Sunday, June 20, 2021

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 Abstract

Excerpted From: Carlos Berdejó, Financing Minority Entrepreneurship , 2021 Wisconsin Law Review 41 (2021) (353 Footnotes) (Full Document)

 

CarlosBerdejóRacial disparities pervade the socioeconomic fabric of twenty-first century America: minorities lag in educational attainment, employment, income, and wealth. The average net worth of white households ($139,300) is over ten times the average net worth of African American households ($12,780) and almost seven times that of Hispanic households ($19,990). White households are over 50% more likely to own equity in their own homes than African American or Hispanic households. Unemployment rates also vary substantially along racial lines: the unemployment rate for African Americans (7.5%) is twice that of whites (3.8%), with Hispanics (5.1%) in between these two groups. Individuals belonging to minority groups are less likely to have a bachelor's degree: while 40% of white individuals graduate from four-year colleges, only 30% of African Americans and 20% of Hispanics do.

Disparities along racial lines also characterize the entrepreneurial space, where minorities are significantly underrepresented. This is evident not only in disparate business ownership rates but also in the share of the self-employed population and in the comparative success rates of entrepreneurial ventures. According to census data, minorities, which form 38% of the U.S. population, own just 19% of businesses. This gap is more pronounced in inner cities, where minorities make up 67% of the population but own 23% of businesses. Self-employment statistics provide a similar perspective: the self-employment rate among whites (10.9%) is twice that of African Americans (5.2%). Notably, there are significant differences in entrepreneurship across minority groups, as African Americans tend to have the lowest self-employment rates, followed by Hispanics and Asians.

Not only are minorities less likely to start and own their own businesses, but those who do financially underperform their non-minority counterparts. Minority-owned firms earn, on average, less than half of the revenue earned by non-minority firms, are less profitable, and experience higher failure rates. As with startup rates, there are notable differences in the financial performance of small businesses across minority groups. Despite numerous initiatives to promote minority business ownership, racial disparities in entrepreneurship stubbornly persist.

What explains the long-standing comparative difficulties faced by minorities in succeeding in entrepreneurial ventures? One of the major hurdles faced by minority entrepreneurs is access to capital, a challenge also faced by non-minority entrepreneurs but to a lesser degree. This Article explores why financing new businesses may be especially challenging for minority entrepreneurs. First, it describes why minority-owned startups are especially likely to face informational asymmetry problems when raising capital. Second, it expands on a theory grounded in behavioral economics literature that highlights the importance of social networks in addressing the informational asymmetries inherent in the financing of small businesses, particularly minority-owned ones. Third, it reviews evidence that many minority entrepreneurs have been excluded from crucial social and professional networks. Building upon these three insights, the Article proposes a policy intervention to facilitate minority entrepreneurs' access to capital.

The framework developed in this Article also explains why private markets have been unable to meet the financing needs of minority-owned businesses and why government programs meant to facilitate minority entrepreneurs' access to capital have instead fallen short. This Article shows that these programs have failed for two reasons: their reliance on debt as a financing mechanism and their reliance on large, hierarchical institutions as gatekeepers, despite those institutions' inability to confront certain types of informational asymmetries. Although private equity's organizational structure and investment strategies are ideally suited for addressing the informational asymmetries associated with investing in minority-owned businesses, the lack of diversity in their ranks has rendered these tools ineffective, leaving fund managers to fall prey to implicit biases. Crowdfunding, which many had hoped would level the playing field, has also failed because well-intentioned investors seeking a financial return cannot individually overcome informational issues.

The Article proposes a program that addresses the shortcomings of prior initiatives in this area through the creation of venture capital style funds (referred to as Local Impact Small Business Investment Companies or LISBICs) that focus their investment efforts on minority-owned businesses and the geographical areas where they are often located. To promote the development of these LISBICs, this Article proposes a series of policy interventions grounded on the existing regulatory framework of the Small Business Administration's Small Business Investment Company program (SBIC). The proposed LISBIC program borrows various elements from former SBIC initiatives, which should facilitate its implementation both from an administrative and political standpoint.

Current events have added to the urgency of addressing racial disparities in entrepreneurship. The COVID-19 pandemic has devastated small businesses and local communities. To survive in a post-pandemic world, minority-owned businesses' access to capital will need to improve considerably. Encouraging the survival and growth of minority-owned businesses would also help rebuild low-income minority communities and address some of the long-standing racial injustices highlighted by recent events. More generally, this Article illustrates how long-standing racial disparities and inequities in society migrate into the entrepreneurial space--a process that feeds into the cycle of poverty that continues to shatter minority communities.

This Article proceeds as follows. Part I summarizes the existing evidence describing the causes and effects of racial disparities in entrepreneurship, highlighting the critical role of access to capital and the reasons why minority entrepreneurs may struggle to finance their businesses. Building upon this evidence, the Article develops a theoretical framework centered on informational asymmetries and the “soft” nature of information relevant to many minority businesses to explain observed disparities.

Part II describes existing programs and initiatives that seek to facilitate minority entrepreneurs' access to capital and uses the framework developed in Part I to explain why these have generally been unsuccessful. Informed by this application of the theoretical framework,

Part III proposes a policy initiative that addresses the key shortfalls of the programs discussed in Part II and discusses the potential challenges raised by its implementation.

[. . .]

In light of recent political and economic events, removing the financial barriers faced by minority entrepreneurs is more crucial now than ever. Promoting the growth of minority-owned businesses is also sound policy, as it would have a considerable impact both at the local and national levels. Locally, it would help the economic development of minority communities in need of new jobs and better infrastructure. Diverting efforts and resources from redistributive transfer and relief to an initiative that mobilizes grassroots and private capital to help minority-owned businesses will strengthen a second front in the war against poverty by providing a market-based channel to remedy long-standing racial inequities. The aggregate economic effect of these efforts would also be felt nationally: due to discriminatory financing practices, our nation is losing over “1.1 million minority-owned businesses, and as a result, foregoing over 9 million potential jobs and $300 billion” in national income.

The problem examined in this Article has been widely acknowledged; the body politic and market participants are more willing than ever to act. That past programs have been relatively unsuccessful should not be discouraging. Understanding why past programs have come up short helps us design ones better suited to solve the problem at hand. Finding the right approach, however, requires identifying specific processes that drive disparities. This Article starts that conversation by highlighting the importance of soft information for minority-owned businesses and explaining how related informational issues have kept mainstream investors away. Most of the ingredients for a successful program, such as the one proposed in the Article, are already in place. The key lies in coordinating different regulatory frameworks and administrative bodies and involving private equity investors and members of the community. The costs and risks involved are great, but the benefits are immeasurable.


Professor of Law and J. Howard Ziemann Fellow, Loyola Law School, Los Angeles.


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