Credit Card Debt Threatens Startup Survival
According to a new study by the Ewing Marion Kauffman Foundation, while credit card debt often fills startup firms' equity gap, it reduces the likelihood that a new business will survive its first three years of operation.
Credit card debt provides needed short-term funding, but it can be very expensive. Reliance on this type of financing may lead many businesses into a long-term liquidity drain that affects their financial stability, and thereby their survival chances. This is especially true for firms with continuing high balances. The results from this new study, The Use of Credit Card Debt by New Firms, suggest that every $1,000 increase in credit card debt increases the probability a firm will close by 2.2 percent.
This finding is relevant considering that entrepreneurs use credit card debt to finance their new ventures in face of limited credit markets. “Credit cards, however, are an expensive way to fund a business, and this new study suggests that escalating credit card debt negatively affects a new company's chance of survival,” explained Robert E. Litan, vice president of Research and Policy at the Kauffman Foundation.
Led by Robert H. Scott, III, Assistant Professor of Economics and Finance at Monmouth University in West Long Branch, N.J., the study based its findings on data from the Kauffman Firm Survey, a panel study of new businesses founded in 2004 and tracked over their early years of operation.
In 2004, those businesses that closed had less credit card debt ($2,365) than businesses that survived ($3,638). This average increases 40 percent by 2005 for surviving firms and increases 190 percent for businesses that closed. However, by 2006, the one-year change in credit card debt balances for surviving firms was a marginal 1.8 percent gain; but the average balance actually decreased by 18.5 percent for firms that closed.
More than half of all new firms rely on debt financing when they begin operations, and credit cards appeal to a vast majority of small businesses in their first year of business (about 58 percent). Some reasons for this include: credit cards help small businesses manage their finances and streamline payments; they are easier to get than traditional bank loans or government business grants; they smooth revenue streams, especially at the startup phase of operations; and, unlike other types of loans, credit card companies will never ask in what money was spent.
“Credit card debt alone doesn't determine how stable a business will be, but it does appear to be a significant influencer in the company's probability of survival,” added Litan.