Why it's too hard to start a new business.

When the Soviets launched Sputnik, in 1957, merica went into a kind of indignant shock. Lyndon Johnson, then the Senate Majority Leader, drawled darkly: "The Roman Empire controlled the world because it could build roads. Later--when men moved to the sea--the British empire was dominant because it had ships. Now, the Communists have established a foothold in outer space."

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 answer? More capital for entrepreneurs, especially "pioneering" manufacturers. This led to the first federal small business legislation, which President Eisenhower signed.

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. 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? The rules of the game have changed forever. Here are the new ones." 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. The average U.S. work week topped a post-World War II high in the winter of 1994, a sign that companies are working their people harder instead of hiring new employees.

So there is clearly a crying need for jobs, and entrepreneurs are the people who create them. After all, small firms employ 60 percent of America' s workers and generated most of the new jobs in the eighties. But the evidence is that despite the current reports of a rebounding economy, investments in job-producing companies--which power true recoveries--are significantly down. Total credit to business has grown just 4 percent since 1990, compared to 13 percent after the 1979-80 recession; two years after each of the five recessions since 1960, bank loans rose an average 10 percent. But since 1990-91, lending has fallen 2 percent. 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.

Why the problem? Simply, there are too many dangerous mines buried between an entrepreneur with a job-creating idea and the money to test that idea. One mine is cultural: Bankers have stopped lending and venture capitalists are attracted to big deals at the expense of the entrepreneurial startup. Another is economic: Small business lending is riskier and more expensive than other, safer, but less productive investments. Mother is governmental: Washington has piled on regulations that big companies can absorb but small companies can't afford.

Does this matter? 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 finn. New enterprises also posted an 18 percent job growth rate each year while the Fortune 500 lost 2 percent of its jobs. And new companies generated four times as many skilled jobs as the rest of the U.S. economy put together.

While bank lending was falling to historic lows, the venture capital market answered the call with... nothing. Only 1 percent of the country's annual 900,000 attempted startups get any of the annual $2 billion in new formal venture capital. Four out of five startups fall, and nobody knows how many other potential entrepreneurs never get the chance to try.

But job-producing possibilities aren't missing; capital is. One of the ways to test this theory is to examine how people react when worries about capital suddenly disappear. That is, what happens when someone inherits money? According to research by Syracuse's Douglas Holtz-Eakin, Princeton's Harvey Rosen, and the U.S. 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. At first blush, this doesn't seem compelling: It's like saying if we were all virtuous, there would be no crime. 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.

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. Unfortunately, at the moment, if entrepreneurs don't have rich friends willing to kick them a few dollars or relatives who happen to die, the market over which Clinton and the Democrats now preside smothers them.

Liberals and conservatives alike must concede points that each hold dear to solve this. Liberals need to recognize that sometimes the best thing government can do is to get out of the way. Some regulations, no matter how noble-sounding, cost too much for small businesses to handle. Some taxes and paperwork are simply too burdensome.

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. The problem is that the playing field is not level right now; lots of good ideas never get a fair hearing (the agreed-on figure in venture capital circles is that one out of every 1 O0 plausible deals gets funded). And government, in many cases, can be the best means of removing the obstacles which keep entrepreneurs from credit and capital. In short, creating small businesses (a slippery term, but basically ranging from businesses straggling 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.

Capital Punishment 

Historically, half of small business credit has come from banks. But banking regulations have been increasing since the late eighties, when the S&L industry collapsed and banks were failing at unprecedented rates. (From 1940 to 1980, an average of five banks a year closed; from 1985 to 1990, about 200 a year failed.) 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.

Both the Federal Reserve and the private Center for Entrepreneurial Management estimate that the average small business loan is $25,000 to $50,000. Yet when the 1989 Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) passed, regulators went overboard, requiting 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. 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.

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. Banks may already have been tight with loans, but the 1989 act turned conservatism into frigidity. 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. That's enough to snuff an entire deal. One Pennsylvania entrepreneur needed $120,000 to build a pre-fabricated office building. The bank decided to make the loan, but FIRREA required a $3,500 appraisal. It was too much, and the customer walked.

Overall, the cost of compliance with bank regulations is $17 billion a year; small banks now spend one out of every four operating dollars on compliance. 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. "We used to have the philosophy that it was up to us to run the bank, to make the decisions, because we know the people in our town," says Stenehjem. "But more and more the decision is the examiner's, and all he's got is what's on paper."

Examiners who stick tightly to collateral rules even on the smallest deals are keeping bankers like Stenehjem from making loans based, in pan, on the borrower's character--James Stewart, small town, It's a Wonderful Life kind of banking. 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. Simpson got together with a friend and figured that they could get started for $40,000. ($40,000 may not sound like much, but Helena, Arkansas, is pan of the Mississippi Delta, which Simpson rightly describes as "the most poorest area of the country.") The plan? Simpson and his partner would mm 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." They wrote a business plan and went down to Phillips County' s First National Bank.

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. 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. (An adverse classification is a regulator's prediction that a given loan is bad and won't be repaid.)

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 automations. "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. "And when they train their loan officers, that reticence becomes embedded in the culture. Now, they have to make loans that look like cream-puff loans. 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. These are 24-year-old trainees assigned to small business loans. Or you get safe MBA-types dealing with entrepreneurs, which is a clash."

So where are banks putting their money? Government securities and bonds, not in enterprises like Simpson's. 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. This is a One World Government conspiracy 1over'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. (It went up to 8 percent at the end of 1992.) 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.

But the Basel Committee never agreed on a similar capital role for government securities. This means banks, already culturally averse to risky loans, can buy government securities with less money in bank capital. The rate of return on securifles 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. Not being fools, U.S. banks have increased their bond holdings by 68 percent since the Basel rules went into effect. 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. At the same time, loan portfolios fell to 16 percent, their lowest point in a decade. 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. That is money being spent on government paper that would be better spent on building Main Street businesses.

Venture Out

Maybe, you could argue, nobody's asking for commercial loans. You could argue this, but you would be wrong. Demand for loans, always higher during a recession, was even greater than usual in 1990-92. (Demand for the Small Business Administration's loan guaranty program was up 35 percent in 1992 from 1991.) 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.

The next stop for entrepreneurs is professional venture capitalists, who raise money from pension funds and insurance companies to invest in new companies. 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. Part of the reason for this is obvious. 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. 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. Only 8 percent actually started up a business.

Take Tom Long, an entrepreneur from Wrightsville Beach, a seafront town on the North Carolina coast. 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. Banks were out of the question; this was high technology, and there would be no inventory for collateral. Venture capital was an equally forlorn hope. "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. Long managed to open only after he put together a little over $100,000 from a dozen friends and relatives. 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. "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. Would more capital earlier on have produced quicker results, more jobs, more money, more taxes paid? 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.

The few deals that do attract venture capital are almost always decided by two factors that do not necessarily favor startups. The first is that venture capital, an industry founded to keep an eye out for the promising small deal, now tends to fund companies that have already basically made it. "Our money comes from very conservative institutions-pension funds and insurers," says David Gladstone, a general partner with Allied Capital in Washington. "They have turned off the spigot for startups because the alternatives---especially public offerings--are so lucrative." Public stock offerings are where early investors cash out, selling their stock shares to public buyers at (hopefully) great profit. In other words, venture capital invested at the initial public offering comes long after the trials of starting out. 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. But logic dictates that fewer startups funded now mean less expansion or fewer stock deals later. "There's no question we' re eating our seedcorn," says Gladstone. "No question at all."

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. Allied, known in the industry as a good place for the small deal, only does about 5 percent of its business with startups; that translates into one or two from-scratch deals a year. And that's from a good place for entrepreneurs. 'There just aren't enough people to look seriously at most startups," says James Lally, a partner with the San Franciscobased firm Kleiner, Perkins. "Your average venture capitalist has six deals going and can't spend enough time evaluating what else comes in."

The second factor hamstringing smaller entrepreneurs is, as Tom Long found, geography. 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. (In fact, although the 11 states of the old Confederacy have the nation's fastest-growing population, they are dead last in venture capital. 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.)

Capital Gains

One solution is to use government to make the market as open to entrepreneurs as possible. Fixing the counterproductive Basel requirements is the first step. 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. And there are other ways for Washington and for states to weigh in.

The fruit of that old 1958 Fed report was the Small Business Investment Corporations (SBICs), which were designed to provide equity capital to entrepreneurs. There have been 1,300 SBICs since 1958, but nearly 1,000 have closed, at a potential cost to the government of $500 million. ("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. 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 SBA's loan guaranty program currently secures $8.5 billion in small loans. 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. The SBA's new director, Erskine Bowles, is a businessman from North Carolina who knows what obstacles are out there. (Bowles is a welcome departure from the Reagan-Bush directors, who tended to be failed COP Senate candidates.) 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.

That means government must unleash the private market's resources. Now making its way through Congress is a tiny $50 million authorization to federalize a Michigan pilot called the Capital Access Program (CAP). This is the most promising proposal in the country. Under it, instead of regulators weighing each bank loan by itself, they would consider a portfolio of loans. 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. So a stronger loan--say $100,000 to expand an up-and-running business--would make it easier to take marginal risks. 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. This way, the bank avoids individual classifications.

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. The failure rate has run about five times a normal bank loss rate--which is to be expected, considering the higher risk. The kneejerk conservative response to this is to conclude government simply cannot work and should stay out of the market altogether. But that's the wrong way to look at the problem. 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.

And the CAP is hardly a giveaway program. 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. Because existing regulators would oversee the federal program, bureaucratic costs would be minimal. In Michigan, the state government added just a single person to its payroll for the CAP. And why not, in addition, keep track of a bank's payup rate and ease back on regulatory second-guessing in proportion to how well customers pay back the loans? 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. This would replace the current rigidity with the more familiar, Jimmy Stewart kinds of lending decisions. 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.

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 11205 corporate returns, quarterly reports, and legions of other documents---costs small businesses $390 for every $100 they pay in taxes. 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. That's crazy. The IRS has already simplified tax returns and requirements for individuals who make little or no money; it should do the same for businesses that are losing money or barely breaking even. Most small businesses turn very little profit; the government should think about having a business owner, under penalty of perjury, certify whether his year was profitable and, if it wasn't, shelter him from most of the blizzard of forms now required. Random audits could ensure compliance, because locking up a few lying owners would scare the rest into honesty.

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. 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. This rewards real investment, not just asset-shuffling. 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. 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. 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. 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. After all, the more jobs generated, the better the economy in the long run, and tax breaks do work. (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. 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. 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. The Clinton/Bumpers capital gains break, carried a step farther, could make the same kind of investments in small enterprises more attractive.)

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. 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. 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.

Taxation and capital access programs are not exactly rousing issues; they're the guts of governing. But the people hunting money--and they are legion--will remember which president and which Congress made the money chase a bit easier. And the more those people get money and create jobs, the better off we all will be.