Small businesses are critical to the U.S. economy and it’s clear that we must do more to understand their needs and realities. One key factor in the success of small businesses is financing, and that’s where the Small Business Credit Survey (SBCS) comes in. The SBCS is an annual survey of small business owners that focuses on firms with fewer than 500 employees. It’s fielded by all 12 regional banks in the Federal Reserve System and aims to address important information gaps about business capital needs and obstacles.
Today, we released the SBCS Report on Employer Firms, which covers small businesses with employees. This is one of several reports that will be released this year about the performance, financing needs, and borrowing experiences of small firms. We also have launched a new website, Fed Small Business, which serves as a hub for small business research and analysis by the Federal Reserve banks.
Against this backdrop, I’d like to look at the critical role of small businesses and what we know about their needs. I’ll also highlight potential ways to break down the barriers to growth that small firms face.
Importance of Small Businesses
How important are small businesses to the U.S. economy?
In addition to their contributions to innovation, small businesses are the primary driver of job growth in the U.S. According to the Small Business Administration Office of Advocacy, small businesses account for 99.7 percent of firms with paid employees and over 60 percent of net new private sector U.S. jobs. Small businesses are also critical to local economies in both urban hubs and rural communities, and they play a key role in empowering minority and at-risk populations. Today’s Employer Firms Report shows that 18 percent of employer small businesses are minority-owned, and 20 percent are women-owned — and these shares have grown in recent years.
Despite the outsized role small businesses play in the U.S. economy, there have always been risks associated with starting one, financial or otherwise.
Today, many small business owners still lack the financing necessary to stabilize and grow their firms. Our national SBCS reports released over the past year and a half — on employer firms, disaster-affected firms, startups, minority-owned firms, and women-owned firms — underscore this point.
While the reports have a great deal of helpful content, I’ll focus on two common themes:
1. A strong reliance on personal finances
2. High rates of financing shortfalls even among promising small businesses
Intertwining of Personal Finances
The SBCS shows that small business owners rely heavily on personal finances and personal credit scores to operate their firms. In fact, today’s Employer Firms Report reveals that nearly 90 percent of all employer small businesses relied on the personal credit scores of owners to obtain financing. We also learned that the vast majority of employer small businesses that faced financial challenges addressed them by using personal finances. This tactic was used much more frequently than other options, such as taking on additional debt or making late payments on existing debt. Startup, minority-owned, and women-owned firms were even more reliant on personal finances.
These findings emphasize that healthy financial foundations and strong personal credit scores play a critical role in the success of small businesses. This is especially critical for young firms that lack business credit histories, since the terms of financing are largely based on personal credit scores. Of course, the recession crippled consumer credit scores nationwide — making it even more important that we find ways to help small business owners establish or rebuild their personal finances.
High Financing Shortfall Rates Even Among Promising Small Businesses
Today’s report also revealed that 53 percent of employer small businesses that applied for financing received less than the amount they needed — a challenge known as a “financing shortfall.” In some cases, financing shortfalls are appropriate, such as when a business is already too indebted or has long been unprofitable. However, our data show that even small businesses with the potential for strong growth are struggling to get sufficient financing. For example, the SBCS reports released last year showed that startup applicants were more likely than mature applicants to face financing shortfalls, even when they had comparable credit scores. The same was true for minority-owned firms with good credit scores relative to their non-minority-owned peers.
We cannot be satisfied with an environment in which many promising small businesses are unable to access sufficient capital to fund their day-to-day operations or expansions. After all, barriers to capital impede job growth. Minority-owned firms are a large and growing economic force, and according to outside research, startups account for nearly all net new job creation and almost 20 percent of gross job creation.
Call to Action: Empowering Small Businesses
Armed with this information, how can we help small businesses grow in today’s evolving economy? I believe it comes down to providing education on managing personal finances, encouraging greater transparency in lending practices, expanding access to capital, and breaking down barriers to procurement opportunities:
· Education on Personal Finances: We, as a nation, should implement programs that educate current and future small business owners about how to strengthen their credit scores and thoughtfully assess lending options. We also should teach prospective owners how to start building business credit histories early and responsibly.
· Encouraging Transparency: We must insist that all lenders are candid and consistent about the terms of their loans so that businesses can determine which products best satisfy their needs. Our reports found many employer small businesses that were dissatisfied with their financing experiences pointed to lenders’ lack of transparency. This is alarming because it indicates that businesses often aren’t fully aware of fee structures and possible penalties associated with their loans, which increases the risk of failure. This is especially concerning for minority business owners who disproportionately seek financing from alternative lenders.
· Access to Capital: It’s also important to develop stronger public-private partnerships that provide financing opportunities and support services. One example of this in action is how banks receive enhanced Community Reinvestment Act credit for supplying capital to Community Development Financial Institutions (CDFIs). CDFIs in turn focus on higher-risk, low-income borrowers and provide advisory services along with capital.
· Barriers to Procurement Opportunities: Access to quality capital alone isn’t enough. Without steady and diverse revenue streams, small firms will quickly hit growth limits. That’s why the private sector, the federal government, and state and local municipalities should also increase procurement opportunities for small businesses. This could include incentivizing experienced firms to involve less experienced sub-contractors in their bids, thereby expanding mentoring and broadening the procurement pool. It’s also important to highlight when organizations are already doing this, since many owners aren’t aware of existing opportunities or how to apply.
At the New York Fed, we are working to provide support on these fronts. Beyond the SBCS, we regularly host forums that bring together small businesses, lenders, and other stakeholders. These events focus on familiarizing small businesses with traditional and alternative sources of financing, exporting strategies, and opportunities for procurement, among other topics.
Because small businesses are essential to the U.S. economy, it is time we start taking additional steps to support them.
NOTE: If you are a small business owner, sign up for our e-mail alerts and fill out our 2018 SBCS questionnaire when it’s released this fall. If you’re an organization that has strong relationships with small business owners and want to help, learn how to become an SBCS partner so that we can continue to provide supportive insight.
This article was originally published by the New York Fed on Medium.
The views expressed in this article are those of the contributing authors and do not necessarily reflect the position of the New York Fed or the Federal Reserve System.