How New Entrepreneurs Can Bank on Social Capital

Dense friend networks and tight community ties give first-time founders better access to bank loans and other investment sources
Alan Morantz
Three tree frogs on a branch.

The essentials

  • Social capital is the product of both dense networks and altruistic norms such as mutual trust, volunteerism and philanthropy.
  • A recent study shows that first-time entrepreneurs located in communities with high social capital have easier access to outside financing—particularly bank loans—and rely less on the founder’s personal guarantees or savings than those based in communities with low social capital.
  • Startups located in high social capital communities also reach peak output sooner, in terms of revenue, total assets and number of full- and part-time employees.

Social capital is like a trump card that improves any hand you’re dealt. Having a dense network of family, friends and colleagues—or living in a trusting community in which members volunteer and look out for one another—is good for your mental and physical health and career development

It’s even good for business. Research in the U.S. has shown that firms located in counties with high levels of social capital receive lower-cost bank loans, enjoy lower audit fees and report higher performance than those located in communities with less social capital. 

Now comes news that social capital gives entrepreneurs an edge in financing, just when they need it the most.

Perhaps the biggest challenge facing new entrepreneurs is attracting sufficient capital to underwrite the development and delivery of their product or service. This is an age-old problem: Formal lenders, such as banks, are leery of backing founders who have little or no track record or tangible assets that can be used as collateral. So for many entrepreneurs, it’s bootstrap or bust.

That’s where social capital can really help to grease the wheels of new-venture financing. An entrepreneur boasting a strong social network or living in a tight community could be less of an unknown to potential lenders. There’s always someone who knows someone who can vouch for the inexperienced risk-taker. This “social collateral” could take the place of physical collateral, says Evan Dudley, Distinguished Faculty Fellow of Finance at Smith School of Business. After all, you’re less likely to misrepresent your venture on a loan application or steal funds after a loan is made if there’s a chance you’d be burning bridges with someone in your social circle. 

“Unlike large firms, young ventures don’t benefit from analyst followings or have access to public debt markets,” says Dudley. “There are no large institutional shareholders and experienced creditors to advise and finance them. The absence of these institutional features suggests that informal arrangements and social institutions play a greater role in explaining these firms’ financing choices.”

Tight communities have an edge

Dudley designed a study to examine the effects of social capital on new ventures at the county level, focusing on survival odds and growth in assets, revenue and number of employees. Fortunately, there is well-established information on social capital at the U.S. county level: number of social and civic associations and nongovernment organizations, voter turnout in presidential elections and the census response rate are all available. And for businesses, Dudley turned to eight years of a unique, highly granular survey involving 5,000 startups. Survey data covered everything from the proportion of owner and bank debt to loans from family and friends and owner versus outside equity. 

When Dudley combined and analyzed the data, the answer was clear: new ventures in counties with higher levels of social capital have more financial leverage. They have easier access to outside financing (particularly bank loans) and rely less on the founder’s personal guarantees or own savings.

Perhaps because they have better access to outside financing, these startups also perform better. Startups in high social capital counties reach peak output sooner, in terms of revenue, total assets and number of full- and part-time employees. And they are better able to withstand the vagaries of the market. In Dudley’s sample, only 38 per cent went out of business compared with 44 per cent of those from low social capital counties. 

Dudley did find that the effects of social capital wane after two years. It’s understandable given that entrepreneurs become more of a known commodity and can eventually offer tangible assets as collateral. But the advantage from social capital is still there. During the 2008-2009 financial crisis, firms with higher social capital enjoyed greater access to outside debt financing such as bank loans.

The full power of social capital may be lost on those entrepreneurs who have a blinkered view of what it offers. Many entrepreneurs see social capital merely as a channel to access informal financing—say, a loan from Uncle Ed—or one-off advice on logo design. As this study makes clear, social capital really gives entrepreneurs access to formal financing arrangements, such as bank loans, which is much more valuable to a new enterprise. A banking relationship is a signal to other lenders and investors that the firm is creditworthy and has the potential to prosper. You can’t put a price on that type of social collateral.

Alan Morantz is a senior editor of Smith Business Insight.

Smith School of Business

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