With Nonbank Loans, SMEs Just Won’t Budge

The U.S. Federal Reserve isn’t the only government body looking at how SMEs seek working capital. The Securities and Exchange Commission recently held its Advisory Committee on Small and Emerging Companies, where analysts presented new research on how small businesses are finding the money they need.

In a presentation at the event held late last month, Milkin Institute Associate Director of Financial Policy at the Center for Financial Markets Brian Knight laid out the findings of Milkin’s latest survey, which looked to provide a “snapshot” of how the typical SME finds working capital.

Co-authored with the National Center for the Middle Martket, Milken spoke with more than 600 small business owners in early 2015 to uncover how SMEs seek funding and why.

According to researchers, debt is the preferred method of outside financing for small business owners. Small businesses’ priorities when pursuing financing include ease of access to, and speed of receiving, the funding, as well as the certainty they hold when they evaluate where to go to find working capital.

While nearly one-third of businesses surveyed by Milken said they don’t plan to seek funding, another third said they plan to seek financing by applying for a bank loan.

Despite the hyped rise of alternative lending and online marketplace players, nonbank lenders were used by just 10 percent of small businesses surveyed in the last three years. That’s the same portion of businesses that turned to retained funds when they needed cash.

According to the report, the prevalence of traditional bank lending increases with the size of the company.

“While roughly one-third of small businesses rely on bank loans, the percentages jump significantly for middle-market companies,” the report said. “Close to half of firms with revenue of $10 million to $1 billion have used a bank loan to raise capital in the past three years.”

Researchers point to an array of factors that lead SMEs to migrate towards traditional banks instead of online lenders.

For one, banks often have the most longstanding and deepest relationships with clients compared to other funding sources, like newer online marketplaces or family offices. Researchers found that 77 percent of SMEs say a strong relationship with a financial institution is a key driver in their interest in bank loans — far surpassing other factors, like better loan terms.

Plus, more than 80 percent of small businesses said they believe that when they borrow from a bank, they’re doing so at around or below prevailing market loan rates.

But, as it turns out, SMEs are largely unaware that alternative lending sources even exist.

Less than a third of the companies surveyed said they were aware of nontraditional loan sources. For instance, just 19 percent said they knew about nonbank small business lenders, while only slightly more — 23 percent — said they are familiar with peer-to-peer lending options.

But it’s not just alternative lending that remains in the shadows for SMEs; according to Milken, government programs — with the Small Business Administration’s loan program taking the lead — are also largely out of mind among the SME community.

In fact, researchers found that only 5 percent of companies surveyed said they have obtained SBA financing in the last three years.

The reason? Red tape. More than one-fifth of SMEs said that the biggest challenge in obtaining an SBA loan was the bureaucratic process of it all. The second most common reason businesses shied away from the SBA, however, was simply that they were unaware that it was an option for them.

Overall, Milken found that small businesses in the U.S. are hesitant to try new things when it comes to accessing financing. The most common reason cited for this is that businesses feel they don’t know enough about alternative financing sources, while an additional 24 percent said that they are weary of what would be legal.

With alternative lenders still largely outside the regulatory scope, it may not be surprising that SMEs aren’t sure of the compliance risks of turning to a nonbank source of financing. About one-fifth of businesses also cited the risk of investor fraud, as well as concerns about not knowing the investors, as key reasons why they would be unwilling to use new financing methods.

The key to all of this might be transparency. With regulators like the SEC and Federal Reserve examining the alternative lending market and with alternative lenders themselves banding together with efforts to boost transparency in the industry through initiatives like the Small Business Borrower’s Bill of Rights, Milken’s next survey on small business borrowing habits may just see the figures budge a bit more on the side of nonbank financing.