Aug 27, 2020

Financing Small Business Creation in the Wake of COVID-19

Entrepreneurs seeking funds to start small businesses face a number of tough challenges
Brian Knight Senior Research Fellow

This is the first in a series of articles that will examine ways to help entrepreneurs who are seeking to start small businesses in the wake of the pandemic to access the capital they need. The second article in this series concerns offering small businesses guaranteed access to credit. The third article examines the rules governing investors in startups. The fourth article concerns easing restrictions on lending by small banks.

The COVID-19 pandemic is a natural disaster whose effects will be felt for years, in ways both obvious and subtle. While the health consequences of the novel coronavirus are significant and tragic, the economic consequences are also severe, especially for small businesses and those that rely on them for their living.

In an effort to slow the spread of the disease, local, state, and federal governments have mandated the reduction or cessation of economic activity. This, combined with a natural desire to limit possible exposure, has led many businesses—especially those deemed “nonessential,” those that support nonessential businesses, and those that rely on in-store sales—to see a significant reduction in activity and revenue.

Approximately 66,000 small businesses have closed since March 2020, many never to reopen. These closures are not mere statistics; they represent the loss of livelihood for millions of owners and their employees, the destruction of established business relationships among the customers and suppliers of the closed firm, and the disruption of community life. Further, concerns have been raised that this disaster will lead to greater concentration in the market because the firms that do survive (which tend to be larger, more sophisticated, and frequently better connected) will be able to fill the space left. To be sure, sometimes increased concentration can be beneficial, but it is not clear this is always the case.

While firm closure is natural and can lead, through what economist Joseph Schumpeter called the “gale of creative destruction,” to an economy that better serves people’s needs, it is not at all clear that the destruction caused by pandemic-related government lockdowns has been creative. Furthermore, in order for society to benefit from the opportunities created by this tragedy, we will need entrepreneurs to rebuild and replace what was destroyed, which means those entrepreneurs will need access to capital to start and build their businesses.

As a starting point, the preconditions for a functioning marketplace must be in place. Both entrepreneurs and those who might provide them with capital need to be confident that they will not face prolonged interruption of business because of either government action, as in the case of shutdowns, or inaction, as in the case of destructive civil disturbances. Uncertainty on these questions will likely force both would-be entrepreneurs and capital providers to stay on the sidelines until concerns are resolved.

But even with essential economic certainties in place, many potential new businesses will struggle to find access to the financing they need to get off the ground. Unfortunately, even in the best of times, raising capital for small businesses in the United States can be challenging. Part of this challenge is the regulatory burden faced by both businesses and providers of capital. Maximizing the ability of small businesses to recover capital that is available when entrepreneurs need it, and on terms they can live with, will be essential.

Bank loans have traditionally been one of the largest sources of capital for small businesses, and it is easy to see why. Banks have traditionally provided loans in a variety of amounts, and working with a bank allows entrepreneurs to use a process that is relatively straightforward both before and after receiving the money.

But, for a number of reasons, small business entrepreneurs may not be able to rely as much on bank lending as they once did. To begin with, banks in recent years have been scaling back their small business lending. For example, small business loans have declined from 40 percent of total bank loans in 1995 to 26 percent in 2012 and down to 21 percent as of 2016. And the small business loans that banks still make tend to be larger and to larger clients. This decline in lending to small businesses, coupled with the uncertainty caused by the pandemic, may make banks unable or unwilling to meet the needs of many entrepreneurs.

Another possible source of funding for small business, capital markets, presents even more challenges. Indeed, while the US capital markets are the envy of the world, they are also difficult for many small businesses to access, owing to both economic considerations and legal burdens. While some potential high-growth firms effectively utilize offering exemptions, and reforms undertaken in the wake of the 2008 financial crisis sought to lower the regulatory hurdle for smaller firms, the capital markets remain largely closed to most small businesses.

The government also serves as a source of capital through the Small Business Administration (SBA). In response to the pandemic, the SBA and Treasury Department, in partnership with bank and nonbank lenders, have distributed billions of dollars of loans through the Paycheck Protection Program and Economic Injury Disaster Loans. The government’s provision of capital to small businesses, both during the pandemic and in general, is controversial, however, with significant questions raised about its effectiveness and propriety.    

It is against this challenging backdrop that entrepreneurs must obtain the capital they need to save, start, and grow the businesses that will not only provide jobs, but also make an essential contribution to civic life. A small consolation is that COVID-19 has opened up the possibility of significant regulatory reform in other areas, and that same spirit may apply to the laws and regulations governing capital formation.

As already noted, this introductory piece is the first in series of articles commissioned by The Bridge at the Mercatus Center. In subsequent articles, a number of experts in academia, public policy, and industry will contribute their views on which discrete reforms can help make it easier for small businesses to obtain necessary capital. We have sought a variety of opinions across the political spectrum in the hope that these ideas can spark a debate on how to best support the much-needed resurgence of American small business.

Image Credit: RichLegg/Getty Images

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