Suc­cess can make en­tre­pren­eurs avoid the au­thor­it­ies

Around the world, millions of entrepreneurs run businesses every day outside the view of the authorities. They do not pay taxes, their businesses are not officially registered, and they have limited access to the banking system.

It could be a street vendor in Ghana, a clothing manufacturer working from home in Pakistan or a local mine owner in Uganda.

Informal entrepreneurs account for a large share of the business community in many developing economies. They generate income and jobs but at the same time they miss out on many of the opportunities available to formal business owners, such as access to loans, insurance, larger contracts, legal protection and public support schemes.

Even so, many entrepreneurs choose to turn down these opportunities and remain informal instead. 

The same solution does not work for everyone

Policymakers and international organisations such as Danida have tried to bring more businesses into the formal economy for a long time. One idea behind these efforts is that registration can improve company productivity, enhance employees’ rights and generate more tax revenue for the government.

Several countries have therefore attempted to make registration cheaper and easier; however, previous initiatives have shown that better information, free registration or lower costs do not always persuade many businesses to change their status.

A new study published in the recognised Journal of Business Venturing now concludes that we should approach the issue very differently. The findings may be relevant to national authorities as well as international development organisations working on business development in Africa, Asia and Latin America.

“One of the mistakes we make is to consider informal entrepreneurs a homogeneous group, but there is considerable diversity among them and their ambitions vary greatly,” says Marcus M. Larsen, Professor at CBS and one of the authors of the study. 

Two entrepreneurs may respond in opposite ways

For entrepreneurs, it is not simply a question of registration costs; their ambitions matter too. Do they dream of growing their business? Are they simply trying to survive? And is the business performing better or worse than expected?

The study therefore distinguishes between entrepreneurs who are primarily trying to secure their livelihood and entrepreneurs who are mainly pursuing growth, higher earnings and personal success.

For a growth-oriented entrepreneur whose business is performing below expectations, registration may be seen as a pathway to larger markets, investment and new contracts.

“If, on the other hand, the business is doing better than expected, the response may be the opposite. The entrepreneur may conclude that the current model works, so why take on taxes, regulations and uncertainty if the business is already making good money?” says Marcus M. Larsen.

From slum to cult status

As an example of the latter, Larsen points to film director Isaac Nabwana, who founded his film studio in Wakaliga, a slum neighbourhood in Uganda’s capital, Kampala. The studio is known as Wakaliwood and operates on an extremely low-budget model.

Neighbours act in the films, and friends make props from scrap metal. Productions take place without many of the formal permits, contracts and administrative systems normally associated with running a business.

But as the business grows, Nabwana faces a classic dilemma: should he continue as an informal entrepreneur with strong local support and low costs, or should he formalise the business to gain access to larger markets and contracts, while potentially gaining greater protection from the authorities against piracy?

The problem is that licences, taxes and other requirements are costly and may threaten the economic model that has made Wakaliwood successful. 

Focus on the entrepreneur’s ambitions

“The example illustrates the dilemma that successful informal entrepreneurs may face. On the one hand, the lack of formalisation may limit opportunities for further growth, funding and protection of rights. On the other hand, they are comfortable with their current business model, which is often very simple,” Marcus M. Larsen points out.

While success may in some cases keep growth-oriented entrepreneurs from registering, the study finds the opposite among entrepreneurs who run businesses to provide food, housing and security for their families. 

If earnings are insufficient, formalisation may be perceived as a risk that threatens the limited security the business does provide. Registration may only become a realistic option once income rises above the level needed to meet basic needs. The resulting financial surplus makes it possible to take a longer-term view and develop the business into a more stable source of income.

“If the authorities want to bring more entrepreneurs into the formal economy, they should pay more attention to entrepreneurs’ ambitions. Some businesses need greater financial security before their owners feel able to register. Others need better access to growth opportunities. It is relatively simple to differentiate the rules, and that is what authorities should do because the same solution will not necessarily work for both groups,” says Marcus M. Larsen.