By SARAH MORGAN
1. "Our businesses will probably fail."
Americans are creating more new businesses now than they have in the past 15 years. But half of those start-ups will fail within their first five years, according to the Small Business Administration. Of those that make it that far, only a third will see their tenth anniversary. In 2009, for instance, 552,600 new businesses were created while 721,737 small firms closed or went bankrupt, estimates the SBA, according to the most recent data available.
Those statistics are bad news for entrepreneurs and their employees for obvious reasons. But investors backing start-ups that falter stand to lose their shirts, too. In fact, 40% of the "exits," or end results, for people who invested in start-ups in 2009 were bankruptcies, rather than successful acquisitions or initial public offerings, according to a report by the Center for Venture Research at the University of New Hampshire's Whittemore School of Business and Economics. That compares to 27% in 2007. Creditors, rather than investors, have first claim to any remaining assets when a business goes bankrupt, so when a start-up goes belly-up, experts say investors may lose everything.
2. "Some of our biggest fans have gone into hiding."
Historically, high-net-worth individuals known as angel investors have been among the first financial supporters of new businesses. But while very young companies have relied on angel investors and venture capitalists to fund them in their earliest stages, such help has been going away. In 2007, 75% of angel deals came at the "seed" or start-up stage, and 45% of angel-backed companies had no revenues, according to researchers at Willamette University. But in the first half of 2011, only 39% of companies backed by angels were in the "seed or start-up" stage, according to the latest report by the Center for Venture Research. In recent years, it's been easier to raise money for companies that are a little more developed, "because those have been the survivors," says David Brophy, the director of the Center for Venture Capital and Private Equity Finance at the University of Michigan's Ross School of Business.. "There's been a cloud over the whole early-stage market," he says.
Small business experts say this trend is just one more sign of how hard the recession has been on entrepreneurs. Not only has it hurt sales, sending many fledgling businesses under, but it has also seriously impeded the ability to raise cash for the next big idea. Banks are reluctant to lend, and it is more difficult for new business owners to access a personal or small business credit card, says Scott Edward Walker, the CEO of the Walker Corporate Law Group, a firm that often advises small businesses. In the past, some businesses also got a form of financing from vendors who would provide machinery or telecom equipment on credit, but those days are gone, too, Walker adds.
3. "We want small investors to risk their money on us anyway."
Investing in privately held companies, including many start-ups, is currently restricted to so-called accredited investors. These individuals must have a net worth of at least $1 million or an income of at least $200,000 for the past two years. A bill recently passed in the House would relax those restrictions. (Two similar bills are also under consideration in the Senate.) Dubbed "crowdfunding," the bills take slightly different approaches, but generally would allow entrepreneurs to raise money online from small investors. There would be a cap on how much money any individual could risk and a limit on how much in total can be raised for one business this way. The danger? "We're taking the riskiest and most speculative securities and moving them to the investors who are least capable of bearing that sort of investment risk," says Heath Abshure, the Arkansas Securities Commissioner and the vice president of the North American Securities Administrators Association.
From the entrepreneur's perspective, changing the investing rules would open up a potentially vital new source of funding, says Walker, who works with start-ups and supports the crowdfunding bills. "The big question out there is whether the accredited investor definition is appropriate," he says. It's not clear that simply having a net worth of $1 million is a sign of greater sophistication than other small investors willing to take a risk, he adds.
4. "Don't count on an IPO."
Imagine sipping champagne and watching the stock price skyrocket. The dream of being on the ground floor for a successful start-up's initial public offering is powerful. Unfortunately, it's also the least likely outcome. In 2009, only 6% of angel investors who exited an investment did so through an IPO, compared to 54% who exited through a merger or acquisition. And the number of IPOs has been shrinking: There were 4,467 IPOs between 1990 and 2000, more than four times as many as the 1,096 companies that debuted between 2001 and 2011, according to data compiled by Jay Ritter, a professor of finance at the University of Florida who studies IPOs.
One reason for the decline, say experts: Going public is too expensive for most small firms. The Sarbannes-Oxley Act of 2002 imposed costly new accounting and disclosure requirements on all public companies. This "limited the IPO as an option to much larger companies," says Wayne Lorgus, a partner at B2BCFO, a company that provides financial services to closely held firms. "Costs for a small company can easily reach a half a million dollars," Lorgus estimates.
Granted, accredited investors can buy and sell shares of pre-IPO companies through online marketplaces such as SecondMarket or SharesPost. That can be a way for some investors to cash in on an investment without an IPO. But that's still no guarantee that an investor would be able to sell at the moment he or she needed to, because there aren't as many buyers and sellers in these markets as there are in the public markets, and buyers may not always be available, warns Gerri Walsh, the vice president for investor education at the Financial Industry Regulatory Authority, a self-regulatory organization for the securities industry.
5. "Even if we do go public, you might not be able to sell your shares."
Here's a little secret. When a hot young company goes public, it's the investment bank underwriting the deal that decides who gets to buy shares, says Lorgus. The goal is to develop an orderly, liquid market for a fledgling stock and that may mean selling only a limited number of shares at first. As a result, investors, founders and other insiders don't always get to sell when they want to. Developing a market for a new stock "often takes a lot longer than shareholders expect," says Lorgus. "If the company isn't large enough or if there's an absence of analysts following the stock, it may take a very long time indeed," he adds.
Investors can try to negotiate up front for the right to sell their shares in an IPO. It's important for anyone considering an investment in a pre-IPO company to get a lawyer who isn't affiliated with the company to look over the terms of the investment to be sure they understand when and how they can get their money out of the company, Finra's Walsh says.
6. "Don't even think about working for us."
For decades start-ups have been an engine for job growth in America. Indeed, there would be no net job growth at all in America without start-ups, according to research by the Kauffman Foundation. Unfortunately, that engine may be running out of gas. Jobs created by small businesses peaked at about 4.65 million a year in 1997 to 2000; in 2010, new companies created less than 2.5 million jobs.
Even before the recession began in 2008, new businesses were starting out with fewer employees than they used to. The downturn only made matters worse, according to a July 2011 report by researchers at the Ewing Marion Kauffman Foundation. New businesses opened their doors with an average of 10.8 employees in 2002, but by 2009, new businesses were starting out with only 8 employees, on average, according to that report.
What's worse, says Dane Stangler, the Kauffman Foundation's director of research, is that young companies are adding fewer employees as they grow. The 2011 Kauffman Foundation report found that new businesses "born" before 2001 retained 90% of the jobs they started out with after two years; new firms started in 2007 retained less than 80% of the jobs they started with after two years. Even with today's high unemployment, small businesses have trouble finding skilled workers willing to take the risk of a start-up. Technology plays a role. You can do a lot more work with fewer people these days, says Stangler. And, labor force participation has been falling in recent years, particularly among men. Women who have left the labor force recently have been more likely to go back to school, but men "are just dropping out," Stangler says.
7. "Those stock options might be worthless..."
Say you're lucky enough to score a job with a new company. You may be offered stock options for privately held shares. Those options entitle you to buy shares of the new company for a set price at some point in the future. Sounds great, but experts warn that because the company stock doesn't trade on a public market, figuring out how much this perk is worth can be tricky. That's especially true when you consider that investors often negotiate agreements that guarantee they get their money back first -- before employees -- if the company gets acquired, Lorgus says.
For example, say a start-up raises $50 million from venture capital investors, and later gets bought by a larger company for $60 million. An employee with stock options worth 1% of the outstanding shares might think he's due a handsome $600,000 payday. But if those venture capitalists have priority, they may take their $50 million out before anyone else gets a slice of the pie. That employee now only owns 1% of the $10 million left over. If the company is bought for $50 million or less, common stockholders would get nothing at all, experts say.
To be sure, that "liquidation preference" should, however, be taken into account at the outset, when the company's board determines the value of the stock options, says David Cappillo, a partner in the technology companies group at Goodwin Procter, a law firm that often advises entrepreneurs. The company's common stock should be given a lower valuation to start with than the preferred stock, to reflect the possibility it'll be worth less later, he says. Sure, if the company is acquired for less than the money it raised from investors, the common stock would be worthless. But if the company ends up with a hugely successful IPO, the common stock would see its value rise a little more because it started out with a lower valuation. (Just ask all those new Facebook millionaires.)
Plus investors need to be compensated for the risk they're taking on, says Alex Finkelstein, a general partner at Spark Capital, a venture capital fund. "We're risking our capital, and for that risk we need to make sure we get money out first in a worst-case scenario" where there isn't much of a payout to split up, Finkelstein says.
8. "...Or they might stick you with a hefty tax bill."
Even if your stock options pay off for a small business employee, tax experts say you may owe Uncle Sam a tidy sum. An option isn't actually a grant of stock. Instead it gives the employee the right to buy a certain number of shares at the fair market price of the stock on the day the option was granted. Generally, employees' stock options "vest," or take effect, in batches over time, to give workers an incentive to stick with the company for the long haul, Cappillo says.
If the shares are worth more when the worker exercises the option (takes advantage of his right to buy the shares) than they were when he was granted the option, the company has just given him something of value and that gain must be factored into the worker's alternative minimum tax calculation for the year. If a worker is granted 100,000 shares' worth of stock options when those shares are worth $1, and then exercises those options when the stock is worth $50, he's going to have to pay income tax on his paper gains of $4.9 million. And that tax must be paid when he buys the stock, not when he sells it, perhaps the only time when a taxpayer must pay tax on income he hasn't actually received yet. "And none of those gains are adjusted for inflation," notes B2BCFO's Lorgus.
9. "I'm telling you everything."
From an investor's perspective, there really isn't much a start-up CEO actually will tell you, says Sohl of the Center for Venture Research. "There's no audited financials, there may not be any financials at all, [the product] may just be a prototype," Sohl says. "The entrepreneur isn't going to tell the investor everything, because then they'll know all the flaws," he says. And with a company at a very early stage of development, the skill of the CEO often matters more than what she actually plans to make or do, Sohl says. "You bet on the jockey and not the horse," he says.
Of course, deciding whether a start-up CEO has what it takes to succeed is more art than science, but one key skill to look for is the ability to learn from previous mistakes, Sohl says. Investors should make sure that entrepreneurs can talk about specific lessons they've learned from past failures and specific things they're doing now to avoid making the same mistakes again, Sohl says. "If you externalize those failures -- it wasn't my fault, the economy tanked or something else happened -- your learning curve is flat and that failure becomes a liability," he says.
Start-up backers agree that evaluating a new company and its leadership is a very subjective process. But some of the most successful businesses are born out of a failed idea, says Jon Karlen, a general partner at Flybridge Capital Partners, an early-stage venture capital firm. For example, one of Karlen's current investments was founded by a Venezuelan who initially hoped to start an English-language tutoring business. But turnover among the tutors was high and the owner realized the business would only grow so much. Now the company, called Open English, is developing an on-demand, online language learning program. "He never would have come up with this if he hadn't already slammed his head against the wall trying to do the offline version," Karlen says.
10. "You're not cut out for this."
Small business owners "get punched in the face daily for a living," says Jason L. Baptiste, the CEO of OnSwipe, a tablet publishing software company. Essentially, entrepreneurs are people who'd rather fail trying to make a billion dollars than just get a regular job, and "that's not rational at all," Baptiste says. The key to successfully taking on such long odds is to "find something you want to see built in the world," Baptiste says. "It has to be a mission, it has to be more than a company, because this gets really hard," he says.
Successful entrepreneurs do need passion, but they also need a concrete understanding of what makes a good product, says Spark Capital's Finkelstein. Personal experience can help. "Often, great entrepreneurs are solving a problem, and it's a problem they've lived with," Finkelstein says. For example, one of Spark Capital's portfolio companies, PeerTransfer, was founded by a Spanish student attending MIT who felt like banks fees for international money transfers were way too high, Finkelstein says.