A new study from University of Texas at Austin confirms that loans are crucial to your business' success.
Lack of capital is one of the primary reasons that businesses flounder. Intuitively, we all know that access to capital will help a business succeed. However, there hasn't been much empirical evidence as to just how important access to capital is and how it directly impacts business' survival…
Researchers at UCLA, NYU, and University of Texas at Austin compiled data over the course of a five-year period from 2006 – 2011 and recently published their findings. The results of this study should serve as a wake up call to encourage you as a business owner to keep a variety of funding options available. Call it preventative medicine, keeping your funding sources ready in case you see an opportunity.
Cesare Fracassi (University of Texas at Austin), Mark J. Garmaise (University of California, Los Angeles – Anderson School of Management), Shimon Kogan (University of Texas at Austin) and Gabriel Natividad (New York University – Leonard N. Stern School of Business) were the researchers who conducted this study. Below are some of the highlights of their findings.
Using our instrumenting strategy, we find that receiving a loan increases survival probability by 51 percentage points, suggesting that the impact of early-stage financing on success is enormous, despite the relatively small size of these loans (with a median amount of about $11,000, not much different from the typical startup capital of U.S. small businesses of comparable size). We also find that receiving a loan has a positive and significant effect on startups' revenue growth rate, revenue levels, and number of employees. While the large magnitude of the effects we document likely reflects the severe financial constraints affecting the specific population that applies to this lender for financing, the results do indicate that providing early-stage loans substantially enhances the future economic performance of small businesses led by subprime owners.
Further, these researchers concluded that not only does external funding benefit small businesses, those who did not apply for additional funding contributed to the 70% rate of business failures. In this study, businesses that had applied for and received additional funding were still going strong 3-5 years down the line. An average $11,000 loan was what was able to keep them from failing to thriving.
Two aspects of our findings are worth emphasizing. First, they indicate not only that external funding is beneficial for these firms, as financial economists may perhaps expect, but that the absence of financing actually explains a large bulk of the seventy percent failure rate that we observe. That is, we find that access to a relatively small amount of funding is the first-order cause of survival for subprime businesses. While these firms are likely subject to more severe financial constraints than others, our results do raise questions about the links between small business failure and restricted access to capital in broader sectors of the economy. Second, for most of the firms in our sample we measure survival 3-5 years after the loan application is made. We are therefore not merely assessing the impact of a loan on the short-term viability of a business. It may well be that certain start-ups immediately collapse without outside credit, while those that receive a loan are able to at least start operations. What is striking about our result, however, is that $11,000 loans have a tremendous influence on firm survival a number of years later.
One of the reasons that this study is so pivotal is because researched subprime businesses and the effects of obtaining capital vs. not attaining capital. A subprime business is defined as a business that has a FICO score less than 640. With the recent economic crisis brought on by mis-used borrowing, traditional bank lenders have become increasingly stringent on their guidelines. Most traditional bank loans are not attainable for these credit scores, but many business owners are in the “subprime FICO range.” These borrowers must source capital from non-traditional sources such as receivables factoring, merchant cash advances, invoice factoring, and short-term business loans from alternative non-bank lenders.
Our findings shed new light on the real consequences of subprime small business funding in the United States. Our study is one of the very few benefiting from privileged access to the internal loan making processes of an American financial institution to assess its broader impact on U.S.-based business clients; in the context of a vast literature on bank-firm relationships in the United States, our methodology offers a new path to a deeper understanding of the role of financial institutions in promoting economic activity.
They complied their findings using data from three different resources, Lexis Nexis, Dun & Bradstreet, and Accion Texas Inc. Lexis Nexis provides records on business owners through a person locator software, Dun and Bradstreet provides a list of current operating businesses, and Accion Texas, which is a nonprofit financial institution that provides loans to businesses, especially start-ups. They took the data from these sources and input an algorithm specifically created for the study to determine borrowing capacity and the financial viability of a business before, during, and after the loan.
In essence, the Lender's algorithm allows us to employ observational data in a quasi-experimental design to assess the causal impact of early-stage credit on small business future success.
They created this algorithm to streamline the analysis of the borrowing process. Borrowing capacity is determined by a variety of factors, including personal income, expenses, business, rent, and pro forma loan payments.
Another important point to note from this study comes from the analysis of the sample businesses that received initial loans for funding. Research showed that while they received the first loan that increased their viability and long-term success, the majority did not have to borrow again within the 5 year period.
One conjecture is that the Lender provides follow-up financing to its borrowers, thereby keeping them essentially on life-support and boosting their survival rate. While this would still arguably be a form a survival, it is not a significant phenomenon in our data. Only 4.3% of the borrowers receive follow-up loans. We find in untabulated results that excluding these borrowers has little effect on the estimated impact of loan provision.
The study goes on to point out that the survival rates for businesses that received a loan, whether they had a high or low credit score were similar. Also businesses that had a well-educated owner or one with senior managerial experience tended to benefit the most from the initial funding. Overall they concluded that the receipt of funding caused robustness and heightened survival rate for start-ups and businesses.
Taken together, our findings suggest that there is significant unmet demand for early- stage funding that is crucial for the success of a broad segment of businesses much talked about but largely understudied. A deeper understanding of whether this capital can be supplied on terms that are attractive to investors is likely to have significant implications for policy and practice.
Through these findings, there is now empirical data to prove that the acquisition of capital in a small or medium sized business is more than necessary. It is critical to long-term success, future profits, employee retention, and ability for expansion in the future. An entrepreneur, in addition to running a successful business, must cultivate a variety of funding sources that he or she can draw on when an opportunity presents itself.
To read the complete study click here.
Fracassi, Cesare and Garmaise, Mark J. and Kogan, Shimon and Natividad, Gabriel, Business Microloans for U.S. Subprime Borrowers (May 14, 2014). Journal of Financial and Quantitative Analysis (JFQA), Forthcoming. Available at SSRN: Here or here.