There is a pill for just about everything today, but the largest problem facing most small business entrepreneurs requires a much more invasive procedure – plastic surgery.
The Use of Credit Card Debt by New Firms, a report released in August by the Kauffman Foundation, found that those startups which relied more heavily on credit card financing were more likely to fail. How likely?
Well, during its first three years, for every $1,000 dollars in credit card debt there was a 2.2% increase in the likelihood that the small business would be forced to close its doors.
The study points out that there are numerous reasons why new businesses fail, but proves that credit card debt plays an important role.
This study shows that credit card debt does play a role in business closure in the first few years of operations. And, while it is not the only determinant of a business’s stability, it appears to be an important factor in a firm’s likelihood to survive.
Why Credit Card Debt is So Appealing
Over the past several years, credit card companies have slowly replaced traditional lenders to small business. In fact, they are now the top lenders. Nearly 6 out of every 10 small business startups use credit card debt to finance the launch of their company.
The report lists multiple reasons why credit card debt is so appealing.
- It helps small businesses manage their finances and streamline payments.
- Credit cards are easier to get than traditional bank loans or government business grants. It
- does not require a business plan, or
- months waiting for the loan to be approved.
- It’s useful for smoothing revenue streams, especially at the startup phase of operations.
- Credit Cards are accepted everywhere. A variety of supplies or even cash can be obtained with one.
- Credit cards are a somewhat anonymous funding source. Unlike other types of loans (those from family, friends, banks, etc.), credit card companies will never ask where their money went.
Why Credit Card Debt is So Dangerous
Whenever we take on debt as small business owners, we also assume the risk and restrictions that the debt places upon us. So why single out credit cards?
Credit Card Debt is Expensive
The main problem with credit cards is that they are an expensive way to finance a business. Interest rates on personal and business credit cards average around 15 percent and can be above 30 percent in extreme cases.
Credit Card Debt Undercuts Successful Business Principles
Two of the items above that make credit cards so appealing do so because the undercut two important business principles – planning and accountability.
First, traditional lenders require small business owners to submit a business plan, but credit card lenders do not. Sadly, without this requirement, many small business entrepreneurs never write a business plan thus increasing their odds of failure.
Second, since credit cards companies never ask where their money went, small business owners lose the sense of accountability and restrictions that come with traditional loans. Given the anonymous nature of credit card spending, small business entrepreneurs are more likely to make unwise purchases.
How Plastic Surgery Helps Small Business Owners Succeed
The study found that 58% of new businesses relied on credit cards to finance operations during their first year of business. Nearly 1/3 of these businesses carried a revolving balance, and at the end of 2004 (the first year of the study) had an average balance of $3,500 across all businesses. Of those that had a balance, the average balance was about $11,000.
When the study looked at the next two years, it showed that …
credit card debt increases and then eventually stabilizes to a manageable level during many firms’ first few years of operation, while firms with high-credit-card debt close and successful firms start paying off their debt.
It is those companies that undergo plastic surgery by cutting up their credit cards and paying off the balances that survive. Unfortunately, the report does not show the results for those companies that refuse to use credit card debt at all.
Small Business Owners Likely to Keep Using Credit Cards
The sad truth is that, despite the findings of this study, the use of credits cards by small business owners is likely to only increase. There is a perfect storm brewing that will swallow up many small business entrepreneurs if they are not careful.
What is this perfect storm?
- The appeal of credit cards has not changed.
- Credit card companies are stepping up their efforts to market credit cards to small business.
- Lack of alternative financing for small businesses in this economic climate.
Consider the following statement from this report …
With the recent contraction of credit markets, many new businesses will face difficulties in accessing traditional forms of credit, which likely will create greater demand for credit cards.
Combined that with this statement from the same report …
While credit card debt provides needed short-term funding, reliance on this type of financing may lead many businesses into a long-term liquidity drain that affects their financial stability—and thus survival.
If these two statements prove to be true, it will not be good news for small businesses.