The Use of Credit Card Debt by New Firms

Credit card debt often fills startup firms' equity gap, but those with continuing high balances have reduced likelihood of success, according to this report.

Credit card debt reduces the likelihood that a new business will survive its first three years of operation, according to findings from the study, The Use of Credit Card Debt by New Firms, released by the Ewing Marion Kauffman Foundation.

The study suggests that, during many firms' first few years of operation, their credit card debt increases and then eventually stabilizes to manageable levels, while firms with high credit card debt close, and successful firms start paying off their debt. The report, The Use of Credit Card Debt by New Firms, bases 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. The new research was conducted by Robert H. Scott, III, assistant professor of economics and finance at Monmouth University in West Long Branch, N.J.

More than half of all new firms rely on debt financing when they begin operations, and a vast majority of these businesses rely on credit card debt to fill any equity gap. Credit cards tend to appeal to small businesses for several reasons. They help small businesses manage their finances and streamline payments, and they are easier to get than traditional bank loans or government business grants. Credit cards smooth revenue streams—especially at the startup phase of operations—and, unlike other types of loans, credit card companies will never ask where their money went.

About 58 percent of the KFS firms relied on credit cards to finance operations in their first year of business. The study results found that every $1,000 increase in credit card debt increases the probability a firm will close by 2.2 percent.

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.