The Future of Small Business Finance

by Mike Paul | May 03, 2016
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“Small business is the backbone of the U.S. economy. Small businesses are primary job creators.” While these statements are popular sound bites during an election, it should be noted that newer firms, regardless of defined revenue and employment size parameters, are net providers of employment growth. What do we mean by small business anyway? The U.S. Small Business Administration defines a small business (eligible for 7(a) and 504 program financing) based on its industry, ranging from $750,000 to $38.5 million in revenues, and having 500 to 1500 employees. For purposes of this article, which reviews funding sources available to small business, let’s assume the definition of small business is closely-held firms with credit needs up to $1 million, excluding real estate financing. This is a more practical limit, based on the manner in which small business is served by lenders.

There are two basic forms of support to a balance sheet - Debt and Equity. While the media often will describe both as “capital,” debt is a liability, structured to be repaid and is subject to repayment analysis, and requires historical cash flow adequate to service existing and proposed debt. Equity is ownership in the firm, and requires no repayment analysis, rather an assessment of the potential return on investment and the likelihood of a liquidity event at some time in the future.

Now that those definitions are clear, let’s look at the various funding sources available to small businesses: commercial banks, credit unions, alternative financing, peer to peer lending and crowdfunding.

Commercial Banks

I was drawn to a financial services career in 1977 and believed banking would provide secure employment and a chance to use and develop my analytical skills. I also expected banks would offer plenty of opportunities to serve walk-in credit seekers. Nearly 40 years later, the analytical part remains paramount, job continuity was deeply impacted by deregulation of the late 1970s and 1980s and the following industry consolidation, and walk-in applicants, like the three martini lunch, was an illusion. For nearly 200 years, commercial lending was the nearly sole domain of commercial banks. The growth of both credit union membership and the information age has allowed other industries to serve small business.

As a current practice, national and regional banks tend to segment commercial clients by revenue and or credit usage size, which are reflections of relative contribution to profitability. Thus, small business, middle market and large corporate segments are served according to the respective perceived potential return. Middle market and large corporate firms are more valuable, based on volume and use of peripheral services like treasury management, foreign exchange, and interest rate protection products. The small business segment tends to use fewer services, having smaller and less complex needs. As a result, most national and superregional banks (assets over $50 billion) tend to serve small business with a local sales representative, centralized or regionalized underwriting, loan servicing and operational service centers. This provides economies of scale in pricing and production resources, a training ground for young bankers, and access to a slate of products and services. Regional banks, based in the Northwest, with assets in the $1 -20 billion range, also tend to deliver business by market segments driven by borrowing level, and also tend to offer centralized underwriting. Community banks, with assets under $1 billion, tend to focus on small business, and offer a less comprehensive menu of services, delivered by more experienced relationship managers. According to the Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Administration (NCUA), small business borrowing from commercial banks represents 93% of the total universe, with 59% served by the national banks with asset levels over $100 billion. Regional banks with assets $1 – 100 billion account for 26% of small business loans, and community banks account for 8%. There are now 5,309 commercial banks in the U.S., with 52 chartered in the State of Washington. Benefits of borrowing from commercial banks are historical expertise, well developed standard practices and availability of peripheral services. Drawbacks include a pro-cyclical regulatory environment which tends to restrict credit during recessionary periods and continuing consolidation which can cause relationship management turnover.

Credit Unions

Credit unions have been making member-business loans (MBLs) since their inception in the early 1900s. In the first 90 years of their existence, there was no cap on business lending. In 1998, Congress imposed the current cap for aggregate MBL at 12.25% of total assets, with exceptions in place and legislation pending to increase the cap in the near future. Like commercial banks, credit unions are depository institutions, with deposit insurance provided the National Credit Union Share Insurance Fund (NCUSIF with regulatory authority being dependent upon state or national charter. Credit unions are cooperative ownership structures. Nationwide, there are now 6,231 credit unions. In Washington, there are 94 credit unions, 52 of which offer member business lending. Initially, credit unions focused on permanent commercial real estate loans, but more recently also began offering construction lending and commercial lending for working capital, expansion and equipment financing support. Consolidation within the commercial banking industry has resulted in more migration of commercial bankers to credit unions, and the ability to create credit administration and portfolio management systems required for safety and soundness. According to the FDIC and NCUA, credit unions account for 7% of small business lending. Benefits of using a credit union for member business services include membership in a co-op, comparable products and services to a commercial bank, competitive pricing and increasingly experienced relationship managers. Drawbacks are similar to those of commercial banks – significant regulatory framework in place, consolidation via merger, although less so than commercial banking.

Alternative Financing

There are several sources of alternative financing for working capital and equipment. In addition to large national providers (i.e. GE Capital), there are many privately owned firms which offer credit with specialized monitoring requirements. Many of these firms can finance a borrower with operating losses, provided cash flow from collateral conversion can revolve the borrower’s debt level. While a large alternative lender like GE Capital has access to multiple financing sources, both short and long term, debt and equity, smaller firms tend to rely more heavily on their own equity. Firms with earnings volatility and or high financial leverage can often find funding here. Benefits of alternative lending are availability and lender expertise, and the drawback is cost.

Peer to Peer Lending

Technology has dramatically changed forever the small business lending landscape. The information world has given birth to Peer to Peer or P2P lending. Since 2007, several firms have shown explosive growth in small business lending. Morgan Stanley estimated the P2P market share at 3.3% in October 2015, and P2P was expected to originate $7.9 billion in new loans in 2015, up 68% from the prior year. These “marketplace” lenders provide an exchange where accredited and institutional investors can fund small business borrowers. Underwriting techniques are broader than depository institutions in this non-regulated market, and include evaluation of social media, product reviews and other non-traditional methods. Loans range from $5,000 to $300,000, with a sweet spot under $50,000. The benefits are convenience, speed of decisioning and more liberal availability, whereas the drawbacks are higher pricing and the lack of a professional financial representative. The bigger players in this industry are Kabbage, OnDeck, Lending Club, Prosper and CAN Capital. To date, this industry shows little signs of slowing down. Some are partnering with commercial banks to generate small business loans from bank referrals. While we do not know how this industry will perform during a recessionary business cycle, its ability to attract equity investors, including institutions has been impressive to date. Crowdfunding The passage of Sarbanes Oxley Act in 2002 provided greater disclosure and financial reporting requirements which did provide more transparency for investors, but raised the cost of becoming and being a public company. In 2012, in order to broaden small business access to capital markets, Congress passed the “Jumpstarts our Business Startups Act” (JOBS Act), and the State of Washington implemented rules in late 2014. The “Crowdfunding” program is intended to simplify, reduce the cost of, and broaden the investor pool for, raising equity by small business. Eligible firms must be located, earn 80% of their revenues, house 80% of their assets and use 80% of the proceeds in the state in which the equity is issued. Generally, eligible firms can raise up to $1 million, with less costly registration, financial reporting and disclosure requirements than are in place for larger firms and offerings. While the program is new, it appears the terms and cost of issuance can be quite advantageous to a small business. Balance sheet-wise, equity is more permanent than debt, and is an excellent source of support for long term growth. Greater detail may be found at the State of Washington Department of Financial Institutions website:


There has never been a period in history where small business borrowers have more choice in providers. The financial services world, owing largely to 7 years of stimulative monetary policy practiced by the Federal Reserve System, has left lending and funding industries with low interest rates and abundant liquidity. Dependent on the length of time in business, the volatility of earnings, depth of management, need for relationship management advocacy, small firms will continue to use depository institutions as their more traditional sources of credit. Start-up firms, those with high growth potential or volatile earnings, are more likely to better be served by P2P sources and crowdfunding. If Moore’s Law applies to the provision of financing, one would expect the growth of the non-bank sources to grow significantly over the next 10 years. While I may be ending my career by that time, the digital financial fun may just be getting started.

Mike Paul is Senior Vice President and Region Director for Harborstone Credit Union. He is a 38-year veteran of commercial lending and business services, having served as a commercial bank, insurance firm and credit union executive. He is a former commercial bank CEO and a past Chairman of the Oregon Bankers Association.

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