On the face of it, 2010 looks like a bad time to start a new business. Early stage capital, whether it is venture funds, angel investors or bank loans, remains tight. And while technically the recession has passed, consumers and businesses are still keeping a tight hand on their wallets. Despite the obstacles, however, start-up formation has increased recently, possibly due to laid-off workers deciding to pursue their entrepreneurial dreams. At the same time, high unemployment has expanded the talent pool for start-ups looking to hire. For those who can find creative solutions to the financing challenge, starting a new business now may turn out to be perfect timing. “The recession is a great time to start a company,” says David Wessels, an adjunct professor of finance at Wharton.
In fact, the numbers show that the pace of start-up formation has picked up despite — or even because of — the recession. According to a report released in May by the Ewing Marion Kauffman Foundation, a non-profit focused on entrepreneurship, the number of new businesses created between 2007 and 2009 was the highest level in 14 years, even exceeding the start-up boom of 1999-2000. In 2009, 340 adults out of every 100,000 started a business each month, up 4% from the pace in 2008.
The uptick in entrepreneurial activity might seem “counterintuitive to some,” says Thom Ruhe, director of entrepreneurship at Kauffman. “But the economic situation of the last few years has shattered the image of job security and economic stability. And it is a natural progression for some people to see entrepreneurship as an avenue for economic determination. People are saying, ‘I will control my own destiny.’”
Yet if more people are willing to make that leap to start their own business, the challenges in keeping that enterprise alive are steep. Angel investments, funds from wealthy individuals that are a source of capital for many start-ups, fell sharply in the wake of the 2008 financial crisis. According to the Center for Venture Research at the University of New Hampshire, angel investing declined 8.3% in 2009 to $17.6 billion, a drop that came on the heels of a 26.2% falloff in 2008. Because deals were slightly smaller in size last year, however, there was actually a 3% increase in the total number of firms that got financing.
At the same time, 2009 saw angels put a greater share of their money into later stage firms, with just 35% going to start-ups. That’s down from 45% going to seed-stage companies in 2008. “We need start-up capital,” notes Jeffrey Sohl, director of the Center for New Venture Research. “If that [35%] figure stays low, then we have problems.”
New, Tougher Terms
Meanwhile, entrepreneurs who are able to land some angel funding are likely to have to agree to some tough terms. Peter Linder, an angel investor in the Philadelphia area, says that many angels may have been too generous in the past in how they valued a company when taking a stake. It’s why he thinks valuations on deals will remain lower than in the past. “People have been burned too many times,” Linder states. “We learned a lesson — that we were paying too much.” His prediction: There will not be a return to lofty valuations for start-ups any time soon.
The turmoil in the venture capital market presents another hurdle for entrepreneurs. According to Wharton professor of entrepreneurship Raphael Amit, a number of factors are currently roiling the venture capital community, including low returns generated by many funds over the last decade. In addition, exits for venture capital investments have been difficult — the result of a nearly shuttered initial public offering market over the last few years and a drop in mergers and acquisitions activity. According to data from Thomson Reuters and the National Venture Capital Association (NVCA), venture capital exits through an M&A deal fell to 271 in 2009, down from 379 just two years earlier. And there were just 12 venture-backed IPOs last year, down from 86 in 2007.
“The banks didn’t want to lend money to companies that wanted to do M&A transactions,” notes Amit. “And when those M&A deals got done, the valuations were low. At the same time, when investors put money into start-ups, they know that the likelihood of an IPO exit is low.” No surprise, then, that venture capital investing activity has been lackluster recently. In 2009, just 2,893 deals were done for a total investment of $18 billion, down from 4,004 deals valued at $28 billion the year before, according to Thomson Reuters and NVCA.
While there is an uptick this year — in the first half of 2010, 1,646 deals were completed for a total investment of $11 billion — Wessels warns that those firms getting funded are typically far along in their development. “The company getting financed now is typically one that doesn’t need financing,” he notes. “It is often a company that is already profitable and has customers, and it’s a question of the speed at which they grow.” Wharton marketing professor Leonard Lodish says this is a shift from even a few years ago. “In 2006 and 2007 it was much easier to get funding if you had a good idea and a good track record. Now you need to demonstrate that you have a business model that really works.”
The high hurdles for funding could mean higher failure rates for start-ups suggests Robert Fairlie, a finance professor at the University of California Santa Cruz and the author of the Kauffman report on entrepreneurial activity. In addition to challenges in the angel investing and VC world, he points out that other sources of funding — bank lines of credit or home equity loans — are also less accessible because financial institutions have tightened up on lending and housing values have dropped. “It is harder to bootstrap now.”
Fairlie says that higher failure rate for start-ups may be evident already in bankruptcy statistics. According to the American Bankruptcy Institute, in 2009 there were 60,837 business bankruptcy filings, up from 43,546 the year before and triple the 2006 rate. And according to the Center for Venture Research, 40% of exits by angel investors in 2009 were in the form of a bankruptcy, up from 26% the year before. Even for those who survive, however, the result could be slower growth. As Amit points out, if valuations on start-ups are lower, on average “less money is coming into the company in any one round of financing.”
The Hot Sectors
But there are some signs that the picture may be growing a bit brighter. Amit notes the pick-up in venture-backed IPO’s — there were 26 for the first half of this year versus 12 for all of 2009. And he adds that valuations also appear to be strengthening in the VC market. According to data collected by the law firm Wilson Sonsini Goodrich & Rosati, 62% of deals done in the second quarter of 2010 were “up rounds” — meaning the valuation ascribed to the company raising money was higher than in the previous round. That figure was just 50% in the first quarter of this year. “This data indicates a continued strengthening of valuations, largely as a result of increased investment activity and improvement in overall economic conditions,” according to the law firm’s report.
But no one is predicting a financing turnaround just yet. That’s why the best positioned industries are those that have continued to attract investment dollars, notably green technology and renewable energy as well as Internet-related business. “It is getting cheaper and cheaper to start an Internet-based company,” Lodish points out, whether it is a web retailer or a company with a business solution delivered over the web. “You can start a company and demonstrate your model for tens of thousands or hundreds of thousands of dollars, not millions.”
In the case of green technology-based businesses, the capital costs may be higher, but the market is just as receptive. Data from the Center for Venture Research shows that angel deals in energy-related businesses were up in 2009. And Lodish says the government’s support for clean energy technologies is driving some of that investor enthusiasm. The American Recovery and Reinvestment Act of 2009, for example, allocated funds for upgrading the nation’s electrical grid. Consequently, companies that have services in that space have been investment darlings.
Amit, however, warns that the excitement around clean energy and green technology may be overdone. “There are too many venture firms zeroing in on this space. It’s not a bubble yet, but you have to ask if there’s room for so many companies.”
Those in less hot sectors, of course, need to be more creative about operating on a shoestring budget. Ruhe says one option is to link up with potential customers before a product is fully developed and then arrange for that customer to fund the final work. “A couple decades ago, big companies had massively funded R&D groups,” Ruhe notes. “Those were the first things that a lot of companies cut when the economy soured. I think entrepreneurs have jumped into this market for outsourced R&D. [Bigger] companies may partner with them and give them lab space, for example.” So while in the past, entrepreneurs might have wanted to keep a new product under wraps and then launch it with a big marketing push, Ruhe suggests that they may be more open now with potential partners who can aid in the development.
According to Wharton management professor David Hsu, start-ups need to pay close attention to how they structure those alliances, however. “It’s a double-edged sword,” says Hsu. “If you get into a partnership with a big company, they could easily expropriate you. But splitting the pie with them [on the new product] mitigates their incentive to come in and compete directly against you.”
There is one silver lining for entrepreneurs amid all the negative economic news: High unemployment makes recruiting talent much easier. “People are motivated to take chances,” Wessels notes. “Very talented executives are willing to [accept] something [like a role at a start-up] that they wouldn’t have a few years back.”
In addition, the ugly employment picture may indirectly help firms keep a lid on compensation costs, according to Hsu. “The labor market is not as competitive as it was. And one of the big advantages of an early stage company is the ability to issue equity. So you can hire someone with some minimum base salary, but if the company hits certain milestones, that person can [earn more] in the form of options or other variable compensation.”