Access to Capital for Local Businesses

A significant share of locally owned businesses are struggling to secure the financing they need to grow. Our 2014 Independent Business Survey found that 42 percent of local businesses that needed a loan in the previous two years had been unable to obtain one. Another survey by the National Small Business Association likewise found that 43 percent of small businesses who had sought a loan in the preceding four years were unsuccessful. Among those who did obtain financing, the survey found, “twenty-nine percent report having their loans or lines of credit reduced in the last four years and nearly one in 10 had their loan or line of credit called in early by the bank.”

Very small businesses (under 20 employees), startups, and enterprises owned by minorities and women are having a particularly difficult time. Even with the same business characteristics and credit profiles, businesses owned by African-Americans and Latinos are less likely to be approved for loans and face greater credit constraints, particularly at start-up, according to one recent study.

One consequence of this credit shortage is that many small businesses are not adequately capitalized and thus are more vulnerable to failing. Moreover, a growing number of small businesses are relying on high-cost alternatives to conventional bank loans, including credit cards, to finance their growth. In 1993, only 16 percent of business owners reported relying on credit cards for financing in a federal survey. By 2008, that figure had jumped to 44 percent.

The difficulty small businesses are having in obtaining financing is a major concern for the economy. Historically, about two-thirds of net new job creation has come from small business growth. Studies show locally owned businesses contribute significantly to the economic well-being and social capital of communities. Yet, the number of new start-up businesses has fallen by one-fifth over the last 30 years (adjusted for population change), as has the overall number and market share of small local firms. Inadequate access to loans and financing is one of the factors driving this trend.

Sources of Small Business Financing

Unlike large corporations, which have access to the equity and bond markets for financing, small businesses depend primarily on credit. About three-quarters of small business credit comes from traditional financial institutions (banks and credit unions). The rest comes primarily from finance companies and vendors.

At the beginning of 2014, banks and credit unions had about $630 billion in small business loans — commonly defined as business loans under $1 million — on their books, according to FDIC. “Micro” business loans — those under $100,000 — account for a little less than one-quarter of this, or about $150 billion. (One caveat about this data: Because of the way the FDIC publishes its data, this figure includes not only installment loans, but credit provided through small business credit cards.)

Banks provide the lion’s share of small business credit, about 93 percent. But there is significant variation in small business lending based on bank size. Small and mid-sized banks hold only 21 percent of bank assets, but account for 54 percent of all the credit provided to small businesses. As bank size increases, their support of small businesses declines, with the biggest banks devoting very little of their assets to small business loans. The top 4 banks (Bank of America, Wells, Citi, and Chase) control 43 percent of all banking assets, but provide only 16 percent of small business loans. (See our graph.)

Credit unions account for only a small share of small business lending, but they have expanded their role significantly over the last decade. Credit unions had $44 billion in small business loans on their books in 2013, accounting for 7 percent of the total small business loan volume by financial institutions. That’s up from $13.5 billion in 2004. Although small business lending at credit unions is growing, only a minority of credit unions participate in this market. About two-thirds of credit unions do not make any small business loans.

Crowd-funding has garnered a lot of attention in recent years as a potential solution to the small business credit crunch. However, it’s worth noting that crowd-funding remains a very modest sliver of small business financing. While crowd-funding will undoubtedly grow in the coming years, at present, it equals only about one-fifth of 1 percent of the small business loans made by traditional financial institutions. Crowd-funding and other alternative financing vehicles may be valuable innovations, but they do not obviate the need to address the structural problems in our banking system that are impeding local business development.

Shrinking Credit Availability for Small Businesses

Since 2000, the overall volume of business lending per capita at banks has grown by 26 percent (adjusted for inflation). But this expansion has entirely benefited large businesses. Small business loan volume at banks is down 14 percent and micro business loan volume is down 33 percent. While credit flows to larger businesses have returned to their pre-recession highs, small business lending continues to decline and is well below its pre-recession level. Growth in lending by credit unions has only partially closed this gap.

There are multiple factors behind this decline in small business lending, some set in motion by the financial crisis and some that reflect deeper structural problems in the financial system.

Following the financial collapse, demand for small business loans, not surprisingly, declined. At the same time, lending standards tightened dramatically, so those businesses that did see an opportunity to grow during the recession had a harder time gaining approval for a loan. According to the Office of the Comptroller of the Currency’s Survey of Credit Underwriting Practices, banks tightened business lending standards in 2008, 2009, and 2010. In 2011 and 2012, lending standards for big businesses were loosened, but lending standards for small businesses continued to tighten, despite the beginnings of the recovery. These tightened standards were driven in part by increased scrutiny by regulators. In the aftermath of the financial crisis, regulators began looking at small business loans more critically and demanding that banks raise the bar. Many small businesses also became less credit-worthy as their cash flows declined and their real estate collateral lost value.

All of these recession-related factors, however, do not address the longer-running decline in small business lending. Fifteen years ago, small business lending accounted for half of bank lending to businesses. Today, that figure is down to 29 percent. The main culprit is bank consolidation. Small business lending is the bread-and-butter of local community banks. As community banks disappear — their numbers have shrunk by nearly one-third over the last 15 years and their share of bank assets has been cut in half — there are fewer lenders who focus on small business lending and fewer resources devoted to it.

It’s not simply that big banks have more lucrative ways to deploy their assets. Part of the problem is that their scale inhibits their ability to succeed in the small business market. While other types of loans, such as mortgages and car loans, are highly automated, relying on credit scores and computer models, successfully making small business loans depends on having access to “soft” information about the borrower and the local market. While small banks, with their deep community roots, have this in spades, big banks are generally flying blind when it comes to making a nuanced assessment of the risk that a particular local business in a particular local market will fail. As a result, compared to local community banks, big banks have a higher default rate on the small business loans they do make (see this graph) and a lower return on their portfolios, and they devote far less of their resources to this market.

More than thirty years of federal and state banking policy has fostered mergers and consolidation in the industry on the grounds that bigger banks are more efficient, more effective, and, ultimately, better for the economy. But banking consolidation has in fact constricted the flow of credit to the very businesses that nourish the economy and create new jobs.

SBA Loan Guarantees Shifting to Larger Businesses

One small but important part of the small business credit market are loans guaranteed by U.S. Small Business Administration (SBA). The goal of federal SBA loan guarantees is to enable banks and other qualified lenders to make loans to small businesses that fall just shy of meeting conventional lending criteria, thus expanding the number of small businesses that are able to obtain financing. These guarantees cost taxpayers relatively little as the program costs, including defaults, are covered by fees charged to borrowers.

The SBA’s flagship loan programs is the 7(a) program, which guarantees up to 85 percent of loans under $150,000 and up to 75 percent of loans greater than $150,000 made to new and expanding small businesses. The SBA’s maximum standard loan under the 7(a) program is $5 million, raised from $2 million in 2010. The SBA’s other major loan program is 504 program, which provides loans for commercial real estate development for small businesses. Under these two programs, the SBA approved loans valued at $23 billion in 2013, amounting to 3.7 percent of small business lending. (The 7(a) program accounts for almost 80 percent of this.)

Although the SBA’s loan guarantees account for a small share of overall lending, they play a disproportionate role in credit access for some types of small businesses. According to a 2008 analysis by the Urban Institute, compared to conventional small business loans, a significantly larger share of SBA-guaranteed loans go to startups, very small businesses, women-owned businesses, and minority-owned businesses.

SBA loans also provide significantly longer terms, which improve cash flow and thus can make the difference between success and failure. More than 80 percent of 7(a) loans have maturities greater than 5 years, and 10 percent have maturities greater than 20 years. This compares to conventional small business loans, almost half of which have maturities of less than a year and fewer than one in five have terms of five years or more.

Given the unique and important role of SBA loans, recent trends are alarming. Over the last few years, the SBA has dramatically reduced its support for smaller businesses and shifted more of its loan guarantees to larger small businesses. (The SBA’s definition of a “small” business varies by sector, but can be quite large. Retailers in certain categories, for example, can have up to $21 million in annual sales and still be counted as small businesses.) The number of 7(a) loans under $150,000 has declined precipitously. In the mid 2000s, the SBA guaranteed about 80,000 of these loans each year, and their total value accounted for about 25 percent of the loans made under the program. By 2013, that had dropped to 24,000 loans comprising just 8 percent of total 7(a) loan volume. Meanwhile, the average loan size in the program doubled, from $180,000 in 2005 to $362,000 in 2013.

What has caused this dramatic shift is not entirely clear. The SBA claims it has tried to structure its programs to benefit the smallest borrowers. Last October, it waived fees and reduced paperwork on loans under $150,000. But critics point to recent policy changes, including lifting the 7(a) loan cap from $2 million to $5 million in 2010. The move, which large banks advocated, has helped drive the average loan size up and the number of loans down.

Policy Solutions

1. Reduce Concentration in the Banking Industry

Rather than allowing a handful of big banks to continue to increase their market share, which would result in even less credit for small businesses and other productive uses, federal and state lawmakers should adopt policies to downsize the biggest banks. Approaches could include resurrecting deposit market share caps, forcing a full separation of investment and commercial banking, and imposing transaction taxes on financial speculation.

2. Expand Community Banks

Policymakers should also enact policies to strengthen and expand community banks, which currently provide more than half of small business lending. At the state level, the Bank of North Dakota provides an excellent model of how a publicly owned wholesale bank can significantly boost the numbers and market share of small private banks, and, in turn, expand lending to small businesses. At the federal level, regulators should address the disproportionate toll that regulations adopted in the wake of the financial crisis are taking on small banks and look to increase new bank charter approvals, which have plummeted in recent years.

3. Allow Credit Unions to Make More Small Business Loans

Current regulations limit business loans to no more than 12.5 percent of a credit union’s assets. Although some have called for lifting this cap, ILSR favors another proposal, which would exempt loans to businesses with fewer than 20 employees from the cap. This would ensure that new credit union lending benefits truly small businesses, rather than simply allowing a few large national credit unions (the only ones close to hitting the current cap) to increase large business loans.

4. Reform SBA Loan Guarantee Programs

The Obama Administration should return to the previous size cap of $2 million on 7(a) loans and adopt other reforms to ensure that federal loan guarantees provide more support to very small businesses. The SBA should also shift a share of of its loan guarantees into programs that are designed primarily or exclusively to work with small community banks.

5. Create Public Loan Funds that Target Key Needs

Although not a substitute for comprehensive restructuring of the banking system to better meet the needs of small businesses and local economies, public loan funds can address specific credit needs. A good example of this is the Pennsylvania Fresh Food Financing Initiative, which has financed about 100 independent grocery stores in low-income, underserved communities.

Rules

401(k) Business Financing: Your Complete Guide to ROBS

Fortunately, ROBS lends itself to almost every kind of business, with very few exceptions. Though the exceptions to the types of businesses ROBS can fund are few, they have a crucial impact on keeping your ROBS transaction tax-free. Here is a checklist to ensure your proposed business meets these standards:

The Business Must be Federally Legal. Any business funded through ROBS must be federally legal and based in the U.S. Pot shops (even in states where it’s permitted) are not eligible for ROBS because they are not federally legal. In addition, businesses operating outside of the United States (even if the owner resides in the U.S.) are also not eligible.

The Business Must Be an Active Operating Company. An operating company is defined as an entity that is primarily engaged in the sale or exchange of a product or service instead of simply the investment of capital. For most business owners, this is a non-issue. There are times, however, when individuals are looking to invest in a hobby. Hobbies are not active businesses and thus are not eligible for this method. Nor can a ROBS arrangement be used for a business for which the primary activity is deemed to be the investment of capital.

The Business Must be Owned by a C Corporation. The ROBS process requires you to create a new C corporation. The parent company must be a C corporation. You’re allowed to operate the business itself as an LLC or sole proprietorship as long as the parent company is a C corporation. In other words, for tax purposes, all finances flow through the C corporation.

Learn more about the ROBS process in Chapter 6.

You Must be a Bona Fide Employee of the Business. You must be a bona fide employee of your business — not solely a passive owner or investor. A common misstep here is when someone wants to use his or her retirement funds to buy a business for a family member or friend. With ROBS, you can’t purchase the business then step away.

Guide to Getting a Small Business Loan

Phase One: Prepare.

Start assessing your small business financing needs by answering the questions below.

Your answers will help you to have a sense of which types of small business loans make the most sense for your situation.

What do you need funding for?

How much business funding do you need?

How fast do you need it?

How long do you want to be making payments?

How quickly do you anticipate seeing a return on your investment?

Know what your business can afford.

It’s important to estimate the additional revenue you think will result from your planned investment. Or, if you need funding to cover a cash flow gap, estimate when you expect to receive payment on delayed receivables or when your business revenue will return to previous levels. Don’t forget to consider seasonal ups and downs, as well as other expenses that might come up during your payment term. From your cash flow projections, you should get a sense for how much you can afford for repayment. As you move forward, keep this amount as a touchpoint. Beware of financing more capital than you can ultimately afford.

Tip: Beware of brokers who work on commission and act as an intermediary between borrowers and lenders. Because they’re paid based on the amount of funding they can secure, they have an incentive to get you the most funding possible – even if you can’t afford it.

Prepare basic business information.

No matter what type of small business financing you decide to pursue, all require some basic business and personal information in order to determine if your business is eligible and for what amount. You should be prepared to provide your contact information, answer basic questions about your business structure and revenue, as well as provide your Social Security number.

Many small business loan providers require recent bank statements and other relevant financial documents. It can’t hurt to have your recent business account bank statements on hand. Often, the more money you’re looking to finance, the more documentation you’ll need to provide. Also, if you’re considering applying for a traditional business loan, many require extensive documentation as part of the application process. Be prepared that gathering and submitting the paperwork required can take a significant amount of time and effort.

Phase Two: Research.

Get to know your financing options.

Make sure you have a basic understanding of the different types of small business financing options available and know which ones make the most sense for your specific situation.

If you’re not sure what’s available beyond credit cards and traditional business loans, start with this overview . It covers popular financing options from fixed term loans to crowdfunding, and the pros and cons of each.

Tip: For fast, simple, and competitively priced business loans, explore PayPal Business Loan and PayPal Working Capital .1

Determine if your business meets basic eligibility requirements.

Loan eligibility requirements differ across providers, but most consider business revenue, years in business, location, and the industry your business is in to start to determine your business’s eligibility. You can usually find minimum eligibility criteria on a provider’s website.

FAQ: What is a soft pull? Many financing companies will use what they call a “soft pull” on your personal credit score to help determine your eligibility. A soft pull allows a business lender to look at your credit score without hitting it with a “hard inquiry.” A hard inquiry is the type of inquiry that may impact your credit score or show up on your personal credit report. While most loan providers are interested in your personal credit score, there are other options. Because PayPal Working Capital is based on your PayPal account history, it doesn’t require a personal credit check. You need to have a free PayPal Business account and a 90-day sales history meeting certain revenue thresholds to apply. 2

Phase Three: Submit your application for review.

Know what lenders are evaluating.

Once you’ve submitted all of the requested paperwork and documentation, your loan application will be reviewed. Depending on the type of business loan, this could take hours, days, weeks, or even months. Regardless of how long the review process takes, small business lenders typically use the same basic set of fundamental metrics to evaluate an application for business funding commonly referred to as “The 5 C’s of Credit.” They include: Capacity, Character, Conditions, Capital, and Collateral. This long-standing approach allows lenders to consider the factors likely to influence a small business’s ability to pay back its financing.

Capacity: a measure of your business’s ability to continue operations and support cash flow while paying down its debts.

Character: a measure of both business and consumer credit indicating whether you’ve been a responsible borrower in the past and how likely you are to be responsible in the future.

Conditions: a measure of your industry, geographic location, time in business, and the economy at large.

Capital: a business’s ability to support the amount of financing it applies for presented as a total dollar amount of cash over time

Collateral: the tangible assets that can be liquidated in the event of default. Some lenders don’t require borrowers to offer assets as secured collateral (which is called “unsecured financing”).

FAQ: Why are they asking for my Social Security number for a business loan?

While business credit reports do exist, many providers of small business loans rely on your personal credit score as an indicator of credit worthiness, and they use your Social Security number to access your personal credit history. Look for small business loans that also take other factors like revenue and business history into account when determining your financing offer.

Phase Four: Understand how the loan works.

Review the structure of the loan.

Once you receive a loan offer, make sure that you understand the basic structure of the loan.

How and when will I receive funds?

How long will I be making payments for?

How and when do I make payments? Can I choose the day of the week?

Will the loan help my business credit?

Compare costs.

Small business financing solutions have a wide range of cost structures. A good rule of thumb is you should be able to calculate the cost of your loan with simple math. Make sure you fully understand your business funding costs:

Total cost: What is the total amount I need to pay back?

Fees: Are there origination fees? Late fees? Early repayment fees?

Tip: Both the PayPal Business Loan and PayPal Working Capital have one, fixed fee that’s easy to calculate. No hidden fees, no surprises.3

Phase Five: Choose the best loan option for your business.

Choosing a business loan is an important decision that you shouldn’t make solely on cost. Also consider the reputation of the loan provider, the complexity of the application process, the time it takes to get funded, and the ability to customize the loan to meet your business’s priorities and goals.