November 2010: Economic Development
When Small is Big: Microcredit and Economic Development
"Microfinance recognizes that poor people are remarkable reservoirs of energy and knowledge. And while the lack of financial services is a sign of poverty, today it is also understood as an untapped opportunity to create markets, bring people in from the margins, and give them the tools with which to help themselves."
Microcredit – the extension of small loans – gives people who would otherwise not have access to credit the opportunity to begin or expand businesses or to pursue job-specific training. These borrowers lack the income, credit history, assets, or security to borrow from other sources. Although the popularity and success of microcredit in developing countries has been trumpeted in the media, microcredit is established and growing in the United States and Canada as well. Its appeal comes from its capacity to provide the means for those who have the ability, drive, and commitment to overcome the hurdles to self-sufficiency.
In this article, the role of microcredit as a stimulant for economic development is examined. First, its importance for the establishment of small business is described. Second, the article provides an overview of the general microcredit climate in the United states and the local situation in the Ottawa area. Third, brief stories about individuals who have received this type of loan reveal the human impact behind the economic benefits. Finally, the role of microcredit in funding startups is analyzed in comparison to other sources of available funding. The article concludes with a summary of the benefits of microcredit as a win-win proposition for economic development.
Microcredit has proven itself as a strong stimulant to economic development. It is an investment in people that pays back many times its initial outlay. Loan recipients support themselves through their increased income, as well as employing others and generating business for their supply chain. Governments benefit through decreased social assistance costs and increased tax income. Most microcredit is offered by non-profit social enterprises; as the loans are repaid, the money is invested into other loans, bringing the benefits of microcredit to an ever-expanding pool of entrepreneurs.
In Canada and the United States, microcredit varies in size, from very small loans of a few hundred dollars to purchase the basic tools to offer goods or services, to slightly larger loans in the thousands of dollars that enable borrowers to cover initial marketing and working capital costs for their business. No definitive upper limits are established for microloans, with each microcredit organization determining its own parameters; however, microloans are generally substantially smaller than those undertaken by most financial institutions.
The Power of Small Business
In the United States, the Bureau of the Census indicates that small businesses (with fewer than 500 employees) create 90% of net new jobs, with the Small Business Administration noting that about 90% of employers have fewer than 20 employees. Approximately 15% of the labour force in Canada is self-employed (with no employees) and almost 98% of private enterprises with employees are classed as small businesses (fewer than 100 employees), with over 85% of these having fewer than 20 employees. These small businesses are a central component of the Canadian economy, especially in uncertain times, creating almost 70% of all new private sector jobs in 2008. In this context, the role of microcredit in economic development is clear: by supporting the formation and expansion of small businesses, microloans help create jobs and stimulate the economy.
The majority of microcredit lenders are not-for-profit organizations with a commitment to community economic development; their funding comes from governments, donors, and foundations. Canadian credit unions such as Alterna and Vancity are also active in microcredit, although their interest rates are often higher than those of non-profit organizations. Most financial institutions do not offer microcredit, since microlenders invest the same staff time as for a larger loan (and frequently more, especially in the case of new businesses), thereby incurring proportionately higher processing and administration costs. As well, the lack of loan security makes it riskier for the lender, even though the vast majority of microloans are repaid, with most organizations citing repayment rates over 90%.
A recent interview in the Globe and Mail with the president of Alterna Savings, John Lahey, indicates why the credit union has taken up microfinance: "Too often, microfinance gets treated as if it's a charitable donation. It is not - it creates real benefits. It's good public policy. It helps create jobs and get people off social assistance." In fact, Alterna estimates that its microfinance program has brought the credit union more than $1 million in additional business, as entrepreneurs take out mortgages and access other services. While the return on the microloan does not necessarily pay for all of the staff time on the original loan, microcredit customers are often loyal to the organization that was willing to invest in them and recommend it to others. There are also microfinance brokers, for example Prosper.com and the Funding Circle in the UK. Microfinance brokers connect individual lenders with small and medium-sized companies that the banks may not find profitable to serve. These organizations charge fees to both lenders and borrowers.
Microcredit plays an especially important role in enabling immigrants to establish small businesses, since they face significant obstacles to accessing loans from mainstream financial institutions, such as language barriers, unfamiliarity with financial norms, and lack of credit history. Many immigrants turn to self-employment as a means of circumventing the difficulties they have in finding jobs commensurate with their skills and experience. The potential for immigrants to be a powerhouse of entrepreneurial activity and job creation is indicated by a study of immigrant entrepreneurs in New York City in 2000, which found that 36% of New York's population was born outside the US, while foreign-born individuals made up 49% of all self-employed workers in the city. As well, "employment gains in neighborhoods where immigrants own a large share of the businesses significantly outpaced the increase in jobs citywide," with new job creation rising up to 27.9% in immigrant-dominated neighbourhoods as opposed to 6.9% citywide. Microcredit organizations assist their clients with business planning, helping immigrants to find their way through the maze of requirements necessary to establishing a successful business. Immigrants' skills, expertise, and experience are considered, offsetting the lack of a credit history. As well, microcredit organizations often work with settlement agencies in offering their loans to newcomers, and some have staff who can work with immigrants in their first language.
Microcredit in the United States
Grameen Bank has become world-renowned for its impact through microloans under the leadership of Muhammad Yunus, who won the 2006 Nobel Peace Prize for his work. Its success has inspired organizations in many countries, including the Grameen Foundation in the United States. According to the Grameen Foundation, more than 37 million people live below the poverty line in the US, with about 74% living in major metropolitan areas. The Grameen Foundation works through Project Enterprise in New York City, giving small loans averaging just $2,600. With over 700 loans disbursed since 1997, the businesses in Project Enterprise's loan portfolio generate US $1.56 million in local wages annually, with a 42% average increase in monthly profit after receiving a microloan.
ACCION USA is one of the largest US microlenders, with more than 3,000 active borrowers across 46 states and over 19,500 loans since 1991. ACCION USA notes that, "106 million people have limited access to mainstream financial institutions in the US and 28 million people are completely unbanked." ACCION USA's average loan of $6,300 allows small businesses to create an average of 1.7 new jobs and increase family income by 18%. Its business survival rate is an impressive 97% for established businesses and 90% for start-up businesses. In fact, the results of ACCION USA's 2009 impact study, conducted in partnership with the Aspen Institute, showed that results in the extremely difficult period from 2007 to 2008 were remarkable, with an average of 3.4 jobs (including the business owner) retained or created, at a median wage rate that was 24% higher than the federal minimum wage. As well, 98% of existing businesses in the ACCION USA study survived to year-end, compared to the national average of 70%.
The Ottawa Story
In Canada, there are a number of groups providing microcredit, including the Ottawa Community Loan Fund (OCLF), in the forefront of microcredit and community economic development in Ottawa since its inception in 2000. The OCLF's mission is, "to turn investments and donations into accessible financing to fuel innovation, expand opportunities, and improve lives." It provides loans for small businesses and for job-specific training, as well as for social enterprises and affordable housing projects. By supporting clients in their efforts to become self-sufficient, the OCLF assists them in moving from dependency on social assistance programs and precarious financial situations to a position of contributing to their families and the Ottawa community.
Initially, the OCLF was established to fill a local need by providing loans up to $15,000 to individuals with a solid business plan and experience who were not eligible for traditional financing. A special focus on youth was made possible through a partnership with the Canadian Youth Business Foundation (CYBF). This partnership with the CYBF has resulted in a direct investment of $355,000 in 26 new youth businesses established to date. The OCLF's training loan program began when a coalition of local immigrant agencies identified a financing dilemma. Qualified internationally-trained professionals were unable to participate in a program to obtain Canadian accreditation and employment in their fields of expertise because they were not eligible for student loans or for loans from mainstream financial institutions. The OCLF stepped forward with a specially-designed loan for newcomers accepted into accreditation programs, bridging the finance gap and allowing these newcomers to gain accreditation in Canada and begin working in their fields. Since that time, the program has been expanded to include all Ottawa area residents entering short-term job-specific training.
As of mid-2010, the OCLF is responsible for over $1.2 million of direct investment in the Ottawa community, including 87 loans to small/micro businesses totalling $860,000. The OCLF's clients come from a wide range of backgrounds, with many new Canadians and youth between the ages of 18 and 35. Their business ideas are as varied as the clients, although the small size of the loans precludes capital-intensive operations, and network or multi-level marketing businesses are not eligible. The key consideration is a realistic plan of how the borrower will use the money to create a sufficient level of cash flow to repay the loan. Most borrowers use the loan to pay for production equipment, initial office rental and deposits, office equipment, opening stock, marketing, business licences, professional fees, or startup working capital.
In order to gain a clearer understanding of the benefits of its microloan program, offered in partnership with Alterna, the OCLF engaged the Carleton Centre for Community Innovation to evaluate the social impact of its program in both 2009 and 2010. The 2010 survey found that the average training loan of $5,285 resulted in 88% of training loan recipients becoming employed, with 11% remaining unemployed. In the previous year, all of the participants found employment or moved to further education. As a result of their training, 68% of clients increased their salaries, with an average increase of $17,707. The average small business loan was $12,340, with 83% of clients financing startups and 17% financing business expansion. With this loan, half of the small business clients improved the location of their business, moving from a home-based business to a storefront location. As well, the small businesses created an average of 3.27 jobs per business, including full and part-time jobs, and increased their business revenue by an average of $14,440 in the time period directly following the loan.
These results are impressive on their own, and become even more significant when combined with the data on the impact of the program on government in terms of increased tax revenue and reduced expenditures. For example, three of the 2010 training loan clients were receiving some form of social assistance before their loan, which they stopped receiving after the loan. For these three clients, the OCLF loans saved the government between $18,000 and $30,000 per year. In addition, the increase in family income for training loan recipients generated an average of $3,019 per person per year in new income tax revenue. For small business loan clients, 66% reported that their income tax increased, 16% reported that it stayed the same and 16% did not disclose this information.
The People Behind the Facts
Each of the OCLF's clients have a compelling story to tell of their efforts to overcome obstacles to economic independence. In addition to accessing financing, OCLF clients cite the individualized assistance they receive in refining their business plans as key to their success. Andriy Azarov had an idea for a floral e-commerce business, but struggled to find financing to take his concept into action. With the OCLF's support, Andriy completed his business plan and attracted additional financing, allowing him to launch Cana Flora, now the second-largest Canadian-based business in its field. Another OCLF client, Berhanu Desta, decided to go into business for himself two years ago, when the recession was making it difficult to find work. The result was Greencare Home & Office Cleaning, a business that combines his passion for environmentally friendly solutions with his experience in the cleaning industry. Berhanu did the research and refined his plan, but when he approached the banks he found them reluctant to lend to a first-time business. When Berhanu came to the OCLF, it did not matter that his idea was new. The OCLF took the time to evaluate his plan and provide feedback. Thanks to OCLF's support, Berhanu is now in business and eager to give back to future entrepreneurs.
Microcredit has given these Ottawa residents and many more the opportunity to improve their lives and contribute to the economic development of their community. From landscaping companies and bakeries to the production of environmentally-friendly electronic devices and state-of-the-art digital green screen videos, the OCLF's clients use their skills and expertise to turn their vision into reality. In the words of an OCLF client, "I had direct business experience and a solid business plan, but what I didn't have was a credit history or collateral to prove I was a good risk. The OCLF has given me the solid foundation that I needed to advance my business."
Microcredit and Startups
Mark Cawley, Director of Lending Operations with the OCLF, outlines factors to consider when deciding whether to take on debt in a startup. "If the proposed debt will be incurred to fund equipment and services that are integral to the success of a business idea, determine whether the business can reasonably be expected to generate sufficient profit to cover the costs of that debt and a living for the principals of the business. If this is the case, and the business would not be established without the loan, then it is reasonable to take on that debt on top of - not instead of - any other funds available to the entrepreneur." Mark continues, "If the prospective borrowers have insufficient confidence in their ability to generate a satisfactory level of return or they feel that the viability of the business depends on a difference of one or two percent interest on the debt they are proposing to take on, then they should work to develop a more robust business idea. In this instance, bootstrapping is also inadvisable, because the weakness of the business idea may well lead them to lose their own money. Bootstrapping alone when other finance is available to accelerate the growth of a business with a strong business case results in missed opportunities."
Other potential sources of financing for startups include bank loans, credit cards, family loans, government funding, and venture capitalists or angel investors. Each has its advantages and disadvantages in comparison with microcredit. Generally, family loans or loans from friends are the most flexible option with the easiest terms, but funds available from these sources are usually limited. The most flexible unsecured source of money is normally a credit card; however, interest rates on unpaid balances are often punitive. Government funding in the form of a grant is desirable but of limited availability, usually only to businesses with an established track record engaging in specific activities (for example, export promotion or research and development). Much government funding is conditional on very specific performance requirements. Venture capitalists and business angels may be prepared to wait longer for a return on their investment, although they will have commensurately higher expectations. Such investors will usually want priority when any funds are available for distribution, as well as the control that comes with an equity stake and an inevitable accompanying shareholders' agreement. In contrast, a term loan is based on a known level of payment over a defined period, after which time the business will have fulfilled all of its obligations and will be independent of the lender.
In the commercial lending sphere, the best rates and the most flexible arrangements are offered when the borrower has a significant unencumbered asset such as a property to offer as collateral, which is not the case for most startups. Interest rates on term loans from commercial lenders tend to be lower when the borrower is making a larger contribution to the overall investment, the loan amount is larger, the term is longer, or the potential disposal value of the items bought with the investment is higher. Many commercial lenders are reluctant to advance funds to startups, often requiring businesses to have a two-year track record to be considered for a loan.
In contrast, microloans are usually "character-based" lending, where the personal commitment, experience, and skills of the applicant are considered along with the quality of the business idea. Microlenders often take more time to assist borrowers with business planning and the application process than commercial lenders, and frequently provide free mentoring after the loan has been disbursed. Microloans can be at preferential rates, for example, the microloans offered by the Canadian Youth Business Foundation and the Community Futures organizations, but are often at commercial rates. The major benefit for borrowers aside from the business mentoring is that their application is considered, when they would otherwise not be an acceptable prospect because of their credit status. However, microlenders do require a sound business plan to ensure the greatest probability of success and a viable self-supporting future for the borrower. The only potential downside for microcredit borrowers is the risk of default, which will set back their creditworthiness even further.
While technology businesses are eligible for microloans, it may not be the most suitable form of financing for these types of enterprises. Most microloans are based on the premise that borrowers will begin to generate revenue and start to repay the loan after a relatively short period of time, whereas technology businesses frequently require a longer incubation period before they become profitable. Angel or venture capital investors are prepared to wait for results, albeit with expectations of a higher return. As well, since microfinance lending is frequently unsecured, microlenders normally restrict the maximum amount that can be borrowed to limit their own exposure to any particular borrower's success or failure. While IT businesses often have limited investments in equipment, they usually need to pay the living expenses of the entrepreneurs and their staff until sufficient cash flow is generated from the business. Microlenders, however, are reluctant to advance funds that are not put directly into the business, because it might encourage their service to be seen as an opportunity for borrowers with unsustainable business models to "keep their heads above water" a bit longer.
A Winning Formula
Microcredit is truly a win-win proposition for economic development, boosting income and adding jobs for individuals, diversifying the regional economy while lowering government support costs and increasing government revenues. The importance of small business to the health of the economy, especially in difficult times, brings home the potential for microcredit to assist people in turning challenges into opportunities.
In addition, the business support provided by microcredit organizations assists entrepreneurs - particularly immigrants - in overcoming obstacles to success. Through microcredit programs, the talents and energy of an ever-increasing number of entrepreneurs are having a positive impact on their lives, the lives of their families and employees, and on the economic development of their regions.
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Editorial: Economic Development (November 2010)
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Major Events: Good Economics and Exposure to the World
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Why Intellectual Property Will Not Save the Canadian Economy
Brown, G. 2010. When Small is Big: Microcredit and Economic Development. Open Source Business Resource, (November 2010). http://timreview.ca/article/392
Ottawa Community Loan Fund
George Brown is a lawyer and social entrepreneur who presently serves as President of the Ottawa Community Loan Fund (OCLF). Prior to this, George spent nine years as a City and Regional Councillor in Ottawa, where he was Chair of the City's Economic Affairs Committee and the Region's Environmental Services Committee. As Chair of Economic Affairs, George played a significant role in initiating and developing the Ottawa Entrepreneurship Centre, as well as promoting community economic development throughout the City of Ottawa including the establishment of the OCLF. George has a Master's of Science degree in Community Economic Development from New Hampshire College's Graduate School of Business (now Southern New Hampshire University) and an LL.B. degree from the University of Ottawa Law School. He was called to the Bar in Ontario in September, 2003.
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