Do Fools Rush in where Angels Fear to Tread?

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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Angel investors backed away from seed and startup investments last year, according to the University of New Hampshire's Center for Venture Research. In 2009, ten percent less private capital, compared to 2008, went to bright ideas or new companies.

On the other hand, despite deep recession and record unemployment, more new businesses were started in 2009 than any year since 1995, according to the Kauffman Foundation.

Are people foolish to start new businesses in this economic climate? Is that why angels are afraid to invest in them?

Why Start A New Business When Times Are Tough?

Record unemployment motivated many people to start about 500,000 new businesses each month last year. People who were laid off, who worked for shaky companies, or who were just exasperated had to find a way to keep groceries on the table. With few job openings and lots of people looking, creating their own job seemed to be a good strategy.

Entrepreneurship was highest among 35 to 44-year-olds, but 55 to 64-year-olds showed the largest increase in new business building, continuing a two-year trend.

Oklahoma and Montana had the busiest beavers, but entrepreneurs in Texas and Idaho were close behind. Alabama, Mississippi, Nebraska, Pennsylvania, and Minnesota produced the fewest new businesses per capita. According to the Kauffman study's author, Robert W. Fairlie, "Entrepreneurial activity generally is highest in western and southern states, and lowest in the Midwestern and northeastern states." Houston had the highest entrepreneurial rate in 2009; Seattle had the lowest rate.

While necessity may be the mother of invention, that's not the only reason people start businesses. And it's not the only requirement for success.

I had dinner a few nights ago with the co-founder of Alpine Access. When data-over-voice communications became possible, he realized that people and computers could use a single phone line at the same time. He understood that technology and future developments could make it possible to build an all-virtual call center. The company he started ten years ago has 2800 agents working from home in 35 states, and is poised to reach $100 million in revenue. His company is no start-up, but angels and venture firms are knocking on the door almost daily.

With new business starts at an all time high, regardless of the motivation, you'd think shopping for good investments would be easier. But private investors aren't going there.

Why Are Angels Afraid of Start-ups?

Seed and startup stage companies have never been a favorite of investors for one obvious reason: They're risky. While the failure rate is nowhere near the mythical "9 out of 10 don't last a year" — it's closer to 6 out of 10 — the fact is that companies that have been around a while are more likely to produce a return on the investor's dollar.

Another reason investment in startups is down is because investors may have to put more money into companies they've already added to their portfolio. Declining consumer spending and lower revenue can quickly deplete a company's cash reserves if expenses aren't or can't be controlled. In a sense, investors are forced to double down to protect their investment.

Finally, angels' tolerance for risk change during a down economy, too. Their own income may be lower for the same reason as everyone else's, and as savvy investors they may decide this is a good time to play their cards close to their vest.

Entrepreneurship Drives the Economy

The sad part about the decline in startup investment is that entrepreneurship drives our economy, yet recent stimulus programs essentially ignored angels and the companies they invest in.

Even in the '81-'82 recession about half of all small business owners thought conditions would improve. Today, only 11% do, which is a huge difference. Business owners and investors, almost unanimously, just don't think things are going to get better any time soon. With that mindset, even people who have money aren't going to spend it.

The scary part is that the people in Washington with no private market experience may continue to try to create jobs (Stimulus II?) by laying on more debt and only making things worse. Instead, legislation that will support new business startups and encourage private investment could fuel the engine that makes our country run.