Article by Rob Mandelbaum | Found on Forbes
Business 101 teaches that entrepreneurs must begin almost immediately to build company credit. That advice has always rankled a certain breed of DIY business owners, the ones who find debt of any kind anathema. Now, though, a new study demonstrates that borrowing money confers a huge advantage on a new business — but only when the debt is in the company’s name. Companies financed by personal debt actually perform worse than those with no debt at all.
The findings are the work of finance professors Rebel Cole of Florida Atlantic University and Tatyana Sokolyk of Brock University in Ontario. Using data found in the Kauffman Firm Surveys, collected annually by the Kauffman Foundation from nearly 5,000 companies that began operating in 2004, the researchers have concluded that a company using a business bank loan to finance its start reported nearly twice as much revenue after three years as a startup of similar size that took on no debt. By contrast, that same company financed by personal debt — say home equity loan or personal credit card — had on average 57 percent less revenues than one that hadn’t borrowed. A company with business debt, then, generated on average more than four times as much revenue as one with personal debt.
Comparing survival rates, the researchers found that the chance of making it past three years was 19 percent higher for business borrowers than for companies without debt. The survival rate for businesses with personal debt was only slightly higher than for companies without any debt. There is a limit, though, to how much debt helps: the study finds that firms with more debt are also more likely to fail.
Cole and Sokolyk offer three possible explanations for their results. For one thing, they say, the businesses most likely to succeed are the ones that ask for bank loans in the first place. Applying for a bank loan consumes time and other resources, so going to the trouble signals the business is serious. But banks are also good judges of what makes a successful business. “If you’re able to get a loan in the name of the business, then the bank is actually taking a look at the business,” Cole explains. But then, having picked potential winners, banks “monitor them and provide mentoring to them” — which further improves borrowers’ performance.
But why does personal borrowing predict such poor performance — worse than taking on no debt at all? It could be a question of selection again, especially if banks are steering the losers toward personal debt. And Cole notes than an owner who immediately borrows from a personal line has less room to grow. “If a firm is borrowing in the name of the owner at start-up, then it has used up at least some of that debt capacity, whereas a firm that does not borrow in the name of the owner retains that debt capacity to use in subsequent years if needed,” he says. “The firm is capital-constrained from the beginning, and must spend less on investments that produce future revenues.”
The researchers can’t determine who is doing the selecting that matters most here: the banks picking winners and losers, or the businesses that choose to present themselves to banks in the first place. But Cole says entrepreneurs who skip the business loan and go straight to the home mortgage, either because they can’t be bothered to jump through the hoops or they figure they’ll ultimately be rejected, are doing themselves no favors.
“It’s really almost a story of financial literacy,” he says. “We still have millions of consumers who don’t have a credit score because there’s not enough information about them and their ability to repay a loan. Businesses are much worse, because there are far more of them that don’t borrow in the name of the firm. Probably half of them or more don’t have a borrowing track record.”
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