Question

The Economics of Small Business Finance: The Roles of Private Equity and Debt Markets in the Financial Growth Cycle by Allen N. Berger and Gregory F. Udell

Synopsis

The article, The Economics of Small Business Finance: The Roles of Private Equity and Debt Markets in the Financial Growth Cycle by Allen N. Berger and Gregory F. Udell, discuss the economics of small business financing in private and debt markets. The article shows the sources of small business finance and how it is done by size and age of the business. The authors of the article examine the impact of the macroeconomic environment on small businesses and show the connection to small business finance. It looks at different parts of small business finance and the investors. The authors point out that small business finance should be viewed through a growth cycle and that most small businesses do not fit into this cycle. The article also provides an analysis of research and policy issues. Finally, the article talks about the importance of private equity to small business finance and the role of private debt markets to small business finance.

Critique

I agree with the authors argument that the capital structure changes with the size and age of the firm. The analysis of the article shows that the three main sources of all small business finance consists of the principal owner, commercial banks and trade creditors. Credit cards are not used very often by small businesses as only 1% of small businesses use them. What was left out of the article was the research of the effects of the availability and cost of small business finance of the creation of new firms and how they change over the business cycle as information processing technology improves. This information is useful to me as a small business owner that if I want to get financing, it would have to come from mainly from myself, family, commercial banks or trade creditors. If I use the commercial bank, I would have to expect to use personal collateral.

Discussion Questions:

1. How do you think small business finance may change over the course of the business cycle?

2. What are the effects of the availability and cost of small business finance on the creation of new firms?

3. How do you think small business finance will change over the business cycle as information processing technology improve?

Answer 1

Case 1

Business cycle has four stages.

Expansion Stage - First stage is expansion stage. In this stage the economy is growing at a faster rate and businesses are also doing well because of high consumption and income levels of the consumers. In this stage there is high rate of investment among firms irrespective of the size. Further, the inflation rate in this stage is low, that is around three to four percent. As a result, financing for the business is easily available through various sources of finance such as equity, debt and more.

For small businesses, finance is also easily available through banks with fair or less rate of interest to the borrowers. Small businesses can take loan from banks for the purpose of working capital, expansion of property or shops, buying some equipment or vehicles which is necessary for the business purposes and other.

Further, if the small business is a startup which is into a sector which have prospects of high growth rate then that small business can also take loan for expansion of the business from private equity. Generally private equity is considered risky as many private equity investments does not yield returns to the investors as expected. Thus, the rate of interest in private equity will be high in comparison to interest on borrowings from the commercial institutions. The benefit to the borrower in private equity will be, less terms and conditions in comparison to commercial institutions and high amount is available in comparison to commercial institutions. Furthermore, private equity investors also controls stake in small business with which they advice owners on various aspects of the business to grow smoothly.

Peak - Second stage is peak stage. In this stage the demand of goods in the economy are slowing down as well as growth in income levels of the consumers are slowing down. Inflation rate in this stage is generally high, in some cases it touches double digits. To control inflation central bank of the country increases the interest rates. As a result, the cost of capital for the businesses increases.

Because cost of capital for the business is increasing or are high, many businesses including small businesses avoid taking loans because cash flow from operations are not sufficient to pay high installments of the banks. However, many small businesses take loan in this stage but find difficulty in procuring the right amount they desired as well as terms and conditions of the lending institutions will be tough.

Contraction -Third stage is contraction stage. In this stage the inflation rates are high, growth in demand for goods in the economy is negative including growth in income levels. The cost of capital in this stage will be highest among all the four stages

In this stage finance for small businesses is negligible and are only provided as per case to case basis by the financial institutions. Sometimes in this stage to give cushion to the economy government intervenes and rollout many financing schemes for the businesses.

Further, many businesses which have taken loan on high rate of interest file for defaults as cash flow from operations are not sufficient to pay installment of the banks. Also in cases where small businesses have taken loan from private equity investors and are not able to pay required amounts of debt, in such cases private equity investors take control of the small businesses.

Trough - Fourth stage is trough stage. In this stage the growth in demand of goods and income levels is around zero to one percent instead of negative. The economy shows signs of recovery or expansion as employment rate in this stage starts to going up. In this stage the inflation rate starts to going down due to which central bank decreases interest rates and cost of capital also starts to going down.

Many small businesses in this stage are able to pay their required amount of debts. As a result, they start investing in expansion of their businesses. Further, many new small businesses in this stage starts to come up but the amount of new small businesses in this stage will be less compared to expansion stage. Financial Institutions also provide loans to the small businesses at lower rate of interest in comparison to contraction stage and on better terms and conditions to the borrowers in comparison to contraction stage. In this stage, many private equity investors starts to invest into small business with huge amounts of investments.

Case 2

Availability of small business finance

There is a direct relationship between availability of small business finance and creation of new firms. If the availability of small business finance is higher than number of new firms will also be higher and vice versa. It can be attributed to the fact that many businesses required high amounts of working capital during initial stages of their businesses. If small business finance is easily available then they will not face shortages of working capital and they can carry on their business activities smoothly.

If small business finance is not easily available then businesses will face many difficulties such as paying to their suppliers, workers or employees, monthly electricity bills and more. As a result, many entrepreneurs will restrict themselves from starting new business or firms.

Cost of small business finance

There is a inverse relationship between cost of capital and creation of new firms. If the cost of capital for small businesses is high then the creation of new firms will be low and vice versa.

It can be attributed to the fact that many businesses require assets for revenue generation such as building, machinery, vehicles and more. If cost of capital is high then businesses will not able to buy such assets and generate sufficient amount of revenue and profits. As a result, the return on investments will go down. Many entrepreneurs will think that it will be better to invest their money into the banks rather than create a new firm and have lower rate of return on their investments with higher risk.

Case 3

As information technology improves small business finance will also be easily available and cost of capital for the business will also be adequate or fairly charged by the financial institutions.

It can be attributed to the fact that because of development in information technology many banks and commercial financial institutions will able to provide better customised finance to the small businesses. Further, due to development in information technology the processing of the applications for loan will also be faster and secure, due to which small businesses can obtain finance within a period of 1 to 2 days. The biggest benefit of this will be, small businesses will not able to face shortages in working capital and they will be able to meet the short term obligations on time.

With development of information technology many new short term business finance products will be provided by the banks or commercial financial institutions to the borrowers. With such products the borrower will not have to apply for the loan again and can directly take the required amount from the product availed to him.

Further, improvement in information technology will also decrease the processing time in banking transactions. As a result, financial transactions will be processed faster and in secured way. The turnaround time will be less and banks will not face liquidity problems in their branches. As there will be no liquidity problem, the bank will be able to provide high amounts of loan or to higher number of applicants.

Thus, improvement or development in information technology will have a positive effect on availability and cost of capital to small businesses irrespective of the stage of business cycle.