The current small business credit crunch is getting much attention and rightly so. We know very little about the overall small business universe because it is so huge and diverse. Most discussions about this topic focus on credit and lending, but the issue is much more complex than that. A more broad-based discussion is necessary to understand the full extent of the current crisis. The crisis encompasses both types of financing, debt and equity.
In good times or bad the top source of small business capital is the personal wealth of the owner. Even beyond startup, owners often tap into their personal wealth like a line of credit, on an ongoing basis. If available, personal wealth is easier to access than other forms of financing and may be the only source available. The primary sources of personal wealth are typically real estate and retirement accounts. Since 2008 both of these sources have taken a huge hit, so the amount of personal wealth available has plummeted. Most owners are experiencing the worst economic times in their lifetime. So even if they have personal wealth available, they are less likely to invest it in their businesses. Instead, they are cutting back or forgoing expansion.
Friends & Family
Another common source of capital has essentially dried up – friends and family. For the reasons discussed above, friends and family have less wealth available and are less willing to invest.
The ability of a private company to borrow funds depends on the cash flow of the company, the available collateral, and the credit of the owners. Most small business revenue, profits and cash flows are down substantially. The value of available collateral, often including the personal residence of the owners, has also dropped significantly. The compensation of the owners is often based on profits, so it is down, too. With both personal income and wealth declining, the credit score of the owners has likely declined as well. All of these factors, in combination, result in less creditworthy private companies.
Another common source of capital is using credit cards typically based on the personal credit of the owner. Credit card companies have tightened credit standards for getting new or increasing existing credit lines. In many cases they have actually reduced existing credit limits. As discussed above, the creditworthiness of both the owners and the company has declined. The result is that credit card financing is less available and tougher to get.
Many banks have funds available and seem willing to increase small business lending, but have other issues preventing them from doing so. The demand for business loans has decreased because many companies are cutting back or forgoing expansion. As discussed above, there are fewer creditworthy companies. Many banks are facing increased pressure from regulators to reduce risk while experiencing difficulties with some of their commercial real estate loans. Although small business loans can be very profitable, they are very risky. Many small banks are more familiar with other types of loans and may have little experience dealing with Small Business Administration (SBA) loan programs. Continuing issues with the funding of SBA programs has created some doubt about the availability of loan guarantees. Again, the result is bank financing is less available and tougher to get.
All of these issues create a complex small business financing crisis that requires broad-based solutions. A vigorous and sustained economic recovery would alleviate many of the issues, but many expect small business to lead us out of the recession. How is that supposed to work? We need better ways to finance small businesses. Ones that will enable institutional and individual investors to invest in small, private companies like they currently do in large, public companies. The expansion and increased visibility of the secondary market for SBA guaranteed loans is a small step in the right direction that will hopefully lead to a more comprehensive solution.