START-UPS THAT GET BUSINESS LOANS MORE LIKELY TO SURVIVE
Start-up firms that take out loans in the name of the business in the initial year of operation, as opposed to personal debt obtained in the name of the firm’s owner, are significantly more likely to survive and achieve higher levels of revenue, according to a new study by faculty at Florida Atlantic University’s College of Business.
The research study, published by the Journal of Corporate Finance , analyzed the relation between different forms of debt financing at the firm’s start-up and subsequent firm outcomes. The researchers distinguished between business debt, obtained in the name of the firm, and personal debt, obtained in the name of the firm’s owner and used to finance the start-up firm. They found start-up firms with better performance prospects are more likely to use debt and, in particular, business debt.
“If you go to borrow $100,000 from the bank to start your business the bank’s evaluating your business, picking winners and losers,” said Rebel Cole, Ph.D., author of the study and the Kaye Family Endowed Professor in Finance at FAU.
As part of this process, Cole explained, the bank is asking: Is this a good firm? Is this a good prospect? Are you going to be able to repay this loan?
“And then after he makes the loan he’s got skin in the game, so he’s going to monitor you and mentor you,” Cole said. “So it makes sense if you can get a business loan that you’re going to have superior outcomes. And that’s exactly what we find.”
Cole and study co-author Tatyana Sokolyk of Brock University found that firms that borrow in the owner’s name actually do worse in terms of future revenues, so it’s actually a negative to use personal credit to finance a business. That makes sense, Cole said, because the owner only has so much debt capacity and if they’re using their own credit line at the start-up it can quickly get tapped out.
“If you then try to get a small business loan you’re probably not going to get one,” Cole said. “You’ve already tapped out your personal line of credit, so you’re not going to be able to invest and grow.”
Much like a young person who just started their first job, a start-up business should establish a credit history, Cole said. Small businesses can apply for credit from a bank, which typically will issue a business credit card to the firm based on the owner’s personal credit score. Once the business establishes a credit history, it can apply for a traditional line of credit for a larger amount.
“We don’t talk about financial literacy for small businesses,” Cole said. “We don’t encourage firms to borrow just to establish a track record, but it’s an important thing. If you want to have that financial flexibility down the line you need to get a loan as soon as you can in the name of the firm, so the firm is getting a public track record.”