Fintech, Small Business & the American Dream
Page 4
Figure 2.3 Non-Employer Businesses Have Grown Compared to Employer Firms
Growth Rates From 2004 to 2015, Indexed to 2004
Source: Author’s calculations based on U.S. Census Bureau Business Dynamics Statistics and Non-Employer Statistics data.
The growth in non-employer businesses has been driven in large part by people working full-time jobs with a part-time business on the side.32 Whether this development is positive, negative, or neutral is debatable. On one hand, individuals now have more opportunities to earn money, and the hours of these part-time businesses tend to be more flexible. However, this may also indicate a structural issue in our economy, in that many people feel the need to take on an additional part-time business because their full-time employment does not pay enough. It could also be that many of these individuals would like to make their side business full-time, but do not have the resources, such as capital or skills, to grow the business.
Main Street Firms
The second largest category of small businesses is what we call Main Street firms. These are the local restaurants, gift shops, car repair operations, and other storefronts that come to mind when we imagine a small business. Most of these Main Street businesses, like florists and cafés, do not dramatically increase their employment from one year to the next, but together, these firms provide jobs and benefits for tens of millions of people.
Although the Internet is allowing some small firms to ship their goods across the country and around the world, Main Street businesses generally produce goods for local consumption. This contrasts with firms that engage in what we call the “traded” economy, in which businesses sell goods or services outside of their regions. However, the local and traded economies are linked through a “multiplier” effect. For every new traded job, two or more local jobs are created due to the demand of the employees at the traded firm to go out to dinner and use other local services.
Supply Chain Firms
A third category of small business is important but often overlooked: small firms that supply large firms and government clients. There are about one million of these supplier firms, which are often focused on growth and managed with greater sophistication than Main Street firms. An example is Transportation and Logistical Services (TLS) in Hoover, Alabama, just outside of Birmingham. Started in 2003, TLS employs about 10 people, has $6 million in annual sales, and provides trucking and logistical services to companies as large as Coca-Cola.
New research allows us to identify and separate supply chain industries from business-to-consumer ones for the first time. This work has shown how important small suppliers, which account for over 12 million jobs, are to the U.S. economy. Although most people just view suppliers as manufacturers of parts, the number of suppliers of traded services is growing rapidly and delivering innovation and high wages33 (Figure 2.4).
Figure 2.4 Supply Chain Employment and Wages (2012)
Source: Author’s calculations of 2012 Economic Census data. This analysis is based on the work of Mercedes Delgado and Karen G. Mills, “A New Categorization of the U.S. Economy: The Role of Supply Chain Industries in Innovation and Economic Performance,” MIT Sloan Research Paper, no. 5241-16, December 11, 2018.
Supplier firms play an important role in local economic growth and development. Cluster theory suggests that strong suppliers impact the ability of both large companies and start-ups to succeed. Co-location of companies and their suppliers leads to more economic growth and innovation, so a dynamic supply chain can be an important factor in encouraging businesses to move to or remain in the United States.34, 35 For example, a research and supplier park established in Prince George, Virginia in 2010 contributed to Rolls-Royce’s decision to locate some of its production there.36
High-Growth Firms
The smallest category of the four kinds of small businesses, at least numerically, is high-growth firms. There are about 200,000 of these companies in the United States, but they contribute a disproportionate share of job creation. An MIT study showed that 5 percent of firms registered in Massachusetts delivered more than three-quarters of growth outcomes and had specific qualities that were evident even as early as the time of their original business registration.37
Most of the jobs at these high-growth small businesses are traded jobs, meaning where these firms are incubated or decide to locate greatly impacts the local economy. Cities have long recognized this and have provided incentives to attract these high-growth firms. As one economist argues, “Because a few, typically young firms grow rapidly and account for much of job creation, finding an effective way to support their growth is important.”38
* * *
Each of these four kinds of small businesses plays a different role in our economy, and each has its own needs. A mom and pop Main Street shop has different financing needs than a tech start-up. The former might be best served by a bank loan, while the latter might need a patient angel or venture capital equity investor. A sole proprietor such as an Uber driver might need a loan to buy a car, while a supplier might need a short-term advance to hold them over until they are paid by the companies to which they are selling. It is not “one size fits all.” The key to robust capital markets for small business and to effective government policy is to understand what it takes to meet the needs of each type of small business.
Fewer Small Businesses: The Long-Term Decline in Economic Dynamism
If there was ever a time to pay attention to small businesses, it is now. In a worrisome trend, the rate of small business creation has been declining for several decades. Researchers who identified this raised the concern that less firm creation would result in reduced economic “dynamism”—the fuel that keeps the American innovation engine pumping.39
For many years, economists and policymakers have understood that economic dynamism means new ideas replacing old ideas, and new and energetic companies and markets replacing incumbents. American entrepreneurship, and its ability to generate innovation, growth, and change, have been the envy of the world. A dynamic, healthy economy requires consistent firm creation, but between 1977 and 2014, the share of new firms in the U.S. economy declined by more than half (Figure 2.5).
Figure 2.5 New Firms as a Share of Total Firms Declining Since 1977
Employer Firms: Firms <1 and Firms 1+ Years Old
Source: U.S. Census Bureau, Business Dynamics Statistics, Firm Characteristics Data Tables—Firm Age.
As a result, job creation from this critical sector has slowed. Economic research has shown that new and young firms are the main drivers of job creation in the United States.40, 41 But between 1994 and 2015, the number of new firms created annually dropped from more than 500,000 to about 400,000 and the number of jobs created by new firms declined as well (Figure 2.6).
Figure 2.6 Decline in New Firms and New Firm Employment
Annual Number of New Firms and Jobs Created by New Firms <1 Year Old (1994–2015)
Source: U.S. Census Bureau, Business Dynamics Statistics, Firm Characteristics Tables—Firm Age.
America still has a strong reputation for innovation, perhaps best symbolized by the tech start-up culture of Silicon Valley. But recall that high-growth start-ups only make up a small fraction of all small businesses, and the number of non-employer sole proprietorships has been growing. A significant part of the decline in firm starts is most likely happening in the largest segment of employer firms: Main Street businesses.
There is no single, clear explanation for the long-term decline of small business formations in the United States.42 Several economists believe that it may be a result of the simple math of having a smaller labor force.43 As baby boomers retire, there are fewer working-age people, meaning there are fewer candidates to start small businesses. Another explanation may be the proliferation of “big box” stores, which can undercut pricing and offer a wider selection of products, and made it harder to start small businesses. The high cost of health care and increasing levels of student debt are also often cited as
barriers to entrepreneurship.44, 45 In addition to these issues, the market frictions dampening the ability of small businesses to access capital are much more pronounced for younger firms.
* * *
The health of the U.S. economy depends on the small businesses that create the majority of net new jobs, drive innovation, and secure economic mobility for millions of Americans. In some ways, as technology puts pressure on repetitive jobs, small firms will be an increasingly important way to employ people displaced by large firms. In the next chapter, to address the issues that small businesses face, we explore one critical aspect of starting and growing a small business in America today: the ability to access capital.
© The Author(s) 2018
Karen G. MillsFintech, Small Business & the American Dreamhttps://doi.org/10.1007/978-3-030-03620-1_3
3. Small Businesses and Their Banks: The Impact of the Great Recession
Karen G. Mills1
(1)Harvard Business School, Harvard University, Boston, MA, USA
Karen G. Mills
Email: kmills@hbs.edu
In 2015, Pilar Guzman Zavala was down to her last chance to seize the opportunity she and her husband had worked years to achieve.1 She had to convince Jorge Rossell, the Chairman of TotalBank in Miami, to give her and her husband Juan a loan to open a new restaurant at Miami International Airport.
As she drove into the parking lot of the bank, she ran through her story one more time. Pilar would explain how she and Juan had rescued their business, Half Moon Empanadas, from the brink of failure during the Great Recession. She would show Rossell how they were now consistently exceeding sales targets, and how they had won the competitive bid to open a new location at Miami International Airport. The new location would be a godsend and was a perfect place for selling their delicious empanadas. Yet, despite their recent success at other locations and even with the airport contract in hand, they had been declined for loans everywhere they went, including at TotalBank. She hoped against all hope that this personal appeal to Rossell might make the difference. As she walked through the doors and up to the C-suite, she took a deep breath, reminding herself that no matter the outcome of this meeting, she and her family, and their business, were far better off than they had been just a few years ago.
The Zavalas were both immigrants to the United States—Pilar from Mexico and Juan from Argentina. Hoping to achieve the American Dream, they opened Half Moon Empanadas in a fashionable dining room in South Beach. The couple also had plans for a delivery business and ultimately wanted to create “a new category of food.”2 Pilar and Juan poured their savings into the idea and borrowed additional money through a bank loan to start the business.
But soon after opening in South Beach, the Zavalas realized that they had misjudged the market for delivery, and they failed to hit their expected sales. They also had the bad luck of opening their restaurant just before the financial crisis cratered the Florida real estate market. As they struggled to find a workable sales model and weather the recession, they missed payments on a $350,000 bank line of credit. Attempting to make it good and gain financial flexibility, they used an injection of money from their family to make a $125,000 payment. Instead of stabilizing their financing, the bank responded to their show of good faith by cutting off the Zavalas’ line of credit.
A few years later, having put $1 million into the business, including all their savings plus bank loans, they could no longer afford to pay rent. They were evicted twice from their business location and then, unthinkably, from their own home. Devastated, the Zavalas questioned whether they should continue with the business. They believed their concept could still work, because although the full-service restaurant had failed, when they took their empanadas to open-air markets and festivals, they could barely keep up with the demand.
Pilar and Juan didn't take a paycheck for nearly four years and avoided the temptation to declare bankruptcy. They adjusted their business plan, got out of their restaurant lease, and took over a food cart at the University of Miami. The previous occupants of the cart had struggled to make $100 per day, but the Zavalas averaged $1,500. Through trial and a fair amount of error, they found the kinds of locations where they could succeed. As Pilar said, “We dusted ourselves off, we tightened our belts, and we survived, never abandoning our bigger dream.”
By 2015, when Pilar walked into Rossell’s office to request an expansion loan, the Zavalas were operating three storefronts at the University of Miami and had the winning Miami airport bid in hand. Given their credit history since 2008, it was understandable that banks were hesitant to lend to them. In fact, they had only gotten the meeting with Rossell due to a timely introduction from Pilar’s mentor. Fortunately for the Zavalas, Rossell looked past the numbers and saw that they really had turned things around. He decided to provide them with the financing for the new location. That bet paid off, with Half Moon increasing its revenues from $500,000 in 2014 to $3 million in 2017.
* * *
Many small business owners across the United States could tell similar stories to that of Pilar and Juan. Getting a small business loan is tough enough on a good day, but during and after the Great Recession, it became nearly impossible for many businesses to access the financing they needed. Even armed with a good idea, hard work, and a willingness to go to great lengths to fund their business, many small business owners were not as fortunate as the Zavalas. With bank credit frozen, small businesses lacking the additional cash to weather the storm were forced to close their doors. Those that stayed open often found themselves in the same position as Pilar and Juan—with rebounding sales, but an inability to access additional financing because the crisis damaged their credit and because of the long and uneven recovery of bank lending to small businesses.
The 2008 financial crisis was a wakeup call for Washington and governments around the world, as policymakers saw the effects of a lack of access to capital for small businesses. Although it was generally understood that access to capital was important to the small business economy, the United States had not seen such a shutdown in the bank credit markets since the Great Depression. In fact, from 2006 to 2007, credit markets for small business loans were so robust that the White House wondered if the government’s role in guaranteeing small business loans was still necessary. The impact of the credit crisis on small businesses was unforeseen and devastating. In the first three months of 2009, the economy lost 1.8 million small business jobs, and more than 200,000 small businesses closed between 2008 and 2010.3
In Chapter 2, we saw that small business is important to the U.S. economy. But how important is access to capital to small businesses, and what happens when that access goes away? In this chapter, we will explore why the financial crisis was particularly devastating to small businesses to better understand the importance of a highly functioning small business lending market. The lesson of the recession is one we know from the work of economists: firms that depend more on credit suffer more from a financial crisis.4 Small businesses depend largely on banks for their credit needs. When banks froze their lending, small businesses had nowhere to turn. Without the liquidity they required, many had to shut down their operations, adding to unemployment and deepening the crisis.
While the financial crisis of 2008 was sudden, the recovery in small business credit was slow and bumpy. Banks sustained severe damage to their balance sheets and were reluctant to take on risk. At the same time, the recession had dealt heavy blows to many small businesses’ sales and profits. But the difficulties in the recovery were also an indication of a deeper problem. As we will discuss in Chapter 4, structural forces also resulted in permanent changes to the landscape of small business access to capital.
Why Focus on Access to Capital for Small Businesses?
Running a small business requires strong products or services, skilled workers, access to the right markets and customers, a trusted brand, and more. But underlying everything a business does is access to capital, both working capital for da
ily operations and capital to fund investments. While many owners of new businesses finance themselves or rely on friends and family to help, a significant number do not have those options or choose not to use them. In those cases, getting access to capital another way, most often through a bank loan, can be the difference between starting the business right away, putting it off, or not starting it at all.
Even once they begin operations, small firms tend to have more volatile sales and profits than larger businesses, as well as thinner margins for error. According to a recent study by the JPMorgan Chase Institute—which tracked daily cash flows for more than 600,000 businesses—the typical small company only holds enough cash in reserve to last 27 days.5 The median cash buffer varies substantially across industries. For instance, the restaurant industry in which the Zavalas operate holds only a 16-day buffer period. This means that a poor month of sales or an unexpected expense can put a small business in a cash squeeze. Securing a line of credit for operational funding can smooth out volatility and provide a source of liquidity when cash is needed.
Access to capital is also important for expansion. When a sole proprietor decides to add their first employee, they might incur incorporation fees, have to purchase a payroll system, or need new office space. When a restaurant owner identifies a market opportunity and expands from one location to two, they will likely need new equipment, furnishings, and a point of service system. According to the 2017 Federal Reserve Small Business Credit Survey, nearly 60 percent of firms that sought financing in 2017 said they did so to expand or pursue a new opportunity.6 These firms required a one-time investment that would often exceed what their businesses could generate internally, or what their owners’ personal resources could handle. In these cases, they had to turn to outside sources of financing.