Perspectives

The View from Next Street

A sharing of ideas and policy perspectives.

 

printThe Truth About Inner City Small Businesses

By Tim Ferguson, Founder, Chair and Managing Partner

 

America’s small businesses are being transformed as demographics shift and the financial landscape continues to evolve. In the inner city, small businesses are often large, profitable, and growing rapidly. Yet they face an array of barriers to getting the financial and intellectual capital they need to make the most of the opportunities that surround them.

Developing a picture of inner city opportunity
Negative stereotypes of inner city businesses abound: they’re small, they’re unprofitable, they’re hopelessly static, always running to stay in place. Of course, like many other companies, those in the inner city face genuine challenges in growing their businesses to scale. However, inner city businesses are often poised for growth and profit.

While ideas and opinions on the challenges faced by inner city small businesses are ubiquitous, reliable data on the promise and potential of this market is scarce. My own interest was piqued by my early experience in investment banking and reinforced by my long-time involvement with issues and organizations in inner city economic development. The picture continued to take shape through informal exchanges with members of the business community, thought leaders in academia, and policymakers. The next step was comparing notes with Ron Walker, who had accumulated many years of direct experience as a senior executive in commercial and retail banking and later joined me as co-founder of Next Street. Our focus groups with inner city small business owners confirmed that traditional financial services often fail to address the needs of inner city small businesses.

Details from our groundbreaking study
To confirm our preliminary research – and our intuition – Next Street commissioned a groundbreaking study by the Initiative for a Competitive Inner City (ICIC). Founded by Harvard Business School Professor Michael Porter, ICIC promotes prosperity in America’s inner cities through private sector engagement. (Next Street is a Sustaining Member of the Initiative’s Inner City Economic Forum.) This study created a set of basic financial performance data from a sample of more than 35,000 companies in inner city Boston, inner cities of the 100 largest U.S. cities, and the U.S. as a whole, analyzing more than 800,000 business addresses in the process. The result: the first reliable quantitative picture of inner city business financials.

When we pooled our experience, intuition, and research, Next Street came up with some striking insights.

First, let’s look at the advantages and assets of inner city companies across the board. A significant proportion – nine percent – have revenues of $20 million or more. On average, inner city businesses are more profitable than non-inner-city companies of similar size. For example, those with sales between $5 million and $100 million are more profitable than U.S. companies as a whole. Inner city companies are less leveraged than U.S. companies as a whole and have similar liquidity ratios. The median inner city company holds significantly less debt than U.S. companies. Many of these businesses are gearing up for growth by considering an acquisition or merger, or looking for equity capital, for example.

This portrait counters the stereotypes of inner city companies as primarily small-scale mom-and-pop firms scrambling to get by. That myth was first challenged anecdotally by ICIC’s “Inner City 100” list of fast-growing firms, a ranking of the nation’s fastest growing small businesses created in a collaboration between ICIC and Inc. Magazine. With the ICIC report commissioned by Next Street, these stereotypes are formally laid to rest.

An overview of the inner-city competitive environment is equally encouraging. Inner city companies often find niches that make them more profitable, such as commercial service businesses, which make up half of all inner city companies. Service industries are at an advantage in cities because face-to-face contact is so important, in contrast to manufacturing. Advantages are also conferred by proximity to downtown businesses and resident density. Specific types of business within a sector, such as health services, may vary from those in a suburban setting.

The demographic changes surging through our cities are also shifting inner city business dynamics. During the next 20 years, the U.S. ethnic minority population is expected to grow eight times faster than the non-minority population, to nearly 40% of the U.S. population. Most recently, baby boomers are repopulating our inner cities, broadening the size and diversity of the economic base even more.

Narrowing the focus, expanding the opportunity: Inner city small businesses
The picture is even more promising for small inner city businesses. Inner city small businesses are equally or more profitable, as liquid, and at least as efficient in delivering return on assets and return on sales than their U.S. counterparts.

The scarcity of large, non-indigenous firms creates a wide range of opportunities and advantages for smaller inner city businesses. The primary advantage, of course, is reduced competition. These “outsider” companies may believe that the unfamiliar pattern of rollout in the market is not worth the time and effort. Those that do venture into this terra incognita must build critical knowledge, expertise, and, perhaps most important, credibility with local residents and businesses.

A review of data on Community Reinvestment Act (CRA) loans is also encouraging. The CRA is federal legislation that encourages depository institutions to help meet the credit needs of their communities, including low- and moderate-income neighborhoods, in ways that are consistent with safe and sound banking operations. Eighty-six percent of banks indicate that CRA small business loans are as profitable as non-CRA loans, and the net charge-off rate of community development financial intermediaries is .5% compared to a net charge-off rate of .9% for commercial banks. Analysis by Standard & Poor’s found that the average loan default rate for companies with $5 million to $100 million in annual revenue was nearly 1/3 of the average default rate of companies with more than $1 billion in annual revenue.

Our focus groups revealed inner city small business “assets” that are more qualitative but just as valuable. We found that many owners of the most promising inner city small businesses are eager to grow. They “know what they don’t know” and are eager to tap intellectual as well as financial capital from sources they trust. Most are unsatisfied with the financing and service they have received from traditional institutions and can benefit from a range of innovative financing solutions and growth capital.

Radical changes and unrealized potential
Despite the substantial – and growing – promise of this picture, many of these small urban companies do not fulfill their potential. The reasons for this gap are as wide-ranging and diverse as the businesses and their environments.

Some of these are measurable and concrete, such as the dwindling availability of loans from the Small Business Administration. Others are attitudinal, such as misperceptions about the risk of investing in urban companies. But the major barriers are related to the radical changes in the banking world over the last 25 years: consolidation and centralization, tightening regulatory and compliance constraints, the decline in relationship management, and loan practices that are designed for much larger businesses in order to facilitate economies of scale.

There’s no doubt that American cities will continue to be dynamic, changing places likely to have an ever-broadening, more inclusive economic base. The inner city small business market is poised for growth, and opportunities abound for perceptive, creative financial services providers.

 
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The demographic changes surging through our cities are also shifting inner city business dynamics. During the next 20 years, the U.S. ethnic minority population is expected to grow eight times faster than the non-minority population, to nearly 40% of the U.S. population. Most recently, baby boomers are repopulating our inner cities, broadening the size and diversity of the economic base even more.

Narrowing the focus, expanding the opportunity: Inner city small businesses
The picture is even more promising for small inner city businesses. Inner city small businesses are equally or more profitable, as liquid, and at least as efficient in delivering return on assets and return on sales than their U.S. counterparts.

The scarcity of large, non-indigenous firms creates a wide range of opportunities and advantages for smaller inner city businesses. The primary advantage, of course, is reduced competition. These “outsider” companies may believe that the unfamiliar pattern of rollout in the market is not worth the time and effort. Those that do venture into this terra incognita must build critical knowledge, expertise, and, perhaps most important, credibility with local residents and businesses.

A review of data on Community Reinvestment Act (CRA) loans is also encouraging. The CRA is federal legislation that encourages depository institutions to help meet the credit needs of their communities, including low- and moderate-income neighborhoods, in ways that are consistent with safe and sound banking operations. Eighty-six percent of banks indicate that CRA small business loans are as profitable as non-CRA loans, and the net charge-off rate of community development financial intermediaries is .5% compared to a net charge-off rate of .9% for commercial banks. Analysis by Standard & Poor’s found that the average loan default rate for companies with $5 million to $100 million in annual revenue was nearly 1/3 of the average default rate of companies with more than $1 billion in annual revenue.

Our focus groups revealed inner city small business “assets” that are more qualitative but just as valuable. We found that many owners of the most promising inner city small businesses are eager to grow. They “know what they don’t know” and are eager to tap intellectual as well as financial capital from sources they trust. Most are unsatisfied with the financing and service they have received from traditional institutions and can benefit from a range of innovative financing solutions and growth capital.

Radical changes and unrealized potential
Despite the substantial – and growing – promise of this picture, many of these small urban companies do not fulfill their potential. The reasons for this gap are as wide-ranging and diverse as the businesses and their environments.

Some of these are measurable and concrete, such as the dwindling availability of loans from the Small Business Administration. Others are attitudinal, such as misperceptions about the risk of investing in urban companies. But the major barriers are related to the radical changes in the banking world over the last 25 years: consolidation and centralization, tightening regulatory and compliance constraints, the decline in relationship management, and loan practices that are designed for much larger businesses in order to facilitate economies of scale.

There’s no doubt that American cities will continue to be dynamic, changing places likely to have an ever-broadening, more inclusive economic base. The inner city small business market is poised for growth, and opportunities abound for perceptive, creative financial services providers.

Printed on Thursday, February 23, 2012
http://www.nextstreet.com/public_sector_initiatives/ideas_and_policy_perspective/the_truth_about_inner_city_small_businesses