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First Published in Wall Street Journal

A Look at the Future of Small Business Financing

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When is it going to get easier to get cash—and what do we do meanwhile?

Those are the questions small-business owners have struggled with since the economy took a nose dive. Many banks reacted to the financial crisis by tightening their standards, driving entrepreneurs toward other sources of financing, such as alternative lenders and crowdfunding. Now, despite the slow but steady recovery, it’s still tough for many small firms to get a traditional loan.

So, what’s the picture for small-business financing down the road? 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 for the Ewing Marion Kauffman Foundation.

Here are edited excerpts of the discussion.

Getting Better?

WSJ: Lending to small businesses has yet to recover to precrisis levels, so where do you see small-business financing heading? 

MR. ZOLLER: Loan demand is certainly increasing as the economy improves. Across the board, bankers are seeing a rebound in credit applications for small-business loans. But the paradox is that banks are not in the position to fill that need to the extent they have been in the past. Regrettably, most of the capital available for debt is with large institutional banks that were significantly impacted by the financial crisis and now face substantial regulatory hurdles in determining creditworthiness for loans.

So, what is now unfolding on the street is a lopsided credit market with the smallest banks—primarily regional and commercial banks—being most active in small-business financing, and the large banks largely retreating or at least becoming more conservative in their loan determinations in the same market.

Unfortunately, one of the inadvertent consequences of the too-big-to-fail phenomenon is that much of our credit capacity in the U.S. is concentrated now 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 around to offer credit facilities for growing small businesses. Any effort on the part of the government to accelerate this workout process would be most welcome by the small-business sector.

That being said, small businesses are generally finding strong partners in regional banks who are familiar with the economic conditions on the ground and are prepared to share the risk with the 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?

MR. ZOLLER: The common strategy would be for businesses to turn to high-net-worth individuals, business partners and suppliers for credit. This can be done through a convertible-debt type of investment, or terms of credit can be established where the firm will pay a simple return to the source of capital similar to a bank debt vehicle.

Convertible debt is a very common investment strategy that provides loan capital which converts to equity if certain milestones are not met. Companies can find investors who will make those types of investments and are prepared to join the firm as an equity partner if they fail to return the capital required under the terms of the convertible investment.

Also, firms can turn to other capital sources such as business partners, suppliers and larger companies who would be willing to provide a loan based on similar terms that a bank would offer.

However, the differences are that these investors know that their capital is at risk, therefore they might want more favorable terms than would be experienced with traditional bank loans. These types of loans are often granted by existing enterprises, family offices and high-net-worth individuals who might know the business and understand the industry in which the business operates.

A third strategy would be to provide capital through managing cash flow carefully. Businesses can often negotiate terms of payment with their creditors so that they can delay payment until receipts occur, and thereby use their own operating capital as a source for their business. However, businesses should be very careful when opting to use this strategy, as there is cash-flow risk associated with counting on that funding source should the business lose control of the status of its receipts.

Effects of Technology

WSJ: How do you see technology influencing lending to small businesses during the next few years?

MR. ZOLLER: While crowdsourcing and crowdfunding platforms are getting substantial attention presently, the debt market is still reasonably conservative and less inclined to change the underlying fundamental business model of lending. Crowdfunding is providing impressive opportunities for new entrepreneurs to access nondilutive funding [which involves finding backers but not offering them equity stakes or in some cases taking on debt], in many cases abrogating the need for debt financing. In a few celebrated examples, this nondilutive funding has completely eliminated the need for the company to take debt.

I expect to see this trend increase over time and for crowdfunding to become more mainstream as a vehicle to provide seed funding to new ventures, particularly new ventures that are prerevenue and are still as yet unproven.

WSJ: What additional efforts can the U.S. government make to increase the flow of its small-business lending? Or are they already doing all they can?

MR. ZOLLER: There are many innovations that the Small Business Administration has implemented to encourage capital formation for small business.

Specifically, through [Small Business Investment Company] regulation, they have improved the equity-investment environment for early-stage funds to be formed. On the debt side, however, it is very difficult for the government to innovate without pledging the faith and credit of the government to collateralize the loans. This is a difficult prospect for the U.S. government, given its current debt position.

However, the current economic recovery would suggest that there is enough activity to warrant increasing the volume of SBA-secured loans made available to national banks.

I would also recommend increasing the allocation of these loan vehicles to banks that have a credit culture that enhances small-business lending, particularly among regional and local banks that understand the regional economic conditions in which these businesses operate. The large banks are suffering from regulatory pressures that make them less capable of making these loans efficiently in the current climate.

Also, continue to provide nondilutive funding through the [Small Business Innovation Research] and [Small Business Technology Transfer] programs to promising early-stage companies; these ventures can leverage a stronger balance sheet to attract capital from regional banks who have the credit culture to support early-stage ventures.

WSJ: What is one thing or factor in small-business lending that is not currently on people’s radar?

MR. ZOLLER: There is a small movement afoot to develop a series of royalty-based approaches toward business investing that hold promise for the future.

The idea in a royalty is that the investor [often set up as a fund in which multiple investors subscribe] receives a percentage of future revenues. As opposed to the investor receiving equity for an unknown future valuation, the investor is betting on the future track record of the company to not only recoup their investment but to provide a long-term return on investment.

A royalty model may in fact be a strong solution for companies with a more predictable revenue stream and a long-term view toward building value in the market.

Mr. Davidson is a writer in San Francisco. He can be reached at [email protected]