Did you know that companies financed by personal debt actually perform worse than those with no debt at all? A new study shows that borrowing money grants a huge advantage to new businesses – but only when the debt is in the company’s name.
A recent Forbes article highlighted the findings of finance professors Rebel Cole of Florida Atlantic University and Tatyana Sokolyk of Brock University in Ontario. These researchers used data found in the Kauffman Firm Surveys, collected annually from nearly 5,000 companies who have been operating since 2004. The findings conclude that companies using business loans to finance their starts reported nearly twice as much revenue after three years compared to that of a startup of similar size that took on no debt. By contrast, that same kind of company financed by personal debt (a home equity loan or personal credit card) had on average 57% less revenue than one that hadn’t borrowed. A company with business debt generated on average more than 4x as much revenue as one with personal debt.
The researchers also discovered a company’s survival rate after three years was 19% higher for business borrowers than for companies who were without debt. Cole and Sokolyk offer several possible explanations for their results.
- Applying for a business loan takes time and valuable resources. Making the commitment to apply for a business loan means the business and its owners are serious about the venture.
- If you qualify for a business loan, this is a good indicator that your business will be profitable. 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. Having picked potential winners, banks “monitor them and provide mentoring to them” — which further improves the borrowers’ performance.
So why are those companies borrowing from their personal pockets performing so poorly? It could be an example of survival of the fittest, where banks steer questionable enterprises toward personal debt. Cole also notes that an owner who immediately borrows from a personal line of credit has less room for growth. “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 study concludes that entrepreneurs who can’t be bothered to jump through the hoops of a business loan or assume they’ll be rejected for a loan aren’t doing themselves any favors. “It’s really almost a story of financial literacy,” Cole 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.”