There are multiple routes to launching a startup, each with its advantages and downsides. Starting a business informally – i.e., without officially registering it or reporting it to the authorities – can significantly benefit its growth until a certain point.
Research on this topic has divided business scientists into two camps: those who are “pro-formal” and those who are “pro-informal”. Neither argument is without its weaknesses, but both make solid points.
Scholars in the “Pro-formal” view assert that operating legally helps a company gain recognition, making it easier to recruit employees and access public services, such as protection by the courts in the event of a dispute.
In contrast, researchers in the “pro-informal” view argue that registering with the authorities in the startup phase stunts growth. Businesses that find their feet while being ‘off the books’ can redirect money usually earmarked for taxes, registrations fees, and so forth, and dedicate it to expanding the company. Studies also find that startups are more reliant on their leaders’ networks than on public services to obtain resources and gain legitimacy.
To determine how entrepreneurs can weigh up these arguments, we conducted research of our own at NEOMA Business School, analysing data from over 49,520 companies from 116 countries. Our published findings show that starting a business informally almost always benefits its development, but for a limited time.
The advantages are reduced to insignificance after around seven and a half years on average, due to the increased costs needed to keep the company afloat, limited access to external resources, and the fact that personal networks become exhausted after a finite period. Of course, these results are heavily influenced by the quality of government agencies from nation to nation – one reason why informal businesses are more widespread in developing countries.
At this stage, it is important to clearly define the informal economy, and dispel some of the myths that crop up about it. While it does typically refer to activities not officially registered with relevant government agencies, enterprises operating in this way are not restricted to performing ‘odd jobs’. Nor are they synonymous with immoral or exploitative practices, despite common perceptions of terms like ‘underground economy’.
Unregistered businesses are growing increasingly important in developing new technologies and services, and operate widely in most sectors, including construction and agriculture. Informal enterprises are not a new or geographically isolated phenomenon. Up to half of all businesses operating in developing countries do so from the shadows, compared to around 15 per cent in OECD (Organization for Economic Co-operation and Development) member states, including France.
These organisations do not pay any form of tax, but, at the same time, they do not benefit from legal or social protection. However, it is possible, and our research suggests beneficial, to transition from informal to formal as your business grows and matures.
Developing countries in particular often provide few advantages for launching startups formally, while requiring them to jump through a complex series of bureaucratic hoops. As a result, many entrepreneurs are pushed towards conducting business in the shadows. Our findings confirm that the poorer the quality of government agencies, the more it benefits companies to operate for a long period of time without being officially declared.
Developed countries have clear regulations backed up by stable agencies that reduce the incentive to pursue this course of action. Nevertheless, we recommend all governments closely examine the systems they have in place, in order to know their limitations.
From a societal perspective, it is beneficial for as many companies as possible to be officially registered, so that they can contribute fully to their local and national economies through taxes and social contributions. In the developed world, this is cajoled through tough sanctions for informal businesses. But harsher consequences will not be enough to turn the remaining 15 per cent of underground enterprises in countries like France.
Instead, nations would benefit from taking a more carrot than stick approach, focusing on swelling the advantages of being formally declared to the authorities. For a start, processes for registering a company need to be streamlined, and the costs cut. Further provisions such as offering training for business leaders could sweeten the deal even more.
Ana Colovic – Ana Colovic, PhD, HDR is Full Professor of Strategy and Entrepreneurship at NEOMA Business School. She has held several visiting research positions in the UK, USA and Japan.
Bisrat Misganaw – Bisrat A. Misganaw, PhD, is Assistant Professor of Strategy and Entrepreneurship, and Director of the M.Sc. Entrepreneurship & Innovation program at NEOMA Business School.
Dawit Assefa – Dawit Assefa, PhD, is a Research Engineer at NEOMA Business School.