOTE: This is an Adobe PDF file. Download the Report in PDF

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Source: Kauffman Foundation