New Financial Tools for Small Businesses: A Commitment Mechanism to Secure Funding

Abstract

We suggest new tools for financing small business newcomers that struggle to overcome bank's unwillingness to finance their operations. Prospective clients fear that the supplier may choose willful litigation by breaching the contract in case of potential operating loss in order to postpone his financial expenditures to a later period. We suggest a commitment mechanism whereby the seller undertakes a commitment to pay a bank the amount of the buyer's damages if the seller will not deliver the good. With the mechanism, the bank reports to credit bureaus of the newcomer's failure to pay the buyer's damages to the bank, and this threat makes the newcomer obligation to deliver the good reliable, and thus enables newcomers to overcome the entry barrier created by the risk of willful litigation. We show that the obligation to a bank is a theoretical equivalent to a special binary option, and how the purchase contract and the obligation to a bank as a binary option can be priced. The commitment mechanism may also provide the bank new tools to assess the newcomer's financial risk, and spread the risk of newcomers' bankruptcy by selling the obligations as binary options in an options market or by securitization of the purchase contracts.

Keywords: small business finance, entry barriers, bank funding, option pricing theory, binary options, options market, securitization, willful litigation, breach of contract, purchase contracts

JEL Classification: G20, G30, K12, K20, K41