Small businesses are the primary source of new jobs in the U.S. economy. From 1990 to 1995, businesses with fewer than 500 employees accounted for 76.5 percent of net new jobs. But small businesses have a very high turnover rate compared to large businesses. Over 13 percent of U.S. jobs in 1995 were in firms that did not exist before 1990 and over 12 percent of jobs in 1990 were in firms that had ceased to exist by 1995.
Despite the importance and the complexity of small business as a contributor to the U.S. economy, there has been surprisingly little academic research on the economic environment faced by small business owners or the effects of policy variables on small business success.
In this paper, we investigate how personal bankruptcy law affects small firms’ access to credit. It is well known that the U.S. has separate bankruptcy procedures for individuals versus corporations. What is less well known is that personal bankruptcy procedures also apply to small firms. When a firm is non-corporate, its debts are personal liabilities of the firm’s owner, so that lending to the firm is legally equivalent to lending to its owner. If the firm fails, the owner can file for bankruptcy and his/her business and unsecured personal debts will be discharged. When a firm is a corporation, limited liability implies that the owner is not legally responsible for the firm’s debts.
However, lenders to small corporations often require that the owner guarantee the loan and may also require that the owner give the lender a second mortgage on his/her house. This wipes out the owner’s limited liability for purposes of the particular loan and makes small corporate firms into corporate/non-corporate hybrids. Thus personal bankruptcy law applies to non-corporate firms and may also apply to small corporate firms.
In this paper we test whether variation in personal bankruptcy exemptions across U.S. states affects credit small firms’ access to credit, using the 1993 National Survey of Small Business Finance (NSSBF). We find that small businesses are more likely to be denied credit if they are located in states with high rather than low homestead exemptions and that, if they receive loans, the loans are smaller and interest rates are higher. We also find that bankruptcy exemption levels affect both non-corporate and corporate firms, suggesting that lenders often ignore small business’ organizational status in making their loan decisions.
The remainder of the paper is organized as follows. After a brief literature review, section 3 discusses personal bankruptcy law. Section 4 discusses a simple model of small business credit markets. Section 5 presents the empirical results and Section 6 concludes.
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