Why it's too hard to start a new business - small business capital

Washington Monthly, March, 1994 by Jon Meacham

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.