(This column originally appeared in The Guardian)
Most small businesses in the US will continue to grapple with a slower economy, inflation, supply chain challenges and labor shortages next year. But our biggest problem will be interest rates. Rates rose sharply in 2022 — in 2023 those rates are going to hurt.
As recently as March, the federal funds rate, which is the rate the Federal Reserve charges banks for its money, was 0.25%. Now it’s 4.33%. During the same period of time, and because of this increase in the cost of doing business, the average prime rate at most banks has risen from 3.25% in March to 7% today.
That’s the prime rate, the very best rate the banks offer to their very best, largest, blue-chip customers. You and I aren’t getting the prime rate when we get a loan from a bank. A typical small business pays anywhere from two to four points above prime. Which means that as I write this, my clients are paying interest of 9 to 11% on their loans, which is more than double than earlier this year. And none of this includes the Fed’s plans to increase rates another 50 basis points soon, with additional increases threatened in order to control inflation.
This is a big deal.
If a small business has a $1,000,000 loan, its interest expense will increase next year from $70,000 to $110,000. That extra $40,000 could pay for an hourly worker, or more employee benefits, or repairs or more materials or a number of other things. But instead it will go to the bank, so the bank can satisfy its obligations to the Fed (and make its profit), which doesn’t really buy anything at all.
And these are the costs for a traditional bank loan, which is something many small businesses simply can’t get, thanks to lack of collateral, history and other risk factors. The costs of alternative financing — online lenders, merchant advances, credit card borrowings — is significantly higher.
The impact of this is going to be significant. When the cost of something more than doubles, it becomes too costly for some to buy. And that’s what will happen in 2023.
Startups will be unable to afford the financing needed to launch, and early-stage companies will be unable to come up with the money for the financing needed to grow. We’re already seeing this in the tech industry, where venture capitalists and other investors have pulled back their funding of unprofitable, early-stage companies resulting in tens of thousands of layoffs and hundreds of closures.
My clients are mostly business-to-business, employer-owned businesses that manufacture, distribute and perform services. Some of these clients have fixed-rate mortgages and equipment loans, received when interest rates were much lower. But few will be interested in new loans to finance new acquisitions because the interest costs severely eat into their return on investment from these investments.
More concerning is the cost of working-capital loans that are extended to small companies and which are almost always variable and exposed to interest-rate fluctuations. Working-capital loans are used to fund inventory purchases, shipments ahead of customer payments, labor costs and other operational expenses. As these costs continue to rise, fewer businesses will be able to afford doing these activities, which will have a significant impact on their profitability, let alone their sustainability.
Mergers and acquisitions will drop in 2023 as companies find it harder to raise funds to buy other businesses, which means those business owners who wish to sell and retire will simply have to wait, or accept lower payouts. And overall financing will tighten as banks — who famously avoid risk — will further avoid taking risks on smaller companies.
The impact of increased interest costs will dramatically increase our expenses. But what about revenues?
Rising mortgage rates have already shrunk most of the residential and commercial real-estate industry, taking away sales and profits from countless businesses that depend on this industry for their livelihood. Bigger projects that require financing will be scaled back, delayed or cancelled. Buying cars is now more expensive thanks to the increased cost of loans and leases, which means those businesses supporting the auto industry suffer.
And besides all of those in the financial services industry who make their money from interest income and capital gains, there are the countless small businesses in manufacturing industries who supply parts, labor and services to their customers, and who build equipment and machines, but who will build less of them thanks to a falling demand for equipment because their customers will defer on paying higher loan rates.
The good news? This won’t last forever. Nothing ever does. The Fed is raising interest rates for the right reasons, which is to rein in the inflationary environment we’re now in. Some businesses will shrug off higher interest rates as long as acceptable profits can be achieved through higher prices or overhead reductions. Anyone running a business for more than 20 years — like me — knows it’s all been done and seen before. And I believe things are now headed in the right direction.
But before we get back to reasonable rates of inflation and interest, there will be pain, because this will take time — at least another year and probably longer. Which means if you’re running a business in 2023 it’s going to be all about interest rates.