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The start-up blues.

You thought banks and venture capital firms help entrepreneurs launch their businesses. Guess again.

Jeremy Schlosberg is a New York writer

They're out there. Right now. Opportunities. The kind that can make you independent, rich, or both.


It's not any secret that running a new business is rough going. The hours. The sweat. The risk. But what's less well understood are the incredible battles entrepreneurs must fight just to open for business-never mind face the competition. Like Walter Payton, they must weave past those institutions that are supposed to help. Venture capitalists who sneer. Bankers who smile politely and say no. Advisers from government development offices who have no useful advice. A tax code that encourages Michael Milken more than Joe Fix-It. Genuine encouragement is frustratingly rare. The best encouragement of all-it's green and fits nicely in a wallet-is all but impossible for many fledgling entrepreneurs to locate. Opportunities may be out there, as BusinessWeek says, but so are the landmines.

Of course, not everyone who wants to start a business is up to the task. But entrepreneurs face a kind of social Darwinism that can quash the fit as well as the unfit. Talk to any entrepreneur who has made it and he or she, with the knowing look of an 1wo Jima veteran, will regale you with tales of how that little start-up was almost blown out of the water. Listen to a few such stories and you'll realize that the astounding failure rate of new businesses-by most accounts, four out of five-isn't just a healthy weeding out of incompetents. Even in this age of the glorified entrepreneur, our society continues to block the path of the aspiring owner.

Who cares? So what if some self-styled Mrs. Fields bombs? The fact is that when the entrepreneur suffers, we all do. After all, 80 percent of new jobs are created by businesses employing 100 or fewer people. And it's more than jobs that the small businessperson brings to the economic table. It's innovation of an order rarely seen in the Fortune 500 world, the expansion of capitalism into areas that are unprecedented, even unimagined. (At Xerox, researchers had worked furiously to develop a personal computer, but management made the brilliant decision to cancel the project.) If a product you use is useful, delicious, or fun, chances are an entrepreneur first conceived it-even if it has since been swallowed by a larger company. An entrepreneur is part inventor, part marketer, part guinea pig, part sacrificial lamb, Big business rarely innovates, but routinely appropriates. When we cut off the entrepreneur we're committing economic suicide.

And the benefits of entrepreneurship can't be measured simply in dollars. If we're serious about the pursuit of happiness, we have to do more to let people do the kind of work that won't put them to sleep or make them feel worthless, For many Americans, that means the responsibility and creativity of running their own business. But instead of building the kind of culture where entrepreneurs are encouraged, we've created an environment where they feellike losers even before they roll the dice.

'Are you crazy?'

Getting money is the Berlin Wall that any entrepreneur must clear. "The biggest problem is always, always, always money," says Peter Francese, an entrepreneur who founded American Demographics.

It's natural to think that seed capital, that first infusion of cash needed by any business, can be readily had from two sources: banks and, venture capital firms. It's natural, but it's also wrong.

As far as banks go, Judy Anderson, president of Venture Management Service, a consulting firm in New York, puts it best when she says, "Banks are not interested in start-ups, period."

Why not? The reason is primarily cultural. The people who "self-select" into becoming entrepreneurs and bankers are, says And"such different people that they have a hard time talking to each other'" Paul Hawken, in his book, Growing a Business, writes"most bank managers and loan officers have never run a business and live in mortal dread that they might have to some day"

Instead of being trained to spot the bold new idea or a solid, well thought-out business plan, bank officers are trained to see how much money you've got. Douglas Castle, a financial consultant in the New York suburbs, admits that a "bank's attitude towards a business plan is that they think them all inherently false." He adds that banks just go by the applicant's financial records. If these look unblemished, the bank officer may "offer you a second mortgage [on your house] and call it a business loan."

This leads to a situation that sounds like an old joke, but it's true: banks want to lend entrepreneurs money only if they don't need it. "I had bankers asking me if I had stock, bonds, or other collaterallike that," says Mary Codd, CEO of Coddbarrett Associates, a Providence-based computer graphics design and systems firm. 'And I'm thinking, 'Are you crazy. Why would I be here if I did?'" When she tried to explain her ideas about graphic design, she wound up with "glassy-eyed stares."

"You could tell they didn't understand what you were saying," she says. To the bankers, computer graphics meant little beyond "visions of Pac-Man." Eventually, she met a local banker who was enthusiastic enough to come and visit her fledgling business. ("I almost fell off my chair," she recalls.) In the end, though, even that brazen banker lent her $100,000 for computer equipment only because she and her husband owned their home. It wouldn't have mattered if she was Steven Jobs. Had she been renting a second-floor walk-up, she would have been stuck working with her old equipment and never would have started her business.

The track record of banks was so discouraging that Peter Barnes never bothered to approach them when he was starting his business a few years ago. Barnes, now the director of a money market fund, had formed a business called The Solar Center, which built solar heating systems for large residential and commercial buildings. The business proved a success, lasting ten years before dissolving. After putting up $30,000 themselves, Barnes and his six partners turned to friends for the next $70,000 they needed. "We didn't even bother to try a bank," Barnes recalls.

The investment banks are just as squeamish about funding start-ups. Ask Hunt Blair. He's the president and co-founder of The WIRE, a national cable radio station in the making in Providence, Rhode Island.

His first sales pitch to an investment firm was an unusually striking lesson in the stodgy politics of fund-raising high above Rockefeller Center in the English-manorized offices of a private investment bank. Despite the baronial environment-he and his partner, Mark McDonough, were expected to spiel from the end of a massive cherry wood table as narrow as a ping-pong table and as long as a lap pool the bankers were genial, but the final word was: let us know when you get some money.

"That's everybody's final word," says Blair.

"People are not interested in starting businesses but in trading businesses," says Steve Tytel, president and founder of Opton, a new retailing chain, and who also founded Ingenuities, a popular chain akin to The Sharper Image. "But somebody has to start businesses, otherwise there will be no businesses for these people to trade back and forth."

Even though he has a sexy product, Tytel has far too many sour experiences with bankers. After submitting a financing proposal, he'll get a followup phone call "and they'll say right away that they're not interested in the deal."

"Nine times out of ten this means they haven't even looked at the paper"' he says.

Tytel flinches with embarrassment recalling the time he programmed his presentation to a major New York City bank into a three-foot robot that he had sold at Ingenuities. Picture a table of J. Press suits watching an R2D2-ish contraption spouting marketing strategy and financial projections while scooting around a skyscraping conference room. A big hit it was not. "All they could do was look at me and say, 'Where's the leverage in the deal?'"

Francese of American Demographics had known enough not to bother with banks for his initial seed capital. He conceived of the magazine while lying on a Delaware beach during a vacation in 1977, ran immediately to his motel room to write his business plan, and plotted where to go for his money. He had long been in the business of using census data to help businesses, and he knew people who might be interested in investing. But of course the first bit of money didn't last long, and as he was struggling to meet his payroll, he turned to his bank to lend him more money. His banker would not only not lend him more money, but said, with measured banker's cool, that the bank now wanted some of the money Francese owed them back. He was flabbergasted. "I said, 'Why would I come and ask you for more money if I could pay back the other loan?'"

The venture adventure

As for non-source number two for fledgling entrepreneurs-venture capital firms-forget it. Liberals and conservatives alike have a picture of these companies as the swashbuckling heroes of the economy-rogues willing to take a chance on the whiz kid with the bright idea. In fact, venture capital firms are a conservative lot. Only 13 percent of the $3.9 billion disbursed by professional venwre capital firms in 1987 went to companies that were in the earliest phases of marketing and testing products, according to Venture Economics, a research firm based in Wellesley, Massachusetts. Less than onefifth of this 13 percent was actually seed financing going to those who had no product, no marketing, just an idea. The other 87 percent got pumped into established ventures.

If it's not the small start-up that sets venwre capital firms salivating, what does? Often it's the prospect of investing in firms that are already in business and about to be traded publicly on the stock exchange. (Indeed, this is the time when many founders of the companies themselves cash in.) For the investors, the bottom line is the big profit, not some long-term nurturing of a small start-up. "We look at the risk/reward equation and go from there," says Robin Grossman, a venture capitalist with Salomon Brothers. "We invest pure and simply for a return on investment."

It is their job to make money, and no one should begrudge them that. Neither, however, should they be commended. The consequence for society is that venture capital is available for businesses that are well enough along, but the money is hardly ever there at that moment of creation when a business is just starting. The venture capitalist is rarely serving any more of a social good than is Kohlberg, Kravis when it does a leveraged buyout.

And because venture capital firms are looking for the most blatantly and rapidly profitable investments, they wind up sticking with only certain kinds of can't-miss ideas. This mentality has led venture capitalists to worship at the altar of high-tech.

"It's extremely hard to find that first little bunch of money you need for a new company, unless you happen to be working with this year's hot technology," says Blair.

"There's a tremendous appetite among venture capitalists for incomprehensible things," said Maurice C. (Tommy) Thompson, founder of Senior Service Corporation, a Wilton, Connecticut company that runs a chain of day-care centers for the elderly. "I think it's considerably tougher to get money for common-sensical ventures the average person can understand."

This reliance of venture capital firms on heavy hitters resembles the power versus speed argument in baseball, only with portentous social ramifications. With the large majority of our venture capital consumed in the hunt for the rare high-tech "sluggers," the more economically, socially, and geographically diverse "spray hitters" are all but abandoned. Is this good for the venture capitalist's profit margin? Certainly. Is it good for the country? What do you think?

Thus has arisen one of the field's most curious ground rules: it is easier to raise a lot of venture capital than a moderate amount. After all, it doesn't cost a venture capital firm much more to disburse $5 million than $500,000 and the return on the former is much greater than on the latter.

Steve Tytel remembers his unsuccessful forays into the offices of venture capital firms "I walked in and immediately had two strikes against me-I'm a startup, which is way too risky, and I'm only looking for $1 million, which is not enough."

For those who do manage to get the venture capital, it's a Faustian bargain. "Your soul, your heart, your children, your wife-everything you own, they want," says Francese of American Demographics, But he knows that they demand a lot of equity-as high as 80 percent-to cover the baths they frequently take.

Some see the attitudes of venwre capitalists changing in the face of the '87 crash. There may have been fewer initial public offerings since then, which has reduced the venture capitalist's ability to rely on what Castle, the investment consultant, calls the "greater fool hypothesis." That was the theory that a venture capitalist would invest money in a company for as short a time as possible before he could find the greater fool who would pay more for the company than he did. "It was a wonderful game," says Castle. Today, venture capitalists must be prepared to live with their investments longer than in the halcyon days of 1983-84. Before, the bottomline question was "Who's getting me out?" Now, he says, it's "Is this thing really going to be valuable?" That's got to be better. But it likewise has put more pressure on venture capitalists to find the heaviest hitters of them all.

Family ties

And it leaves the truly little guy with but one choice for start-up money. Some call it the "informal investment network." Others call i"creative financing." What it comes down to is begging friends, family, and acquaintances for cash.

These informal investors are the Medicis of startup capital. A recent study for the Small Business Administration came to the startling conclusion that the flow of informal equity is "probably several times larger than professional venwre capital investment." The report went on to characterize the typical informal investor: the median age of the informal investor in new companies is 47, the median family income $90,000. While the report stresses that these informal investors are not typically millionaires, neither are they hurting. Their median family net worth is $750,000.

There's a scary social lesson in all of this. To be an entrepreneur you need people with money. It's true that when it comes to getting a job, society has become more meritocratic. Coming from a rich family is no longer guarantee of a seat at Princeton or Morgan Stanley. But when it comes to starting a firm it is desperately important to know someone. If you've grown up poor, or haven't forged any connections, you're sunk.

"Entrepreneurs almost have to come from the upper-middle or upper classes," says Blair, "because your first financing has to come from rich private sources. These are very hard to come by unless you're related to them."

Typically, you must have at least a house to mortgage, and therefore a hundred grand or two as a head "Everybody says to us, 'Why don't you have any of your own money in this?'" says McDonough of The WIRE, the cable station. "We say, 'Because we don't have any money,' and they don't quite believe it. 'Oh, come on-surely you have some money.' Well, I've got $88 in my savings account."

"Of course, the right-wing response to that is, 'Well, you're going to have to work for a while,'" says Blair, who really hates that one. Twenty-eight years old, he's worked at more jobs than he cares to remember, often two at a time. But he's also spent the last five years committed to The WIRE, which is envisioned as the long-awaited rebirth, on cable, of eclectic rock 'n roll radio. You wait until you save enough money that way, and you'll be far too old to rock 'n roll, or do much of anything else.

"The traditional rags to riches thing is a real tough go," says McDonough, Blair's partner. At least The WIRE boys went to Brown. "We would absolutely be nowhere if we had gone, say, to Rhode Island College instead," says McDonough. "It would have made everything ten times tougher."

The bottom line is if people don't know you, they don't want to know you. You can have a good idea, you can even have an idea that will serve society well, but if you have few contacts you're going to get bruised by all the brick walls you'll run into. Tommy Thompson, who runs the centers for the elderly, readily acknowledges that he could not have started Senior Service in 1985 if he had not had a 20-year record as a turnaround specialist for ailing companies; he was already a millionaire. "It's extremely difficult to get anyone to take a real chance on someone without a track record," he says. It's kind of the same problem people have who want to bring an original show to Broadway, he notes. Revivals just seem so much safer.

What about the federal government? Isn't it helping? The federal government, of course, has the granddaddy of all business support organizations, the Small Business Administration. But the agency's usefulness to the fledgling start-up is, at best, debatable. Paul Hawken has described it as "one of the strangest institutions known to mankind"; Paul Resnik, author of the Small Business Bible declares, "I've never heard of a small businessperson who has gone to the SBA for money, never mind advice."

But the real last word comes from Joseph Mancuso, founder of the Center for Entrepreneurial Management in Manhattan, which, at 11 years and 4,000 members, is the oldest and largest such organization in the country. "The government provides jobs to 5,000 bureaucrats in the SBA," he says. "They spend a lot of money doing nothing. And we count on them zero." As for the small businessperson just staffing, he says, "If you've got a really good idea, stay away from the government."

As for those SBA loans, they are effectively, if not intentionally, anti-entrepreneurial. The paperwork is monumental, and the process might typically take 18 months "The question is, where do you want to devote your energy-to getting your business going, or to trying to get an SBA loan?" says Tytel.

State programs have been a little more active and useful for entrepreneurs, including one, the Small Business Development Center program, that operates in conjunction with the SBA. The premise is to have SBDCs in every state (they are now in 46) to advise and educate entrepreneurs, each tailored to the needs of a particular state's business environment.

Some state programs do help. Michael Leckrone, founder and CEO of Vaser, an Indianapolis developer and manufacturer of laser/catheter systems, was literally saved by a $500,000 loan from a state agency established to fund high-tech companies. But more typical is New York City where the tax breaks are lavished on huge companies to encourage them to stay in town. As Judith Anderson of Venture Management Services puts it, aside from a few incubator projects, the city has made "no effort to produce an atmosphere that is congenial to starting businesses." Jane Startup's tax tangle

How then to help the entrepreneur? Most everyone agrees that tax breaks to encourage new investment would be of the greatest benefit to the widest crosssection of entrepreneurs. "We do not have a tax policy which rewards people for the risks they take," says Bo Burlingham, executive editor of Inc magazine. "And that is stupid. The government has the power to have a major impact on the now of capital to start-up companies. Right now it's not using that power."

If anything, the government has curtailed many of the crucial tax incentives that once helped the start-up business. It used to be that the investor in a new business had a big, soft cushion: a 50 percent write-off of his losses. That has been reduced to 28 percent. What's more, it's hard to take advantage even of that small deduction. Whereas the investor once could have written off his losses against any income-salary, interest, whatever-now it can only be written off against what the IRS calls "passive income," which few people earn. The bottom line is that there's much less protection if the investor loses his shirt.

And the tax laws that govern how you set up that new business can also be a hindrance. Let's say you're an entrepreneur. You could organize your new business as a limited partnership. This allows you to have an unlimited number of investors, but it also means that the general partner-most likely you-is liable for what goes wrong. The alternative is to organize the Subchapter S corporation, where there is no personal liability. But the drawback of the Subchapter S rule is that you can't have more than 35 partners-and the last thing you need when starting a small business is a limit. You'll need every nickel and dime you can get.

There is a trick to getting around this but you need a Sacajawea to lead you through the tax forest: form a limited partnership but instead of appointing yourself as general partner, create a Subchapter S corporation to be that general partner. That gives you the best of both worlds: the advantage of raising money from an unlimited number of partners but without having to assume the liability.

Unfortunately, much of the debate over taxes and business centers around established businesses-not brand new businesses. For instance, lowering the capital gains rate-a priority of President-elect Bush-would only encourage more trading and investment in businesses with an established track record. It would spur investments in GM as much as it would investment in Jane Startup. But since the promise of return from a new company is less than certain, investors have little incentive to back a startup rather than an existing company.

"You must motivate risk capital," says Edgar T. Mertz of the Liposome Company, a Princeton hightech firm. While some argue that a great return inherent in a great risk should be motivation enough, risk capital could be best encouraged if we didn't treat all investors equally, but instead delivered tax breaks to those who invest precisely in new businesses. One of Gary Hart's new ideas worth remembering was a proposal for a "new capacity" stock that would be spared the capital gains tax on its first resale and would thus give investors the incentive to target their investment on new plants and equipment instead of simply trading old issues.

As for the start-ups themselves, all are plagued with the prospect of high Social Security taxes when they make those first couple of hires. If those taxes could be paid as a percentage of profit, rather than as a flat rate, then businesses wouldn't need so much money to get started. In fact, most any kind of tax holiday for new businesses-and only new businesses-would be worth cheering.

Ideas like these don't get floated often, not because they're not worthy but because there is no one out there to speak for the start-up entrepreneurs themselves. Washington is rife with business lobbies, of course, from the National Grocers' Association to the Sporting Good Manufacturers Association. But these lobbies are organized to fight for breaks for companies that are already established. You see them pounding the pavement on Pennsylvania Avenue trying to get breaks for Safeway and Spalding not exclusively for Mom's Grocer's or Frank's Tennis Balls. What we we need is a spokesman for the start-up.
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Title Annotation:entrepreneurs, banks and venture capital companies
Author:Schlosberg, Jeremy
Publication:Washington Monthly
Date:Jan 1, 1989
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