From the May 2002 issue of Entrepreneur

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.

Technology: First it leveled the playing field. Where's it headed now?
Money: Capital was scarce 25 years ago. Here's its state today.
Management: Trends are multiplying fast. What will stand the test of time?
Marketing: Technology and personalization will rule this arena.
Franchising: Get ready . . . the golden age of franchising is upon us.

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."

HOW YOU GET IT
Percentage of small-business owners in 2000 who used the following to finance their capital needs in the preceding 12 months.
Credit Cards 50
Commercial bank loan 43
Leasing 24
Vendor credit 23
Asset-based/inventory as collateral 20
Personal or home equity bank loan 19
Angel investors 19
Private loan 18
SBA-guaranteed loan 6
Selling/pledging accounts receivable 3
Private placement of stock 2
Venture capital 2
Public issuance of stock 1
Other 1
SOURCE: Arthur Andersen/National Small Business United

Charge It

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.

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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

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.)

VC FUNDING
1980-2001 (in millions)
Year Amount
1980 $548.07
1981 $1,133.49
1982 $1,567.58
1983 $2,845.27
1984 $2,913.13
1985 $2,707.72
1986 $2,977.29
1987 $3,146.32
1988 $3,253.35
1989 $3,304.90
1990 $2,760.41
1991 $2,241.74
1992 $3,405.95
1993 $4,361.08
1994 $3,883.92
1995 $7,345.38
1996 $13,200.62
1997 $16,091.94
1998 $21,936.51
1999 $55,715.80
2000 $111,471.18
2001 $42,312.96
SOURCE: Thomson Financial Venture Economic/National Venture Capital Association

As Congress' debate over bankruptcy will affect financing decisions, so will its funding of the SBA. The Clinton era saw an expansion of SBA loan guarantees. "The SBA has an availability of capital that it didn't have before," notes David Minor, the William M. Dickey Entrepreneur-in-Residence at Texas Christian University in Fort Worth. For the second year in a row, the Bush administration's budget has proposed a reduction in SBA loan programs. Last year, Congress parried the move, and senators and representatives have been very vocal in their opposition to this year's cuts. Whether they will beat back the administration again remains to be seen.

If SBA loan guarantees stay at the same level, however, that will mirror the overall stability of non-SBA bank lending to small businesses. And that's a good thing. Small-business lending is an entrepreneur's second most important source of funding, according to the NSBU study. Fortunately, recent studies by the Federal Reserve indicate that small-bank lending is steady-as-she-goes.

One reason, according to the Fed, is that 3,875 new banks opened between 1980 and 1998. New banks-frequently community banks-lend a greater portion of their portfolio to small businesses than larger banks.

"It's not that hard to get a banking license," says Edmunds. "Our banking regulations encourage these boutique intermediaries."

Banking regulations underwent a serious overhaul during the S&L crisis of the late 1980s. Banks' ability to weather the recent economic downturn in great shape indicates the system is working. Don't expect any major tweaking in the future. Your needs will continue to be met by a local banker doing business based on a good relationship.

Keep It in the Family
Friends and family remain a major source of funds. "There's a lot of availability of start-up capital from parents," says Minor. "That's not the case for the whole country, but certain groups have that access."

As with angel investors, friends and family will be getting wealthier. Aging baby boomers will have a chance to place the $50,000 investments formerly covered by angels.

Of course, not everything will be rosy. In addition to the inevitable credit crunches in business cycle troughs, beware of flameout fads in financing. Freeman points to the boom in investment-based business incubators during the dotcom era. "That turned out to be not such a great device," he says.

Still, the pie continues to grow. "Americans are still buying the argument that they have to own risky securities," says Edmunds, "so the availability of capital for small business will be strong."