NAICS Defined: The North American Industry Classification System, or NAICS, is a system created to classify companies operating in the US, Canada and/or Mexico, based on the industry they operate in.
Developed under the cooperation of the U.S. Economic Classification Policy Committee, Statistics Canada and Mexico’s Instituto Nacional de Estadistica y Geografia, NAICS replaced the Standard Industrial Classification (SIC) system in 1997.
Now, the main purpose for creating NAICS, as explained by the US Census Bureau, is to classify businesses “for the purpose of collecting, analyzing and publishing statistical data related to the U.S. business economy.”
NAICS enables the governments of the US, Canada and Mexico to better understand the goings-on within their respective economies.
But, as we’ll discuss throughout this article, NAICS codes are also used for an entirely different purpose by insurance companies, banks and other such institutions. Unfortunately, the implications of this “alternative” use to NAICS can potentially have far-reaching consequences for your business overall.
Before we dig into what these implications are, let’s quickly explain exactly how this classification system works.
What Is a NAICS Code?
A NAICS code is a five- or six-digit number used to quickly identify the type of business a given company is.
A few examples:
- 336111 identifies automobile manufacturing companies
- 337124 identifies companies that manufacture metal household furniture
- 423420 identifies a company as an office equipment wholesaler
The numbering system for NAICS works as follows:
- The first and second numbers designate the economic sector a company operates in
- The third number designates the sub-sector of the company
- The fourth indicates the industry group the company belongs to
- The fifth identifies the specific industry of the company
- The sixth number identifies the national industry the company belongs to
For a real-world illustration of the classification process, take a look at the following image:
Here, we see the classification process for resort businesses operating in Canada:
- 72 designates a business operating in Accommodation and Food Services
- 721 specifies the business as an Accommodation Service
- 7211 further specifies the service as Traveler’s Accommodation Services
- 72111 filters down to hotel and motel companies not related to casinos
- 721113, finally, identifies the business as a resort
Now, it’s worth mentioning that businesses aren’t given a NAICS code by their respective government. Rather, it’s the business owner’s responsibility to determine which NAICS code most accurately and honestly represents the services their company provides.
Additionally, for businesses that perform multiple functions or services, owners should choose the NAICS code that identifies where the majority of their revenue comes from.
Finally, conglomerates made up of multiple companies will need to assign a NAICS code for each individual company within the corporation.
How NAICS Codes Can Affect Lending Decisions
As we said, though the intended purpose of NAICS codes is to merely track economic activity throughout North America, the codes are often used as a sort of “cheat sheet” for many institutions that provide services to other businesses.
For our purposes, we’re going to focus on how your NAICS code can affect your ability to secure business loans from financial institutions and other such investors.
Essentially, when considering whether or not to provide a loan to a given company, financial institutions will go straight to the company’s NAICS to determine the level of risk involved in providing said loan.
To be sure, the word “risk” in that previous statement is pretty broad—and rightly so. Obviously, a lending institution wants to be near-100 percent sure that it will be able to collect regular payments from their borrowing companies, and will need to consider a variety of factors while coming to an informed conclusion.
Some examples of the factors lending companies consider include:
- The risks (to employees, equipment and consumers) involved in the actual service provided by a company
- The past, current and projected future state of the industry in question
- The business model(s) typically used by companies in a specific industry
Now, it’s worth pointing out that financial lenders would, of course, go through this vetting process in some other way had NAICS never been created. And, even with the NAICS acting as a cheat sheet, said lenders will do their due diligence to get a more granular understanding of each individual borrower-candidate they work with.
That being said, the reality is that NAICS codes that designate high-risk companies can easily get lenders started off on the wrong foot when it comes to deciding to approve or deny a specific business loan.
Let’s dig a bit deeper into what we mean by this.
NAICS and High-Risk Industries
Based on what we discussed in the previous section, you probably have a ballpark idea of the types of industries lenders often consider as “high-risk”—and why these industries are considered so risky.
Here, we’re going to discuss the three highest-risk industries within the NAICS, and explain some of the key reasons companies in these industries are often denied business loans altogether.
(Note: While we’ll be discussing entire industries as a whole, keep in mind that each specific type of business within these industries carries their own set of risks. While some specific businesses might not be as high of a risk as others within the same industry, the industries we’ll be discussing are on average designated the riskiest on the list.)
Transportation and Warehousing
There are two main reasons the transportation and warehousing industry (more specifically, the transportation sector) is considered the riskiest industry in the NAICS for lenders.
First of all, transportation services—be it public or private, people- or goods-focused—inherently have a high risk of experiencing damages or losses at any given moment. If, for example, a truck transporting produce breaks down mid-transit, the produce may spoil—with the trucking company being held liable for the loss. To add to that, the trucking company will also need to cover the cost of any repairs that need be made to the vehicle and other equipment.
Another issue with the transportation industry is the low barrier of exit for sole proprietors wanting to move on from their business venture. When disasters, such as the one mentioned above, strike, it’s not exactly uncommon for sole proprietors to cut their losses and walk away from the business entirely.
These factors—among many others—culminate in a sector-wide default rate of almost 50 percent. Needless to say, this represents a huge gamble for lenders—meaning the vast majority of transportation businesses are likely to see their loan applications denied almost immediately.
Wholesale and Retail Trade
The riskiest sectors within this industry lie on the retail side—but that doesn’t mean wholesale businesses are completely free and clear.
The main culprit:
Retail companies essentially live and die by the level of demand their customers have for their products. On the one hand, if demand falls, retail companies aren’t going to be pulling in as much revenue as when demand was steady. On the other hand, if demand skyrockets—and a retailer can’t keep up with the spike—consumers will likely defect to a competing brand to get the products they need.
Another area of concern, depending on the types of products being sold, is the low profit margin of many retail companies. This, in turn, leaves little room for such companies to comfortably repay their loans while still being able to keep business going (let alone growing). And, again: if even the slightest thing goes wrong, there’s a good chance it will cause major problems for the retailer (and their ability to repay their business loans).
Administrative Support and Waste Management
Here, we need to get a bit more specific to clarify exactly where the risk lies.
Within the administrative support and waste management industry, admin-focused services are typically seen as the riskiest. This includes staffing agencies, temp agencies and travel/tour guide services.
Businesses in these sectors often have very low profit margins, due to the nature of the business in the first place. Temp agencies, for example, collect payments from their clients—but then need to use most of this income to pay their temp employees for their services.
Now, because of these low margins, such companies often rely on business loans to get a more sturdy command over their cash flow. But, as discussed in the previous section, with little wiggle room left after paying off major business expenses, said companies can find it difficult to find the cash on hand to pay back their loans in full and on time.
Lending Alternatives for High-Risk Industries
Now, if your business happens to be one that’s often considered high-risk for lenders, you do have other options for securing funding.
Let’s quickly go over three of the most common—and lowest-risk—paths you can choose when looking to secure a business loan.
Invoice financing refers to business loans that cover outstanding balances on accounts receivable from the company’s customers/clientele. For a fee equal to an agreed-upon percentage of the overall loan, your business can immediately collect cash that would otherwise be collected from customers over time.
Say, for example, your company completes a $10,000 project for a client, agreeing to collect $1,000 from them each month for the next ten months. You can then work with an invoice financing lender to receive the entire $10,000 upfront, then pay the lender back as your client pays off their balance to your company.
In turn, you can then reinvest the $10,000 into your business right away—which, ultimately, will be much more effective than investing $1,000 at a time.
Crowdfunding is becoming an increasingly popular—and effective—means for businesses of any kind to raise funding with relatively little risk.
When crowdfunding, a business solicits small monetary investments from large population segments. Typically, those who donate funds will be those who either:
- Have an interest in, or need for, the products or services the business is developing
- See the potential value of the product or service, even if it doesn’t directly apply to them
Often, those who invest in crowdsourced projects will receive some kind of intrinsic reward that relates to the overall business. For example, the company may give investors early access to a new service, or gift them a personalized item of some kind.
More and more, though, we’re now seeing equity-based crowdfunding come into popularity, as well. Here, investors receive a percentage of the business’s equity equivalent to their initial investment.
Angel investors are wealthy individuals who know a good idea and business plan when they see one—and who also know that investing in such companies can potentially lead to major gains for themselves, as well.
Compared to business loans provided by financial institutions, receiving funds from angel investors is much less risky—and definitely more cost effective. Basically, angel investors give their money to startups with no expectation of being paid back in full; in other words, it’s not a loan—it’s a gift. So, for companies in high-risk industries (from the perspective of financial institutions), catching the eye of a well-off angel investor can potentially be the best way to get your company up and running.
The Risk/Lending Correlation & How to Overcome It
It’s just a simple fact that some business ventures pose more risks than others.
Unfortunately for entrepreneurs looking to break into these more risky industries, this can potentially mean facing an uphill battle in terms of securing business loans.
But that doesn’t mean it’s impossible for such companies to receive funding altogether. It just means you’ll need to be extra diligent and strategic when approaching investors or lenders to make them feel 100 percent confident that funding your business is the right decision.