Another Reason for Declining Business Formation

I often criticize others for attributing 100% of any bad trend to their personal pet peeve.  To some extent I am guilty of that in my last post, where I blamed declining business formation on increasingly complex regulation and licensing.  I think there are good reasons for doing so -- I have spent the last 6 months passing up on business growth opportunities because I was too consumed with catching up on regulatory compliance minutia, particularly in California.  And I have watched as many of my smaller competitors who have fewer resources to dedicate to such compliance issues have left the business, telling me they could no longer keep up with all the requirements.

But there is seldom just one single cause for any trend in a complex, chaotic system (e.g. climate, but economics as well).  One other reason business formation may have dropped is the crash of the housing market and specifically in the equity many have in their homes.

Home equity has historically been an important source of capital for small business formation.  My first large investment in my company was funded with a loan that was secured by the equity in my home.  What outsiders may not realize about small business banking nowadays is that it is nothing like how banking is taught in high school civics.  In that model, the small business person goes to her local banker and presents a business plan, which the banker may fund if they think it is a good risk.

In the real world, trying to get such an unsecured loan from a bank as a small business will at best result in laughter.  My company is no longer what many would call "small" -- we will do millions in revenue this year.  But there is no way in the world that my banker of over 10 years will lend to my business unsecured -- they will demand some asset they can put a lien on.  So we can get financing of equipment purchases (as a capital lease on the equipment) and on factored receivables and inventory.  But without any of that stuff, a new business that just needs cash for startup cash flow is out of luck -- unless the owner has a personal asset, typically a house, on which the banker can place a lien.

So, without home equity, one of the two top sources of capital for small business formation disappears (the other top source is loans from friends and family, which one might also expect to dry up in a tough economy).

Postscript:  Banks will make cash flow loans if guaranteed by the SBA.  This is another whole can of worms, which I will not discuss today.  SBA loans are expensive and difficult to get, and the SBA has a tendency to turn the money spigot on and off at random times.  I have often wondered if the SBA helped to kill cash flow lending by banks.  First, why make risky small unsecured loans when you can get a government guarantee?  And second, with more formulaic lending criteria, SBA lending eliminated the need for loan officers who were good at evaluating business risks.  I can say from personal experience that the folks who can intelligently discuss a business plan and its risks are all gone from banks now (at least in the small business market).

  • mahtso

    I wonder if the blogger has underestimated the costs of doing business. It appears that he is quite successful and without question he knows far more than I do about running a business. But in some posts he criticizes government workers and in other posts he asserts that government run parks etc have too many managers and not enough people on the ground. Maybe he cannot pursue new business ventures because he is running his business without enough administrative support.

  • marque2

    :)

  • Chris

    Not sure if serious...

    If Warren needed more admin support, the parasitic class isn't where it would come from

  • jim collins

    I'll throw another reason on the table. Extortion by special interest groups. I had to go to a City Council meeting last week. While I was waiting for them to address the issue that I came for, I watched a proposal by a company that wanted to open a business in the City. When they completed their presentation, the floor was open for comments about it. The first was a group who wanted to know how much pollution they would create and how much money were they going to donate to "environmental charities"? The second group wanted to know how many women and minorities they were going to hire and how much money were they going to donate to "civic charities"? It went on with a few more groups including the local unions. All of these groups had one thing in common. They all wanted something and if they didn't get it, they had lawyers that would make it too expensive for that company to open it's business.

  • NL7

    So the solution to time-consuming bureaucratic wrangling is to convert it into money-consuming bureaucratic wrangling? It may make more sense for an entrepreneur to hire people who have lower hourly productivity (you can buy compliance services but you can't buy more hours in the day). But that doesn't eliminate the problem, it just converts some portion of his lost time into lost profits.

    Note also that government regulation is a black hole. For businesses of sufficient size, operating in multiple states, you can usually find at least few "mandates" with which you are less than fully in compliance and for which you could hire more people. Followed by more surprise mandates you didn't know were required and more people to fulfill them. And often you'll find that different agents recommend different paths to compliance, or different agencies have conflicting intentions.

    It's not an exaggeration to say that 100% compliance is often not achievable at a reasonable cost. Most medium to large businesses in the US tend to adopt an approach of doing the compliance they must do, where it's expensive to be caught, or where they have previously been confronted. But otherwise, since many agents are not aware of non-compliance and often unaware of even the mandates, it doesn't make calculated sense to strive for compliance.

  • Craig Loehle

    Part of the "cure" for the 2008 crash was to require banks to lower their risks and raise their cash on hand. A big company can get a loan still (though it has other means of raising capital) but small businesses are too "risky" so banks won't lend. And then Congress yells at the banks because they aren't lending...

  • ErikTheRed

    I share the author's suppositions on SBA loans. We started a new business six years ago and our business plan was basically used as a source of free comedy for every SBA lender we spoke to. We managed to do it with about a quarter million out of pocket and a LOT of sweat equity, but most people don't have that kind of money lying around (and it made things somewhat tight for us). But that also says a lot - even with plenty of assets to back it, our proposal was still considered a joke. My personal opinion is that SBA loans have completely sucked the air out of small business lending. Nobody we spoke to had a decent grasp of business principles - just a really good grasp of lending guidelines, which are not the same thing.

    Anyway, the business is still around and had 40% year-on-year revenue growth over the last two years. We would have started that growth at a higher baseline with more startup capital, but we're still chugging along. It just takes four or five years longer to get it to where we want to be, but we also have the happiness of the business being completely debt free. Goes to show what they know...

  • http://www.lushfun.com/ lushfun

    You also have to consider declining margins as distribution-retailing-services collapse into one another. Ergo if the seller of a thing has a dedicated distributor/service under contract and eats part of that cost to pass on the benefit to consumer while making sure that servicing that item out of their network is either prohibitive cost wise or undoable due to part shortage (discontinuation and planned obsolescence).

    The other aspect is financialization by large companies say a big chocolate maker would be able to finance inventory roll-out via very cheap unsecured loans (or issued bonds) that keeps a small producer considerably disadvantaged via the cash-cycle with the retailers being so against them in addition to pricing ability negotiation and shelve space negotiation. Granted in some sense the small producer can collapse and self-distribute via a small area and do niche targeting to optimize price differential and profit the overall burden is not neutral between them.

  • Nelly Perry

    Brilliant piece of information.
    business formation