The Smallest of Small Firms: How Are They Financed?

Nonemployers—or firms with a sole employee—make up more than 80 percent of all U.S. businesses, but how do they obtain financing? New Atlanta Fed research looks into the question.

August 20, 2015

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More than 80 percent of businesses in the United States are nonemployer firms, meaning they have no employees besides the owner. But little is known about the finances of these one-person operations.

Researchers Ellie Terry and Stephanie Rosoff of the Federal Reserve Banks of Atlanta and New York, respectively, explored the financing and credit needs of nonemployer firms by examining data from a new survey created by the Federal Reserve Banks of Atlanta, Cleveland, New York, and Philadelphia. The 2014 Joint Small Business Credit Survey (SBCS), conducted last fall, asked small businesses detailed questions about their experiences seeking financing during the first half of the year.

In an Atlanta Fed community and economic development discussion paper published in July, Terry and Rosoff wrote that nonemployer firms tend to rely more heavily than employer firms on personal funding sources. One-person shops are generally smaller and less-often profitable than are firms that have employees. And often with scant history of sales and profits, nonemployers who seek outside financing tend to face a difficult market.

Heavy reliance on personal savings

When asked in the SBCS how their business was funded during 2013, 40 percent of the nonemployers said they relied on personal savings as their primary funding source compared with fewer than 20 percent of employer firms. Nonemployers were also much less likely to use loans and lines of credit from banks and much more likely to use credit cards.

The relatively high reliance on personal savings suggests that some nonemployers have a lower demand for credit than do employer firms while others have difficulty obtaining outside funding. When asked if they applied for financing in the first half of 2014, 19 percent of nonemployers said yes, compared with 35 percent of employer firms.

Why do one-person operators apply for financing less frequently? It seems to be a combination of factors. Many don't apply because they don't need it, while others prefer to avoid debt. But it's also clear, Terry and Rosoff wrote, that an expectation of credit denial often plays a role in the decision not to borrow. And the dearth of debt among the one-person operations appears related to the reality that most nonemployer businesses are small. Smaller companies, employers or not, tend to carry less debt.

Tough for sole operators to land financing

The credit needs of nonemployer firms are hard to meet for several reasons. Perhaps most important, half of nonemployer firms are under five years old and thus have little sales history. Without a reliable revenue stream, it is difficult for creditors to assess risk. Nonemployers also were less likely to have been profitable—25 percent compared to 45 percent of employer firms turned a profit in the first half of 2014, SBCS data show. Ultimately, in the first half of 2014, fewer than half of self‐employed applicants were approved for any financing compared with 61 percent of employer applicants, the SBCS shows. The survey also showed that nonemployer applicants were nearly twice as likely to apply online for loans and lines of credit as employer firms in the first half of 2014. While this could be a positive sign that alternatives are developing to meet the needs of nonemployers, it could also be detrimental to the firm's and owner if the terms are not well understood by borrowers. In the survey, "poor credit score" was the reason nonemployers cited most for being denied credit. "Given these factors," Terry and Rosoff write, "it is not surprising that a greater portion of nonemployer applicants were denied credit compared to firms with employees."

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Charles Davidson

Staff writer for Economy Matters