Why It's Too Hard to Start a New Business
Meacham, Jon
Why It's Too Hard to Start a New Business Got a great entrepreneurial idea? Pray you win the lottery, because the odds of getting money from banks or venture capitalists aren't much better BY JON...
...The SBA's new director, Erskine Bowles, is a businessman from North Carolina who knows what obstacles are out there...
...New enterprises also posted an 18 percent job growth rate each year while the Fortune 500 lost 2 percent of its jobs...
...40,000 may not sound like much, but Helena, Arkansas, is part of the Mississippi Delta, which Simpson rightly describes as "the most poorest area of the country...
...Venture capital was an equally forlorn hope...
...With benefits already costing 33 percent of salary packages, it's past time to consider funding at least health care with a broader, national tax...
...And there are other ways for Washington and for states to weigh in...
...And when they train their loan officers, that reticence becomes embedded in the culture...
...Capital Punishment Historically, half of small business credit has come from banks...
...And the CAP is hardly a giveaway program...
...In 1993, Arthur Andersen and National Small Business United found that small businessmen reporting trouble with their banks were twice as likely to cite too many regulations as the problem than they were to say the bank wasn't interested in their idea...
...lots of good ideas never get a fair hearing (the agreed-on figure in venture capital circles is that one out of every 100 plausible deals gets funded...
...The administration's plan for small business is a grab bag of good ideas (guaranteeing more Small Business Administration loans, for example) to free up more capital...
...work week topped a post-World War n high in the winter of 1994, a sign that companies are working their people harder instead of hiring new employees...
...The bank decided to make the loan, but FIRREA required a $3,500 appraisal...
...Long managed to open only after he put together a little over $100,000 from a dozen friends and relatives...
...In fact, although the 11 states of the old Confederacy have the nation's fastest-growing population, they are dead last in venture capital...
...This would replace the current rigidity with the more familiar, Jimmy Stewart kinds of lending decisions...
...Beyond fixing capital gains, Washington needs to recognize that the growing tax burden on the employer-employee relationship is no longer just a conservative hobbyhorse...
...Beginning in the 1970s, the world's industrialized nations began meeting to regulate bank capital standards—that is, to decide how much money banks had to keep in the vault, no matter what the loan demand or the economic climate...
...that translates into one or two from-scratch deals a year...
...According to a 1993 study by the Tax Foundation, reported by The New York Times in January, complying with federal tax law—filing the 1120 and 1120S corporate returns, quarterly reports, and legions of other documents—costs small businesses $390 for every $100 they pay in taxes...
...But since 1990-91, lending has fallen 2 percent...
...The average U.S...
...The possibility of losing even a few billion dollars, at a time when so many people are out of work means anything we can do to responsibly increase the flow of capital makes sense...
...Your average venture capitalist has six deals going and can't spend enough time evaluating what else comes in...
...five recessions since 1960, bank loans rose an average 10 percent...
...The failure rate has run about five times a normal bank loss rate—which is to be expected, considering the higher risk...
...Some regulations, no matter how noble-sounding, cost too much for small businesses to handle...
...Banks were out of the question...
...The jobs and products that would inevitably shake out of a busier startup market are what we want, and tax revenue will still be coming in from the sale of established stocks at the ordinary income rate...
...The reserve funds cover the losses and banks must still be shrewd since they are responsible for losses above the 14 percent the reserve fund covers...
...We've been on the edge a lot, but we've crept along and stayed in business," says Long, who has survived on research grants and private investors, and is now negotiating with several major pharmaceutical companies to sell them marine products for anti-cancer drugs and infant formula...
...And government, in many cases, can be the best means of removing the obstacles which keep entrepreneurs from credit and capital...
...Fixing the counterproductive Basel requirements is the first step...
...But the evidence is that despite the current reports of a rebounding economy, investments in job-producing companies—which power true recoveries—are sig-nificandy down...
...The IRS has already simplified tax returns and requirements for individuals who make little or no money...
...Leland Stenehjem, chairman of First International Bank and Trust, a small bank in North Dakota, has 39 employees, 13 of whom work nearly full-time on meeting regulations...
...Because existing regulators would oversee the federal program, bureaucratic costs would be minimal...
...The Clinton/Bumpers capital gains break, carried a step farther, could make the same kind of investments in small enterprises more attractive...
...Liberals and conservatives alike must concede points that each hold dear to solve this...
...Some taxes and paperwork are simply too burdensome...
...nothing...
...Our money comes from very conservative institutions—pension funds and insurers," says David Gladstone, a general partner with Allied Capital in Washington...
...Take Tom Long, an entrepreneur from Wrightsville Beach, a seafront town on the North Carolina coast...
...Total credit to business has grown just 4 percent since 1990, compared to 13 percent after the 1979-80 recession...
...Banks may already have been tight with loans, but the 1989 act turned conservatism into frigidity...
...Allied, known in the industry as a good place for the small deal, only does about 5 percent of its business with startups...
...And why not, in addition, keep track of a bank's pay-up rate and ease back on regulatory second-guessing in proportion to how well customers pay back the loans...
...One of the ways to test this theory is to examine how people react when worries about capital suddenly disappear...
...Capital Gains One solution is to use government to make the market as open to entrepreneurs as possible...
...That may not sound like much, but remember that just 1 percentage point change in the amount of money banks lend equals $26 billion—money that would fund 100,000 new companies with $250,000 in capital each...
...That means government must unleash the private market's resources...
...Pray you win the lottery, because the odds of getting money from banks or venture capitalists aren't much better BY JON MEACHAM When the Soviets launched Sputnik, in 1957, America went into a kind of indignant shock...
...These are 24-year-old trainees assigned to small business loans...
...In Michigan, the state government added just a single person to its payroll for the CAP...
...This led to the first federal small business legislation, which President Eisenhower signed...
...After all, the more jobs generated, the better the economy in the long run, and tax breaks do work...
...capital is...
...That means, for example, that for a banker to lend $100,000 to an entrepreneur opening a store, the bank would have to have at least $8,000 in capital...
...Public stock offerings are where early investors cash out, selling their stock shares to public buyers at (hopefully) great profit...
...Treasury's David Joulfaian, if you take two ordinary wage-earning people and give one of them a $100,000 inheritance, the one with the windfall is more likely to start a business than the other guy...
...The kneejerk conservative response to this is to conclude government simply cannot work and should stay out of the market altogether...
...Yet when the 1989 Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) passed, regulators went overboard, requiring extensive paperwork on all loans, which makes it just as expensive to make a small loan as it is to process a multimillion-dollar one...
...In the ensuing 10 years, Long has employed 40 people, from a low of four in bad times to a high of 12 in better ones...
...At the same time, loan portfolios fell to 16 percent, their lowest point in a decade...
...Americans suddenly felt they were losing ground, and one of the results was a 1958 Federal Reserve report, commissioned by Congress, to figure out what the economy most needed to keep it strong...
...The real reform would be to charge the usual top income rates on short-term deals where the trader's goal is clearly quick paper profits, not a company's long-term prospects...
...An adverse classification is a regulator's prediction that a given loan is bad and won't be repaid...
...Under it, instead of regulators weighing each bank loan by itself, they would consider a portfolio of loans...
...It was too much, and die customer walked...
...In short, creating small businesses (a slippery term, but basically ranging from businesses struggling to open to firms with 100 employees) challenges the shibboleths of left and right and requires thinking about government and the market in ways that do not fit neatly into party platforms...
...Why the problem...
...But banking regulations have been increasing since the late eighties, when the S&L industry collapsed and banks were failing at unprecedented rates...
...But the Basel Committee never agreed on a similar capital rule for government securities...
...Now, they have to make loans that look like cream-puff loans...
...Impossible to say, of course, but it is undeniable that the early stage companies which do luck into venture capital have a much better chance of making it...
...In 1984, Long put everything he had—including maxing out his Visa and MasterCard for $9,000—into starting up a marine biology research company...
...You could argue this, but you would be wrong...
...Another is economic: Small business lending is riskier and more expensive than other, safer, but less productive investments...
...The United States funds its retirement and health care on the backs of employers and employees, and the Clinton health plan proposes to pay for universal care by attaching another tax (the administration calls it a "premium") to the payroll...
...So a stronger loan—say $100,000 to expand an up-and-running business—would make it easier to take marginal risks...
...One Pennsylvania entrepreneur needed $120,000 to build a pre-fabricated office building...
...A version of this idea—backed by Clinton and Bumpers—passed in 1993: small business stock sold after five years pays half the going capital gains tax rate—currently, half of 28 percent...
...Bowles is a welcome departure from the Reagan-Bush directors, who tended to be failed GOP Senate candidates...
...That way, banks making smart loans—based on whatever criteria, including character—that are paid back are rewarded with more leeway to keep making such loans...
...A New York venture capitalist flat out told me that a big reason he couldn't fund me was that he had to change planes in Charlotte just to get here," remembers Long...
...Later—when men moved to the sea—the British empire was dominant because it had ships...
...from 1985 to 1990, about 200 a year failed...
...The SBA's loan guaranty program currently secures $8.5 billion in small loans...
...The rules of the game have changed forever...
...At first blush, this doesn't seem compelling: It's like saying if we were all virtuous, there would be no crime...
...Another sign that there is demand for credit is that while loans fell by $30 billion from 1989 to 1992, corporate bond issues—another form of credit—increased by $200 billion...
...We used to have the philosophy that it was up to us to run the bank, to make die decisions, because we know the people in our town," says Stenehjem...
...But that's the wrong way to look at the problem...
...Government securities and bonds, not in enterprises like Simpson's...
...But the bank couldn't grant a loan because even though Simpson and his partner had good credit histories, their collateral did not quite meet the minimum standard...
...This rewards real investment, not just asset-shuffling...
...No question at all...
...Consider Herman Simpson, a Helena, Arkansas, man who, in 1992, came up with a great business idea: open a day care center for the elderly...
...Simply, there are too many dangerous mines buried between an entrepreneur with a job-creating idea and the money to test that idea...
...Capital gains tax cuts can seem a pallid answer to economic problems—recall how tinny the idea sounded on George Bush's lips in 1992—but targeted cuts to stocks in startup companies held over time would encourage the right kinds of investments...
...Simpson and his partner would turn a building the partner already owned into a day care center, "plus a chore service which would help them with heavy cleaning and yard work and stuff, and also some homemaker stuff that the elderly need...
...Demand for loans, always higher during a recession, was even greater than usual in 1990-92...
...And the more those people get money and create jobs, the better off we all will be...
...Now making its way through Congress is a tiny $50 million authorization to federalize a Michigan pilot called the Capital Access Program (CAP...
...Part of the reason for this is obvious...
...That is, what happens when someone inherits money...
...But conservatives, too, need to give up their automatic assumption that the free market always works—that on a level playing field, people who are diligent enough and smart enough will win...
...While the Monthly has not exactly enjoyed great prosperity, the result has been 25 years of steady employment and production: 200 man-years of jobs, as the economists put it...
...Demand for the Small Business Administration's loan guaranty program was up 35 percent in 1992 from 1991...
...This is the most promising proposal in the country...
...Breeden and Isaac argue that if the accords had never made it out of the conference rooms in Switzerland, $130 billion in loans would have been made since 1992...
...They have turned off the spigot for startups because the alternatives—especially public offerings—are so lucrative...
...Before 1989, for example, to make small lending easier, bankers would simply take a "blanket lien" on a small borrower's assets and base the credit decision on cash flow and other business factors...
...it should do the same for businesses that are losing money or barely breaking even...
...they're the guts of governing...
...Or you get safe MBA-types dealing with entrepreneurs, which is a clash...
...There have been 1,300 SBICs since 1958, but nearly 1,000 have closed, at a potential cost to the government of $500 million...
...Instead of concentrating their examinations on big dollar deals where losses could be greater and there might be banker-client corruption, regulators are wrongly spending a lot of time worrying over small loans where the chance of a bank's customers getting ripped off is minimal...
...Creating jobs and helping entrepreneurs were centerpieces of Clinton's campaign, and at a time when the largest U.S...
...corporations are downsizing, these tasks—always important—are even more critical than usual...
...Both the Federal Reserve and the private Center for Entrepreneurial Management estimate that the average small business loan is $25,000 to $50,000...
...Late last autumn, the cover of Time magazine, a reliable gauge of middle-class worries, featured a classic black-and-white postwar Organization Man in a three-button suit, fedora, and briefcase over the headline, "Whatever Happened to THE GREAT AMERICAN JOB...
...Lyndon Johnson, then the Senate Majority Leader, drawled darkly: "The Roman Empire controlled the world because it could build roads...
...But job-producing possibilities aren't missing...
...Venture Out Maybe, you could argue, nobody's asking for commercial loans...
...One mine is cultural: Bankers have stopped lending and venture capitalists are attracted to big deals at the expense of the entrepreneurial startup...
...These new rules are indisputably bad: Ten million people are now out of work, and the Bureau of Labor Statistics estimates another 6.2 million have taken part-time jobs because that is all they could find...
...Consider that from 1987 to 1991, new companies' sales growth clobbered the Fortune 500,35.4 percent to 1.6 percent, according to Coopers & Lybrand, a national public accounting firm...
...That is money being spent on government paper that would be better spent on building Main Street businesses...
...Looked at another way, Washington got $4.1 billion from these businesses in 1990, but the businesses spent $15.9 billion filling out the forms...
...The next stop for entrepreneurs is professional venture capitalists, who raise money from pension funds and insurance companies to invest in new companies...
...Does this matter...
...The plan...
...The situation is if you make a loan that's classified—if you take a risk that you wouldn't have thought of as a risk five or six years ago—your job is in trouble...
...There's no question we're eating our seedcorn," says Gladstone...
...According to research by Syracuse's Douglas Holtz-Eakin, Princeton's Harvey Rosen, and the U.S...
...Of course, funding expansions, which is where the most jobs are actually created, is a good thing, and finding sound startups is one of the most difficult tasks any investor faces...
...Unfortunately, at the moment, if entrepreneurs don't have rich friends willing to kick diem a few dollars or relatives who happen to die, the market over which Clinton and the Democrats now preside smothers them...
...From 1940 to 1980, an average of five banks a year closed...
...And that's from a good place for entrepreneurs...
...Only 1 percent of the country's annual 900,000 attempted startups get any of the annual $2 billion in new formal venture capital...
...Most small businesses turn very little profit...
...Banks are scared to death that their loans will be classified," says Ronald B. Cohen, a senior partner in a Cleveland accounting firm that specializes in company financing...
...Would more capital earlier on have produced quicker results, more jobs, more money, more taxes paid...
...It works pretty well, allowing banks to take risks they would not take on their own, and the default rate is only marginally higher than regular commercial defaults...
...Another is governmental: Washington has piled on regulations that big companies can absorb but small companies can't afford...
...economy put together...
...Four out of five startups fail, and nobody knows how many other potential entrepreneurs never get the chance to try...
...This means banks, already culturally averse to risky loans, can buy government securities with less money in bank capital...
...two years after each of the Research assistance for this article was provided by Adam Marcus and Scon Jones...
...But most of the 600 venture capital firms in the country deal with entrepreneurs who are already up and running, not people who really need the most help...
...Taxation and capital access programs are not exactly rousing issues...
...They wrote a business plan and went down to Phillips County's First National Bank...
...While bank lending was falling to historic lows, the venture capital market answered the call with...
...Day-to-day working reality makes it easier for a big venture capital firm to consider a few $5 million or $10 million proposals—usually, these are high tech ventures which require expensive technology—than 100 proposals for $100,000...
...Because bankers who either abuse this or are unlucky would be punished by having to continue to live under obsessive regulatory scrutiny, bank security would be protected...
...Only 8 percent actually started up a business...
...More capital for entrepreneurs, especially "pioneering" manufacturers...
...Hie answer...
...The rate of return on securities is a bit lower than the return on successful commercial loans, but, as Richard C. Breeden, chairman of the SEC, and William M. Isaac, a former FDIC chairman, pointed out in The Wall Street Journal, bankers can buy more securities at less risk with less capital on hand...
...An example, close to home: In the case of The Washington Monthly, its founder, Charles Peters, raised only $47,500 before a tax attorney figured a break that would enable investors to write off the investment...
...But SBICs did happen to invest in Apple Computer and Federal Express (both of which began as tiny, unfunded, improbable ideas), so they have accomplished clear good...
...The bankers later told Congress in hearings on the small business credit crunch that what stopped First National was the fact that bank regulators would have "classified" the loan...
...By mid-1992, the FDIC could report that banks had 21 percent of their assets invested in government securities—the highest percentage in 20 years...
...But more and more the decision is the examiner's, and all he's got is what's on paper...
...So there is clearly a crying need for jobs, and entrepreneurs are the people who create them...
...The few deals that do attract venture capital are almost always decided by two factors that do not necessarily favor startups...
...According to Venture Economics, a trade publication, expansion money accounted for fully 55 percent of all venture capital investments in 1992, while just 3 percent went to seed new ideas...
...Examiners who stick tightly to collateral rules even on the smallest deals are keeping bankers like Stenehjem from making loans based, in part, on the borrower's character—James Stewart, small town, It's a Wonderful Life kind of banking...
...There just aren't enough people to look seriously at most startups," says James Lally, a partner with the San Francisco-based firm Kleiner, Perkins...
...The second factor hamstringing smaller entrepreneurs is, as Tom Long found, geography...
...So where are banks putting their money...
...If someone has to pay the 39 percent rate on stock trading that he pays on ordinary income, he will be encouraged to invest in the startup stocks, whose capital gains rate after five years could be dropped to zero percent...
...A successful startup ultimately needs expansion capital, and an expanding business is a safer bet than a guy fresh out of his garage workshop with dreams of shaking up the electronics industry...
...banks have increased their bond holdings by 68 percent since the Basel rules went into effect...
...Not being fools, U.S...
...The problem is that the playing field is not level right now...
...this was high technology, and there would be no inventory for collateral...
...But think about it: This means there are thousands of people willing to take a risk, not sock it away, if the money were available...
...It went up to 8 percent at the end of 1992...
...Now, the Communists have established a foothold in outer space...
...This way, the bank avoids individual classifications...
...The law required, for instance, a 14-point certified appraisal of all property proposed as collateral on loans over $100,000, at a cost of $2,500 to $10,000...
...And new companies generated four times as many skilled jobs as the rest of the U.S...
...To cover the risk, the bank, the borrower, and the government pay a small percentage—between 1.5 to 3.5 percent—of the loan amount into a reserve fund...
...But the people hunting money—and they are legion—will remember which president and which Congress made the money chase a bit easier...
...In other words, venture capital invested at the initial public offering comes long after the trials of starting out...
...That is, rather than a First National having to judge a Herman Simpson in isolation, riskier loans would be part of a package on which the bank would be examined...
...Random audits could ensure compliance, because locking up a few lying owners would scare the rest into honesty...
...Clinton understands this problem and has issued some deregulation orders, but five years of tight oversight has turned bankers—never the jazziest, boldest guys around anyway—into terrified automatons...
...In Michigan (13 other states have followed), 21 percent of the CAP loans have gone to startups—compared, remember, to less than 5 percent of private venture capital...
...That's enough to snuff an entire deal...
...Overall, the cost of compliance with bank regulations is $17 billion a year...
...Liberals need to recognize that sometimes the best thing government can do is to get out of the way...
...That's crazy...
...Simpson got together with a friend and figured that they could get started for $40,000...
...If you are looking for capital within a 40-mile radius of, say, Boston, New York, Chicago, or Silicon Valley, you stand a far better chance of getting funded than you do in Nebraska or even Atlanta...
...the government should think about having a business owner, under penalty of peijury, certify whether his year was profitable and, if it wasn't, shelter him from most of the blizzard of forms now required...
...However, remember the federal government controls only about $10 billion in venture capital altogether and invests in only one out of every 1,000 small business startups every year...
...But logic dictates that fewer startups funded now mean less expansion or fewer stock deals later...
...Just 3 percent of the nation's capital is available there, compared to 48 percent in New England and 27 percent on the West Coast...
...Today, while there is no Sputnik to galvanize the public imagination, signals of economic and national discontent are again growing, and the Fed could dust off that report and reissue it almost verbatim...
...After that, Peters raised between $600,000 and $700,000, meaning that less than 10 percent of the magazine's financing came in the absence of a break...
...As W. C. Fields used to say," notes Senator Dale Bumpers, "That ain't beanbag.'") This is unquestionably a difficult business, even for private firms...
...If you knew, for example, that you would have to pay higher taxes on short-term deals, then deals with low or no capital gains tax would immediately become more appealing...
...After all, small firms employ 60 percent of America's workers and generated most of the new jobs in the eighties...
...The first is that venture capital, an industry founded to keep an eye out for the promising small deal, now tends to fimd companies that have already basically made it...
...Here are the new ones...
...This is a One World Government conspiracy lover's dream: Called the "Basel Committee" (after the Bank for International Settlements in Basel, Switzerland), regulators decided banks would have to keep 7.25 percent of the value of business and most consumer loans on hand...
...small banks now spend one out of every four operating dollars on compliance...
...The fruit of that old 1958 Fed report was the Small Business Investment Corporations (SBICs), which were designed to provide equity capital to entrepreneurs...
Vol. 26 • January 1994 • No. 3
