Financing challenges of the smallest of small businesses

When it comes to obtaining financing, owners of firms that employ only themselves would prefer to use loans or lines of credit, but more often than not they will resort to using credit cards. And the less revenue the business generates, the more likely it is to rely on the owner’s personal credit card, rather than a business credit card.

In a survey of more than 5,500 single-employee firms, 45% relied on a credit card for external financing, compared with 27% that used a loan or line of credit, according to a new report from the Federal Reserve banks of New York, Richmond and Cleveland. Thirty-six percent did not use external financing at all.

The findings suggest that banks could be missing out on opportunities provide financing to what the Fed calls “nonemployer firms.” Between those who did not receive all the financing they applied for and those who were discouraged from applying in the first place, the report estimated that 46% of all these firms have some unmet financing need.

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“Some segments of these firms—especially those planning to hire employees in the future—are more prone to face financial challenges and may have unmet funding needs,” Claire Kramer Mills, assistant vice president at the New York Fed, said in a news release. “These obstacles may limit their near- or longer-term growth prospects.”

Nonemployer firms can include gig-economy workers supplementing their primary income, startups that have yet to hire other employees, or firms that rely on contract workers.

These businesses represent a significant chunk of the economy, accounting for 81% of all small businesses and employing 17% of the total U.S. workforce. They also generate roughly $1.2 trillion in sales every year.

Yet traditional banks have also largely ignored the financing needs of this segment.

One reason is because banks are often unsure of whether to categorize them as retail customers or small-business customers, said Anju Patwardhan, the managing director of CreditEase Fintech Investment Fund. Unpredictable income and a lack of credit history can also mean they are more difficult and expensive to underwrite and finance.

“Most banks tend to stay away because from a risk-reward perspective, it doesn’t work out so well,” she said.

A number of fintech companies have offered their own solutions to smooth out volatile cash flow for contract workers, said Leslie Parrish, a senior analyst at Aite Group. Examples of this include fintechs like EarnIn and DailyPay, which essentially give contract workers a cash advance on wages they’ve already earned ahead of their actual payday.

While those can be a good stopgap, they don’t necessarily address longer-term issues that self-employed workers may have.

“In terms of overall financial wellness it’s just a short-term solution to more vexing issues of lack of savings and income volatility,” she said.

Some tech and fintech companies, including Amazon, PayPal and Square, have begun to extend credit to these types of small businesses, largely underwriting them with cash-flow data they already have on those borrowers, Patwardhan said.

Many nonemployer firms are interested in bank financing, however. The survey found that these firms were more likely to apply for a loan from bank than from a credit union or online lender. Firms with annual revenues over $100,000 were much likelier to seek bank financing than their smaller counterparts.

The loans these firms are seeking are generally not large. Nearly 80% of all nonemployer firms that sought financing requested less than $100,000, and more than half of smaller firms applied for $25,000 or less.

Financing shortfalls were more common for the smaller firms, with 40% of those businesses receiving no financing at all. Those that had been denied credit cited a low credit score or insufficient history as the top two reasons for being denied.

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