Obama’s small-business proposal would help high-growth start-ups, experts say

Creative commons licensed from Flickr user jurvetson/Obama is shown touring the SpaceX facilities in 2010 with entrepreneur Elon Musk, head of both the space exploration company and the electric car company Tesla Motors.

On the one-year anniversary of the Startup America Partnership, President Obama urged Congress Tuesday to pass legislation that would make it easier for start-up companies to raise money and grow. The initiative is the latest push by the federal government to encourage more entre­pre­neur­ship and to boost fast-growing companies.

The $48-billion proposal, which will be part of the president’s 2013 budget, calls for tax cuts for small businesses that create jobs, an elimination of capital gains taxes for small-business stock and an expansion of the Small Business Investment Company program, which supplements private equity investments.

Obama also proposed clearing a path to public offerings for small companies by loosening regulations for younger companies in their first years after going public.

Creating an environment that allows small companies to proliferate and hire has taken on an increased importance in the national political agenda. Launched last year with former AOL CEO Steve Case at the helm, the Startup America initiative set out to boost high-growth start-ups through improved access to capital, mentors and other business resources.

The interest in high-growth companies reflects recent research from the Kauffman Foundation and others finding that small businesses create most of the nation’s jobs, and fast-growing companies, which make up less than 1 percent of all businesses, generate 10 percent of net new jobs in any given year.

“The data show that job creation is disproportionately concentrated in a small portion of high-growth firms,” said Sean Greene, the associate administrator for investment at the U.S. Small Business Administration and a former venture capitalist and entrepreneur. “In this economic environment, we need to be doing everything we can to help those companies start, scale and grow.”

Tuesday’s so-called “Startup America Legislative Agenda” aims to address many of the hurdles that some venture capital experts and economists say have long been a drag on the start-up economy.

Desperately seeking capital

The lack of funding for early-stage companies in particular is sometimes called a “valley of death” in the start-up world. In clean technology alone, for example, data from the moderate think tank Third Way shows that venture capital funding in late-stage companies was more than double that in early-stage ones in 2010.

What’s more, there are less than half as many venture capitalists now as in 2000, and nearly 70 percent of VC funding is doled out in California, New York and Massachusetts, leaving entrepreneurs in other areas without much-needed cash.

“There’s a lot of start-ups that need capital that are close to getting funded, but can’t,” said Jeffrey Sohl, director of the Center for Venture Research at the University of New Hampshire.

Joshua Konowe, founder of Washington-based texting start-up Uppidy, said he pitched multiple angels in D.C. but had trouble raising a round initially. There are fewer investors in Washington than in other tech hubs, he said, and funders seemed interested in investing either too much or too little money. (He was looking for hundreds of thousands, not millions.)

Eventually, he turned to Silicon Valley firms and got what he needed with relative ease.

“How many millionaires have been printed out of California?” he said. “There doesn’t seem to be a problem with getting money there. Here, though, it’s a much smaller investor pool, and if you don’t do your homework, you’re gonna have a long battle.”

Sohl said public-private investment partnerships for early-stage companies are preferable to a simple influx of cash from the government because it keeps the power to choose the beneficiaries with investors, not bureaucrats.

“Instead of making a direct investment in a start-up, this type of arrangement allows investors that are in the market to make the decision on what to invest in and where,” he said.

The proposed expansion of the Small Business Investment Company to $4 billion announced Tuesday comes on top of the $1 billion Early Stage Innovation Fund announced in December, which will match a venture fund’s investment one-to-one for early-stage companies. Applications for venture capitalists for the program will open up in the spring, Greene said.

Experts say changes to certain Securities and Exchange Commission rules could also help early-stage companies raise money from a large group of small-dollar investors, rather than going after a few large ones. It’s currently illegal for a private company to offer profit-sharing to hundreds of unaccredited investors, but some argue that’s just the sort of funding that early-stage start-ups need.

“If you can only pitch to angels and VCs, your investment world is much smaller than if you could pitch idea to lots of people who have $1,000 each, for example,” said Patrick FitzGerald, a professor of entrepreneurship at the University of Pennsylvania’s Wharton School of Business.

There are several such so-called “crowd-funding” bills currently working their way through Congress, and in Tuesday’s proposal Obama formally called for allowing non-accredited investors to get equity stakes in start-up companies.

“If crowd-funding passes, that should radically change the game in terms of how fast companies can grow,” FitzGerald said. “You’re not limited to raising capital only from accredited investors. You can open the door to the masses.”

Scaling back regulations

If they pass, several elements of the administration’s proposal would ease the path for small companies’ initial public offerings, which have decreased significantly since the early 2000s. There were 1,975 venture-backed IPOs in the 1990s and just 478 in the last decade, according to a report from Thomson Reuters and the National Venture Capital Association (NVCA).  Companies have also been taking twice as long to make it to public markets in recent years.

That’s a problem because the initial public offering is one of the most important events in the life of a high-growth business, said Paul Maeder, chair of the NVCA and investor at Highland Capital Partners. Not only does it pay out the founders for years of hard work, thereby creating inspiration and motivation for other entrepreneurs, going public helps companies grow faster and larger. Nearly 92 percent of job growth at VC-backed companies occurs after the company goes public, according to NVCA data. (Start-ups that never get sold or acquired are sometimes called “the living dead” in the venture capital world, Sohl said.)

But going public has become expensive, costing about $2.5 million on average for the initial regulatory compliance and several million each year afterward, according to the IPO Task Force, a group of investors and entrepreneurs that presented to the Treasury Department last fall.

Experts say one way to ease the financial burden of going public is to scale back Sarbanes-Oxley, the 2002 financial accounting law, for small companies only. Born out of Enron and other corporate scandals, the law comes with significant transparency and auditing requirements for public companies.

“Sarbanes-Oxley was passed to address a big-company problem,” said Maeder said. “The law has made it so hard for small companies to go public, they’ve been denied access to growth.”

Obama’s proposal would change how Sarbanes-Oxley and other rules are phased in during the initial years following an IPO, which could also potentially lower the barriers to going public for young companies. It also calls for raising the limit on public offerings from $5 million to $50 million for companies that are exempt from SEC registration requirements under Regulation A, in effect opening up the market for more small IPOs.

“We have to give these entrepreneurs every incentive to succeed and grow their companies here,” said SBA Administrator Karen Mills in a conference call with reporters following Tuesday’s announcement. “This will streamline paperwork for companies trying to raise capital.”

Of course, there are downsides to this IPO free-for-all. Sarbanes-Oxley and other SEC requirements are intended to protect investors from sham deals, and “some believe that allowing a company to raise $50 million without the proper audited financial statements and other disclosures could be bad for investors,” said Laura Oppenheimer, a senior policy adviser with Third Way. “Likewise, allowing average Joes on sites like Kickstarter to invest their money in a business without the proper information could be a magnet for fraud.”

Some venture capitalists argue that in order to prepare for IPOs, mid-size companies also need more coverage from analysts — the researchers who provide information about a company so that investors feel more comfortable buying into it. Certain regulations make it less lucrative for analysts to cover start-ups, and the Startup America legislative package doesn’t do anything to change that.

“When the U.S. economy has been healthiest, it’s when there has been a productive IPO market,” said Matthew Howard of Norwest Venture Partners. “If there were more analyst coverage, we would know more about these companies, so there would be more IPOs.”

Making it easier to invest

The new proposal does feature small-business tax deductions for equipment expenses and a 10-percent credit for companies that increase jobs or wages stateside, which follow on the “17 and counting” small-business tax credits Obama touts having signed into law.

“For the small business that is unsure about whether to accelerate hiring, this 10 percent wage credit provides as an incentive for them to take the next step,” said Gene Sperling, director of the White House National Economic Council.

Some economists dispute the idea that tax cuts incentivize hiring, however. Entrepreneurs start firms or increase hiring when they see opportunities in the market, not when they see a marginal savings on their tax bill, said Antoinette Schoar, a professor of entrepreneurial finance at the Massachusetts Institute of Technology’s Sloan School of Management.

Even research from developing countries, where some governments pay entrepreneurs to hire, show that such efforts don’t often yield employment boosts, she said.

Many of the venture experts said the more important break in Tuesday’s proposal is the renewal of the capital gains tax exemption for small business stock, which was 100 percent until January 1 of this year. Maeder said a capital gains reduction is important for two reasons: One, it gives individuals an incentive to invest and grow other companies. And two, it helps venture capital firms attract top talent that might otherwise go to hedge funds and other high-paying finance fields.

“Hedge funds give giant bonuses,” Maeder said. “All I can do is say, if you work hard here, you’ll become a partner. When companies go public 15 years from now, you’ll get some of the distribution of the stock. I need that differential in order to attract talent in order to help start the next great companies.’”

 
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