Examines Kauffman Firm Survey data for credit card debt characteristics of small startups and whether and to what extent they affect the firms' survival rates. Explores average balances over three years and links between debt amounts and survival rates

Robert H. Scott III

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August 2009Sixth in a series of reports using data from the Kauffman Firm SurveyThe Use of Credit Card Debt by New FirmsKauffman Firm SurveyThe 20042005200620072008200920102011Prepared By:Robert H. Scott, IIIAssistant Professor of Economics and FinanceDepartment of Economics and Finance,Leon Hess School of BusinessMonmouth UniversityAugust 2009© 2009 by the Ewing Marion Kauffman Foundation. All rights reserved.Kauffman Firm SurveyThe 20042005200620072008200920102011Sixth in a series of reports using data from the Kauffman Firm SurveyThe Use of Credit Card Debt by New FirmsPrepared By:Robert H. Scott, IIIAssistant Professor of Economics andFinanceDepartment ofEconomics and Finance,Leon Hess School of BusinessMonmouth UniversityThe author acknowledges the financial support of the Ewing Marion Kauffman Foundation through a small grantand access to the KFS data in the NORC Data Enclave. Any opinions, findings, and conclusions or recommendationsexpressed in this material are those of the author and do not necessarily reflect the views of the Kauffman Foundation.T H E  K A U F F M A N  F I R M  S U R V E Y: T H E  U S E  O F  C R E D I T  C A R D  D E B T  B Y  N E W  F I R M S 1EXECUTIVE SUMMARYThis report uses data from the Kauffman Firm Survey (KFS) to study the credit card debt characteristics ofnew firms.1 It specifically investigates whether revolving credit card debt reduces a firm’s probability ofsurvival. More than half of all new firms rely on debt financing when starting operations. A vast majority ofthese businesses rely on credit card debt to fill any equity gap. This debt financing strategy can be veryexpensive. While credit card debt provides needed short-term funding, reliance on this type of financingmay lead many businesses into a long-term liquidity drain that affects their financial stability—and thussurvival. Credit Cards’ Role inNew Business FinancingSmall businesses play an integral role in the U.S.economy. They employ roughly half of all private-sector workers and, each year since the mid-1990s,small businesses were responsible for creatingbetween 60 percent and 80 percent of new jobs(Kobe, 2007). This is not surprising, considering thatduring this same period an average of more than550,000 new businesses were created annually inthe United States. It is important, therefore, to studynew businesses and identify the primary factors thatmost influence their success or failure. Shane (2008)estimates that 45 percent of new businesses survivefive years. The three-year survival rate for new firmsin the Kauffman Firm Survey is 78.5 percent.2 Oneof the most commonly cited reasons businessesclose is financial problems (Berger and Udell, 1998;Shane, 2008). New businesses have less access toformal credit markets  than established businessesdo (Blumberg and Letterie, 2008). As a result, creditcards have become a common form of new-businessborrowing. With the recent contraction of creditmarkets, many new businesses will face difficulties inaccessing traditional forms of credit, which likely willcreate greater demand for credit cards. Little isknown, however, about the effect that credit cardborrowing has on new firms. Examination of CreditCard Debt on SmallBusiness SurvivalThis study uses the longitudinal Kauffman FirmSurvey to investigate whether, and to what degree,revolving credit card debt affects survival rates ofnew firms in their first three years of operation.Studies have analyzed the reasons new businessesfail (see, for instance, Cressy, 2006; Esteve-Perez andManez-Castillejo, 2008; Shane, 2008); however,none have specifically examined the influence thatcredit card debt has on new businesses in their earlyyears of development.This report focuses on small businesses, which arethe most common type of business opened in theUnited States (e.g., coffee shops, Web sitedevelopers, etc.). The KFS is especially usefulbecause it captures young businesses, regardless of1. Because borrowing terms (interest rates, fees, etc.) are similar between personal credit cards and business credit cards (Manning, 2000), thisanalysis combines the two so that the term “credit cards” encompasses both types. 2. The Kauffman Firm Survey data were collected in 2005 on businesses that started in 2004. So, it is possible that some businesses started andclosed in 2004 that are not represented in these survival figures. The survival figures for businesses in these data, therefore, will likely be upward biased.T H E  K A U F F M A N  F I R M  S U R V E Y: T H E  U S E  O F  C R E D I T  C A R D  D E B T  B Y  N E W  F I R M S2whether they are self-employed individuals or limitedliability corporations, meaning the KFS capturesemployer and non-employer businesses (Reedy andRobb, 2009). For example, nearly 60 percent of thebusinesses in the baseline (2004) have zeroemployees, and 82 percent have two or feweremployees. Small businesses with few (or no)employees are the type of businesses most likely toaccumulate credit card debt. A recent estimate ofthe average cost to start a new business fromscratch is about $31,150 (in 2008 dollars), althoughwe know this varies widely by industry (Shane,2008). In the Kauffman Firm Survey data, medianstartup expenses for firms that started operations in2004 were $20,182 (in 2008 dollars). From 2007 to2008, about 92 percent (25 million) of smallbusiness loans in the United States were microbusiness loans (business loans of less than$100,000), most of which came in the form ofbusiness credit cards. Only 8.1 percent (2.2 million)of small business loans were between $100,000 and$1 million (SBA, 2009). The frame for the KFS was the Dunn & Bradstreetdatabase of new businesses started in 2004. Firmswere screened to ensure that they started in 2004.The sample includes businesses that were created bya person (or group of people), or those purchased asa franchise. Therefore, the sample eliminatesbusinesses already in existence, inherited businesses,and not-for-profits. Each business’s originalentrepreneur (primary owner) was surveyed using anonline Web survey or a telephone survey. A total of4,928 businesses were included in the baseline(2004) dataset (DesRoches and Robb, 2008). Thisstudy uses the KFS data from the baseline and firsttwo follow-up surveys, which cover 2004 through2006. Benefits andDisadvantages of CreditCard FinancingUnited States pop culture is filled with manyexamples of creative entrepreneurs using credit cardsto jumpstart their businesses. Spike Lee’s first moviewas funded by maxing out his credit cards, whichresulted in launching his career as a director. TheBlair Witch Project, a film that grossed more than$250 million, was funded almost exclusively withcredit card debt totaling around $35,000 (Manning,2000). It is not surprising that these types ofbusiness ventures would rely on credit cards. Credit cards are appealing to small businesses fora number of reasons. First, they help smallbusinesses manage their finances and streamlinepayments. Second, they are easier to get thantraditional bank loans or government businessgrants; getting one does not require a business planor months waiting for the loan to be approved.Third, they are useful for smoothing revenuestreams—especially at the startup phase ofoperations. Fourth, they are accepted almosteverywhere. So, a variety of supplies and even cashcan be obtained with credit cards. Finally, creditcards are a somewhat anonymous funding source.Unlike other types of loans (those from family,friends, banks, etc.), credit card companies will neverask where their money went. They are mainlyconcerned with a credit card user’s ability to make atleast the minimum payment. The main problem with credit cards is that theyare an expensive way to finance a business. Interestrates on personal and business credit cards averagearound 15 percent and can be above 30 percent inextreme cases (Manning, 2000). New Businesses thatStabilize Debt Are MoreLikely to SucceedTable 1 shows the demographics of newbusinesses in the baseline data. About 58 percent ofnew firms relied on credit cards to financeoperations in their first year of business. Nearly 33percent of these businesses carried a balance ontheir credit cards through 2004. At the end of 2004,the average outstanding credit card balance amongall small businesses was about $3,500. Forbusinesses that had outstanding credit card debt,the average balance at the end of 2004 was about$11,000.T H E  K A U F F M A N  F I R M  S U R V E Y: T H E  U S E  O F  C R E D I T  C A R D  D E B T  B Y  N E W  F I R M S 32004(baseline) NVariablesAverage revolving credit card debt balance $3,559 4,928Used credit card debt to start business 57.9 4,886Firms with one owner 60.8 4,919Firms with two owners 27.1 4,919Firms with three owners 6.3 4,919Firms with more than three owners 5.8 4,919Number of employees 0 58.8 4,8231 14.4 4,8232 8.6 4,823>3 18.2Median revenue from sales $40,000 2,602Previous new businesses started by primary owner 0.97 4,912Age of primary owner 44.9Years of experience (in same area as new small business) 11.7 4,913Gender (male) 68.5 4,919Race of primary owner White 82.2 4,928Black 9.1 4,928Other 8.7 4,928Education of primary ownerNo high school diploma 2.5 4,928High school diploma 18.6 4,928Some college 31.0 4,928College degree 29.7 4,928Post-college degree 17.9 4,928Table 1 Descriptive results for all new small businesses in baseline Kauffman Firm Survey, 2004Note: Sample weights appliedAs shown in Table 2, in 2004 those businessesthat closed had less credit card debt ($2,365) thanbusinesses that survived ($3,638). This averageincreases 40 percent by 2005 for surviving firms andincreases 190 percent for businesses that closed.However, by 2006, the one-year change in creditcard debt balances for surviving firms was amarginal 1.8 percent gain; but for firms that closed,their average balance actually decreased by 18.5percent. These findings suggest that credit card debtincreases and then eventually stabilizes to amanageable level during many firms’ first few yearsof operation, while firms with high-credit-card debtclose and successful firms start paying off their debt. T H E  K A U F F M A N  F I R M  S U R V E Y: T H E  U S E  O F  C R E D I T  C A R D  D E B T  B Y  N E W  F I R M S4Credit Card Debt AffectsLikelihood of SurvivalA multivariate regression model was developedand tested using the KFS data (not shown), whichfound that credit card debt reduces the likelihoodthat a new business will survive in the first threeyears of operation. The results, which werestatistically significant, found that every $1,000increase in credit card debt increases the probabilitya firm will close by 2.2 percent. No relationship wasfound, however, between using credit card debt tostart a business and that business’s survival orclosure. Many factors explain why new businessessucceed or not. The growth in credit card useamong small businesses has raised the question ofwhether firms with credit card debt were less likelyto survive during their beginning stages ofdevelopment. This study shows that credit card debtdoes play a role in business closure in the first fewyears of operations. And, while it is not the onlydeterminant of a business’s stability, it appears to bean important factor in a firm’s likelihood to survive. 2004 2005 2006Average year-end credit card debt balance $3,638 ($2,365) $5,099 ($6,861) $5,191 ($5,595)Used credit card debt to start business 58.4 (50.9) 58.5 (61.2) 57.6 (59.0)Median revenue from sales $43,000 ($20,000) $85,000 ($30,000) $109,645 ($45,000)Percentage of firms survived 93.9 93.1 91.5Cumulative percentage of firms survived 93.9 86.9 78.5Table 2 Descriptive results for new small business that survived and those that closed, 2004–2006Note: Businesses that closed in parenthesis. Sample weights applied.© 2009 by the Ewing Marion Kauffman Foundation. All rights reserved.Kauffman Firm SurveyThe 20042005200620072008200920102011REFERENCESBerger, A. N., and G.F. Udell (1998). The economics of small business finance: The roles of private equity and debtmarkets in the financial growth cycle. Journal of Banking & Finance, 22 (6), 613–673.Blumberg, B. F., and W.A. Letterie (2008). Business starters and credit rationing. Small Business Economics, 30 (2),187–200.Cressy, R. (2006). Why do most firms die young? Small Business Economics 26 (2),103–116.DesRoches, D., and A. Robb (2008). Kauffman Firm Survey (KFS)—Baseline/first/second follow-ups: Study Metadata documentation. SSRN. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1024312.Estevez-Perez, S., and J. Manez-Castillejo (2008). The resource-based theory of the firm and firm survival. Small Business Economics, 30 (3), 231–249.Kobe, K. (2007). The small business share of GDP, 1998–2004. SBA Office of Advocacy.http://www.sba.gov/advo/research/rs299tot.pdf.Manning, R. D. (2000). Credit card nation: The consequences of America’s addiction to credit. New York, N.Y.:Perseus Books Group.Reedy, E. J., and A. Robb (February 2009). Comparisons between the Kauffman Firm Survey and other businessdata sources. SSRN. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1352601.Shane, S. (2008). The illusions of entrepreneurship: The costly myths that entrepreneurs, investors, and policymakers live by. New Haven, Conn.: Yale University Press.Small Business Administration. (May 2009). Small business and micro business lending in the United States, fordata years 2007–2008. SBA Office of Advocacy. http://www.sba.gov/advo/research/sbl_08study.pdf.4801 ROCKHILL ROADKANSAS CITY,  MISSOURI  64110816-932-1000www.kauf fman.org0809PRINTERQTY

The Use of Credit Card Debt by New Firms

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The Use of Credit Card Debt by New Firms

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