The Golden egg

Entrepreneur, May, 2002 by Chris Sandlund

Regardless of what term you use to describe the current economy, the fact remains that investors are sitting on a whole lot of cash. we know--for 2 1/2 decades, we watched them make it.

THE REVOLUTION IN BUSINESS FINANCE IN THE PAST 25 YEARS HAS created a tremendous amount of wealth. As that money feeds back into the economy, experts say, the best is yet to come.

A radiant future might seem illusive to any entrepreneur who tried to fund a new venture in 2001, but some perspective is in order. Up until the 1970s, raising capital was almost impossible for entrepreneurs.

"The U.S. was capital-scarce," says John Edmunds, professor of finance at Babson College in Wellesley, Massachusetts.

That changed courtesy of two 1978 laws. The Revenue Act of 1978 cut capital gains tax rates, immediately increasing the returns that investors reaped from risky ventures. That same year, a technical change to the Employee Retirement Income Security Act allowed pension managers to invest a small percentage of their money in venture capital funds.

Suddenly, a ready source of capital had the means and incentive to invest. Venture capital took off like a rocket. According to the National Venture Capital Association (NVCA), investments increased from $561 million in 1980 to $37.7 billion in 2001.

But VC funding wasn't the only capital source undergoing changes. During the 1980s and 1990s, credit card companies greatly expanded the reach of consumer credit, and entrepreneurs jumped at the opportunity. According to a National Small Business United (NSBU)/Arthur Andersen study, half of small businesses financed their capital needs in 2000 with credit cards-making it the most common form of financing.

Banks are also aggressively accepting collateral. The NSBU found 20 percent of entrepreneurs in 2000 used assets or inventory as collateral--up from 4 percent in 1997.

It may have been tough to fund an enterprise in 2001, but you certainly had more options than in 1977.

What Lies Ahead

What will finance look like five, 10 or 20 years hence?

After years of unprecedented growth, a chastened VC community is ready for some housecleaning. John Freeman, the Helzel Professor of Entrepreneurship and Innovation at the University of California, Berkeley, notes that returns for VCs have returned to the 30 percent per year range common in the early 1990s rather than the 100 percent returns of the bubble years. "There are lots of limited partners that got into venture funding because of the astronomical returns," he says. "Next time around, some of them will be reluctant to invest again." He sees fewer VC firms investing less money 10 years from now. Other experts aren't as pessimistic, but still predict a flat industry for a while.

Still, no growth isn't necessarily as bad as it sounds because the plateau is set at such a high level. Entrepreneurs will continue do well with venture capital. "A higher percentage [of entrepreneurs] understand the game, which will lead to a higher success rate," says Freeman.

The dearth of entrepreneurs getting VC funding in the past may have had more to do with the entrepreneurs than the VCs. "To get VC funding, you have to ask for it," says Edmunds. When more entrepreneurs have success with VC funding, will more of them be willing to develop the high-growth-rate businesses that VCs demand and seek it out?

In the future, entrepreneurs will benefit from an ever-growing pool of angel investors as an increasing number of Americans meet the Securities and Exchange Commission's definition of an accredited investor: $1 million in net worth and an annual income of $200,000. Today, 4.6 million Americans have a net worth of $1 million. Ten years from now, some demographers project that number will grow to 20 million. As the population of multimillionaires expands, so will the number of angels. Even if some angels got gun-shy during the pullback from the boom years, the long-term trends favor more investors willing to fund your business. Associate professor of finance Chris Leach at University of Colorado, Boulder, notes that these individuals will continue to cluster in various geographic regions and do deals locally.

Angels will not be funding mom and pop operations in the future. They've begun to emulate the VC community. "Angels are much more inclined to do larger deals," says Leach. "The ability of the angels to meet together and talk about deals in which they have expertise has made them more comfortable in syndicating their deals."

Charge It

Those syndicates allow angels to move up the scale from the $50,000 deals of days gone by. Leach says angels are being forced in that direction by competition from credit cards and mortgages to fund smaller deals. After all, why should you give up a piece of your company when a home equity line can float it for six months?

Which leaves Leach wondering what vehicles will continue to be favored. "Personal bankruptcy is an issue in both cases," he says. "Bankruptcy reform, if effective, may push entrepreneurs to go for equity capital." (Each house of Congress passed a reform package last year, but they have yet to iron out the differences.)