In Virginia, as elsewhere, the quality of life is influenced by the level and nature of economic activities that either have emerged within the state or are attracted to the state. But as we move toward the new millennium, significant differences are emerging in economic development activities in urban and rural areas. Huge challenges loom in rural areasespecially in those communities where the economic base is integrally tied to commodities like tobacco.

Large, well-known businesses may have little trouble obtaining the funding they need to move into an area or to expand an existing facility. The story is often very different, however, for those small business entrepreneurs who need between $10,000 and $100,000 to start or expand their businesses. The programs designed to aid these businesses must have a banking partner, and that partner can be difficult to find.

Small business owners often live and work in the same community. They hire local people. They spend their earnings in the community. The same cannot necessarily be said of the large national and international corporations. While they do provide jobs for local citizens and while some of these jobs are high-paying and high-quality jobs, their corporate earnings often leave the community for headquarters in a distant city, state, or country. Depending upon the nature of the business, some of these large firms may cause local small businesses to close because they cannot compete. The large firms usually enjoy economies of size through lower operating costs that small businesses cannot achieve.

Some of these same issues face farmers, the prototype small business firm. In many communities, farmers are selling their operations to other farmers because they cannot be as efficient and cost effective as the larger operations. Those farmers who continue to operate on a small scale and those who have sold their farms or leased them to other farmers often need jobs to support their families. If the rural community where they live cannot provide those jobs, people will eventually move away. Out-migration decreases the tax base of the community and weakens its entire social fiber. This process is not new to agriculture, but it is now reaching a heightened sense of urgency for tobacco growers. To the extent that farmers leaving the shrinking tobacco industry cannot find jobs because they lack the required skills or because jobs do not exist in their communities, their quality of life and that of the entire community will decline.

Against a backdrop of sometimes disinterested banks and mounting pressure for change, local entrepreneurs are seeking ways to supplement or replace what they previously earned by growing tobacco or by providing supporting services to growers. In late 1995, the Tobacco Communities Project, which included the Institute for Quality Health and the Institute for Environmental Negotiation at the University of Virginia, the Rural Economic Analysis Program (REAP) in the College of Agriculture and Life Sciences at Virginia Tech, and area study committees from the Roundtable Meeting Discussions and Dialogue, presented its "Recommendations to the Joint Legislative Sub-Committee Studying Alternative Strategies for Tobacco Growers." The recommendations for credit and financing were developed by a committee comprised of representatives from Virginia banks, the Virginia Department of Agriculture and Consumer Services (VDACS), the Virginia Department of Economic Development, the Virginia Small Business Financing Authority, Department of Agricultural and Applied Economics at Virginia Tech, and Virginia Cooperative Extension. The committee found that most programs offered by the commonwealth are geared toward large manufacturing and industrial businesses. Committee members heard many expressions of concern that the lack of reasonable access to capital was blocking diversification efforts and making new economic activity very difficult in rural communities that badly need diversification, new investments, and change.

Based on the committee's findings and recommendations, the 1996 General Assembly passed Joint House Resolution 34 (JHR 34). The resolution directed the Small Business Commission to study capital access and the financing of agricultural enterprises. The commission shall examine the following: (1) new initiatives and existing state programs that may increase the accessibility to public and private capital; (2) programs implemented in other states, such as Michigan, aimed at increasing access to capital; and (3) the appropriate role of the state in providing the agricultural communities greater access to capital.

A lender appearing before the joint subcommittee studying rural access to credit told the committee that reserve levels of banks are regulated and tied to the soundness of loans made. “Consequently, high turn-down rates rather than a resistance to credit extension or economic development” (see under references, Summary, p.3.)

A Farm Bureau representative told the subcommittee that the Farm Bureau had surveyed its membership and found “credit was not indentified as an area of significant concern” (Summary, p.3.) The United States Department of Agriulture (USDA) has also studied the issue of access to credit in rural areas and found “serious market failures are [not]...epidemic in rural areas. Nonetheless, based on the structure of rural credit markets and anecdotal evidence, it is likely [that] market imperfections may persist in many rural areas" (USDA, p. 33).

Do these observations and anecdotal evidence contradict the results of the then on-going Rural Economic Analysis Program's research, which indicated that there are, in fact, significant problems? REAP found that market inadequacies and inefficiencies (table 1) in rural Virginia capital and financial markets do exist. And they do hinder diversification efforts, new economic activity, and rural development.

THE SURVEY

Partially because of its early involvement in the Tobacco Communities Project, REAP conducted research to answer some of the questions raised by JHR 34. Farmers grow tobacco in the five counties selected for the study Grayson, Patrick, Halifax, Mecklenburg, and Brunswickbut the counties were selected to ensure relevancy across Virginia. These counties represent diverse levels of economic growth and development and significantly different combinations of agricultural and non-agricultural enterprises. With the exception of Halifax, the counties all had less than average population growth from 1990-1995. All have experienced decreases in the number of farms and increases in average farm size from the 1980s into the 1990s.

All bank headquarters and branch offices in the five counties were surveyed. A second mail survey was sent to a random sample of 2,000 farmers, agribusinesses, and non-agricultural businesses. Their questionnaire focused on the experiences of respondents as they sought credit and were either successful or unsuccessful in obtaining it. A major limitation of the sample was that only people currently in business were surveyed.

Typically, lenders say that the pre-venture and start-up phases of a business (see table 2) are the most difficult, costly, and time-consuming to finance. They spend more time developing financial and marketing forecasts, making on-site visits, counseling, providing personal finance and tax planning, and arranging outside assistance for these first two stages than for other stages in the business life cycle. Because of the additional time spent on these loans, the total cost per dollar loaned increases.

Most of the responding lenders felt that they were facing, or will face, increasing competition from other lending sources. Lenders had mixed responses to the need for government loan guarantees. By and large, they prefer to make loans without government guarantees because these guarantees increase the time and paperwork required to process a loan. On the other hand, lenders said these guarantees were often important for businesses in stages one and two and may sometimes be a necessary condition for a loan to be extended.

Commercial banks are the primary source of credit, according to survey respondents who requested loans. Generally, borrowers in Virginia are conservative in their use of credit, with most loans being less than $50,000 and debt-to-asset ratios well below national averages. Being conservative in their use of financing leads potential borrowers to be less aggressive in seeking new or alternative sources of financing for their enterprises. Unfortunately, this same conservatism, which will help them weather adversity, might also be a barrier to new investments when a community most needs an economic stimulus.

Financing a business generally takes two forms: debt and equity. Debt financing involves borrowing money that is either secured or unsecured. Equity financing involves an infusion of capital from new or existing partners in a partnership or sale of stock for a corporation. Sixty-six percent of the respondents reported using debt financing; only 26 percent reported using equity financing. Venture capital, they said, was generally not an option to new businesses, but some businesses in the on-going and stable stages (see table 2) have made use of it. Reinforcing this rather negative evaluation, Virginia's Small Business Development Centers (SBDCs) reported having received numerous applications for which they sought banks and other investors to provide venture capital, but the investors typically were uninterested, especially for new businesses.

Both potential borrowers and lenders agreed that the reasons most often given for loan denials were poor cash-flow projections (whether they meant poorly prepared or projections showing inadequate cash flow cannot be determined from the survey), weak financial statements (again, whether they meant poorly prepared or inadequate assets relative to debt to be incurred could not be determined), insufficient equity, and limited or nonexistent collateral. The state's SBDCs are expected to provide technical assistance in preparing business plans, financial projections, and market (sales) projections. However, the SBDCs admitted that they often lack the resources or the personnel with the expertise to provide this type of technical assistance. Properly prepared business plans; logical, well constructed cash flow projections; and carefully prepared financial statements make the evaluation of the riskiness of the loan easier. Many borrowers do not have the expertise to prepare this information themselves, and given the responses of the SBDCs, this type of assistance is not easily obtained.

In the absence of rigorous business plans, collateral often becomes a key component of the lending decision. While collateral-based loans may not necessarily be sound loans, many lenders view the presence of collateral as necessary to make any loan. If the collateral has limited use; is industry-specific; or, like computers, is quickly obsolete, lenders are not willing to attach much value to it. Another reason given for loan denials had to do with trends in sales. Businesses with increasing sales are considered viable and generally succeed in securing loans. Businesses downsizing to remain viable, those with declining sales but still exhibiting excellent firm-level performance in a sector facing economic difficulties, or firms too new to have track records for sales are often denied loans. While lenders' concerns about these issues are legitimate, they illustrate the nature of the problems facing small businesses.

Non-risk characteristics of borrowers and lenders were also identified by the surveys as reasons for loan denials. Non-risk characteristics of small businesses include the number of non-local locations the business has, the number of business competitors in the local market, and the total amount of short-term loans held by the same lender.

According to survey responses, a small business with non-local branches is more likely to obtain financing from a bank in the community that hosts the headquarters of the business. Local banks are reluctant to help finance local business activity when the head office of that business is located elsewhere. Conversely, a local bank is often very anxious to meet the needs of the business headquarters in their areaperhaps to forestall competition from other banks.

A second non-risk factor is characterized by the number of competitors in the local market, suggesting that local lenders are more likely to be familiar with the type of business activity. The more familiar bankers are with a type of business, the more easily they can make decisions about its viability, and consequently, they are more willing to extend a loan. When lenders are unfamiliar with a business, they have no benchmark against which to evaluate the borrower's financial position and financial performance. Certainly, lack of knowledge on the part of the lender is symptomatic of market inefficiency and can become a major problem for the aspiring businessperson.

A third non-risk characteristic, the total amount of short-term loans held by a single lender, may be a function of internal bank policies that limit the total outstanding loans to one borrower. Debt load is a risk factor, but a large amount of debt may be quite acceptable when viewed in a debt-to-equity context. Still, loans were often denied when debt appeared to be large. These policies would suggest a market inadequacy. Assuming the borrower is credit-worthy, denying the loan on the basis of internal bank policy is not an issue of risk associated with the loan. Arguably, loan-specific risk is the only legitimate reason for denying a credit request. Furthermore, if bank portfolio diversification is the reason for loan rejection, the real cause may be insufficient competition in the financial market or weak portfolio management in the bank itself. Either of these situations is evidence of a market failure.

Lack of capital available to make loans also seems to be a function of the size and number of banks in a community. The larger the bank, the less likely is capital availability to be an issue. However, a mismatch between the request and the type of financing available often appears problematic. A mismatch is characterized by well-established businesses sometimes being unable to finance growth and expansion locally or non-locally, small loans ($5,000 to $10,000) being difficult for creditworthy businesses to obtain, some businesses being unable to secure operating loans, and lack of understanding of the business activity on the part of the potential lender.

AVAILABLE PROGRAMS

Volunteer and government programs are in place to provide technical assistance to potential borrowers. Other programs provide loan guarantees, bonds, and grants. But the general attitude of responding borrowers and lenders toward available state and federal programs was basically negative. A question, therefore, arises about the proper role of government in providing these services. Is Commonwealth of Virginia activity in this area correct? Is it adequate? Does it match the needs of borrowers? The evidence from the surveys clearly indicates that the commonwealth's programs are not adequate, are not always correct in their orientation, lack resources and expertise, or exhibit a combination of these factors.

Many potential borrowers, however, do not even know that the various state programs exist. Most respondents to the borrower survey said that banks were their primary source of information about loan programs. Two possible explanations can be given for this lack of knowledge. First, lenders themselves are sometimes unaware of the programs. Second, the lenders, because of the additional time, paperwork, and costs associated with using the programs, do not want to use them and, therefore, do not inform borrowers about them. Most of the existing programs require a banking partner to participate with the borrower. Supplying potential users with information about these programs and providing banks with incentives to use them appear to be necessary if the market is to function properly.

POSSIBLE SOLUTIONS

How financing needs are met in various sectors of the rural economy is a policy issue. Agricultural production and some agribusinesses are eligible for financing through the Farm Credit System (FCS). The economic well-being of a rural community depends on all sectors, however, not just agriculture. Mark Drabenstott (see references) has suggested designing a program similar to FCS to finance rural small businesses of all types. Creating such a system may not be a panacea, however. It could interfere with competition in and access to existing rural financial markets. Commercial banks view FCS as a threat to their market share. An FCS-type program that is in any way subsidized might drive existing lenders from the community or cause them to change their loan program orientation and emphasis. On the other hand, such a system could provide additional competition and might improve the performance of all financial institutions.

With inadequate collateral being a primary reason for loan denials, the need for a state guarantee or grant program of some type is clearly evident. Rural communities can be ideal locations for modern computer-based operations as communication technology grows rapidly. Yet, the collateral, computers, quickly becomes obsolete and loses its value.

Another major source of loan denials is the lack of sound cash flow projections and market plan development. These areas need to be addressed through educational programs. For the state to enhance existing educational programs and develop additional programs to fill gaps would not interfere with existing financial markets and could be a major boost to economic investment and economic activity in rural communities.

The consolidation of the banking industry is widely known. Many small businesses finance locally. As bank consolidations continue, will the new, larger bank always be interested in local small businesses? At what price, or interest rate, will they continue to be interested? Small loans cost more per dollar loaned, especially when the loan is for new and different types of economic activity. Whether the large banks will be interested is not clear.

Michigan, facing many of the same problems Virginia faces, developed a Capital Access Program (CAP). The goal of the program is to provide credit so that a business can get started and become eligible for commercial credit. CAP is based on the concept of risk pooling. Instead of the traditional equity requirements or guarantees provided by other programs, CAP has a special reserve fund for each bank. The bank makes the loan. The borrower pays a one-time risk premium in addition to any normally required bank fees. The bank matches the premium, and the cost of these risk premiums is passed to the borrower. The Michigan Strategic Fund, the overseer of CAP, matches the sum of the premiums. These premiums provide the pool of reserves for any losses from loan defaults. CAP does not allow the bank to be less prudent in its lending. Any loss greater than the CAP reserve is the bank's loss. What the fund does do is to provide access to capital for firms that otherwise might not be able to obtain it.

Responses to this urgent need in Virginia have been positive in direction but modest in magnitude. The Legislative Record reports a $100,000 appropriation to the Virginia Small Business Authority to support a pilot capital access program patterned after the Michigan program.

The pilot program has been conducted with Central Fidelity Bank, which was recently purchased by Wachovia. A 1997 bill to establish a statewide program was introduced by Delegate Vic Thomas, chair of the Agribusiness Subcommittee of Virginia's Small Business Commission. The bill, passed as House Bill 2424, provides financing totaling less than $1 million for the 1997-1998 biennium. This bill appears to be a step in the right direction, but the dollar support is still small, even though significant leveraging of the state-provided funds is expected. For example, a new cotton harvester costs $250,000, and a 100-horsepower, four-wheel drive tractor can cost over $100,000. Farmers looking to diversify will need money, and the situation is just as difficult for the non-agricultural small businesses looking for a chance to contribute economic activity and jobs in rural communities.

Unless changes are made, it appears that rural Virginia is likely to remain in a relatively weak position, poorly prepared to face diversification and unable to meet new investment needs and to respond to the economic challenges that are certain to occur. Until documented financial-market inadequacies and inefficiencies are addressed, rural Virginia communities will be constrained in their ability to respond. Agriculture is changing rapidly; it is

becoming more global and more industrialized. The tobacco sector is especially vulnerable to economic pressure as the tobacco companies are allocating billions of dollars to pay for health care and changes for tobacco growers and tobacco-growing communities. Many tobacco-producing families, and families producing other

commodities, will be forced to find off-farm jobs in order to stay on their land fand in their homes and to be productive members of their communities. The availability of local jobs will depend in a significant way on whether local entrepreneurs and small businesses are able to finance planned operations. If Virginia's rural communities are to avoid the social and economic disruptions accompanying impending challenges, they must have reasonable access to credit. Financing is a necessary condition to economic development in our rural communities and will ultimately be an important determinant of the quality of rural life those communities are able to reach and sustain.

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