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Best and Worst States for Start-Ups 2012

Figuring out how to nurture startups has never been more important to the U.S. economy or those of its states. Here are the best and worst states for start-ups in 2012.

Figuring out how to nurture startups has never been more important to the U.S. economy or those of its states. Entrepreneurism and, correspondingly, job growth have hit a rough patch in America over the last five years, even pre-dating the Great Recession.

The number of businesses created in the United States each month last year dropped by an average of nearly 6 percent compared with a year earlier, according to research by the Kauffman Foundation, a Kansas City-based outfit that studies and supports small-business growth. And the fastest-growing sector of new companies, construction, only ranked No. 1 because so many Americans with that vocational background had been laid off by large companies caught in the housing bust.

Yet startups remain the lifeblood of any vibrant economy. The top one percent of growing firms of all ages account for 40 percent of net new jobs created in any given year in this country, Kauffman says.

So what states and localities do the best job of helping entrepreneurs start companies and of nurturing them through the crucial first 18 months of their existence? Where should a would-be entrepreneur hang his or her “shingle”? Identifying the most fertile spots is much easier said than done.

Wyoming, for example, looks good on paper because it has extremely low business and personal tax rates. However, the state registered no increase in entrepreneurial activity last year over 2010, Kauffman data showed. Meanwhile, metro Los Angeles produced the highest rate of entrepreneurs in the country despite the egregiously anti-business policies of California; overall, the state still matched business-friendly Texas for the highest total rates of entrepreneurial activity last year. Cauldrons of entrepreneurial fervor, such as Silicon Valley, Austin and Boston remain great petri dishes for startups despite state-government policies that are basically unfriendly or hostile to small business. And yet less-obvious places, including Chattanooga, Chicago and Royal Oak, Michigan, can be welcoming, too.

Many states and localities are striving to enact the right policies, initiatives and attitudes to tilt the playing field toward startups, so they can help small companies through that perilous initial year and a half. Nevertheless, innate characteristics such as climate, demographics and an area’s economic history can play significant roles, as well, in helping entrepreneurs determine just where to launch.

Here are some ways in which the policies and characteristics of locales around the United States are making a difference—for better or worse:

Taxation

This may seem like something penny-pinching corporate executives moan about more than entrepreneurs, but state tax policies also can be influential and even decisive for the siting and success of many startups.

“As small businesses get started, it’s difficult to pay for normal operating expenses, let alone high [personal] income-tax rates and property-tax rates,” said Debra Sweeney, CEO of MyCorporation, a Calabasas, California, outfit that helps new companies incorporate. “Small businesses in those states may choose not to start at all.”

Tax-code simplicity is another virtue for startups. “It’s a big issue,” said Mark Robyn, an economist for the Tax Foundation in Washington, D.C. “Having more special tax provisions in your tax code and one that looks like Swiss cheese will make things more complicated for business.”

For those reasons, the Tax Foundation’s most recent, annual analysis rated Nebraska, then Louisiana, Ohio, Wisconsin, Oklahoma, Georgia, Kentucky, Arkansas, Wyoming and Utah as the 10 most favorable in state tax costs on new firms. Note that only three of them are on any coast and all, arguably, are part of the nation’s heartland.

But big and influential tax differences can exert varying pulls on startups within regions. For example, Ohio has waived corporate income taxes for small businesses, but two states west, in Illinois, the legislature continues to punish them, raising the tax rate on corporations to 9.5 percent last year, among other boosts. And beyond these tax increases is the fact that Illinois suspended the availability of tax-loss carry-forwards for four years.

“That means if a startup is generating losses, not income at first, and then down the road becomes profitable, it won’t be allowed to use those losses to offset income for a period of years,” said Brian Browdy, director of the tax-strategy practice of Ryan LLC, a Chicago-based tax-consulting firm. “It’s a very unattractive feature of the tax code.”

Targeted Incentives

States and cities can be all over the map with particular hooks for start-ups, depending on where they see the chance to make an overall economic impact and how they perceive their own advantages and disadvantages to new businesses.

For instance, Colorado is one of a handful of states that laxly enforce non-compete agreements, which often stifle the spread of talent and ideas from existing companies to startups—and, thus, dampen a state’s economic performance. Furthermore, Arizona has fielded a number of incentives targeting “green energy” startups.

A few states and localities have quickly built area-wide, broadband-communications networks that are very attractive to many high-tech startups. Westchester County in New York is one of them. Another is Chattanooga, Tennessee, where Dr. James Busch moved several years ago largely because the city was laying a robust matrix of fiber optics precisely to lure startups like his.

“Our main thing is availability and cost of bandwidth,” explained the CEO of Specialty Networks, a cluster of physicians and assistants who read diagnostic images from hundreds of doctors, clinics and hospitals now scattered around the country. “We have to be able to have images delivered in seconds. If you’re a radiologist on our network and it takes just a few extra seconds, if you multiply that by 20,000 procedures a year, it can cost you 50 to 60 hours.”

Meanwhile, one of Georgia’s advantages is an aggressive effort to help its small companies export, featuring the state’s own network of representatives tasked with boosting Georgia companies’ goods around the world. For SASCO Chemical Group, for example, such assistance helped spur sales to Mexico, specifically, by 27 times in just two years and earned footholds in South American and European markets.

“The state saves us a fortune because we don’t have to go over somewhere for two years and do our own reconnaissance of a market,” said Marc Skalla, president of the third-generation, family-owned company with eight-figure annual revenues.

In Cleveland, one big lure for the proliferation of biomedical startups is a medical nexus that includes the world-famous Cleveland Clinic and Case Western Reserve University, and a concentration of software engineers stemming from major, area employers such as Philips and NASA’s Glenn Research Center.

The decisive reason for CardioInsight’s location to Cleveland was a state-sponsored program called Third Frontier that provides grants and loans to startups and related venture-capital outfits. The company, which makes cardio-diagnostic vests that cost $1,500 apiece, received rounds of financing, including a Third Frontier grant for $1 million. CardioInsight also got housed in a state-funded incubator called BioEnterprise. “It’s allowed us to have buildings and labs that are reasonably affordable and all kind of right here near [the medical institutions],” said CEO Steve Arless of CardioInsight, which now employs 25 people.

Licensing

Many potential startups get hung up in state regulations over occupational licensing that can pose enormous barriers to entry, according to research by University of Minnesota Professor Morris Kleiner. These include requirements concerning masseuses, tour guides, hair braiders and tree trimmers—each, potentially, a source of small-business growth and jobs, but whose strict regulation can hardly be called key to protecting public health.

In his home state, for instance, startup-thwarting, strict licensing that creates “a reverse Robin Hood effect” is responsible for as much as one percentage point of the Minnesota unemployment rate, Kleiner calculated.

Immigration

Few factors are identified as favorably with states’ entrepreneurial climates as a strong flow of immigrants. Immigrants were more than twice as likely to start a new business in the U.S. last year as were the native-born, Kauffman said.

Many immigrants come to the United States for entrepreneurial opportunities and freedom. They have an edge translating cultural trends and products from their countries into potential startups in America. If they’ve had to cross an ocean, they likely “had to have some money just to get here in the first place,” said Robert Fairlie, economics professor at the University of California-Santa Cruz and author of Kauffman’s annual study of state-by-state entrepreneurial activity.

“And if you’re an immigrant coming to the U.S., you’ve already been somewhat entrepreneurial because you left your home country to come here,” he added.

This factor helps make even states such as Massachusetts competitive for many startups despite its ranking of 43rd for new firms in the Tax Foundation index and onerous requirements on small companies, such as a new family-leave law.

“Immigration is even a positive when it comes to lower-skilled immigrants because they’re able to provide the kind of services that allow other people to move on and up” as entrepreneurs, said Frank Conte, author of the annual State Competitiveness Report by Boston’s Suffolk University that just ranked Massachusetts No. 1.

Know-how

Conte noted that Boston’s huge roster of leading colleges and universities also gives the state a specific and powerful edge in technology, just as it did a generation ago when MIT birthed the entrepreneurs and the energy that led to the success of Wang, DEC and other startups on Route 128, which rings the city.

Such a base has allowed Boston’s startup culture to thrive even after the creative destruction wrought by sea changes in the computer business. The area has been “very good at reinventing itself,” Conte asserted. “The firms that are no longer on the Route 128 landscape have been replaced by biotech firms and major software players, such as Siemens and Oracle.”

But Conte and other experts said that most states can boast—and leverage the advantages of—some sort of educational concentration where the extent and types of resident know-how constitute a lure for some startups and, potentially, the nucleus of an entrepreneurial culture.

“These kinds of human resources are important,” Conte said. “That’s why Massachusetts shines. But also in our [state competitiveness] index, so does North Dakota because they’re well-educated though the economy is resource-based.”

Such workforce advantages extend beyond tech-geekdom. Metro Detroit ranked at the bottom of Kauffman’s measure of resident entrepreneurism last year, with only about 30 percent the rate of Los Angeles. Nevertheless, in suburban Royal Oak, Michigan, startup Collegiate Bead—which designs and manufactures beads with intricate designs for popular, Pandora-style women’s jewelry—is flourishing because of another endemic characteristic of Detroit: local access to CAD operators who’ve been shed by the auto industry. “It’s a huge advantage at this stage of the game,” said CEO Dave Schowalter.

Legacy Differentiators

Every state has unique characteristics endowed by nature and centuries of history that it can harness in the pursuit of startup success. Over the last several decades, a few have built such a history of entrepreneurial accomplishment that this legacy serves as a powerful, native edge.

Included is Austin, Texas, where an annual, music, digital and entrepreneurship festival called South by Southwest (SXSW) is adding to the city’s long and growing history of success in nurturing new companies, which has been fed by the University of Texas and the track records of past startups. There’s also Silicon Valley, California, where the unparalleled startup culture continues largely to overwhelm even the nation’s most business-hostile state policies.

Nest Collective, for example, is an example of a Silicon Valley startup in an entirely different business sector than its digital neighbors—better-for-you foods. The parent of fast-rising, kids-food brands, including Plum Organics, sprouted in an area of the East Bay known locally as the Golden Rind, headquarters to Clif Bar, a nutrition-bar giant, and organic leader Annie’s Home Grown. “We developed in the heart of the innovation capital and applied a philosophy like [nearby] companies, Twitter and Google,” explained Neil Grimmer, Nest’s CEO and co-founder.

The flip side of Nest’s good fortune is the struggle that startups in places like Chicago undergo. Inspired by a handful of local firms, such as Groupon, that have managed to succeed in the digital realm, a growing group of tech founders is trying to make an entrepreneurial beacon out of the city, led by angel and VC investments and not-for-profit incubators such as Catapult Chicago.

Unfortunately, a shortage of qualified engineers is hindering the effort—along with the state’s pesky tax demands. Last year, Chicago ranked with Detroit as the least-prolific place for startups. Consequently, Chicago may never become sufficiently hospitable to digital enterprises, but there is one big advantage that the Windy City enjoys over most other places: it’s square in the middle of America.

That geographic placement matters a lot to some startups. Intercon Solutions moved to Chicago Heights, Illinois from Silicon Valley several years ago because its business is recycling used electronics devices from across the country. Now, the $10-million company employs 70 people in Illinois.

“It’s the hub of the United States,” said CEO Brian Brundage, “and freight expenses are important to the budgets of the companies that do business with us. Being here works out very well for us.”

Looking to Relocate

Startups shopping for a site should consider these tactics:

Look to the city: Often, the most attractive lures and most aggressive recruiting of startups are developed by cities or metro areas, rather than states. Municipalities and their enthusiastic residents can be more precise in packaging their locations with the aims of new businesses than can states, which tend to be restricted to relatively obtuse measures, such as tax policy and financing.

The not-for-profit Idea Village, for instance, has created a startup mecca in New Orleans out of the debris of Hurricane Katrina. So far, it’s helped raise $2.7 million in seed capital for more than 1,100 local entrepreneurs, creating more than 1,000 jobs and $83 million in annual revenue. As a result, New Orleans has gained a growing reputation among Millennials as a great place to launch a business.

Search for contests: More states are offering cash and other prizes to the winners of startup competitions that will locate within their borders. These contests can indicate which states are the most serious about accommodating new companies. For instance, this year, Arizona doubled funding of its Arizona Innovation Challenge to $3 million, all of which will be packaged in six-figure awards to winners of a promising-technology competition. St. Louis has launched Arch Grants, a contest with a $50,000 prize, mentoring support and highly subsidized o!ce space going to the champion.

Gauge the political winds: In an era when business has become so politicized, startups can take advantage of political sea changes on the state and local level, but beware—they can also get whipsawed.

The founders of Raleigh Michigan Studios, for example, seemed to have a tiger by the tail two years ago after Democrat-dominated Michigan made its financial incentives for film-makers the richest in the country. They put up a cavernous new building in downtrodden Pontiac, Michigan, projecting eventual employment of 3,000 people.

Then, Republican Rick Snyder became governor 18 months ago and slashed the state’s movie-making incentives. After staging the new Walt Disney movie, Oz: The Great and Powerful, financially strapped Raleigh now employs only about 15 people and has defaulted on a $630,000 interest payment.

About dale buss

dale buss
Dale Buss is a long-time contributor to Chief Executive, Forbes, The Wall Street Journal and other top-flight business publications. He lives in Michigan.