Small business: the Entrepreneurial financing Problem

The demand for small-business financing is greater than the supply, particularly for early-stage businesses. Almost half of new firms begin with less than $5,000 in capital, less than 20 percent of the capital considered necessary. It is usually provided by the owner, family members, and friends. Consequently, most new businesses are under capitalized from the beginning. They stay that way for most of their early lives.

KEY POINT: Equity is always hard to find for the small business, regardless of the price the company is willing to pay. Debt is also hard to find. Banks, the principal source of debt financing for small enterprises, prefer not to lend to a business that is less than three years old.

Many professional investors use five categories to define the various stages of a company’s financial development: startup, development stage or second round, expansion stage or third round, growth stage or fourth round, and public offering. The first four stages are equivalent to the first three life-cycle stages. A public offering can occur anytime after late life-cycle stage three.

Until it has achieved revenue and moved to the developmental or growth stages, it is hard for a small business to get external financing of any type, debt or equity. Once established, small businesses, like larger businesses, use a variety of types of financing to meet their financing needs. The types of financing a small business uses vary with its development stage and its cash flow situation.

Most small firms use external financing only occasionally. Less than 50 percent of small firms borrow at least once during a year. In their early development, this external financing is usually some form of equity. Small firms in their early development usually lack the demonstrated success necessary to obtain credit from institutional lenders. Overall, small firms rely more on equity capital and short-term debt, and less on external debt capital and long-term debt, than larger firms do. For the smallest firms, mom-and-pop operations with or without hired employees, owner capital is the most important source of financing.

Small firms experiencing rapid growth or those with high volumes of receivables, however, require frequent use of external financing. A 1990 national survey of small firm financing completed for the Federal Reserve revealed the following financing patterns in 1990:

  • Of all small firms, 26 percent had lines of credit, 9 percent had financial leases, 6 percent had mortgage loans,14 percent had equipment loans, and 24 percent had motor-vehicle loans.
  • Of larger firms with 100 to 499 employees,60 percent had lines of credit, 30 percent had financial leases, 19 percent had mortgage loans, 29 percent had equipment loans, and 26 percent had motor-vehicle loans.

Banks are the dominant suppliers of these types of financing. Thirty-seven percent of small firms obtained some financing from commercial banks. Other major suppliers include finance companies, leasing companies, and other non financial institutions. The cost of borrowed funds is higher for small firms — interest rates on bank loans average two to three percentage points over the prime rate. Fixed-rate loans are usually more expensive than floating-rate loans, at least at the time the loan is negotiated.