Key Takeaway: Small business owners are more like consumers than big businesses, yet we expect small business owners to have the savvy of Wal-Mart or Microsoft, rather than of your friend or next-door neighbor. That’s especially problematic since applying for a small business loan can be complicated and opaque, and regulation protects consumers in lending transactions much more than businesses.
Politicians usually manage to get at least one thing right—small businesses really are the backbone of American society. The people agree—a recent study found that Americans have a more positive view of small business than they do of churches and universities. From the corner store that sells your favorite meatball sub to the drycleaner that gets red wine out of white silk, or from your family attorney to your dentist, all of us rely on small businesses, often without fully realizing the depth of this reliance.
A small business is usually defined as a business with fewer than five hundred employees, according to the U.S. Census Bureau, the Bureau of Labor Statistics, the Federal Reserve, and the Small Business Administration. By that definition, there are 28 million small businesses in America, 23 million of which are one-person shops (think your CPA or your plumber).
It’s first important to understand that not all small businesses are created equal. The vast majority of America’s small businesses — about 23 million — are sole proprietorships, employing just one person and reflecting an array of professions from consultants and IT specialists to painters and roofers. Recent research shows that sole proprietorships are achieving record profit margins—and the number of these businesses will continue to grow as technology allows more geographic flexibility and baby boomers look to open their own firms.
Analysis of Census Bureau data shows that there are about 5.7 million employer establishments with fewer than 500 employees (hence why the total number of small businesses adds up to 28 million!). The vast majority of these establishments are modest in size, with more than one‑half of them employing fewer than 5 employees and nearly an additional one‑third employing between 5 and 19 employees. In fact, of the 5.7 million active employer businesses, it is estimated that about 5 million are “Main Street” or “mom and pop” small businesses. These are the dry cleaners, mechanics and medical clinics that form the fabric of our communities. Many of these businesses exist largely to support a family and are not principally focused on expansion. While these businesses have high churn rates—opening and closing frequently—and contribute less to net job creation than high growth businesses, they are critical to America’s middle class.
This distinction is critical because each of these types approaches their business in different ways, and each of the businesses has varying degrees of experience with financial loan products. But, one thing is certain: small business owners, particularly sole proprietors and main street ‘mom and pop’ businesses, often know just as much about the loan process as everyday consumers. In fact, while there’s no question that these business owners are knowledgeable in a particular industry (think dentists or grocers), they often have little or no background in management, accounting, or finance. Still, our lending, tax, and regulatory systems expect a certain level of expertise in these fields and as such, navigating this part of owning a business is extremely difficult for many small business owners.
No budding entrepreneur starts a business because she relishes the prospect of traveling from bank to bank, applying for credit; nevertheless, this is the first step for many small business owners. Unsurprisingly, some small business owners, such as those in high-growth industries like technology or those with advanced business degrees, are prepared for the credit application process, but the vast majority of small business owners are simply people who had good ideas or were trying to fill market gaps in their communities. Too often, their courageous decision to make a move is often rewarded with entry into a market for loans that provides no safeguards for borrowers.
Many aspects of financial regulation, though, rest on the assumption that consumers require more protection than businesses. Private and public law generally treat consumers and businesses differently, often for good reason. Consumers are protected — including with measures like interest rate caps and standardized term disclosure as well as with rules that often require lenders and/or brokers to be state-licensed representatives, for example, increasingly in the mortgage lending space — largely because of concerns about fairness, but these concerns dissipate somewhat for transactions between corporations. We do not expect an individual to have the same expertise or savvy that a large bank has in lending transactions; thus, the government regulates transactions between these consumers and banks so that no financial institution can take advantage of an information asymmetry. Big businesses, on the other hand, are advised by armies of lawyers and can afford to hire employees whose entire focus is the company’s financial state. Barney Frank, one of the sponsors of the Dodd-Frank Act and a champion of consumer financial protection, has even stated that businesses do not need the protections that consumers receive.
This all makes perfect sense—until you consider the unique plight of the small business owner. An individual who takes out a loan for a house or a car receives the benefits of numerous consumer protection regulations; if that same person wants to take out a loan for her business, she loses that protection without suddenly gaining insight into business lending. In the small business context, the assumed distinction between business savvy and consumer awareness is unfounded and often inaccurate. The dichotomy, which rests on the assumption that businesses are sophisticated and consumers are not, falls apart because small business owners are treated like businesses but have the expertise of consumers. Even though small businesses are afforded little protection, as Professor Larry Gavin at Ohio State University has argued, “in many ways, small businesses most resemble consumers and non-merchants in their abilities to deal with risk, whether financially or cognitively, to secure and process information, and to fend for themselves in the market.”
Additionally, many small business owners use personal funds to guarantee business loans; all of a sudden, their entire livelihoods are on the line. Many small business loans, including those offered by SBA banks, are guaranteed by personal assets; if a small business loan goes into default, the lender has recourse to the small business owner’s personal assets. The result is if the business fails, the borrower not only loses her job and her business, but her personal assets may also be at risk, including property and savings. In turn, this could affect her ability to make rent or mortgage payments, car payments, and student loan payments; it also can have serious repercussions on her ability to pay for everyday items for herself and her family.
To be sure, personal guarantees are an important method of ensuring that small business owners do not take unnecessary or frivolous risks, and they help lenders offer lower rates while tolerating higher risk. However, when personal guarantees are made in a world in which the lender can easily take advantage of a borrower because there is no regulation, this can lead to an unfair environment and perverse incentives.
When a consumer uses his life savings to buy a house, he knows that there are laws in place to ensure he is getting a fair deal. On the other hand, if he uses his life savings to take out a loan to start a small business—perhaps a hardware store in a small town that has none—there is nothing ensuring that he will get a fair deal.
In reality, consumers are the same people who own dry cleaners, nail salons, hardware stores, grocery shops, and bookstores; they do not suddenly learn how to spot and avoid shady lending practices when they apply for a business loan. They often lack the ability to hire a team of lawyers, or in most cases, even one person whose job is to focus on the company’s finances.
Because small business loans often have serious repercussions for the consumer behind them, perhaps they should be seen as consumer financial products themselves. At the very least, strong legal protections for borrowers should not remain tied to a false dichotomy between consumers and businesses. Small business loans are not unlike consumer loans, because in both cases, the borrower is likely to have less information about the financial product and less time to learn every small detail. Certainly there are exceptions—a small business owner may have studied finance in college, for example. However, so have many consumers, and they do not lose protection.
The current state of financial regulation makes it very difficult to extend consumer financial protection to small business owners, but that can be changed. As small business lenders expand into the wild, Wild West that is online lending, regulation only becomes more sparse, and borrowers even less protected.
Ariel Dobkin was co-contributor for this post while Policy Fellow at Fundera until May 2015. She currently studies at Yale Law School, and was previously a Financial Analyst in the Office of the Director at the Consumer Financial Protection Bureau.