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May 20, 2014
Where Do Young Firms Get Financing? Evidence from the Atlanta Fed Small Business Survey
During last week's "National Small Business Week," Janet Yellen delivered a speech titled "Small Business and the Recovery," in which she outlined how the Fed's low-interest-rate policies have helped small businesses.
By putting downward pressure on interest rates, the Fed is trying to make financial conditions more accommodative—supporting asset values and lower borrowing costs for households and businesses and thus encouraging the spending that spurs job creation and a stronger recovery.
In general, I think most small businesses in search of financing would agree with the "rising tide lifts all boats" hypothesis. When times are good, strong demand for goods and services helps provide a solid cash flow, which makes small businesses more attractive to lenders. At the same time, rising equity and housing prices support collateral used to secure financing.
Reduced economic uncertainty and strong income growth can help those in search of equity financing, as investors become more willing and able to open their pocketbooks. But even when the economy is strong, there is a business segment that's had an especially difficult time getting financing. And as we've highlighted in the past, this is also the segment that has had the highest potential to contribute to job growth—namely, young businesses.
Why is it hard for young firms to find credit or financing more generally? At least two reasons come to mind: First, lenders tend to have a rearview-mirror approach for assessing commercial creditworthiness. But a young business has little track record to speak of. Moreover, lenders have good reason to be cautious about a very young firm: half of all young firms don't make it past the fifth year. The second reason is that young businesses typically ask for relatively small amounts of money. (See the survey results in the Credit Demand section under Financing Conditions.) But the fixed cost of the detailed credit analysis (underwriting) of a loan can make lenders decide that it is not worth their while to engage with these young firms.
While difficult, obtaining financing is not impossible. Over the past two years, half of small firms under six years old that participated in our survey (latest results available) were able to obtain at least some of the financing requested over all their applications. This 50-percent figure for young firms strongly contrasts with the 78 percent of more mature small firms that found at least some credit. Nonetheless, some young firms manage to find some credit.
This leads to two questions:
- What types of financing sources are young firms using?
- How are the available financing options changing?
To answer the first question, we pooled all of the financing applications submitted by small firms in our semiannual survey over the past two years and examined how likely they were to apply for financing and be approved across a variety of financing products.
Applications and approvals
While most mature firms (more than five years old) seek—and receive—financing from banks, young firms have about as many approved applications for credit cards, vendor or trade credit, or financing from friends or family as they do for bank credit.
The chart below shows that about two-thirds of applications on behalf of mature firms were for commercial loans and lines of credit at banks and about 60 percent of those applications were at least partially approved. In comparison, fewer than half of applications by young firms were for a commercial bank loan or line of credit, fewer than a third of which were approved. Further, about half of the applications by mature firms were met in full compared to less than one-fifth of applications by young firms.
In the survey, we also ask what type of bank the firm applied to (large national bank, regional bank, or community bank). It turns out this distinction matters little for the young firms in our sample—the vast majority are denied regardless of the size of the bank. However, after the five-year mark, approval is highest for firms applying at the smallest banks and lowest for large national banks. For example, firms that are 10 years or older that applied at a community bank, on average, received most of the amount requested, and those applying at large national banks received only some of the amount requested.
Half of young firms and about one-fifth of mature firms in the survey reported receiving none of the credit requested over all their applications. How are firms that don't receive credit affected? According to a 2013 New York Fed small business credit survey, 42 percent of firms that were unsuccessful at obtaining credit said it limited their business expansion, 16 percent said they were unable to complete an existing order, and 16 percent indicated that it prevented hiring.
This leads to the next couple of questions: How are the available options for young firms changing? Is the market evolving in ways that can better facilitate lending to young firms?
When thinking about the places where young firms seem to be the most successful in obtaining credit, equity investments or loans from friends and family ranked the highest according to the Atlanta Fed survey, but this source is not highly used (see the first chart). Is the low usage rate a function of having only so many "friends and family" to ask? If it is, then perhaps alternative approaches such as crowdfunding could be a viable way for young businesses seeking small amounts of funds to broaden their financing options. Interestingly, crowdfunding serves not just as a means to raise funds, but also as a way to reach more customers and potential business partners.
A variety of types of new lending sources, including crowdfunding, were featured at the New York Fed's Small Business Summit ("Filling the Gaps") last week. One major theme of the summit was that credit providers are increasingly using technology to decrease the credit search costs for the borrower and lower the underwriting costs of the lender. And when it comes to matching borrowers with lenders, there does appear to be room for improvement. The New York Fed's small business credit survey, for example, showed that small firms looking for credit spent an average of 26 hours searching during the first half of 2013. Some of the financial services presented at the summit used electronic financial records and relevant business data, including business characteristics and credit scores to better match lenders and borrowers. Another theme to come out of the summit was the importance of transparency and education about the lending process. This was considered to be especially important at a time when the small business lending landscape is changing rapidly.
The full results of the Atlanta Fed's Q1 2014 Small Business Survey are available on the website.
By Ellyn Terry, an economic policy analysis specialist in the Atlanta Fed's research department
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