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10 Things Start Up Won't Tell You
10 Things Start Up Won't Tell You
10 Things Start Up Won't Tell You
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SMARTMONEY.COM
10 THINGS FEBRUARY 6, 2012, 8:53 A.M. ET
mericans 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.
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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.
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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.
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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.
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force recently have been more likely to go back to school, but men "are just
dropping out," Stangler says.
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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.
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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.
NEXT
2. "Some of our biggest fans have
gone into hiding."
FINANCIAL GLOSSARY
Words used in this article: self-regulatory organization, initial public offering,
North American Securities Administrators Association,
alternative minimum tax, accredited investor
self-regulatory organization, initial public offering,
North American Securities Administrators Association,
alternative minimum tax, accredited investor
self-regulatory organization, initial public offering,
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