Thoughts on small business financing options

I’d like to thank everyone who read a recent post I wrote last week related to alternative financing. I’ve been asked to follow up with some more thoughts on the issue. I am doing so here with the creation of a monthly newsletter. I hope you will subscribe. It will remain free forever. 

Now, last week’s post was in response to the theme of “alternative finance”, which can be loosely described as non-bank financing (credit and equity), but not traditional insurance or securities markets activities. I think of it as leasing, factoring, specialized credit for housing, autos, credit card securitization, etc. It is also crowdfunding, crypto, and the variety of digital relationships (B2B, etc.) that have emerged in recent years. 

Alternative finance is helpful to markets, economies and the small business sector because of the choice it offers. Across the globe, countries that rely heavily on banks or bank-based models often lack choice, or find “affordable” credit to be in limited supply. Alternative finance enhances financing instruments and options available in the market.

The absence of alternatives typically triggers two responses—government-backed credit for small business that is partly subsidized via guarantees or other mechanisms, or a general lack of alternatives and stagnation. In broad strokes, OECD countries typify the former, lower income economies with underdeveloped financial sectors the latter.

Countries like the US and UK are hybrids, with very broad and deep capital markets that supplement core bank offerings. Commonwealth countries like Canada, Australia, India and New Zealand likewise follow this hybrid model, albeit with less capital markets activity as measured by trade volumes and capitalizations. Most other economies have some degree of non-bank financing, sometimes specialized in focus (e.g., housing, agriculture).

New technologies and approaches can help to reverse some of the challenges small businesses face. In places like Africa, the greatest amount of start-up financing in recent years has been in fintech, particularly in Nigeria but also in places like Kenya, Egypt and South Africa. This has not only improved payments and transfers, enabling businesses and households to engage in digital transactions. It has also provided a mechanism for working capital availability in capital-scarce markets.

These trends have been building for the last couple of decades, powered initially by telecommunications links. Safaricom and Mpesa in Kenya were the groundbreakers, inspired by some of the innovations and reforms that countries like Bangladesh introduced in the 1990s as cell phone usage spread and microfinance emerged as a force.

Leapfrogging based on technological developments is not new—many ex-socialist countries like Hungary bypassed the introduction of checking systems when the Wall came down and moved on to more efficient payment and transfer systems in the 1990s. Brazil, one of the largest countries by land mass in the world and with a substantial population, likewise has been a pioneer in payment systems. India and China have also made major advances in these areas in recent decades. 

For small business, these developments are relevant because of the choice and possibility of access to non-bank alternatives. However, there are some catches for small business, which means that fundamentals in financial management and planning are inescapable.

• • First, alternatives are usually funded by investors. This means investors also have choices on how and where to invest to achieve return targets. Therefore, SMEs are only one category of investment options these investors have. In this regard, SMEs are competing with households, because of the vast markets for housing and consumer finance that exist, in addition to competing with corporate and government segments of the economy.

• • Second, competition with government is a challenge for SMEs. As governments run up debt, they require financing. Domestic banks are typically a major source, which means the old thesis of “crowding out” still echoes across the globe in many if not most markets. It is easier and less costly for banks to purchase government securities than to lend. It is also safer in terms of meeting regulatory capital and liquidity requirements.

• • Third, because SMEs are perceived to be higher risk, they are charged more for credit than governments and large corporates.  The OECD recently showed SMEs typically pay at least 100 basis points more for loans than do larger firms.

• • Fourth, SMEs also have to provide collateral for loans in most cases, which is harder in the absence of owned property, plant and warehousing facilities. Machinery and equipment have lower depreciated values, and are less useful as collateral for bank loans. Yet small businesses typically show an asset profile heavily oriented to inventory, machinery and equipment, not the kind of assets that are of high value in an insolvency or default scenario.

There is more to the story, but this provides a snapshot of challenges for small business. The bottom line here is that alternative financing offers choice across the board, which is beneficial to markets and small business. However, small business needs to compete for access, and ultimately be able to afford such access. Otherwise, there is less market activity, which has been true in recent years based on OECD and other data.

My next newsletter post will show the impact of higher interest rates on small business, and why so many decide to not borrow at higher rates. After all, when small business is offered credit or other financing, the terms may not always be acceptable. This is why the newsletter has a reference to the Pecking Order Theory in its title.

Thank you, and have a good month. You can reach me on LinkedIn or on my website: borish.com