1 Introduction

The financial crisis in the USA that began in the summer of 2007 provides a reminder of the importance to small business of external capital from the banking system.Footnote 1 Start-up firms always rely heavily on personal savings and family, with external equity injections a rare occurrence – even for ventures that have highly valuable but uncertain growth opportunities (Reynolds and Curtin 2008; Robb et al. 2009). Although banks are not the direct primary source of capital for starting a new firm, they are the primary source of funds for small firms once started, providing working capital and funding for investment in plant and equipment (Berger and Udell 1998). The ongoing consolidation of the US banking industry since the ­early-1990s, however, continues to raise concerns about the availability of bank financing for small firms because the merged bank generally devotes a small percentage of total assets to small business loans (Peek and Rosengren 1998). Yet during the past 15 years the number of new charters expanded by over 1,500 and the total number of bank offices increased as a result of a boom in branch openings. In addition, a small group of large banks expanded their lending to small firms via another channel – credit cards – while other large banks focused on mid-market lending to replace the lower interest margins from highly competitive large-company financing.

Since the mid-1990s, scholars directed their attention to the financing of small firms through two distinct channels. The first channel is the special role banks play in resolving the information asymmetry associated with small firm lending that can otherwise lead to credit rationing (Stiglitz and Weiss 1981). While the intellectual foundations of this literature date back to Diamond’s (1984) idea of a delegated monitoring role for banks, much of the work since then is empirical. Beginning with Berger and Udell (1995), the idea of relationship banking was established, where banks accumulate private hard and soft information to mitigate the inherent information asymmetry associated with lending to information-opaque small firms. They empirically documented how stronger relationships – using length of time at their primary bank as a proxy for relationship strength – can improve the credit availability and pricing for information-opaque small firms. This paper was also one of the first, along with Petersen and Rajan (1994, 1995), to use the newly initiated Board of Governor’s of the Federal Reserve System Survey of Small Business Finances (SSBF). An entire literature subsequently developed based largely, but not exclusively, on the SSBF surveys that examines the role of private information acquisition, bank size, and bank distance on small firm credit availability and pricing.

The other channel is the role of venture capital in financing innovation. This work, mostly the legacy of pioneering work by Gompers (1995), Gompers and Lerner (1996) and Lerner (1994, 1995), began by addressing such issues as the structure of limited partnership funds, the staging and syndication of investments and the performance of venture-backed IPO offerings. More recent studies rely on hand-collected data to perform more firm-level analysis, addressing such questions as characteristics of term sheets (Kaplan and Stromberg 2003; Kaplan and Strömberg 2004), venture-capital returns (Kaplan and Schoar 2005), the evolution of companies from start to becoming public, (Kaplan et al. 2007), and the geography of venture-capital expansion (Chen et al. 2009). Although the supply of venture capital continues to grow – especially with institutional demand for alternative investments, the number of principals per firm remains constant and the total number of principals has been stagnant since 2000 (Metrick, Chap. 2). With less attractive exit economics (attributable by many to Sarbanes-Oxley) and the low returns in the 2000s (NVCA 2010), VC financing is likely to remain a very limited channel for financing entrepreneurial firms.

The operating environment for small firms is much different than in the mid-1990s when scholars began a serious investigation into the special challenges of small firm finance. Deregulation (e.g., Riegel-Neal, Gramm-Leach-Bliley), new regulation (e.g., Sarbanes-Oxley), the growth in entrepreneurship programs at universities, along with scholarly documentation of their role in the job generation process (Birch 1979, 1981) attracted the interest of policy makers. Unlike the securities markets where comprehensive secondary market data is widely available for analysis (e.g., CRSP, Dealscan, etc.), no such source exits for small business finance that allows analysis of the effect of changes in regulation or macroeconomic conditions on small firm financing. This interest dramatically increased in 2009 because of concerns in the USA and elsewhere about the ability of small firms to obtain the credit they need (Spors and Flandez 2008; Eckblad 2009; Thirwangadam 2009; Chan 2010).

The primary sources of data on small firm financing are panel studies and periodic surveys of various small firm populations. The Fed’s SSBF surveys conducted in 1987, 1993, 1998, and 2003 are the most comprehensive sources of information on existing firms but the surveys have been discontinued because of the cost. Although US bank call reports (FFIEC, Consolidated Reports of Condition and Income) have a line item for small business lending, these data only allow scholars to look at aggregate changes, without the ability to relate changes to local market conditions or the credit quality of the borrowers. In addition, the definition of “small” for the loan size categories includes two loan size categories: under $100,000 and $100,000 to $1 million. Given that the average loan sizes in the SSBF have generally been under $50,000, loans in the latter category are likely to be capturing the activity of firms that do not fall within the typical definition of a small- and medium-sized enterprise. The Panel Study of Entrepreneurial Dynamics, (PSED) (Reynolds and Curtin 2008), has a wealth of data on nascent entrepreneurs, that is, those in the start-up process. More recently, the Kauffman Foundation launched a panel study of new firms with a focus on high-technology businesses (Robb et al. 2009). The National Federation of Independent Business (NFIB) conducts monthly surveys of its membership (since late 1973) that ask questions about credit availability and terms, as well as periodic surveys of its membership on issues related to bank credit. Venture-capital data sources are largely aggregate numbers (e.g., National Venture Capital Association), although some research uses hand-assembled confidential data sets (e.g., Kaplan and Strömberg 2004; Kaplan and Schoar 2005) to investigate both the structure of term sheets and rates of return on private equity investments.

This chapter summarizes the current state of knowledge about small firm finances and then offers some perspectives on future research opportunities. Our focus is primarily on empirical studies and data sets, but we also identify key theoretical work that forms the basis for many of the most widely cited empirical papers. We begin with an historical analysis of small firm credit availability (over the past 35 years) using the National Federation of Business’ Small Business Economic Trends survey. We provide a perspective on the current policy debates regarding small firm credit availability with a time series analysis of the experience of over 500,000 small firms. This section also provides a chronological review of new firm financing panel studies, including the Kauffman Firm Survey and Panel Study of Entrepreneurial Dynamics, as well as the key trends identified in the Board of Governor’s SSBF. This section also addresses the evolution of credit cards (both business and personal) as a source of funds, the role of real estate collateral in shaping small business credit availability, and the limited, but special, role of venture capital (including angel financing). Finally, we examine current issues in small firm finance. Among the topics addressed are the effect of bank consolidation and changes in market structure on small firm access to credit, the role of market structure on availability and pricing of small firm loans, the increasing distance of small firms from their primary lenders, the unique role of community banks in facilitating small firm finance, and recent survey evidence on the impact of the credit crisis of 2007–2009 on small firm credit availability.

2 Time-Series Perspective on Credit Availability and Cost

The National Federation of Independent Business (NFIB) began economic surveys of its membership in 1973. Since that time, a virtually identical three-page questionnaire is mailed to a sample of the NFIB’s small business owner members: from October of 1973 through 1985 the survey was mailed on the first day of every quarter and since January 1986, the survey is mailed on the first day of every month. The yield is between 1,300 and 2,300 responses in the first month of each quarter and 500–900 in each of the following 2 months. A report based on the findings of the survey, “Small Business Economic Trends” (SBET), is produced each month and is available from the NFIB at nfib.com/research. These data are meaningful because they apply to about half a million employer firms (out of an estimated 6 million employer firms) and NFIB members have been shown to be reasonably representative of the population of small business in the USA (Dunkelberg and Scott, 1983).

The SBET includes a number of questions related to credit availability: (1) “If you borrow regularly, at least once a quarter, are loans easier or harder to get than they were 3 months ago?” (2) “Do you expect to find it easier or harder to obtain your required financing during the next 3 months?” (3) “During the last 3 months was your firm able to satisfy its borrowing needs?,” and (4) “What is the most important business problem facing your business today (with “financing and interest rates” as one of ten choices provided)?” The survey also asks regular borrowers how the interest rate on their most recent loan compares to 3 months ago and the rate they are paying on loans for maturities of 1 year or less. Figures 7.1 through 7.5 show the time-series responses to these questions.

Figure 7.1 reports the percent of owners who reported borrowing at least once a quarter (which includes accessing lines of credit). Regular borrowing activity was highest during the pre-1983 period when exceptionally high nominal interest rates and inflation that created a need for borrowing because of the pressure that high inflation rates (input prices) put on cash flows. Even with interest rates near 20%, small firms continued to borrow to operate their businesses but endured much lower margins. As inflation declined, nominal interest rates fell, profit margins and cash flow improved, and the number of firms borrowing on a regular basis fell (Figs. 7.1 and 7.2).

Fig. 7.1
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Regular borrowing activity (at least once/quarter) (Small Business Economic Trends NFIB)

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Fig. 7.2
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Rate paid on most recent loan (Small Business Economic Trends NFIB)

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Regular borrowers are asked if their last loan was “easier” or “harder” to get than the previous attempt (Fig. 7.3). Loans were most difficult to arrange in the pre-1983 period, with reports of “harder” (net of those reporting “easier”) rising to 27%. Since then, reports of difficulty in accessing credit follow a predictable pattern shown in Fig. 7.3. Reports of credit problems start off at low levels at the beginning of an expansion and then become “harder” as the economy peaks, the Fed tightens, and a recession sets in. While not shown in Fig. 7.3, small business difficulties accessing credit generally lag reports of credit tightening by the Fed survey of money center banks (Senior Loan Officer Opinion Survey on Bank Lending Practices).Footnote 2 The recent (2007–2009) increase in those reporting net “harder” shows a much quicker increase since the early-1980s and through 2009 continues to persist at post-1983 high levels. An apparent leveling off appears to be taking place in early 2010. The nature of the connection between thousands of smaller community and regional banks to the money center banks in terms of credit cost and availability and the impact of monetary policy merits a more careful examination.

Fig. 7.3
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Credit availability versus last try (% harder to get – % easier) (Small Business Economic Trends NFIB)

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All small firms are asked to report the most important problem facing their business. Figure 7.4 shows that financing and interest costs are barely on a small firm’s radar. Even as credit became harder to obtain in the last two economic slowdowns (1991 and 2001), financing costs and difficulties did not rise to the top of their list of concerns. The data in Fig. 7.4 clearly indicate that in the recent recession (2007–2009), the state of the economy as reflected in weak sales is threatening small business survival, not the fragile condition of many banks and the financial markets in general.

Fig. 7.4
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Single most important problem (Small Business Economic Trends NFIB)

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Starting in 1993, the survey asked owners if all of their credit needs were met in the prior quarter (Fig. 7.5). Unfortunately, this series covers only one recession, 2001, that was a rather mild event. Focusing on the percent of owners who reported “No,” the incidence of complaints did not move out of the recent historical range until the first quarter of 2009. At its worst in 2009, only 10% reported that all their credit needs were not met (turned down or didn’t receive all the credit the desired or credit terms were unsatisfactory). Still, the percent reporting needs not meant doubled in a very short period of time. The true number is likely to be higher (in all periods) if discouraged borrowers could be identified, that is, those who did not apply for fear of being turned down. For the remaining 90% of owners, they either received the credit they wanted or didn’t want to borrow.

Fig. 7.5
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All credit notes NOT satisfied (Small Business Economic Trends NFIB)

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Overall, the SBET data suggest that many of the problems small firms faced in the early-1980s have largely disappeared. Much of the improvement is due to a more stable macroeconomic environment with lower inflation and less severe cyclical contraction – at least until 2008–2009. The number of competitors in many markets is much greater because of deregulation that began with the lifting of many branching restrictions in the 1980s. Although the number of charters has fallen dramatically and deposit concentration has been increasing in some markets, new charters continue to provide alternatives for small firms. And finally, advances in information technology have opened several new channels of borrowing for small firms, of which business credit cards are the most important. We address these topics in more detail below.

3 Current Sources of Funding

Any analysis of funding in the context of entrepreneurial finance needs to distinguish between nascent firms, that is, firms in the start-up process as described by Reynolds and Curtin (2008), new firms, and existing (or established) firms. Even with this classification, a further cut of new/existing firms should be based on “growth opportunities.” The term growth opportunity generally differentiates entrepreneurial finance from small business finance, but a widely accepted definition of entrepreneurial finance remains elusive. With these caveats in mind, we begin this section with a summary of the findings (in chronological order) related to start-up financing, regardless of whether the firm is nascent (PSED) or established (Kaufmann and NFIB surveys), and present conclusions about the availability of start-up financing. Next, we summarize the trends for existing small firm financing from the Fed’s Survey of Small Business Finances with a focus on the importance of credit cards versus direct bank lending.

3.1 Start-up Financing

In a 1979 NFIB study of how new firms were financed, Dunkelberg and Cooper (1983) report that 47% of the owners cited personal savings as the major source of capital (“major” is not defined as a percentage), with 28% depending on financial institutions and 13% on friends and relatives.Footnote 3 Only 4% cite independent investors as their major capital source. For owners reporting more than one source, personal savings accounts for 63% of the major financing sources (as reported by the owner), financial institutions for 47% and friends, and relatives for 26%. Reports of venture-capital use are virtually nonexistent and government sources accounted for 1%.

In 1985, the National Federation of Independent Business undertook a panel study of all its members who reported starting a business within the past 18 months (Cooper et al. 1990). In the panel’s first year, of the 3,951 eligible survey respondents, 71% start their business from “scratch” and 29% start by purchasing an existing firm. For those starting from scratch, 49% provide at least 50% of the start-up investment from their own funds (primarily savings).Footnote 4 Thirty percent report bank loans as the major source of funding (since banks are not venture capitalist, these loans are likely secured by personal assets).

The Panel Study of Entrepreneurial Dynamics II, which began in 2004, tracks the sources of informal and formal funding for emerging firms. Reynolds and Curtin (2008) report that informal financing of 882 nascent firms is most likely from personal savings (84%), followed by personal credit card, bank, and mortgage loans (27%), and then personal, family, and friend loans (23%). Thirteen percent of these firms report no financing for their nascent firm. Formal financing for 435 established firms, that is, after a firm is legally registered, is led by personal loans from team and family members (39%), followed by additional team equity (27%), and financial institution lending via credit cards, bank loans, or working capital loans (20%). SBA-guaranteed loans, which are through bank lenders, are reported by 26% of new firms. Reynolds and Curtin (2008) note that the firms with the largest outside funding are not closely associated with significant growth opportunities, for example, a technology focus or market innovation. His observation is another piece of evidence illustrating the difficulty of identifying entrepreneurial finance opportunities ex-ante.

The Kauffman Firm Survey (Robb et al. 2009) may come closest to identifying entrepreneurial start-up firms but with a focus on high-technology status, which excludes most “Main Street” types of businesses. But their choice of North American Industrial Classification System codes includes some rather prosaic industries such as chemicals and allied products (identified as high tech) and cigarettes (identified as medium tech). Commercial bank lending plays an important role for the firms in this survey as well, confirming the findings in the PSED and NFIB panel studies. Forty-five percent of over 4,000 start-up firms in 2004 reported outside debt with an average amount of $85,681 (Robb and Robinson, 2008). Most of this debt is bank-related (either business/personal loans or business/personal credit cards), with very few respondents reporting a nonbank loan or reporting a government business loan. The low incidence of government loans stand in contrast to the high incidence of SBA-guaranteed loans in the PSED. Many of the bank loans reported in the Kaufmann survey are SBA guaranteed but may not be reported as such. The average business bank loan is $9,357 ($150,704 for those reporting a loan), while the average credit line is $3,237 ($62,156 for those reporting a line). Personal bank loans to the owners (survey respondent plus other owners) almost equal the total for business bank loans with an average of $147,932. During the first year of operations, 48% report new personal debt, while 28% report new business debt.

Despite the difficulties involved in direct data comparisons, several conclusions can be drawn from the above studies. First, start-up businesses rely heavily on owner (and founding team) equity, along with significant contributions from what is affectionately known as “family, friends, and fools.” Second, both business and personal credit cards have become an important source of financing for start-ups. And third, banks continue to remain an important source of external capital outside of credit cards, either through working capital lines, asset-backed (mortgage) loans on business property, or other loans (e.g., equipment).

All of the panel studies report a very low incidence of venture capital as a source of financing. In 2004 (the base year of the Kauffman and PSED II surveys), there were only 192 seed/start-up deals, 862 early-stage investments, 1,205 expansion investments, and 765 late-stage investments (PWC Moneytree 2009). The 192 seed investments pale in comparison to the over 600,000 business starts for 2004 estimated by the SBA, as well as the total venture-capital investments – just over 3,000 – compared to some 6 million small firms with employees in 2005 (SBA). Another source of early-stage capital is angel funding. Shane (2008) reports that angel investment was approximately $23 billion per year between 2001 and 2003, an amount that is very close to the $21.8 and $19.7 billion invested by venture capitalists in 2002 and 2003, respectively. The typical angel investment is $10,000, usually an early-stage investment, and frequently placed in companies not considered to have high growth opportunities. For example, Shane (2008) reports that 25% of the angel investments made between 2001 and 2003 went into retail firms and 12.5% into personal services firms.

3.2 Ongoing Small-Firm Financing

The Board of Governor’s Survey of Small Business Finances (SSBF) is the most comprehensive and most recent source of information about ongoing small firm financing. These surveys, conducted in 1987, 1993, 1998, and 2003, focus on small firm sources and uses of financial services along with data on firm and owner characteristics. Although the structure of financial markets changed dramatically since the first Fed survey in 1987, small firms continue to rely on commercial banks as their primary source of external capital. Ou and Williams (2009) report that almost 90% of small businesses in 2003 use some form of credit, with 48% using commercial banks and 22% using finance companies. Commercial banks continue to be the most important source of lines of credit (80%), mortgage loans (53%), and equipment loans (48%). While the Kaufmann Firm Survey provides a look at start-up financing over a short window, the reliance of start-ups on bank financing (personal bank loans and business credit cards) for surviving firms is reported by over 40% of the respondents in that survey. This figure from Kaufmann is not that far from the average experience of existing small firms reported in the Fed’s 2003 SSBF.

Mach and Wolken (2006) identify two important changes in the SSBF since the first survey in 1987. First, small firms are diversifying their providers of financial services, with an increase in importance of non-depository institutions such as finance and leasing companies – especially for larger small firms. By 2003, about 41% of the respondents to the SSBF obtain credit from the banking sector, down from 44% in 1987 (Cole et al. 1996). Between 1987 and 2003, small usage of lines of credit from banks increase to 29.5% from 19.5%, but usage falls in all other credit categories (mortgages, vehicle loans, equipment loans, capital leases). By 2003, commercial banks supply more credit lines and mortgages than non-depository institutions, but non-depository institutions supplied more vehicle loans and capital leases. These diversified sources suggest that small firms now have more choices among lending technologies (Berger and Udell 2006) that have moved beyond pure relationship lending to different types of transaction lending (e.g., leasing).

The second change Mach and Wolken (2006) noted is a big increase in the importance of business credit cards. Ou and Williams (2009) conjecture that this increased business credit card importance is related to the activity of a small number of large-bank credit card issuers. They find a decline of small banks’ share of small loan markets, especially in the smallest loan markets, where small firm lending is defined as loans under $1 million in the bank call reports and the CRA reports. Using 2007 CRA data, Ou and Williams (2009) find that about 12 banks comprise 75% of the loans in the smallest category (under $100,000) and the average size in June 2007 was $3,200 compared with $20,000 from other lenders. These large credit card lenders have limited participation in other small loan markets accounting for only 3% of loans between $100,000 and $1 million.Footnote 5

Credit cards, whether business or personal, are important to new firms. Scott (2009) reports that almost 60% of new firms in the Kauffman Firm Survey used credit cards in their first year of business and about one-third of the firms carried balances through the first year. Mach and Wolken (2006) report that the percent of small firms using personal credit cards remained about the same in 2003 (47%) but those firms using business credit cards increased by 14 percentage points to 48% since 1998. Confirming evidence regarding credit card usage is provided in a recent (2008) NFIB poll conducted by the Gallup Group (Dennis 2008a) where 84% of the respondents use credit cards for their business (business or personal cards). Interestingly, over one-third of the respondents with business or personal credit cards in the NFIB poll do not report any other line of credit at another financial institution. The Poll also reports that about 75% of small firms pay their balances in full every month, indicating that the credit card is more a transaction service than a line of credit. These firms that rely on credit cards without a local bank lender may contribute to findings of an increasing distance between small firms and their primary lenders over time (Petersen and Rajan 2002; Agarwal and Hauswald 2008; Brevoort and Hannan 2006; Hannan 2003; DeYoung et al. 2007). However, Brevoort (2006) finds that increases of out-of-market lending in MSAs is largely attributable to either large banks and/or smaller loans, which suggests that the impact of distance on competition may be limited to a small set of banks and borrowers that are related to credit card lending. In addition, Brevoort et al. (2009) using the 2003 SSBF find that while distances increased in the early 1990s, they decreased in the latter half and that a wide variation in distance exists depending upon the supplier of financial services.

4 Current Issues in Small Firm Financing

4.1 Bank Consolidation and Small Firm Finance

With the start of an easing in bank branching restrictions in the early-1980s, considerable consolidation in the US banking system left small firms with fewer choices among independent banks, often forcing them to a larger banking organization as their primary financial institution. Between 1989 and 2006, the number of small banking organizations decreased by 36%, while large banks’ share of domestic assets increased from 66% to 80% (Jagtiani 2008). Yet at the same time, advances in information technology increased both the range of services offered, as well as the ability of financial institutions to offer credit services to small firms outside their local market. This extended reach is certainly seen in the widespread market penetration of business credit cards during the past 15 years.

Concerns over this consolidation led to a change in the call reports in the mid 1990s. A new section (currently Schedule RC-C part II) requires banks to report the number and amount of small business and farm loans. Scholars using these data initially found that the proportion of small loans in a bank portfolio declined with bank size, raising concerns that mergers reduce the supply of small firm credit (Peek and Rosengren 1998; Strahan and Weston 1998). Other papers showed that this static analysis of balance sheet proportions could be misleading and needed to take into consideration the response of other lenders in the market. For example, Berger et al. (1998) find that in markets where mergers took place and resulted in the combined banks lending less to small firms, the increase in small firm lending by banks that did not merge offset most of the merged banks’ decline. Consolidation also triggers new market entry by de novo banks as documented by Berger et al. (2004).

Scott and Dunkelberg (2002), using data from the NFIB membership collected in early 1995, find that bank mergers had no significant effect on the ability of small firms to obtain a loan or the contract loan rate on the most recent loan. However, mergers are more likely to result in an increase in non-price terms and increased shopping for a new bank. A subsequent survey in 2001 confirmed the earlier findings (Scott et al. 2003).

Recent work by Berger et al. (2007) finds a more nuanced impact of market structure on the availability of new lines of credit for small firms. They document how the presence of a large-bank branch in local markets, not size or deposit concentration, affect credit availability. Along a similar line, Scott and Dunkelberg (2010) identify that lender actions, in addition to deposit concentration, affect small firm credit availability, loan terms, and non-credit service quality.

While an individual small firm may have had problems with mergers over the past 20 years, no systematic relationship can be found between credit availability with mergers and firm size, firm age, location, or industry. Part of the reason for this finding may be an increase in the number of new charters by over 2,500 between 1990 and 2008 (or over 140 per year) as well as an increase in the use of business credit cards by small firms, often issued on the basis of proprietary commercial credit-scoring models. All of these new charters are small banks by definition, and usually referred to as “community banks” in the scholarly literature as well as the statutes.Footnote 6 Community banks, typically banks with assets less than $1 billion, play a special role for small firms because of their flatter organizational structure (Berger and Udell 2002; Scott 2004). As such, they can make quicker decisions and can give private hard and soft information significantly more weight in the credit granting decision. This underwriting approach stands in stark contrast to a larger bank with a more structured, less flexible underwriting system. Several papers (e.g., Cole et al. 2004; Berger et al. 2005) show that the use of private information, the basis of relationship lending in the literature, by community banks gives them a comparative advantage over larger banks in this type of lending.

4.2 Credit Crisis of 2007–2010 and Small Firm Finance

The global credit crisis that began in the summer of 2007 and its impact on small firm financing is critical according to business press reporting. However, as noted above, there is no evidence over time that financing has become the most important problem for small firms, but the difficulty in obtaining credit has reached the highest level since in the early-1980s. The percent of small firms experiencing financing problems has crept up since mid-2007 as the duration of the recession lengthened and the net percentage not able to satisfy their credit needs in the late-2009s twice as high as it was in early 2007 (see Figs. 7.3 and 7.5). A NFIB poll conducted by the Gallup Group in early September 2008 asks a sample of small firms drawn from the Dun & Bradstreet file about their recent credit experiences as the economy, stock market, and property values headed towards a freefall (Dennis 2008b). At that time, only 32% of the sample report applying for credit, 59% report they do not want credit, and 8% reporting that do not think they can get credit. This survey identifies a somewhat higher incidence of problems with credit availability based on those who tried to get credit: 41% of small employers report obtaining all the credit they wanted, 22% most or some, while 34% report obtaining none of what they want.

The primary finding of the survey, however, is the importance of business and/or personal real estate as a source of collateral to provide capital for their business. Ninety-six percent own their personal residence, 49% own all or part of the building and/or land on which their business sits (excluding the one-quarter who operate primarily from the home), and 41% own investment real estate, excluding their residence and business.Footnote 7 Real estate, particularly home mortgages, is frequently used to finance or collateralize other business assets. Seventy-six percent have at least one mortgage on the real estate they own with 13% having three or more mortgages and 22% with at least one mortgage to finance business activities. Sixteen percent use real estate to collateralize other business assets, including 10% who use their homes as collateral. About one in 10 (9%) own at least one currently upside-down property, that is, a loan where the unpaid loan balance exceeds the market value of the property.

The widespread use of real estate collateral for business loans and the falling real estate values creates a very different problem for small firm financing than previous recessions – even in the early-1980s. More heavily mortgaged owners and those who are upside-down are less likely to obtain all the credit they wanted (for those trying to get credit) after controlling for sales growth, business size, and age. Real estate values also play a role in determining which owners report not trying for credit. After controlling for firm characteristics, more heavily mortgaged owners and those who are upside-down are more likely to report not applying for fear of being turned down (as this shows up on credit reports). In other words, owners experiencing falling real estate values self-select out of applying, knowing that they have insufficient collateral for borrowing. These results suggest that the adjustment of real estate values back to their fundamental values in the most severely affected areas in the USA (California Central Valley, Las Vegas, Florida, Atlanta, Michigan, and Ohio) will be a significant obstacle for small firm access to capital.

The 2008 NFIB poll conducted by the Gallup Group was repeated in September 2009 and the results are basically unchanged from a year earlier (Dennis 2010). Fifty-one percent of small employers cite slow or declining sales as their most immediate economic problem, followed by uncertainty about the economy for 22%. Access to credit is the most immediate problem for only 8% of small employers, as was falling real estate values (8%). Fifty-five percent of the owners report applying for credit and 40% received “some” (13%), “most” (12%), or “all” (22%) of what they require. Slightly fewer than 20% are unsuccessful in obtaining the credit they required, either because of a turndown, a rejection of the terms offered, or not applying for fear of rejection. The results of these two polls show a clear disconnect between the extent to which small business credit availability is affecting their business outlook as well as the business press reporting of small business credit rationing by banks. The most telling result of the 2009 poll is that twice as many owners who could not get credit cite poor sales as the reason versus credit rationing. Credit rationing would suggest that “bankable” small firms are denied credit, whereas the reports from the NFIB polls suggest that credit may be harder to get for small firms because of the perilous state of their balance sheets.

5 Suggestions for Future Research

The theoretical underpinning for much of the work on small/new firm access to credit relies on the idea of information opacity and its role in creating an information asymmetry between lenders and small/new firm owners. The result of extreme information asymmetry is credit rationing where credit is not granted to otherwise creditworthy firms because the lender cannot adequately assess the risk. The nature of the information opacity that leads to information asymmetry problems needs to distinguish between business risk and management risk. Many small firms (and start-ups) are in businesses where enough data exists to estimate the probability of default and loss given default (e.g., restaurants). In other words, the source of the information opacity is unlikely to be with the characteristics of the business. In these cases, the primary uncertainty is the ability of the manager/owner to navigate the business through the challenges of start-ups and business cycle fluctuations. However, for other endeavors (such as biotechnology), business risk is very difficult to assess because the outcomes are dominated by uncertainty, not risk (Knight 1921). In these cases, both business and owner/manager uncertainty contribute to the information opacity. Future empirical work would benefit from a better model of the interaction of business versus manager risk. With such a model, testable hypotheses involving soft versus hard information could be better specified.

The association between bank size and small firm credit outcomes needs further research. While small banks have an advantage over large banks in the production of soft information and the attendant benefit in granting credit, these results may be due to the rapid consolidation of the banking system from the 1990s through the early 2000s. While consolidation is accelerating with the FDIC case resolutions attributable to the current credit crisis (2007–2009), the future pace will likely resemble the mid-2000s, rather than the frenetic pace of the mid-1990s. Large banks specialize in small firm lending but often times via credit cards or credit scoring. Presented with these opportunities, small firms could be selecting banks depending on their specific loan needs and the least cost lending technology.

A related issue with bank size is the role of technology and the importance of distance in small firm lending. Whether or not the “tyranny of distance” (Petersen and Rajan 2002) is removed because of credit-scoring and business credit cards remains to be seen. In the venture-capital market, proximity of the venture capitalist to their investment’s success is still an important determinant (Chen et al. 2009). This topic can be a fruitful area for empirical research, especially focusing on how credit card use and the implementation of new credit card regulations (Credit CARD Act of 2009) might affect small firm access to capital.

Finally, the recent credit crisis has generated a tremendous amount of focus on the problems small firms have with access to capital. The data presented in this chapter show no pervasive, persistent problem with access at the same level small firms faced in the early 1980s. However, when compared to the 1990s and 2000s, the recent experience of small firms reveals a marked increase in credit access ­difficulty. While some firms will always have difficulty accessing capital, many of the access problems identified in the early 1980s appear to be resolved through technology, the quest for profitability (large banks focusing on small firms), or the continuing chartering of new banks (new small firm lenders). The ongoing consolidation that has increased the market share of the largest banks, along with much tighter restrictions on credit cards and small firm reliance on real estate collateral, suggests the need for a clear, data-driven analysis of small business credit availability and whether a public policy response is necessary.

6 Conclusions

The title of this chapter, The Changing Landscape of Small Firm Finance, is an appropriate point of departure for concluding remarks. How much has the landscape changed in the past 20 years for small firm finance? In some ways, the changes are dramatic when viewed through the lens of the number and distribution of banks and changes in lending technologies. The consolidation of the US banking system reduced the number of banking organizations by one-third over this period, many of which were small banks that served the financial needs of small firms. Yet the number of banking offices increased by almost 30,000 (www.fdic.gov/hsob) as a result of increased branching. Over the same period, the costs of information technology fell just as dramatically, enabling the rapid growth of business (and personal) credit card lending that expanded credit access to small firms, either at the business or personal level. The growth in personal credit card lines is clearly an enabler for nascent firms based on the PSED data. Unfortunately, these credit card lenders were concentrated in a few very large banks, many of which have incurred large losses resulting in a contraction in this source of funds during the Great Recession of 2008–2009.

The macro environment for small business financing is much improved since the early-1980s. The elimination of inflation in the early 1980s and the associated reduction in interest rates was a benefit to small firms. Since that time financing costs receded as an important problem for small firms. Although periodic tightening of credit by the Fed has been felt by small firms attempting to obtain credit, their difficulty is nowhere the level of the early 1980s. The recent uptick in reported problems with credit availability is not due to higher rates but reflects the impact of a weak economy on small firm financial strength. In addition, many small firms have relied on the rapid rise in real estate values as collateral for loans and the bursting of the property bubble has significantly affected their ability to offer additional business or personal collateral for loans.

But in other ways, the landscape has remained the same when viewed through the typical sources of funds for start-up firms. Personal savings and funds (equity) from friends and family still remain the most important source of start-up funding, while venture capital and other outside equity will continue to be available only for exceptional growth opportunities. Banks still remain a primary source of outside capital for new firms despite the dramatic industry consolidation during the past 25 years. The mix has changed, however, from direct lending to a mix of direct lending and credit cards, where the credit card is likely to be issued by a different bank. Despite – or perhaps because of – consolidation, approval of new bank charters by state banking regulators continues. These new banks are an important alternative to large banks for many small firms and have a comparative advantage in relationship lending that large banks cannot provide.