WW-07565     2000  

Enhancing Capital Access for Rural Businesses

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KENNETH A. KRIZ, DAVID S. WILSEY, AND DEBRA ELIAS MORSE

Several observers have noted the development gap between rural and urban areas. Rural areas do not create as many businesses or jobs as urban areas. This paper examines one explanation for this phenomenon. We document lower access in rural areas to traditional forms of capital financing. Lack of financial capital creates a situation where entrepreneurs may not be able to undertake viable projects. The result of this is bad both for individual businesses and the rural economy as a whole. We then examine some differences in debt and equity financing, and conclude that access to both types of capital financing should be enhanced. Existing efforts largely focus on enhancing access to debt capital, so we conclude that more needs to be done in the area of enhancing access to equity capital in rural areas.

Kenneth A. Kriz is Assistant Professor, University of Minnesota Hubert H. Humphrey Institute of Public Affairs.

David S. Wilsey is Research Assistant, Sustainable Financing for Rural Minnesota.

Debra Elias Morse is Lead Consultant, Sustainable Financing for Rural Minnesota.

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Introduction

Observers have long been concerned about uneven economic growth between metropolitan and rural areas. Studies of recent employment data confirm these fears. Urban areas and rural areas adjacent to urban areas have seen strong growth throughout the 1990s. However, more remote rural areas have lagged behind significantly. Those rural areas that are heavily dependent on agriculture have fared worst of all, with job growth rates that are only 80 percent of job growth in cities (Drabenstott, 2000). During 1999, employment growth in rural areas of the nation has declined precipitously while metropolitan area growth has remained robust. This divergent trend is true in all regions with the exception of New England, but is most pronounced in the West North Central region, which includes Minnesota, Iowa, the Dakotas, Nebraska, Kansas and Missouri (Center for the Study of Rural America, 2000).

Why aren't rural areas developing as quickly as urban areas? Part of this is no doubt due to poor conditions in agriculture. However, another factor is the slower growth of business development in rural areas, especially in "high-growth" sectors such as technology (Glover, 1998). Access to capital markets (markets for financial capital, which are the financial resources necessary to create or expand businesses) is essential in strengthening and sustaining business development. Increasingly, it has become obvious that rural entrepreneurs have less access to capital than do urban entrepreneurs. This is due to the changing structure of the commercial banking industry (Drabenstott and Meeker, 1998), as well as problems in rural equity markets (Brophy and Mourtada, 1998).

The question of what might be done to improve the operation of rural financial markets has received considerable attention in the last few years, as evidenced by three major conferences on rural finance issues given by the Federal Reserve Bank of Kansas City, and the opening of their new Center for the Study of Rural America in October of 1999. Closer to home, an initiative called Sustainable Financing for Rural Minnesota (SFRM) was developed in 1999 to better link the financial, entrepreneurial, natural, and cultural resources of southeastern Minnesota. This initiative, identified as a pressing need by citizens on the board of the Experiment in Rural Cooperation (one of five Regional Sustainable Development Partnerships), is intended to develop a means to provide equity capital from local and regional investors to locally owned and operated businesses. SFRM feels that connecting these three components " equity capital, local and regional investors, and locally owned and operated business " is critical to supporting rural economic and community growth. While the SFRM initiative focuses on all three components, this paper focuses on access to debt and equity capital for rural businesses, the characteristics of debt and equity capital, and policy implications of capital access for rural economic development.

Definitions of Debt and Equity Capital

In general, there are two types of capital financing: debt and equity. Debt capital is resources that are loaned to an entrepreneur that must be paid back, generally over a specified period and with a fixed repayment schedule. Equity capital, by contrast, is an investment in business operations where an investor purchases an ownership share of the enterprise. As profits are made by the business, equity investors are paid their portion of profits; this payment is either through cash dividends or through profits retained by the business, which add to the value of the equity ownership share.

The Problem: Rural Businesses Have Trouble Raising Capital

Historically, commercial banks have provided the majority of formal capital to entrepreneurs in rural areas. Entrepreneurs (including farm entrepreneurs) seeking to finance business development have traditionally approached the local bank for debt capital. To frame the discussion that follows, consider an entrepreneur that needs to raise money to finance a business start-up or expansion. She most likely approaches a local bank, which examines her past credit, her available financial resources and the feasibility of her business plan. If the project is good (more likely than not to generate profits large enough to pay the bank and afford the entrepreneur a good return on her money), it would benefit the local economy if she would get the loan. If the project is not good enough to at least generate enough profits to repay the bank, we should hope that the entrepreneur is denied the loan. If the bank gives out too many bad loans, depositors will lose confidence and the bank would likely be forced to restrict lending or may go out of business entirely. In this way, lending to entrepreneurs with projects that are not good may hurt the local economy.

Theories of the Problem

The fact that some entrepreneurs are denied credit is therefore not the important question with regard to the economic effects of capital access in an area. The question that must be answered is whether this is a reflection of an efficient banking system denying loans to entrepreneurs with projects that aren't good, or if this is an indication of entrepreneurs being denied the credit they need to carry out good projects. Prior to the late 1970s, it was widely believed that the former was the correct explanation; banks operated efficiently and loan turndowns saved the banking system and indeed the local economy by not financing bad projects.

Two important papers brought this belief into question. These papers showed that when there is sufficient uncertainty about a borrower, banks would turn down loans instead of simply asking for higher interest rates on the loans, as what was previously predicted (Stiglitz and Weiss, 1981; Jaffee and Russell, 1976). This greater uncertainty could be specific to the borrower, such as the borrower being a relatively new business, the existence of a large amount of existing debt compared to the equity in the business (the owner's cash investment), the presence of a large amount of intangible assets such as superior training and human capital development as opposed to hard assets such as equipment or buildings, or the business having a unique product with a limited market. The uncertainty could also be general to the economy as a whole, such as during a recession. Consider the experience of rural areas during the latter part of the twentieth century. With a deteriorating agriculture-based economy and shrinking local markets for manufactured goods, there is increasing uncertainty regarding the creditworthiness of potential borrowers. It is hardly a surprise that the flow of bank loans to rural areas largely does not meet the demand for capital.

Entrepreneurs who are blocked in this way from using the traditional debt capital market must seek alternative sources of financing. The other traditional source of capital is the market for equity capital, generally consisting of venture capitalists, "angel" investors (high net worth individuals interested in providing equity to growing businesses) and the public offering (IPO) market. However, the use of traditional equity financing has not been robust by small businesses in general. And rural businesses may face special problems when attempting to get equity financing. First, the characteristics of rural businesses do not meet the standard criteria of national equity providers. The small size, lower growth potential, and high geographic distribution of rural businesses conflict with the typical characteristics sought by investors of equity capital. Second, both public and private rural equity markets are poorly developed. Finally, rural markets face cultural impediments to equity market development (Drabenstott and Meeker, 1998).

Empirical Evidence of the Problem

At least three separate analyses of data collected in the National Survey of Small Business Finances (NSSBF), administered by the Federal Reserve System, have documented the problem of small businesses access to traditional capital sources (Glover, 1998; Cole and Wolken, 1995; Petersen and Rajan, 1994). The results show that small businesses use large amounts of nontraditional financial services. The youngest firms in the NSSBF sample rely most heavily on loans from the owner and his or her family. Another significant portion use nontraditional credit services such as trade credit (short-term loans from suppliers used to finance purchases of supplies) and personal credit cards. Importantly, the use of nonfinancial sources declines as the age of the businesses increases. In any case, the portion of small businesses using equity financing is relatively small. Options for rural borrowers appear to be even more limited. They more often turn to nontraditional sources of capital to finance business investment (Glover, 1998).

Given that these problems exist in rural areas and may have a negative effect on the economic growth of these areas, there is scope for programs that enhance access to traditional capital sources for entrepreneurs. The question that emerges next is whether these programs should have a debt or equity focus. We next discuss some differences between debt and equity financing in an attempt to reach a conclusion about the proper focus of a program that enhances access to capital investment.

Differences Between Debt and Equity Financing

Equity is flexible and patient

Equity does not require a fixed repayment schedule. Also, equity investors assume that their investment may be "locked up" for some time before returns are realized in the form of capital gains or dividends. In the case of debt, if profits from otherwise good projects are sufficiently uncertain or not immediately realized, the business may be unable to obtain debt financing, or it may have difficulty servicing its debt. This assertion has been made in the case of smaller agriculture concerns (Carter, 1988), for young and small businesses (Petersen and Rajan, 1994) and for businesses that are "unique" in their products (Titman and Wessels, 1988).

Debt "screens out" bad projects better, but may also screen out good projects

Entrepreneurs who apply for debt financing must produce financial records and estimates of future cash flows and also open themselves up to examination by lenders. This process of examination allows debt investors to "screen" out potential bad risks (this is partially a self-selection issue, as weak entrepreneurs never apply for credit if they believe they will be turned down) and mitigate the adverse selection problem described earlier. Also, as pointed out by Jensen and Meckling (1976), debt contracts may "force" an entrepreneur to undertake only those projects that produce positive value for the business. Equity financing may allow an entrepreneur to more easily engage in inefficient projects or projects that create benefits only for the entrepreneur (such as building large offices). If an entrepreneur can use equity capital for projects, she is less likely to be concerned about their impact on the value of the business. Debt financing forces entrepreneurs to take only those projects in the best interest of the business.

One should note, however, that the screening function of debt is what creates the problem of capital access. In a world with sufficient uncertainty regarding the quality of loan applicants, some entrepreneurs with good projects will be screened out along with those with bad projects (Diamond, 1991). Recent advances, such as automated credit scoring of loans, have been thought to increase access to capital for small businesses by reducing the number of entrepreneurs with good projects that are screened out from borrowing, but the new loans to small entrepreneurs may resemble nontraditional debt (Mester, 1997).

Debt is More Easily Understood by Potential Borrowers

Debt contracts are relatively simple to understand. The borrower makes a pledge to periodically pay the lender interest on the borrowed money and repay a portion of the amount originally borrowed. The responsibilities of the borrower are usually clearly defined in the debt contract. Equity contracts entail the lender of capital to an ownership share in the business. However, what portion of control will be given over to the new owner (the lender) is sometimes difficult to understand. Also, the daily responsibilities between the original owner and the new owner are sometimes difficult to delineate in a contract. To date, however, there is no research that has examined the potential difficulties created by having a contractual relationship that is more difficult to understand.

Owners May Fear Loss of Control with Both Debt and Equity

The benefits of business ownership often extend beyond the simple economics of profit and loss. Owners feel the pride that goes along with the development of a business. This pride emanates from several sources, but is at least somewhat related to the feeling of control over one's future. Some of that feeling of control may be lost when the owners take on partners. As we saw earlier, when the owner borrows money from a bank she takes on responsibilities to the bank and its customers. This is a partial loss of control over the fortunes of the business. Since the owner must pay the bank before any profit is realized, both the risks and potential rewards of business ownership are shared.

With the use of equity capital, some control is also ceded to the new partial owners of the business. The new owners will share in the profits of the business. There may also be the feeling that new owners will "look over the shoulder" of the existing owners, involving themselves deeply in business planning and management. This may further reduce the feeling of control over the business. Whether debt or equity will produce a greater feeling of loss of control cannot be assessed theoretically and no research has been done comparing the two forms of capital in this dimension.

Debt and Equity Require Different Organizational Structures for Delivery

Debt contracts require an active banking institution that is lending to the community. This institution is supported by several organizations and mechanisms. First, government oversight and deposit insurance mechanisms must inspire confidence in individuals to provide deposits, which provide the capital needed by the bank to lend to entrepreneurs. Second, legal regulations must provide for the proper enforcement of contracts to allow the bank to commit loans for long periods of time. Third, accounting standards must be followed to the extent that bank officials are able to make accurate determinations of borrower creditworthiness. Fourth, risk management tools such as property and casualty insurance must be available to allow borrowers to preserve their capital assets from loss.

For equity investments, there is no requirement for government oversight and deposit insurance. Contract enforcement is important because an ownership interest must be delineated and protected. Another legal institution that is important in equity investing is the protection of limited liability for owners in a corporate or limited partnership form. Limited liability means that equity investors risk only their investment when taking an ownership share in a business. They cannot lose other personal assets due to the performance of the business. Accounting standards have increased importance in the case of equity financing because those investors who provide capital must be able to properly value their share of the equity of the business enterprise at any point in time. Risk management is as important for equity as it is for debt financing. An additional institutional requirement for equity financing in the corporate form is the provision of a market mechanism. Markets work best when there are many bidders for a product. "Thin" equity markets " those with few buyers and sellers of shares of stock " may not properly value companies receiving equity capital. This requirement is less applicable to equity investment through limited partnerships.

To sum up the discussion of this section, there are marked differences between debt and equity financing. However, none of the differences weighs heavily in favor of advocating debt or equity capital programs. Programs should be developed that enhance access to both types of capital, so that business owners can pick the form that they prefer.

Existing Capital Enhancement Programs are Largely Programs to Enhance Access to Debt Capital

The previous section detailed the differences between debt and equity financing and concluded that there should be efforts to enhance access to both types of financing. The experience of rural areas has generally shown that this is not happening. Existing programs largely seek to enhance access to debt capital. The U.S. Small Business Administration (SBA) has actively been guaranteeing small business loans in rural (and urban) areas for several years. There are several programs sponsored by both the U.S. and Minnesota Departments of Agriculture in place to help farm entrepreneurs get loans. The Minnesota Department of Trade and Economic Development also sponsors numerous grant and loan programs. There are some small investment funds and economic development funds sponsored by local organizations or funds geared toward a specific type of business, but there have been no large-scale policy interventions on the behalf of equity capital.

There is also some evidence that these types of programs are missing a large segment of businesses with capital financing needs. A recent paper found that while SBA guarantees appear to partially mitigate borrowing problems, there are several businesses that aren't helped. Also, the benefits of the loan guarantee program tend to be concentrated in areas where lending is concentrated in a few large financial institutions (Haynes, 1996).

Conclusions

If rural areas are to develop to their fullest extent, there is a need for a regional or state program aimed at enhancing access to equity capital. Entrepreneurs who need capital to develop business opportunities must have the ability to raise that capital with certainty and in a way in which they are comfortable. There are some interesting models already in place at the local level. In Austin, the Development Corporation of Austin is working to match "angel" investors with business owners. In Duluth, Northeast Ventures Corporation is providing venture capital to businesses in Duluth and the St. Louis County area. Minnesota Technology, Incorporated, is providing venture capital to technology businesses.

A challenge going forward will be to develop a mechanism for businesses that provides the best possible access to capital while preserving investors' confidence and maintaining a focus on rural small businesses and their communities. The Sustainable Financing for Rural Minnesota (SFRM) task force is currently conducting interviews and focus groups with community business, financial and economic development leaders throughout southeast Minnesota in order to develop a capital enhancement program that accomplishes these goals. Initial research has shown that there is a need for such a program and that implementation of such a program would enhance business value and economic growth in rural areas of Minnesota and other states.

References

Brophy, D. J. and Wassim Mourtada. "Equity Finance and the Economic Transition of Rural America: A New Framework for Private-Sector Initiatives and Positive Economic Public Policy." Equity for Rural America: From Wall Street to Main Street, Federal Reserve Bank of Kansas City Conference. October 8-9, 1998, Denver, Colorado.

Carter, M. R. 1988. "Equilibrium Credit Rationing of Small Farm Agriculture." Journal of Development Economics. February, 28:1, pp. 83-103.

Center for the Study of Rural America. 2000. The Rural Economy Briefing Room. http://www.kc.frb.org/RuralCenter/briefroom/BriefMain.htm.

Cole, R. A. and J. D. Wolken. 1995. "Financial Services Used by Small Businesses: Evidence From the 1993 National Survey of Small Business Finances." Federal Reserve Bulletin. July, 81:7, pp. 629-67.

Diamond, D. W. 1991. "Monitoring and Reputation: The Choice Between Bank Loans and Directly Placed Debt." Journal of Political Economy. August, 99:4, pp. 689-721.

Drabenstott, M. 2000. "Has Main Street Shared in the Nation's Economic Boom?" The Main Street Economist: Commentary on the Rural Economy. February, p. 1.

Drabenstott, M. and Larry G. Meeker. "Equity for Rural America: From Wall Street to Main Street"A Conference Summary." Equity for Rural America: From Wall Street to Main Street, Federal Reserve Bank of Kansas City Conference. October 8-9, 1998, Denver, Colorado.

Glover, J. W. "Small Business Finance in Rural and Urban Regions." Equity for Rural America: From Wall Street to Main Street, Federal Reserve Bank of Kansas City Conference. October 8-9, 1998, Denver, Colorado.

Haynes, G. W. 1996. "Credit Access for High Risk Borrowers in Financially Concentrated Markets: Do SBA Loan Guarantees Help?" Small Business Economics. December, 8:6, pp. 449-61.

Jaffee, D. M. and T. Russell. 1976. "Imperfect Information, Uncertainty, and Credit Rationing." Quarterly Journal of Economics. November, 90:4, pp. 651-66.

Jensen, M. C. and W. H. Meckling. 1976. "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure." Journal of Financial Economics. October, 3:4, pp. 305-60.

Mester, L. J. 1997. "What's the Point of Credit Scoring?" Business Review " Federal Reserve Bank of Philadelphia. September/October, p. 3-16.

Petersen, M. A. and R. G. Rajan. 1994. "The Benefits of Lending Relationships: Evidence From Small Business Data." Journal of Finance. March, 49:1, pp. 3-38.

Stiglitz, J. E. and A. Weiss. 1981. "Credit Rationing in Markets with Imperfect Information." American Economic Review. June, 71:3, pp. 393-410.

Titman, S. and R. Wessels. 1988. "The Determinants of Capital Structure Choice." Journal of Finance. March, 43:1, pp. 1-20.

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