How Small Businesses Start, and How They Keep On Going

Chances are, if you were to poll your students, you would find that a significant number of them dream of starting their own business. In 2008, Extra Credit ran a story addressing the role of entrepreneurship in the economy. It looked at how entrepreneurs can bring together factors of production to take a new idea for a product or service to the market, as well as how small businesses can provide the foundations of growth for large enterprises.

In the midst of the recession—about the time the article appeared—it became obvious that small businesses were experiencing a credit crunch. Because small businesses are often thought to be economic engines, economists at the Atlanta Fed wanted to find out more about trends in the small business environment. So in 2010, the Federal Reserve Bank of Atlanta developed an online questionnaire to assess general business conditions. The Small Business Survey, issued to businesses of various industries throughout the Southeast that have fewer than 500 employees, asks these business questions about credit needs and sources of funding. Atlanta Fed economists analyze survey results to gain insight not only into small businesses but also into broader economic conditions and credit flows.

Sources of funding
To find out where businesses are successful at obtaining funding, the Small Business Survey asks where they applied for a loan or line of credit, whether from a large national bank, a large regional bank, a small regional or community bank, or from friends or family. A firm might apply for credit to accommodate growth in the business, to make capital investments in machinery or equipment, to manage the cash flow—to pay employees and buy inventory, for example—or to acquire another business.

Survey results indicate that large financial institutions frequently do not grant small loans, which are classified as less than $100,000, to new business ventures. Small loans have high administrative costs and are thus not very cost effective for banks. Large banks may turn down a small business loan application because the business does not yet have collateral or a proven revenue stream. Commercial lenders may also view young businesses as high-risk ventures and unattractive borrowers.

Individuals may be able to increase the likelihood of obtaining a loan for a small business by using housing as collateral. In addition, a customer who develops a relationship with a small community bank may increase the likelihood of a successful loan. Small businesses can also rely on microloans programs. Community development financial institutions and nonprofit organizations facilitate such programs, according to Anil Rupasingha, research adviser and economist at the Atlanta Fed. The U.S. Small Business Administration is the largest federal program dedicated to supporting the credit needs of very small businesses.

Because of the difficulty in financing early-stage growth, young businesses often seek informal sources of financing until commercial lenders consider them creditworthy. For example, businesses might rely heavily on credit card loans which have very high interest rates. More commonly, according to the survey, is that new firms tend to use personal savings and loans from friends and family as dominant sources of funding. Investing initial profits from the business is also a common way to continue business operations. Another source of financing comes from "angel investors," or wealthy businessmen who provide guidance and funding to young businesses. In such instances, although the business owner may receive the advice of an experienced business person, he or she may lose some power in making decisions. The angel investor owns part of the start-up, so receiving help from such an investor partially depends on the business owner's willingness to share power.

More than money
Although access to credit clearly plays an important role in establishing a small business, many other factors come into play when we determine the success of a business. The education level and management expertise of the business owner are important, as is the level of community support. Social capital—that is, the level of engagement in the community that can be measured by the participation of town inhabitants in civic and religious life and voting—has a positive effect on fostering small business, according to Rupasingha.

"Gazelles" and growth
Recently, many of those interested in small business trends have shifted their focus to "gazelles." This term describes young firms with high-growth potential. A high-growth company, according to the Organization for Economic Development (OECD), is one that starts with at least 10 employees and has an average annual growth rate in employment of 20 percent or more over a three-year period. Although technology-oriented firms may come to mind when we think of high-growth businesses, rapid growth can emerge in many industries. For example, the temporary help services industry has experienced rapid growth in recent years. High growth is also present in manufacturing, retail, and distribution industries.

Researchers are currently seeking to understand the reasons for extraordinarily fast growth in any business's early years because they've found that when businesses experience high growth during the first five to seven years, they can contribute to job creation and the stability of the local economy. It's also true, however, that though a local community may feel the positive impact of the high-growth firm, it is relatively rare for a business to achieve such high growth: only 1 percent to 2 percent of small businesses can be considered high growth. The data show that there is constant turnover among small businesses; in fact, fewer than half of small businesses survive after five years.

Still, the innovation and the generation of new ideas is a critical part of growing the economy. So any insight into what makes a new business successful has far-reaching effects.

Questions for the classroom

  • Why might new small businesses have trouble obtaining financing?
  • How can a small business without a proven revenue stream improve its chances of getting a loan?
  • What is social capital, and how can it affect the success of small businesses?
  • How can "gazelles" impact the labor market in a community?

Related links

By Elizabeth Bruml, an economics major at Emory University in Atlanta, who contributed this article as part of her internship at the Federal Reserve Bank of Atlanta

September 30, 2013