THE ROLE OF CREDIT CARDS IN PROVIDING FINANCING FOR SMALL BUSINESSES David G. Blanchflower, Dartmouth College David S. Evans, NERA Economic Consulting 77 78 The Role of Credit Cards in Providing Financing for Small Businesses 1. INTRODUCTION When Mark Fasciano and Ari Kahn started their software company, FatWire, in 1996, each of them contributed $20,000 from their credit cards to pay for the equipment and services that the company needed. In 2001, the company was named to Deloitte and Touche’s Fast 50 list of rapidly growing technology firms in New York. Today the company generates $10 million in annual sales, and its newest clients include Crown Media, Hallmark Channel, Bank of America, Andersen Windows and Aventis Behring.1 Business successes like these have helped the U.S. economy grow. Small businesses provide most workers with their first jobs and initial on-the-job training in basic skills and employ more than half of the private work force.2 Stories like FatWire’s abound.3 Financing a business is difficult, and entrepre- neurs tend to resort to credit cards for financing when other loan sources are scarce. Personal credit cards provide an increasingly large pool of capital for small business startups. Credit cards did not even exist in their current form before 1966. They have grown explosively since the end of the 1981-1983 reces- sion. According to data from the Survey of Consumer Finances (SCF), which is discussed in more detail below, the amount of credit card financing available to the American public was $1.5 trillion in 2001.4 That pool of credit was just as available to people to start their own businesses as it was to buy stereo equip- ment. Indeed, $298 billion of credit card financing was available to households headed by someone who had their own business in 2001. And, of course, credit cards have continued to grow since 2001 so that the amount of credit card financ- ing available to consumers in general and small business owners in particular is even larger today. Of course, stories of credit cards helping people to start successful businesses do not show that credit cards are an important source of financing any more than stories of successful businesses started in garages show that having a garage is key to business prosperity. This paper examines the role of credit cards in financing small businesses using two sources of data. The SCF provides general 1 Bridget McCrea, Masters of Survival, Fortune Small Business, December 21, 2002. 2 Id. 3 See id. See also John Tucker, More Businesses Start Up on Plastic Entrepreneurs Use Credit Cards to Get Set Up, The Idaho Statesman, December 28, 1997, at 1e.; and John Pletz, Need Capital? Just Charge It, Indianapolis Business Journal, October 27, 1997, at 39. 4 The SCF survey has strengths and weaknesses. It provides data on the use of credit cards from a random sample of the population along with extensive detail on the socioeconomic characteristics of these house- holds, but the data people report to survey takers often are not completely reliable. For example, people tend to understate the amount of debt they have. So the SCF is not the best source of data, for example, on the total bankcard debt of the American public—Visa and MasterCard have more reliable information—but the SCF is the best source of data for making comparisons between different segments of the public. Other esti- mates place the amount of credit available at over $4 trillion. David G. Blanchflower and David S. Evans 79 information on the use of credit cards by small business owners from 1970-2001. The 1998 Survey of Small Business Finance (SSBF) provides detailed informa- tion on the use of credit cards by small businesses in that year. Together, these data sources provide a broad and deep understanding of how small businesses use credit cards.5 II. CREDIT CARDS AND SMALL BUSINESSES Before we get into our main story, it is useful to say a few words about our two protagonists. We begin with credit cards and then turn to small businesses. A. Credit Cards Credit cards are available from four systems—two associations of banks and two proprietary companies.6 The bank associations are Visa and MasterCard. Member banks of these associations issue cards under those brand names.7 Discover Financial Services is a proprietary company that issues the Discover and Private Issue credit cards.8 American Express is a proprietary company that issues the Optima and Blue credit cards.9 In addition to personal credit cards, American Express, MasterCard and Visa have developed credit card products that are targeted towards small businesses, as we discuss in part B below. B. Small Businesses There are many different ways of defining small businesses.10 The U.S. Small Business Administration defines small businesses as those with fewer than 500 5 This paper focuses only on payment cards that provide lines of credit. Certain cards, such as the American Express Corporate Card and the Visa Purchasing Card enable businesses to charge purchases but not to finance these purchases (except for the interest-free loan between the date of purchase and the due date for the monthly bill). 6 See David S. Evans, “The Growth and Diffusion of Credit Card Society,” The Payment Card Economic Review: The Industry and Its Legal Challenges, Volume 2, Winter 2003. See also David S. Evans and Richard L. Schmalensee, Paying with Plastic, The Digital Revolution in Buying and Borrowing (MIT Press, 1999) for more details on credit cards and their role in the economy. 7 The term “bank cards” refers to credit cards issued by MasterCard and Visa. 8 Lisa Fickenscher, Dean Witter Discovered That New Card Strategy Required the Old Name, American Banker, October 16, 1998. See also Discover website (last visited February 24, 2003) <http://www.discovercard.com/discover/data/>, and Private Issue website (last visited February 24, 2003) <http://www.privateissue.com/>. 9 See American Express website (last visited February 24, 2003) <http://www66.americanexpress.com/cards/apply/jsp/fmac/i_know_which.jsp?csi=0/20/b/2/0/05511073979/2 0/n&from=0>. 10 For general background on small businesses, see William A. Brock and David S. Evans, The Economics of Small Businesses: Their Role and Regulation in the U.S. Economy (New York: Holmes and Meier, 1986). 80 The Role of Credit Cards in Providing Financing for Small Businesses employees. According to that definition, there were roughly 26 million non-farm small businesses in the United States in 2001.11 Small businesses, those with less than 500 employees, accounted for 99 percent of all businesses that year.12 Another way of defining small businesses is by type of business organization. There are four major types of business organizations for tax purposes. C corpo- rations file 1120-C tax returns with the Internal Revenue Service and pay taxes on corporate income. Sole proprietorships are unincorporated businesses that have a single owner, who reports his business earnings as part of his personal tax return. Partnerships have several owners, each of whom has a financial interest in the business and reports his business earnings as part of his personal tax return. S corporations do not pay tax on their income; instead, income and expenses are passed through to shareholders. Only businesses with fewer than 75 sharehold- ers can obtain this often-preferred tax treatment. According to the SSBF, which contains data on businesses with less than 500 employees, approximately 20 per- cent are organized as C corporations, 49 percent as sole proprietorships, 7 per- cent as partnerships, and 24 percent as S corporations.13 Finally, people who say they are “self-employed” are small business owners. Many census surveys ask people whether they work for themselves (self- employed) or work for someone else (wage workers). The self-employed are generally people who own, sometimes with others, their own incorporated (C or S) or unincorporated (sole proprietor or partnership) business.14 The number of small businesses has grown considerably over time. The number of sole propri- etorships, partnerships and S corporations––which are comprised mostly of small businesses––rose from 6.9 million in 1970 to 22.2 million in 1999, while the number of C corporations rose from 1.4 million to 2.2 million. The number of self-employed individuals who work full-time for themselves grew from 8 million in 1970 to 10.6 million in 1995, then dipped to 9.7 million in 1999, and 9.6 in 2001.15 11 Small Business Administration Office of Advocacy, Small Business Economic Indicators for 2001, February 2003, at 3 (visited February 24, 2003) <http://www.sba.gov/advo/stats/sbei01.pdf>. 12 Id. at 11. 13 Although the large majority of non-S corporations are C corporations, the IRS recognizes several other types of businesses as corporations. Because the SSBF does not distinguish between these different types of corpo- rations, whenever we mention “C corporations,” this refers to “C and other corporations.” 14 The IRS recognizes many types of businesses as corporations, including joint-stock companies, S corpora- tions, insurance companies, and unincorporated associations such as business trusts. 15 These figures are based on Current Population Survey (CPS) data. David G. Blanchflower and David S. Evans 81 III. FINANCING SMALL FIRMS A budding entrepreneur has various resources for obtaining financing, ranging from personal savings to securing a loan from friends, family, a local bank, or a bank loan guaranteed by the Small Business Administration.16 Venture capital may be another source. Venture capital firms and other investors provided $18.2 billion of venture capital to American businesses in 2002.17 Friends and family do not necessarily require a high rate of return on their loans, but are often not able to provide the large sums of money needed to get a busi- ness off the ground.