These are the questions small business owners have wrestled with since the economy took a nosedive. Many banks responded to the financial crisis by tightening their standards, pushing entrepreneurs towards other sources of funding, such as alternative lenders and crowdfunding. Today, despite the slow but steady recovery, it is still difficult for many small businesses to obtain a traditional loan.
So what is the situation for small business financing in the future? The Wall Street Journal asked Ted Zoller, director of the Center for Entrepreneurial Studies at the Kenan-Flagler Business School at the University of North Carolina at Chapel Hill, and senior fellow at the Ewing Marion Kauffman Foundation.
Here are edited excerpts from the discussion.
WSJ: Small business lending has yet to recover to pre-crisis levels, so where do you see small business financing headed?
SIR. ZOLER: The demand for loans is certainly increasing as the economy improves. Overall, bankers are seeing a rebound in credit applications for small business loans. But the paradox is that the banks are not able to respond to this need as much as they have been in the past. Unfortunately, most of the capital available for debt comes from large institutional banks that have been significantly affected by the financial crisis and now face significant regulatory hurdles in determining the creditworthiness of loans.
So what is playing out on the streets right now is an unbalanced credit market with the smaller banks – mainly regional and commercial banks – being the most active in financing small businesses, and the big banks largely withdrawing or at least becoming more conservative in their lending decisions in the same market.
Unfortunately, one of the unintended consequences of the too-big-to-fail phenomenon is that much of our credit capacity in the United States is now concentrated among a handful of large banks. It will take several years of stable economic conditions and strong business fundamentals for these banks to come back and provide credit facilities to growing small businesses. Any effort by the government to accelerate this recovery process would be welcomed by the small business sector.
That being said, small businesses generally find strong partners in regional banks who know the economic conditions on the ground and are willing to share the risk with business owners.
WSJ: What can businesses do in the meantime until lending improves across the board? What avenues can they turn to? What strategies can they use?
SIR. ZOLER: The common strategy would be for companies to look to high net worth individuals, business partners and suppliers for credit. This can be done through a convertible debt type investment, or credit terms can be established that the company will pay a simple return to source of capital similar to a bank debt vehicle.
Convertible debt is a very common investment strategy that provides debt capital that converts into equity if certain steps are not followed. Businesses can find investors who will make these types of investments and are willing to join the business as a partner if they do not return the capital required under the terms of the convertible investment.
Additionally, companies can look to other sources of capital such as business partners, suppliers and large corporations who would be willing to provide a loan based on terms similar to those offered by a bank.
However, the differences are that these investors know their capital is at risk, so they might want more favorable terms than would be applied with traditional bank loans. These types of loans are often made by existing businesses, family offices, and high net worth individuals who may know the business and understand the industry in which it operates.
A third strategy would be to provide capital by carefully managing cash flow. Businesses can often negotiate payment terms with their creditors so that they can delay payment until receipts occur, and thus use their own working capital as a source for their business. However, companies should be very careful when choosing to use this strategy, as there is a cash flow risk associated with relying on this source of funding if the company loses control of the state of its receipts.
Effects of technology
WSJ: How do you see technology influencing small business lending over the next few years?
SIR. ZOLER: While crowdsourcing and crowdfunding platforms are currently receiving considerable attention, the debt market is still reasonably conservative and less inclined to change the underlying fundamental business model of lending. Crowdfunding offers new entrepreneurs impressive opportunities to access non-dilutive funding [which involves finding backers but not offering them equity stakes or in some cases taking on debt], removing the need for debt financing in many cases. In a few famous examples, this non-dilutive financing has completely eliminated the need for the company to take on debt.
I expect to see this trend increase over time and see crowdfunding become more mainstream as a way to provide seed funding to new businesses, especially new businesses that are revenue-generating and don’t have not yet been proven.
WSJ: What additional efforts can the U.S. government make to increase the flow of its small business loans? Or are they already doing everything they can?
SIR. ZOLER: There are many innovations that the Small Business Administration has implemented to encourage capital formation for small businesses.
Specifically, through [Small Business Investment Company] regulation, they have improved the equity investment environment for the creation of seed funds. On the debt side, however, it is very difficult for the government to innovate without pledging government faith and credit to back the loans. This is a difficult prospect for the US government, given its current debt.
However, the current economic recovery seems to indicate that there is enough activity to warrant an increase in the volume of SBA-backed loans made available to national banks.
I would also recommend increasing the allocation of these lending vehicles to banks that have a credit culture that enhances small business lending, especially among regional and local banks that understand the regional economic conditions in which these businesses operate. The big banks are suffering from regulatory pressures that make them less able to provide these loans effectively in the current climate.
In addition, continue to provide non-dilutive financing through the [Small Business Innovation Research] and [Small Business Technology Transfer] programs for promising start-ups; these companies can take advantage of a stronger balance sheet to attract capital from regional banks that have the credit culture to support start-ups.
WSJ: What is one thing or factor in small business loans that is not currently on people’s radar?
SIR. ZOLER: There is a small movement underway to develop a series of royalty-based approaches to business investment that show promise for the future.
The idea of a royalty is that the investor [often set up as a fund in which multiple investors subscribe] receives a percentage of future earnings. Unlike the investor who receives equity for an unknown future valuation, the investor bets on the future track record of the business not only to recoup their investment, but to provide a long-term return on investment.
A royalty model can actually be a solid solution for companies with a more predictable revenue stream and a long-term view of creating value in the marketplace.
Mr. Davidson is a writer in San Francisco. He can be contacted at [email protected]
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