Posted by: John Tozzi on August 6, 2009
Startups that lean too much on credit cards are more likely to fail, according to a new report (PDF) from the Kauffman Foundation. The study found that every $1,000 of credit card debt increases the probability that a new firm will close by 2.2%.
Credit cards have increasingly replaced traditional loans, and this study suggests that taking on credit card debt is one factor that contributes to business failure. Researcher Robert Scott examined 5,000 firms started in 2004 and tracked their progress through 2006 using data from the Kauffman Firm Survey. About 58% of them used credit cards to fund their business in the first year, and nearly one-third of those carried a revolving balance. The average debt for those companies with outstanding balances at 2004 was $11,000. (When you also include those with no credit card debt, the average was $3,500.)
Most of the firms in the sample (59%) had no employees when they were founded, and only 18% had three or more, so this applies mainly to microbusinesses. That also likely means that many of the owners had their personal credit intertwined with their business finances. Simply using credit cards did not correlate to success or failure, but carrying a balance on them did. Scott found that “credit card debt increases and then eventually stabilizes to a manageable level during many firms’ first few years of operation, while firms with high credit card debt close and successful firms start paying off their debt.”
The report notes that “with the recent contraction of credit markets, many new businesses will face difficulties in accessing traditional forms of credit, which likely will create greater demand for credit cards.” Small business’ shift to credit card financing was well underway for years before the credit crunch, as card issuers aggressively pushed into what had been an relatively untapped market over the past decade. The top small business lenders are credit card issuers.
Let’s think about the implications for a second. The most readily available source of credit for new small businesses is one that, the evidence suggests, damages the business’s chance of survival. Does that strike anyone else as an enormous failure of our financial system?
Recent credit card reforms, while a step in the right direction, fail to give small business owners the same protections that consumers will have. But it seems like there’s a market opportunity for a new methods of small business financing that don’t actually damage the borrowers’ chance of success. We began exploring some of them a few months ago in this post — ideas like peer-to-peer lending through Kiva or loans and investments through community development financial institutions. It’s a conversation worth continuing. What other alternatives to credit card borrowing are emerging?