For Subprime Business Borrowers, Small Loans Go a Long Way



  • A loan of about $11,000 can increase a company’s three- to five-year survival rate by 51 percent
  • Subprime entrepreneurs who receive loans create twice as many jobs as similar borrowers who are denied loans
  • Researchers hope to give large banks better tools for lending to small businesses that don’t have access to investor capital

Lending as little as $11,000 to small-business owners who are unable to get conventional bank loans can dramatically boost their companies’ rates of survival, sales, and employment growth through their first five years. That’s the key finding of a new study by a group of researchers including McCombs’ Cesare Fracassi and Shimon Kogan, who examined data from the San Antonio–based microfinance institution Acción Texas.

The results described in the paper underscore the importance of loans to small businesses. Looking at 5,400 Acción loan applicants from 2006 through 2011, the researchers found that getting a loan of about $11,000 increases a company’s three- to five-year survival rate by 51 percent. Successful borrowers also saw a 77 percent increase in sales and created twice as many jobs as similar applicants that were refused loans.

Measuring Creditworthiness

The researchers took a unique approach in designing the study and selecting the type of data they would analyze. Assistant Finance Professor Fracassi says he was looking for non-traditional and local sources of data on small-business finance. He found it at Acción, which has been capturing data from small-business loan applicants for more than a decade to use in its in-house credit-scoring system.

Acción’s process for making lending decisions yielded data that offered specific insights into each loan’s effect on firm outcomes. Acción uses a proprietary formula to calculate an internal score similar to the familiar FICO credit scores used by many lenders. Under Acción’s system, applicants with internal scores just above a certain threshold were much more likely to get loans than applicants just below the cutoff point, even though the firms were not greatly dissimilar in terms of creditworthiness — which was generally low. The FICO score of the typical Acción client was 606, well below the level most lenders consider acceptable.

Because the 2008–2009 financial crisis was partly blamed on credit being extended too easily to subprime borrowers, many lenders have become unwilling to lend to these types of risks.

Similar Companies, Different Outcomes

The researchers found big differences in survival rates, sales, and employment growth for successful borrowers with scores only slightly better than those who had been turned down for a loan. They identified this as strong evidence that the ability to secure a loan is the key variable in the success of a young company.

“This is a perfect experiment for us,” Fracassi says, “because we can look at people who are very similar, but some are slightly above the threshold, and some are slightly below the threshold.”

Fracassi says that when he and his coauthors present their paper at conferences, they tend to get two types of reactions. Some people claim the notion that getting a loan helps businesses succeed isn’t news. Others dispute the findings because they conflict with conventional wisdom in financial circles, which suggests the key variable in business success isn’t getting a loan, but rather the quality of the company’s business model and the team of people who run it.

Based on that theory, a good business, even if turned down for a loan at a bank, will simply find financing elsewhere, be it from a venture capitalist, angel investor or another source. Fracassi describes the prevailing viewpoint: “It’s not that the loan is making companies better. It’s simply that in the screening process, you try to give a loan to good companies and try not to give a loan to bad companies.”

This study raises doubts about that idea, because it shows that very similar companies — as measured by their internal credit scores — experienced very different outcomes depending solely on whether or not they were approved for loans. However, Fracassi stresses that these findings only apply to the particular type of businesses they studied: small startups led by entrepreneurs with poor personal credit histories (an average credit score of 603) and little or nothing in the way of assets to pledge a security for a loan.

Most other studies of the influence of financing on entrepreneurial success have examined high-tech firms seeking venture capital. In the case of those firms — which are often led by seasoned entrepreneurs with more education, experience and financial strength than the subprime borrowers Fracassi and his team looked at — it’s more likely that if one lender turns them down, they’ll just get a loan elsewhere. However, such high-growth-potential firms represent a tiny fraction of small businesses, compared to millions more like the ones the McCombs researchers examined.

Tools for Smarter Lending

When the researchers began the study, they weren’t sure what they’d find — they even considered the possibility that getting a subprime loan could harm a business’ prospects. Because the time period they examined includes the economic contraction that began in 2008, they speculated that businesses engaging in credit-fueled expansions just before a big downturn could be more likely to fail than those that could not borrow.

The size of the effects they observed — especially considering that they occurred over a span that included the worst recession in many years — reinforce the idea that small loans to subprime business borrowers can have outsized effects on survival, sales, and employment growth. However, Fracassi cautions against concluding that it would be smart to lend indiscriminately to all small, credit-impaired business borrowers.

“We’re not saying you should give a loan to everybody,” he says. “Let me tell you, I’ve seen some of these applications. Most are for businesses that are failing or are just not good ideas.”

Acción, he notes, funds less than 20 percent of its applicants, and despite this discriminating approach, the nonprofit is still barely breaking even on its financing efforts.

Fracassi would like to see further study of this issue, including more research on the effectiveness of refined tools like the one Acción uses to assess creditworthiness. If big commercial banks could economically and effectively lend small amounts to subprime business borrowers, he says, that might support the expansion of an important segment of the economy.

“We need to develop better tools to predict who is going to be a successful entrepreneur so we can provide funds to the people we think are going to be good,” Fracassi says.


Faculty in this Article

Cesare Fracassi

Assistant Professor, Finance

Cesare Fracassi researches corporate finance, social networks, firm governance and other areas of finance.

Shimon Kogan

Assistant Professor of Finance McCombs School of Business

Assistant Professor of Finance Shimon Kogan specializes in behavioral finance, capital markets, market efficiency, and investment management.

About The Author

Mark Henricks

Freelance Writer, Mark Henricks' Website

Mark has reported on business, technology, investing, science, travel and other topics for more than 20 years. He earned a bachelor's of...

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