Tight Credit Puts The Squeeze on Small Business

The main pump for the economy is not being primed.

The credit crunch that has defined the financial meltdown threatens to derail small business activity in the United States. Many small firms rely on credit for everyday operations because they lack the liquidity to fund their business activities. And, potential startups may remain stillborn as entrepreneurs find it increasingly difficult to obtain necessary seed money.

Many economists predict the credit crunch will lead to higher unemployment because, overall, small companies create many more jobs than do big corporations. But faced with rising health care costs, increasing costs of production, a cutback in demand because of the soft economy, lack of consumer confidence and precipitous decline in bank lending, many are expected to cut back on jobs or close their doors completely.

At press time, most economists were forecasting a severe recession in the United States that would have a dramatic impact on small businesses because they often lack extensive capital resources to weather a liquidity crisis. Turning to credit cards to get over the hump could only make things worse for these firms, management experts said.

The U.S. Small Business Administration reports that companies with 500 or fewer workers pay nearly 45 percent of the U.S. payroll for nongovernment employees. The agency has a complex formula for defining small businesses, but most observers define these firms as not being dominant in their industry, being independently owned and having either fewer than $5 million in annual sales or fewer than 500 employees.

This credit crunch, economists say, is substantially bigger and more complex than the last major financial crisis: the savings and loan (S&L) bailout of 1989 and the recession that followed a year later. Back then, most of the carnage occurred at thrifts, financial institutions originally chartered to make home mortgages but that became involved in risky, high-yield loans. Commercial banks generally did well then as did big stock brokerage houses.

The price tags also were much smaller, maybe as much as $200 billion to cover the cost of about 1,000 failed S&Ls, historians estimate. By contrast, what many think of as the Wall Street bailout will cost a minimum of $700 billion, a figure that does not include shoring up Fannie Mae and Freddie Mac with combined assets of more than      $2 trillion. In an unprecedented move, the U.S. government began directly investing some  $200 billion in commercial banks.

With the great S&L debacle, family homes lost value in some key states such as California and Texas, but no massive wave of foreclosures spread across the nation as with the meltdown of 2008. Also, at that time lending did not come to a screeching halt the way it did in the fall of last year when commercial banks would not even lend to each other, prompting a coordinated response from the United States and its major trading allies to inject new capital.

Small businesses are coping with the crisis by tightening their belts. They are cutting back on marketing and advertising, delaying new hires, keeping inventories low and reducing health coverage for employees.

Mike McFarland is happily out of step with many of his colleagues in the nation’s small business community. While the credit crunch is wreaking havoc on small companies throughout the United States, McFarland’s Acree Technologies Incorporated is sailing ahead, thanks to several ongoing federal contracts.

Based in the Bay Area suburb of Concord, California, Acree provides research and development for specialty coatings that protect critical metal parts such as engine impellers from damage such as high-pressure exposure to sand and dust. It is this expertise that has landed Acree several federal contracts that encompass all branches of the Defense Department as well as the Defense Advanced Research Projects Agency and the Department of Energy.

Armed with a doctorate degree in physics from the University of California at Los Angeles, McFarland seems like the quintessential high-technology entrepreneur. Less than five years ago, he and a friend founded Acree in McFarland’s garage at his modest Oakland Hills home with sweeping views of the San Francisco Bay. Each ponied up $20,000 in savings and incorporated the company by dividing equity shares in the enterprise.

Six months later, the firm moved 25 minutes northeast to Concord and signed a lease on 2,000 square feet of space. With the company having grown to six employees and $1.3 million in annual revenues, McFarland, a former carpenter who is the firm’s chief executive officer, relocated the company to a light-industrial space with 6,000 square feet, yielding more room for anticipated expansion.

If McFarland is worried that he expanded into a declining market brought on by the meltdown on Wall Street and the evaporation of loans to businesses and individuals, he certainly does not sound like it.

 “A lot of people are being hit by the credit crunch,” McFarland says. “Right now, I see no impact on us because most of our contracts are either phase one type contracts or phase two. Phase ones tend to be six to nine months, and phase twos tend to be two-year contracts.

 “Our funding right now basically is fairly stable,” he continues. “These contracts are in place, and we just got two more that go for nine months each. The nice thing about the government is that even if they are broke, they still print money and give it to you somehow. When you sign a contract with the government, as far as I know, you are pretty much guaranteed to get paid.”

For his part, McFarland hopes to reduce his reliance on federal funding by obtaining more commercial contracts as a hedge against budget cuts, tax increases or a combination of the two. “I can see where maybe a year from now there will be less funding for the type of work we do,” he says. “That will probably start to dry up a little bit. It’s probably going to become more competitive, more companies going after fewer dollars.”

Actually, economic observers note, small business was one of the bright spots in the economy going into fall 2008. The ADP National Employment Report stated that employment nationally had declined by 98,000 people, but companies with fewer than 500 employees increased their employment by a net 137,000 positions.

However, that trend changed dramatically in the fourth quarter with a surge of layoffs at small companies, which left this segment with a net decline of several thousand jobs. The exact figure was not available at press time.

The National Small Business Association, a Washington, D.C., trade group, states that nearly half of all private sector workers in the United States—about 70 million people—work for or operate a small enterprise. Over the past 15 years, this segment of the economy created nearly 22 million jobs, compared with 1.8 million for large companies, the trade group says. Even before the financial meltdown last fall, the association warned of ill effects of a credit crunch.

The organization said a member survey found the proportion of small business owners with access to bank loans fell to a 14-year low, with 368 banks dropping out of programs fostered by the Small Business Administration. Forty-four percent of respondents reported using credit cards as a primary source of financing, and terms were growing worse.

“I don’t think people really appreciate what frozen credit markets mean to small business,” says Robert Fowler, president and chief executive officer of the Small Business Association of Michigan in Lansing. “There are a lot of small businesses that run on credit every day.

“Lots of companies use short-term credit because they may have accounts receivables but have current bills or payroll to make. We have talked with a couple of our member companies who are talking about not making payroll. When you don’t make payroll, you are in big trouble. I don’t think the full impact of this situation has been appreciated yet.”

Fowler predicts small businesses will drastically reduce or even eliminate health care coverage for their employees. He says they also will try to improve cash flow by billing clients early and paying invoices later than usual.

Karen Schnatterly, a management expert and business professor at the University of Missouri-Columbia, says the liquidity crisis and consequent downturn may have an especially dramatic impact on would-be entrepreneurs exiting the corporate world and looking to start their own firms. In previous recessions or economic slowdowns, managers who were laid off or offered early retirement or corporate buyouts would decide to start their own companies, fueling the next round of job growth.

Many entrepreneurs will take out second mortgages on their homes to capitalize their companies, Schnatterly observes. But with falling home prices and tight credit, many will not have this typical access to funds. Taking cash advances on credit cards also will become more difficult, especially for those who do not have nearly perfect credit scores.

Schnatterly’s advice is very simple. “Don’t panic,” she says. “Trying to drill down to a silver lining, I think there is a chance to re-examine your business model: how do you make money and are you doing it as efficiently as you can. And the answer to that is usually not as efficiently as possible.

“And if you do manage to survive this period, it means you will be better positioned for rapid growth once we do get a recovery—and we will get a recovery. It’s just not imminent.”

Web Resources
Acree Technologies Incorporated: www.acreetech.com/index.php
National Small Business Association: www.nsba.biz/