By Richard Kasmin, NJEDA Chief Economist
 

Innovation is an essential ingredient for economic growth. But what exactly do we mean when we speak of innovation? At its core, it’s economic evolution – the process of taking what has been discovered and applying those discoveries to create improved ways of using finite resources to get things done. 

Innovation can be in the form of a process or a product. For example, learning ways to use available technologies to produce things more quickly, or cheaper, or with less energy consumption are types of innovation. 

The creation of something as seemingly simple as a pencil was the product of uncountable innovations over hundreds of years. Think of what it takes to produce a pencil: the raw materials, the ability to arrange for those resources to come together, and the labor and machinery required to make a pencil. And that’s to say nothing of getting the pencil to the market, where the value of the product is finally realized.

The big differences between the pencil and what we consider more modern examples of innovation can be measured on two dimensions: time and value. In terms of time, we’re talking about past and present. It’s difficult, in the year 2020, to consider a pencil the product of innovation. DNA engineering, by contrast, is happening now, and it seems almost magical in terms of potential economic impact. In terms of value, different innovations have different economic impacts. The pencil certainly created economic value, but when compared to the potential benefits of DNA engineering in terms of health care, the economic benefits of a pencil seem small.

Many state policy makers understand the value of innovation in terms of economic growth and increasing standards of living, and they are implementing various policies to encourage innovation. No matter what the innovation, there is one thing they all have in common – risk. Innovators and the people who invest in innovators take risks. Thus, this is where policy makers generally focus their attention – how to mitigate the cost of taking risk to encourage innovation investment.

The Angel Tax Credit

One such policy we have in New Jersey to encourage investment in innovation is the Angel Tax Credit. As the name suggests, The Angel Tax Credit provides tax credits to so-called angel investors against qualified investments in New Jersey technology and life sciences businesses. It is meant to boost access to funding for early-stage businesses engaged in technology and life sciences. Moreover, assuming the tax credit does encourage investments that would not have otherwise occurred, it increases the size of the innovation economy and helps to build a robust angel investment community.

Angel investors are a special breed of investors. More than just funds, angel investors also tend to invest their time and expertise into the firms they support. They fund early-stage entrepreneurs and often serve as mentors or outside directors of startups.

Research indicates angel investors have significant positive effects on the firms in which they invest. As evidence, a study conducted by the National Bureau of Economic Research showed firms with high angel investor interest were more likely to succeed than firms with low angel interest (Fig 1). The researchers concluded, “Firms that attracted a high level of interest among angel investors were more likely to grow, issue patents, win new rounds of funding, and have a successful exit from the startup phase.”

Figure 1 – The Positive Impact of Angel Investing

Source: National Bureau of Economic Research

In 2020, the size of the tax credit will rise from 10% to 20% of qualified investments. Moreover, there will be an additional 5% credit for investments made in firms located in Opportunity Zones and minority- or women-owned firms.

Increasing the size of the tax credit makes sense. To understand the right size of the incentive, one must consider the motive to invest in the first place. Angel investment are high risk investments – the investor is making an investment in a firm at its earliest stages of existence. Firms during this time are more likely to be engaged in research and development and are likely to have little-to-no revenue. Thus, these firms have no clear market value – you can’t really assess economic value without generating some revenue. Thus, the value of these firms is based more on a bet for what it will be worth once their products hit the market. And a lot must go right for all that to happen. 

Thus, these tend to be very high-risk investments where investors are making a bet to hopefully generate multiples of their original investment. As such, a larger incentive is likely necessary to alter investment decisions, which is what incentives like the Angel Tax Credit are meant to do.

Angel Tax Credit History

Since the program’s inception in 2013 through 2019, the NJEDA has approved around 1,400 Angel Tax Credit applications for almost $600 million in investments in around 90 New Jersey-based businesses.  Looking at the sector destinations of those investments, 45% went to life sciences companies and 55% went to technology companies (of which, 14% went to clean technology companies).

The two charts below show flows of approved applications and investments broken down into three sector destinations — clean technology, life science, and other technology. Figure 2 depicts applications by year for the life of the Angel Tax Credit program. Figure 3 depicts the investment flows for which those tax credits were applied. Focusing on the last four years, approved applications have averaged around 240 per year for an average of around $120 million in investments per year. 

Figure 2 – The Number of Applications Per Year

Figure 3 – Investments Supported by Angel Tax Credits

The Geography of Venture Capital and Angel Tax Credits

One question we might ask is, where do we see venture capital flows in New Jersey, and how representative of geographic coverage in the state are Angel Tax Credits? To answer the first part of that question, we mapped data from Crunchbase, a web-based platform that provides data on the locations of headquarters who received venture capital funding (2011 to present). As the map below shows (Figure 4), there is evidence of what looks like a Start-Up Corridor, with hot spots around Jersey City and Princeton. There are some concentrations of firms along the shore and near Camden. When we look at the locations of headquarters for firms that benefitted from angel tax credit investors (Figure 5), we see some similar hot spots in and around Jersey City, Newark, New Brunswick, and Princeton. Most all activity is in the northern portion of the state, north of 195. It may be worthwhile to consider whether more can be done to expand the geographic coverage of the Angel Tax Credit outside some of the current hotbeds to attempt to expand the venture capital ecosystem.

Fig. 4 – VC in New Jersey

Fig. 5 – Angel Tax Credit HQs

Underrepresented Communities

As noted earlier, the new iteration of the Angel Investor Tax Credit will provide bonuses for investments made in opportunity zones or firms that are minority- or female-owned. That begs the question, what evidence do we have firms in such categories require more attention? 

According to a recent survey by DiversityVC and RateMyInvestor, nationwide only one percent of venture-backed founders are black and less than two percent are Latinx. Clearly, black and Latinx populations lack access to venture capital. 

Female-owned firms – companies that are both solely owned or owned in partnership with male owners – do not fare much better. In the eleven years of data released by Pitchbook (2008-2019), female-owned firms in New Jersey generated 176 deals capturing $769 million in venture capital flows. The flow during this period accounted for approximately 13 percent of deals and 9 percent of capital flows. Clearly females are underrepresented in this corner of the economy. 

Yet, as depicted in Figure 6, the data shows female-owned firms in New Jersey are seeing a growing share of flows. Looking at the linear trend (depicted in the dotted lines), since 2008, the share of deals and flows in New Jersey going to female-owned firms has increased approximately one percentage point per year. In 2008, female-owned firms accounted for approximately 7 percent of deals and just 4 percent of capital in New Jersey. In 2019, those shares rose to approximately 23 percent and 14 percent, respectively. 

Figure 6 – The Share of Venture Capital Flows Going to Female-Owned Firms
 

In conclusion, policymakers are focused on supporting the growth of innovation ecosystems for good reason – innovation is instrumental for economic growth and increased standards of living. Given the risk commensurate with angel investing, increasing the size of tax credit should incentivize increased investment and encourage growth of New Jersey’s innovation ecosystem. Furthermore, the evidence shows women- and minority-run firms have historically faced challenges in accessing capital, and the focus of the Angel Investor Tax Credit on these populations should lend needed support.

For more information on the Economist’s Corner, or to view the archive of Economist’s Corner postings, please visit www.njeda.gov/economistcorner.

Under Governor Murphy’s leadership and his plan for a stronger and fairer New Jersey economy, there has been an increased emphasis on the importance of small businesses and new business creation within the Garden State. Last year, the NJEDA realigned its operations to create a new small business-dedicated team, and has since introduced a variety of new small business programs. 

Defining small business

Before we can begin to understand the impact of small business, we need to establish what constitutes a small business. The simple answer is, there is no one generally agreed to principle of what constitutes a small business. The US Small Business Administration uses a definition of an independent business with fewer than 500 employees. But this definition has a couple of inherent flaws. For one thing, this definition creates a net that snares a lot of relatively large businesses in terms of revenue and the scope of the customer base. Moreover, emphasis on number of employees misses an important point – more than 80 percent of all business entities in the US have no employees at all and likely never will.

For the sake of this brief, we’ll constrain our definition of small business to two groups of businesses:
 

Lastly, there is a lot of dynamism and growth in the nonemployer business ecosystem. From 2012 through 2017, the number of nonemployer business in New Jersey increased at a 3.3 percent annualized rate and nonemployer business receipts in New Jersey grew at a 3.9 percent annualized rate. These growth rates are both faster than underlying GDP growth in New Jersey, showing nonemployer businesses are a growing segment of New Jersey’s economy.

“Small” Employer businesses in New Jersey

There are approximately 160,000 small employer businesses in New Jersey, accounting for around 87 percent of all employer businesses. Although they are such a large share of businesses, they account for only around 19 percent of New Jersey jobs and 13 percent of payrolls. The reason is most of these small employer businesses are truly small, employing one-to-four employees with an average payroll of around $77,000. Yet, these numbers add up. In sum, approximately 665,000 employees work for small businesses, generating around $28 billion in payroll income per year. 

As with nonemployer businesses, small employer businesses are more likely to be minority- or female-owned than larger businesses. Of small businesses, approximately 27 percent are minority owned and 31 percent are female owned. It’s also important to note the significance of small employer businesses varies depending on the industry. For instance, around half of total construction industry income in New Jersey is generated by small employer businesses. This share drops to less than 8 percent in finance and insurance. In construction, 16 percent of small employer businesses are female-owned and 12 percent are minority-owned. In retail, these shares jump to 40 percent minority-owned and 38 percent female-owned. The point being, the impact small businesses have on the economy varies significantly from industry to industry. Graphics depicting the impact of small businesses in New Jersey by industry are displayed at the end of this brief.

The Aggregate Small Business Landscape in New Jersey

Adding together data on small employer businesses and nonemployer businesses allows us to examine the impact of the entire small business universe on New Jersey’s economy. To do so, it is useful to relegate impact into buckets of influence. In the following graphic we’re looking at four main buckets:
 

But when it comes to job creation, it’s new businesses – not small businesses — that matter

It’s really the creation of new firms, rather than small firms, per se, that’s the lifeblood of an economy. New firms, led by entrepreneurs, are essential to what the famous economist Joseph Schumpeter coined “creative destruction” — the process through which economic growth occurs as new firms replace older, less productive firms. Whereas new firms create net new jobs, firms that have existed for one year or longer essentially shift a lot of employees between firms and create very few net new jobs.

This is not to say movement of jobs between firms, often referred to as labor market churn, is not important. Quite contrary, it is very important for income growth of people who leave jobs to take better opportunities elsewhere. But when it comes to actual job creation and productivity, it’s new firms that matter most.

Conclusion

In sum, small business is certainly a lifeblood of economic opportunity for certain segments of the population, especially when we consider these businesses create jobs for their owners. Given the important contributions these businesses make to the economic lives of many New Jerseyans, the state should certainly do what it can to enable the creation and ongoing health of these businesses by lowering barriers to entry, providing efficient licensing and regulation, and ensuring a stable legal and tax backdrop so these businesses understand the “rules of the game” and owners feel comfortable investing in and growing their businesses. Moreover, it is important current and prospective small business are well informed about the resources New Jersey provides, such as the Small Business Lease Assistance Program, CDFI Initiative, NJ Ignite, and the recently-expanded Angel Investor Tax Credit, to support small businesses and startup development and growth.

The Small Business Landscape, by Industry