Money for startups: The key to creating more companies?

We can all agree that anything that contributes a third of a country’s gross domestic product is fairly important, right? According to the Ministry of the Economy and Commerce (MEIC), Costa Rica’s small and medium businesses pitch in a whopping 33% of our nation’s GDP. According to the same study, the SMEs (or PYMES, using the Spanish acronym) generate roughly half of private-sector employment. Anybody generating public policy has to wonder: how can we support such an important sector and help it grow?

Helping existing SMEs reach the next level of development is a subject for another day, and is certainly a complex task depending on the industry, the competitive landscape, and the maturity of the market; most of all, it depends on the entrepreneur and his or her family. But let’s take a step back and consider how we can get these businesses started in the first place. How do we keep the pipeline flowing and ensure that more and more companies get created every day?

What is the most important factor in starting a company? The idea? The entrepreneur? Having access to adequate funding? The timing? The business model?

While access to funding has been shown to have the least impact of all these factors in the success of the startup, it seems to be at the top of everybody’s list, from entrepreneurs to government officials to private parties. That belief has fueled a decade of startup competitions and awards that lure hopeful entrepreneurs eager to take home the purse. In the same way, the government has tried to jumpstart the entrepreneurial ecosystem by providing flexible loans and seed money through the Banca para el Desarrollo (Banking System for Development). Incubators are popping up like Starbucks on every corner, offering not only office space but also the long-term promise of investment.

The general agreement has been to focus on providing money as a strategy to create more companies. The issue here is that the way this money is being channeled often creates incentives that don’t match the reality of startups, or that aren’t necessarily in line with the intended goal.

Let’s take the case of flexible loans. Through the Banca para el Desarrollo, you can go to a local bank and get a loan with low interest rates and sometimes long terms. Sounds good, right? The catch is that banks’ mechanisms to assess risk and determine eligibility are appropriate for individuals or established companies, but not startups. How do you determine the repayment capacity or cash flows of a company that has not yet started generating income?

The second problem is collateral. Since young companies rarely have any assets to offer as collateral, it is up to the entrepreneur to mortgage her house or provide some other guarantee of payment, which of course adds to the pressure of starting a company. The truth is, this Banca para el Desarrollo requirement could very well support established companies, but when it comes to startups, this hurdle can get in the way of company creation.

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Even for established SMEs, relying on flexible bank loans for their financing needs seems like a long shot. In spite of representing a third of GDP and half of the jobs in the private sector, the SMEs’ total balance amounts to only 8.6% of  the credit portfolio of supervised financial entities. Of course, the banks are in it to make money, and they have to adequately protect their exposure to risk, but these figures show that we need to rethink the mechanisms through which we make this money available to startups or SMEs if we really want to boost the sector.

Another agent in making funds available for startups is the aforementioned competitions and awards. Again, although perfectly well-intentioned, these competitions are unsuspectingly creating incentives that in many cases not only contribute little to the development of startups, but might also be detrimental.

Let’s examine how these competitions usually work. Normally there’s a call for applicants that draws what lately has been a growing number of participants, usually in the hundreds. Because of the volume of applications, the organizations running the competition don’t rely on anything as complicated as a business plan to make their selections, since it would be impossible to read and properly assess hundreds of business plans. So they either rely on a set of ten or so questions, or on a two- to three-minute pitch.

How well can you really get to know a business from this limited input? That’s debatable, but I suspect that this mechanism ends up, albeit unintentionally, measuring and rewarding something else. It is usually the most articulate entrepreneurs, the most charismatic, and the best communicators, who end up in the qualifying rounds. Since competitions don’t spend much time checking facts and figures due to volume and time constraints, what really creates the impact is the story, and that is creating a new breed of entrepreneurs: great storytellers for competitions. I am not implying that all winners lack viable businesses, but after having participated as judge or consultant in many competitions, and having followed winners through the years, it is clear that many startups are recognized on the basis of a great story, but not necessarily a great business.

Access to funding is without a doubt a factor in startup success and therefore in company creation, even when it is not the most important one. Eager to solve a problem, we often take shortcuts or overlook the fact that even a reasonable solution, when poorly delivered, might fail to create the desired outcome. Precisely because funding seems to be one of the factors that get the most attention, it is important that entrepreneurs, policymakers and investors alike pay attention to the mechanisms through which those funds get channeled and the incentives they create. We have to make sure those incentives trigger the right behavior so that we actually achieve the goal we’re after – in this case, lots and lots of successful startups.