Wednesday, November 19, 2014

Why are start up businesses not creating jobs?

I posed this question to a Fed economist today. Her answer: lack of capital.

The above chart is from a Federal Reserve Bank of San Francisco Economic Letter: Slow Business Start-ups and the Job Recovery published in July.

But in strategic planning retreats that I moderate, community financial institutions insist that they lend to small businesses. In fact, when I recently spoke to a group of New York bankers, I opined that community FIs would lend to small businesses only if they have three years of operating profit and a building as collateral. Some took offense.

The chart above, taken from a Harvard Business School Working Paper: The State of Small Business Lending written by a former SBA Administrator and also published in July, shows that only 34% of small businesses use a regional or community bank as their primary financial institution. The second chart shows the primary sources of capital. Yes, a loan is the most often cited. But trade credit and credit cards also weigh in heavily.

The above chart, taken from the same HBS working paper, shows the use of proceeds of small business credit. Given a community FIs lending proclivities, one would assume that small businesses borrow to finance a building. But no, the primary use of proceeds is for cash flow. Real estate structuring is pretty low on the list.

I discuss this disparity between how bankers perceive they contribute to small business capital formation, and why businesses need capital. In March 2010, I wrote about the decline in business lending among community financial institutions in a blog post titled: Have we checked out of business banking?

So we limit small business lending to those businesses with three years of operating profit and have real estate as collateral. Not exactly lending into the industries that are projected to grow, such as service firms and professional/technical practices. These businesses are commonly located in an office building that they do not own. 

Another challenge is the number of businesses that do not borrow. According to the HBS working paper, only 40% of small businesses apply for credit. Out of the forty percent, 43% did not receive the credit they requested (see chart). 

So let's extrapolate... eleven percent of small businesses borrow for real estate structuring and another 13% for debt restructuring. But only 40% of small businesses borrow. So 40% of 23% is 9.2%. But only 43% get approved for the amount of loan they requested. So about 4% borrow for real estate or debt restructuring and get the credit they requested. But only 34% of small businesses bank with regional and community banks. 

So for 1.35% of small businesses, community FIs stand ready to lend!

Of course, I exaggerate, because many small business loans used for cash flow, inventory, etc. are collateralized by a commercial or residential building and financed by community FIs. But I think our participation in small business funding is far smaller than we claim.

So if we want our communities to thrive now and into the future, small business formation and growth will be critical. Lack of capital is always a top of the list constraint to small business success.

Are we participating in this critical segment of our economy?

~ Jeff