For many, entrepreneurship means risking the promise of a stable income and benefits for a shot at greater long-term financial success. Yet, in an economy characterized by increasingly unpredictable income volatility—even within a single job—many individuals view entrepreneurship as a necessary tool to realize a more certain economic future. Particularly for entrepreneurs of color, business ownership holds the promise to reduce generations of financial disparity. In fact, a report published by the Association for Enterprise Opportunity and funded by the W.K. Kellogg Foundation reports that business ownership reduces the average wealth gap between black and white adults from a multiplier of 13 to a multiplier of 3.
Small business ownership’s promise of long-term asset generation is not without tradeoffs. Unexpected shortfalls in revenues or increases in expenses can be devastating to a young business, and recent research by the JPMorgan Chase Institute reveals that small businesses operate with tenuous cash reserves to cover these costs. In fact, the typical small business could only cover expenses for 27 days in the case of a financial emergency. For businesses in low-wage industries, that time window drops to 19 days.
The consequences of small business cash flow volatility extend to the business’ employees, as well. The JPMorgan Chase Institute found that most small businesses experience unstable payroll and employment volatility. Volatility in payroll outflows is highest for younger small businesses with employees, and those with more volatile payroll patterns tend to have fewer cash buffer days.
Building on unstable ground
Recent research commissioned by mission-based small business lenders Accion in the U.S. and Opportunity Fund (made possible with lead funding from the W.K. Kellogg Foundation and JPMorgan Chase & Co.) confirms that for many entrepreneurs, financial stability is equally important – if not more important – as business growth. Yet, as soon as a year after receiving their loans, many Accion and Opportunity Fund clients continue to cite finances as a key source of worry. Additionally, most business owners in the study said they are not prepared for a financial emergency. “It's a huge concern as a business owner, that something could just happen one day and it could really, really damage us as a young business,” said one Los Angeles entrepreneur.
Business cash flow volatility often has consequences for household finances. Most small business owners (76%) respond to cash flow challenges by using personal funds. This could mean drawing from personal savings, foregoing a personal salary or maxing out credit utilization limits, which can damage one’s credit score and impact opportunities to secure future sources of financing. (The majority of small business owners use personal credit scores to apply for business capital.) Accion and Opportunity Fund borrowers generally re-invest business profits into the business rather than the household – 55% of study respondents experienced an increase in business profits in the previous six months but only 30% increased their household savings over the same period.
When the solution is the problem
The declining availability of traditional small business credit means that fewer and fewer business owners have access to a critical source of working capital to help them withstand financial emergencies. The gap has also fueled the rise of high-cost alternative finance providers, which promise rapid access to funds that address business owners’ acute financing needs but can come at a cost. Because the industry is unregulated, there is broad diversity in the quality of these products from a consumer perspective—including variance in the level of effort made by the provider to disclose costly fees and pricing features and ensure that the customer can afford to repay the loan.
Often, small business owners find themselves in a cycle of debt after taking out a high-cost loan. In fact, approximately one in four small business loan applicants cite refinancing existing debt as their main reason for applying. Recognizing this trend in their own applicant pool, Opportunity Fund analyzed alternative loan contracts for 104 small business owners seeking relief from high-cost loan debt. Their analysis found that the average loan imposed an annual percentage rate (APR) of 94%. Further, the average monthly loan payment for business owners was nearly double their net income.
What is the role of mission-based lenders?
The challenges that arise from high-cost alternative loans illustrate that access to capital does not necessarily support economic prosperity. Even for those who access responsible finance products, financing is just one component of an entrepreneur’s journey toward long-term economic stability and resilience. What else should mission-driven lenders do to meet these challenges?
- Lending innovation: alternative finance products fulfill an important demand—to keep the doors open in the case of a pressing financial need. Mission-based small business lenders must better meet that immediate need before entrepreneurs turn to costlier options. For example, Opportunity Fund has a partnership with Lending Club that automatically pre-qualifies applicants for an Opportunity Fund loan, based on the data they provide through their Lending Club application. Accion is working with Common Cents Lab to use behavioral science research to help small business owners get through the application process, and is working with Salesforce, Cloud Lending and DemystData on a major innovation project to reach more business owners and improve the online application experience.
- Financial advising: Among those who participated in Accion and Opportunity Fund’s study, just over a half (54%) used a business financial plan. This illustrates the imperative of increased investment in financial advising that better equips business owners to plan for and manage financial emergencies while building long-term stability. Accion is working with the Center for Financial Services Innovation to better understand the barriers business owners face to adopting financial behaviors such as saving and business planning. These insights will be used to prototype, test and refine scalable solutions to help entrepreneurs overcome these barriers.
- Education: The financial landscape is convoluted and ever-changing, and entrepreneurs need support in navigating their options. Accion publishes 90+ online resources per year to help business owners build their business and financial skills. Opportunity Finance Network’s Venturize campaign, which helps small business owners understand their financing options, generated over 73 million impressions in its first year.
- Leadership: Advancing responsible lending practices is not just a moral imperative. It’s also a business imperative to ensure client satisfaction and business survival. That’s why more than 80 organizations—including for-profit and non-profit lenders, brokers and small business advocates—have signed on to abide by and promote the Small Business Borrowers’ Bill of Rights, a cross-sector consensus on the rights that small business owners deserve and what lenders and brokers should do to uphold those rights.
Business ownership is a powerful tool to foster inclusive economic growth. In order for that power to be realized, mission-based lenders must do everything in their power to ensure that the financial products and services available to underserved entrepreneurs are centered around their long-term success.
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