AMERICA’S SMALL BUSINESSES – some 26 millionstrong – form the heart of our nation’s economy, creatingtwo out of every three new jobs and making up more than99.7% of businesses in the United States, according to theSmall Business Administration.

Of these businesses, all of which employ fewer than 500

individuals, less than 1% generate morethan $10 million in annual sales. Yet, as awhole, small businesses contribute an estimated 50% of the country’s gross domestic product.

This means financial institutions frequently lend to small businesses – andthis can be a sizable risk category for defaults. Still, the potential in the mar-ket has led lenders to build targeted mar-keting plans and dedicate budgets togrowing business in this group.

The shift in spending on small-businesscards will grow at a 12.8% annual ratethrough 2009, reaching an estimated 71%of the $429 billion market by then,according to TowerGroup, a financial research company. The growth is expectedto come from more spending rather than a shift from consumer card use forbusiness expenses.

Despite the importance of the small-business market, many lenders are not using the best tools to tap its potential. Foryears, lenders relied on either straightconsumer or commercial credit scores to

determine whether to extend credit to small businesses.While each score contains valuable information and

insight, relying on just one provides only a partial pictureof whether a business is creditworthy and is not as effective as looking at a blended score.

With considerable stock market volatility and talk of

The Commercial & Consumer Credit Authority / June 2008

By Dan Meder

Reaching Out to Small Businesses

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recession, it is not surprising thatDiscover Small Business Watch foundthat only 24% of small-business own-ers felt the economy was improving inApril, down from the 45% who felt thatway in April 2007.

Small businesses are highly suscep-tible to economic changes. With fewerresources to draw from, one or twoconsecutive difficult selling seasons canseriously squeeze cash flow for smallbusinesses and put their survival atrisk. With many analysts predictingcontinued economic turbulence, it willbe important for lenders to have themost complete and accurate data aboutthe small businesses in their portfolioand on their prospect lists.

Commercial vs. Consumer Understanding how the commercialand consumer worlds differ in theirviews of credit is critical. Given thatthere is one commercial business forevery 10 consumers in the UnitedStates, lenders on the commercial sidedeal with much less volume than theirconsumer counterparts.

Commercial credit scoring is much less regulated than consumer credit scoring. The commercial environmentis multidimensional.

There are single individuals in the consumer world versus multiple busi-ness structures; industry differencesthat are not found in the consumerworld; and major differences betweensmall and big businesses. The broad-based nature of the commercial worldmeans it inherently comes with moreexposure than the consumer side.

Furthermore, business credit infor-mation relies on diverse sources of data beyond pure financial aspects such asa loan or business credit card.

A crucial part of business credit information comes from the network of

business-to-business suppliers. For example, an auto repair shop does notpay cash every time a headlight is deliv-ered. Rather, it might pay on a term basis, typically 30 or 45 days. This webof suppliers report on their relation-ships, but the process is not as well-established as is the consumer process.

In contrast, in the consumerworld, the use of scoring has beenaround since the 1970s, driven by theneed to evaluate thousands of creditcard applications quickly and consis-tently. Consumer credit informationcomes from credit cards, mortgages,home equity loans and other sourcesthat report regularly. The data is easily retrieved.

Single Score DrawbacksMany issuers still size up the poten-tial performance and risk of smallbusinesses with one limited measure– the owners’ consumer credit infor-mation. Other small-business credi-tors track credit reports on the actualbusiness to watch for signs of trouble.

Advocates of relying solely on consumer data to determine small-business creditworthiness often pointout that these owners tend to act likeconsumers and fail to separate busi-ness and personal expenses.

While the percentage is dwindling,the TowerGroup study indicated thatmore than 30% of small-business purchases are made with personalcredit cards. This means that businesstransactions could be locked within asmall-business owner’s consumer per-formance information. For example,the same van a florist uses to take his or her kids to soccer practice also may be the van used to deliverflowers. Given this factor, are the owner’s van payments a business orpersonal expense?

Relying solely on commercial in-formation for small-business creditscoring presents different challengesand complexities that provide only apartial picture of creditworthiness.

Business reports can be inconsis-tent and incomplete. Making smartdecisions in the commercial world re-quires a different paradigm. A morereliable system looks at a completecredit profile, which takes into ac-count both the owner’s individualcredit history and the business’s com-mercial credit score.

There is considerable research tosupport this newer, holistic view. Astudy by Experian looked at a samplingof 50,000 small businesses and theirowners over four years to determinewhich method of evaluation, businessor consumer credit, was a better indi-cator of default risk.

The study analyzed hypotheticaland real business data to validate theperformance of blended scoring mod-els using the Kolmogorov-Smirnov(KS) measure, the powerful test of amodel’s accuracy. (The KS statisticmeasures the separation between com-panies that are a good credit risk andthose that are bad. The better the model, the greater the separation – andthe higher the KS.)

The study demonstrated that whentrouble hits the business, blendedscores dropped an average of 30%over the four quarters leading up to the financial difficulties.Meanwhile, business owner consumerscores showed no statistically signifi-cant decline over the same period.Therefore, creditors relying on theconsumer score alone would miss the cautionary red-flag warnings provided by the blended score.

That being said, tracking businesscredit alone is not much better,particularly in the micro-business

segment – those with fewer than fiveemployees. The study found that ofbusinesses that experienced signifi-cant credit problems, about 53% re-vealed their first signs of difficultythrough their business credit report.However, nearly half of the time(46%), problems showed first on anowner’s personal credit report.

For microbusinesses, it appears thatpersonal and business credit activitiesare far more intertwined than for com-panies with more employees.

Data indicated these owners’ creditwas a leading indicator of trouble 70%of the time. But when looking at smallbusinesses with more than five em-ployees, the first signs of trouble con-sistently are shown through theirbusiness credit.

For more information about theExperian study, detecting signs of cred-it trouble among small businesses andthe advantages of using blended scores,watch for part two of this column in the

July issue of Collections & Credit Risk.CCRDan Meder is vice president ofExperian’s Business InformationSolutions group.

Another strong argument can be made for a blended approach by diving deeperinto one company – a large small-business card issuer. The company analyzed

its portfolios of more than 100,000 credit records and found that the blended scorewas able to match 99.1% of the accounts in its portfolio and produce a KS in themid-30s, a strong showing in predicting commercial performance. In contrast, whencompared to different commercial-only scoring methodologies, the performance ofthe blended model more than doubled against the commercial-only scores.

When one examines the scores of a portfolio of businesses over a 12-monthperiod and checks to see how each of these businesses actually performed, thebenefits of the blended score are clear. Across portfolios, blended scores outper-form consumer-only scores by 10% to 20%.

The key reason for the success is that, unlike consumer scores, blended scoresare designed to predict business performance. The consumer score utilizes person-al data to predict consumer financial behavior. Conversely, the blended score evalu-ates the personal information on the owner as it relates to business performance.

A CASE STUDY

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