Credit Crunch Is Major Crisis for Small Businesses

Why Scott Shane is worried about entrepreneurship in the credit crisis

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Scott Shane
Scott Shane

Right now, the system for financing small businesses in this country is in bad shape, and I'm worried about how the financial problems will affect entrepreneurship in America.

Specifically, I'm concerned that small businesses that face cash flow problems resulting from the current recession will be unable to get the money necessary to keep their businesses afloat until the economy rights itself. And I'm worried that a bunch of entrepreneurs who are starting businesses right now will end up undercapitalizing their businesses, thereby setting up a higher failure rate for start-ups in the coming years.

Entrepreneurs always have financing issues, so you might wonder why I'm so concerned about them right now. Basically, for two reasons. First, the recession that we're in appears to be longer and deeper than many we have had in the past, making it difficult for entrepreneurs to wait it out. A lot of good businesses are going to go under simply because there is no financing available to tide them over until demand picks up.

Second, financing has become very difficult for entrepreneurs to come by. A big chunk of the money that entrepreneurs use to finance their businesses comes from their own savings. With investments in stocks and bonds down so much, many entrepreneurs can't take their savings and plow it into their businesses, nor can they borrow much against their retirement plans.

Other major sources of capital for entrepreneurs—banks and trade creditors, which together account for about 30 percent of the capital provided to entrepreneurs—are harder to access. Trade creditors are cutting back on their lending because, as businesses, they are facing financial problems themselves.

The situation is even worse with the banks, which alone account for 16 percent of the external capital supplied to young small businesses. Businesses without stellar credit are having trouble borrowing, as banks are becoming much more conservative about credit risks.

Moreover, the ability to personally guarantee and personally borrow to support one's business is evaporating. As many as half of the founders of small businesses less than six years old personally guarantee the debts of their businesses, and two thirds of founders of new businesses borrow personally to finance their companies. Most entrepreneurs are having a lot of trouble getting this kind of financing because their houses, which are the major source of their collateral for personal borrowing, have dropped so much in value.

Without access to capital, a lot of American entrepreneurs will fail. Some will do so right away, while others, currently undercapitalized, will go under in a few years.

While the difficulties at the big banks and the auto companies are a problem, at least policymakers recognize it. The problem in the small-business sector is largely unrecognized because no individual entity's demise would have much effect alone. But the big increase in the failure rate of small businesses we are starting to experience will have major implications, given the number of people employed in the sector.

In short, we need to get credit flowing to small businesses again right away, or we will face significant problems.

Scott Shane is A. Malachi Mixon III professor of entrepreneurial studies at Case Western Reserve University. He is the author of The Illusions of Entrepreneurship: The Costly Myths That Entrepreneurs, Investors, and Policy Makers Live By, among other books.