The next step is to look at the private markets for debt that help finance small businesses. As we have discussed, the capital structure decision between debt and equity differs for smaller businesses compared to large companies because small companies tend to have more information ambiguity than larger ones. Furthermore, since small companies are typically owned by the owners, their owners and managers are enticed to issue debt from outside rather than outside equity to maintain control and ownership of their businesses.

Table 1 provides the estimated percentage distributions for the nine kinds of private debts for US small businesses, three of them from the main groups of financial institutions and nonfinancial businesses and government, as well as individuals. Financial institutions comprise 26.66 percent of the total funding for small firms, or less than half of the total funding for the debt of 50.37 percent of commercial banks, which account for the most significant portion of 18.75 percent. Government and nonfinancial debts provide 19.26 percent of small business financing (mostly trading credit), and individual debt makes up just 5.78 percent of small business financing. After briefly addressing the second two categories, we will take most of our time looking at research related to the debt of financial institutions.

4.1. Nonfinancial debt and government business

A significant 15.78 percent of all small business assets are financed by trade credit, determined by the number of account payables at the close of the preceding year. Trade credit is a crucial aspect of small-scale business finance. However, it has been less researched interest than commercial bank lending, which only offers slightly more credit to small businesses. While it is costly, a small quantity of credit for trade is ideal from the cost of transactions, liquidity, and cash management. It could also provide the borrower and supplier information to identify cash flow trends ( Ferris, 1981).

It is sometimes unavoidable, however, if working capital financing is better offered by suppliers rather than an institution that provides the credit line. In certain situations, the advantages of suppliers are more significant than those of financial institutions because they have more private information regarding the business’s production and industry and may be better able to leverage their resources by preventing future supply to address problems with incentives more efficiently ( Biais & Gollier, 1997). Suppliers are also placed to resell and repossess the goods they supply ( Mian & Smith, 1991).

Trade credit can also be an additional cushion in times of credit crisis and monetary policy tightening or other shocks that render financial institutions less able or able to offer small-scale business financing ( Nilsen, 1994; Biais & Gollier, 1997). In these periods, the big companies may temporarily obtain funds through public markets, for example, commercial papers, or then lend additional funds to small companies through trading credit ( Calomiris et al., 1995).

However, credit for trade that goes beyond a couple of days of liquidity can be costly. A typical trade credit agreement has the payment due within 30 days. However, it provides a discount of 2% for payments made within ten days of the due date ( Smith, 1987). The implicit rate of 2 percent per 20-day period (although it is not always implemented) is significantly higher than rates typically associated with loans offered by financial institutions, which is why it should only be considered in situations when the credit limits of banks are exhausted. We will be seeing this shortly. Approximately half of small companies can obtain loans from financial institutions. Therefore, costly trade credit could sometimes be the best or the only source of outside financing to fund working capital. An earlier study discovered that transactions and financial factors affect the percentage of late trade credit paid by small-sized businesses (e.g., Elliehausen and Wolken 1993). It was also observed within the US that when a small-sized business gets older. Its relationship with financial institutions improves and, presumably, becomes more transparent in its information – it is more likely to pay off its credit card debts faster. It is less dependent on credit from trade ( Petersen & Rajan, 1994; Petersen & Rajan, 1995). Recent research from Russia suggests that in emerging economic systems, trade credit is the signal to get more excellent banking credit ( Cook, 1997). The evidence suggests this is true in areas with weak infrastructures for information, and banks that are less well-developed trading credit could play a more significant function due to its effectiveness in dealing with information issues.

The information from Table 1 suggests that direct loans from businesses that are not financial and the government are both small, with just 1.74 percent and 0.49 percent of small business financing and government funding, respectively. However, the government does provide financial assistance in different ways. For instance, it was reported that the SBA provided guarantees for small business loans of 135,859, totaling $21.2 billion as of September 1994, which is about 1.27 percent of all US small-business finance (although these figures are from a slightly different time in time to the information listed in Table 1.) ( US Small Business Administration 1995, page. 281.).

4.2. Small individual business loans owned by individuals

When it comes to personal loans, the loans they hold account for only 5.71 percent of the total small business financing. Most of this (4.10 percent) results from debt financing from the primary owner and his equity stake in the company. In some instances, they could be a simple option to provide short-term financial assistance for the company. In contrast, they could provide tax advantages by substituting dividends with interest in other instances. The amount of money obtained through credit cards – which has garnered plenty of media attention as a possible alternative to traditional loans from banks (e.g., Ho, 1997), is believed to be relatively modest at 0.14 percent of total small business financing. However, the figure could be undervalued as it comprises just the debt incurred following the month’s payment made, leaving out any float between the date of purchase and the payment date. Also, 1.47% of small business financing comes from loans from other people, most likely from friends and family or other insiders.

4.3. Financial institution debt

In the remaining segment, we will concentrate on finance companies, banks, and other financial institutions that provide the bulk of the loans for small-scale businesses. As we have mentioned, they specialize in screening, contracting, and monitoring techniques to deal with the issue of incentives, information, and incentive issues. We will discuss some of the most crucial of these strategies within the space we have.

Table 2 summarizes the facts regarding the financial institutions they work with and their strategies. Panel A shows that just about half of small-sized businesses, 54.23%, have any leases or loans from financial institutions. Of course, some small companies with no debt from financial institutions would be eligible for leases or loans, but they refrain from taking out loans ( Levinson & Willard, 1997). The data suggest that small businesses tend to focus on borrowing from one financial institution – just one-third of lending firms (19.30 percent / 54.23 percent) can borrow from more than two institutions. In 86.95 percent of cases, small companies identify the commercial bank as the “primary” financial institution, as banks have the upper hand over other institutions for deposit services and transactions and also provide the majority of the loans for small companies that get credit from financial institutions (40.57 percent or 54.23 percent). 20 The numbers in Panel B indicate that small-sized businesses are likelier to remain in their banks. Smaller businesses remain with current institutions for over 6.64 years, compared to 9.01 years with their primary institution. The results in panels A and B that smaller firms tend to obtain their credit from one institution and remain with their institution for long durations – suggest advantages to these relationships, which will be discussed later.