This excerpt is taken from a chapter of the new book, Credit Card Nation, The Consequences of America's Addiction to Credit, by Robert D. Manning, who looks at the present and future dependence on credit in the U.S. Manning goes beyond cards, examining the history of credit in the U.S. over the last 20 years and the beginning of deregulation of financial services. The following is an excerpt from his chapter on small businesses. It has been edited for length.
CHAPTER 8: The Credit-Card Hustle: The Commercial Credit Crunch and the Crisis of Small Business
After founding a company with credit cards and demonstrating their business acumen, most inexperienced entrepreneurs are shocked to learn that business growth and longevity do not necessarily attract greater interest from commercial lenders. This is due to the banking industry's discrimination, or "red-lining," policy against small businesses -- especially entrepreneurs in the information- and service-based economy. For instance, Jo-Anne Dressendorfer uses her six credit cards with combined credit lines of $100,000 to finance computers, software, and office supplies for her 10-year-old technology marketing business in Morristown, N.J. Even with $10 million in annual revenues, "banks still spurn requests for loans [because] all I have is bodies. They cannot collateralize anything. [I] shop for teaser credit-card rates of around 4.5% and switch when the rates go up. It is a brilliant strategy." It is also becoming more risky with fewer banks competing for consumer accounts due to the ongoing consolidation of the credit card industry.
Even small-business owners with substantial equity for collateral are finding that their local banks are reluctant to refinance their credit card debts with conventional loans. For instance, Robert Allen and his wife Mae invested their life savings of $30,000 as well as an additional $15,000 from a military credit-union loan in a Cleveland restaurant in 1998. Although they have a stable outside income (Mae's full-time job, Robert's part-time job, military pension), the Allens had no choice but to go plastic after five banks rejected their loan applications. According to Robert, a certified chef and former Arthur Treacher's franchisee, "'You don't have to explain to anybody what you're going to do with it. You can make a cash advance and just work with it.'" After only five months in business, they are now encumbered with $30,000 in credit-card debt at 14% to 18% APR. They now realize that there is little chance of refinancing with a bank loan in the near future.
For those who have exhausted their credit-card limits, the need for financing has even spawned television and online small business "beauty pageants." For example, the Money Hunt TV show features aspiring entrepreneurs who, as contestants, compete on-air for potential financial angels and venture capital. By summer 1999, this contemporary version of Ed McMahon's Star Search had expanded to nearly 100 metropolitan markets. The escalating demand for commercial financing has led the SBA to develop a Web site for matching entrepreneurs with angel investors. Both groups must submit registration and certification documents before they can be listed in the online database for funding from $250,000 to $5 million.
One issue is whether the credit-card industry merits commendation for the expansion of the U.S. small business sector in the '90s. Industry representatives often point to these entrepreneurial success stories as evidence of the increasing importance of bank credit cards in leveling the playing field for aspiring entrepreneurs. They even refer to the proliferation of bank credit cards as a way of "democratizing" access to credit for those most in need, or excluded from, traditional sources of credit. The industry fails to explain, however, that the low approval rate of small-business loans does not correspond with their risk assessment profiles.
The banking industry's rule of thumb that four out of five business startups will fail is not empirically substantiated. For instance, Bruce Kirchhoff's 1989 analysis of the SBA's small-business database found that only 18% of all new businesses end in involuntary failure after eight years, and other subsequent studies have confirmed the higher-than-expected longevity rates of small-business startups. In 1996, for instance, there were about 5.4 million companies with fewer than 500 employees but only 71,811 business failures and 53,549 official bankruptcies; the latter fell to 44,367 in 1998. Furthermore, SBA research indicates that only 1 out of 7 enterprises that go out of business has unpaid loan obligations.
Not surprisingly, as the credit-card industry faced a profitability crisis due to the saturation of its traditional consumer markets, American Express and Visa began aggressively marketing corporate credit cards to fledgling small enterprises and the self-employed in the late '90s. In two 1999 television ads, for example, two novice male entrepreneurs "go for it" and lease business furniture for their new office on their Corporate Visa card. Similarly, American Express touts the benefits of its Corporate Card, which includes a wide range of financial and consulting services (tax and business services [TBS]), to the young founders of a fast-growing landscaping company.
Today, TBS generates one-quarter (26 percent in 1999) of AMEX's corporate revenues -- up from 10% in 1994. The growing demand and profitability of small-business credit have fueled the expansion of American Express's initial foray into the consumer-credit market (Optima card) with its new hi-tech Blue card. Significantly, the emphasis on personal freedom and empowerment is strikingly similar to the marketing themes on college campuses. Aspiring entrepreneurs are encouraged to take advantage of a good investment opportunity or the once-in-a-lifetime chance to escape an unsatisfying job and become their own boss.
In contrast to the generous offer of easy money to unemployed students, the growing use of credit cards by small businesses is often the result of increasingly restrictive lending policies by commercial banks. In the same way the withdrawal of first-tier banks from low-income communities has sharply increased the demand for costly second-tier loans, banks are profiting handsomely from the commercial credit crunch by issuing credit cards rather than approving small business loans. The problem is that credit-card applications do not ask questions about long-term business plans and how the loans will be repaid. As a result, rather than paying 6% to 8% on profit-enhancing small-business loans, eager entrepreneurs soon find themselves burdened with 14% to 24% APR consumer loans that they often cannot repay.
According to Maria Coyne, director of the Small Business Development Center in Cleveland, "'In many cases, these [entrepreneurs] are desperate. This is the only recourse they have to get money...Without it, their business might go under or they might not be able to pay critical vendors.'" As a result, the flip side of this "democratization" of credit is the growing number of families in financial difficulty due to the increasing use of consumer-credit cards for business expenses.
Jay Seaton, president of Consumer Credit Counseling Services (CCCS) of northeast Ohio, has found this problem "so staggering" that CCCS began offering seminars in 1999 to inform business owners about the signs of credit trouble and the potential hardships that it could impose on family members.
In sum, the decision to go plastic reflects (1) a lack of access to alternative sources of start-up capital (including community-based "incubators" and other nonprofit programs), (2) a calculated preference not to exhaust the "last lines of defense" of other informal sources of credit, (3) the expectation that high-interest debt will be paid off with future business revenues, and (4) the assumption that banks will refinance with lower-interest loans after the business demonstrates a viable track record.
For most aspiring entrepreneurs, higher-cost credit card loans are well worth the nonpecuniary costs of SBA and personal loans in the short term. And the immediate use of bank cards could be the difference between whether a lucrative business opportunity is pursued or lost. Consequently, this trend has important implications for future success rates of individual entrepreneurs as well as U.S. employment and macroeconomic growth patterns. Excerpted from Credit Card Nation, The Consequences of America's Addiction to Credit, by Robert D. Manning. Copyright 2000 Robert D. Manning. Reprinted with permission of the publisher Basic Books, a member of the Perseus Books Group