Lines of credit are one of the most misunderstood subjects among startup founders and entrepreneurs. It’s not their fault. Most of the information out there is too generic to be actually useful. And, in some cases, it’s even outright inaccurate.
So here’s a primer on startup lines of credit. You are going to learn:
- How they work
- If you can qualify for one
- Their advantages and disadvantages
- Options that may work better
The big myth
Let’s start by debunking the biggest myth about lines of credit – the myth that a bank will give you a loan or line of credit based on the strength of your business plan alone.
This myth has been circulating for years. It’s often coupled with the nice story of an entrepreneur who boldly walks into a bank and, through the sheer power of persuasion, convinces a banker to take a risk and lend him the money.
This never happens. Period. End of story.
This doesn’t mean that banks will not provide you a line of credit for your business if your company is a startup. They can. However, you have to meet some very tough requirements. More on that later, though.
Let’s start with the basics.
The basics: How does a line of credit work?
A line of credit is a simple financing product that allows you to withdraw funds up to a predetermined amount. You pay charges on the outstanding balance and reduce it by making payments. The process works much like taking a cash advance from a credit card, though it’s slightly more complex.
Lines of credit are incredibly flexible and can be used for many things. Businesses use them to pay suppliers and operating expenses. Lines of credit are also very useful for helping cover gaps in your cash flow. This makes them very popular with business owners.
By the way, a line of credit is not a good option to pay for large capital expenditures such as machinery. Business loans and leases are usually better alternatives.
Here is a link with more detail about lines of credit and how they work.
The truth: Lines of credit are hard to get
Getting a line of credit is hard. Lending money is risky and banks are careful. Therefore, banks and lenders have lots of requirements and provide loans only if they are certain that they will be paid back.
Lenders make loans based on three criteria:
- Cash flow
If you want a line of credit, you or your business must have all three. There are no exceptions to this rule. Usually, the owners must have good personal credit to indicate they have good character. The business must have enough cash flow to repay the line of credit. Lastly, the business (and/or owners) must have collateral to back the line of credit.
Also, most lenders will give a line of credit only to companies that have a minimum of two years’ worth of operating history. This is why new startups can seldom get a line of credit – they don’t have the trading history and they don’t have the cash flow to support it.
Keeping a line of credit can also be difficult. Banks usually add covenants to their loan agreements which you must meet. A covenant is a rule, such as: your company must maintain certain financial ratios, pay back the line regularly, use the loan in a certain way, and notify the bank of certain material events.
Plan B: Personal lines for business use
Startups that don’t meet lender criteria can still get lines of credit if their owners have assets and great personal credit. Basically, you get a business line of credit based on the strength of your personal assets.
For example, a business owner who owns a home can get a home equity line of credit (HELOC) and use it to finance the business. If things go wrong, the bank can eventually foreclose on the home and get paid back.
Alternatively, you may get a line of credit simply because your personal credit is very good. Some banks offer these and don’t require that you directly pledge assets. These lines are often referred to as “unsecured.”
Unsecured lines of credit don’t really exist
Unfortunately, the term “unsecured” is a bit of a misnomer. Most entrepreneurs think that an “unsecured” line protects them from having to pay the bank back if they default on the line.
This is flat-out wrong! Think about it for a second. Why would a bank lend money without having a way to guarantee repayment?
An “unsecured” line simply does not have direct assets as collateral. You get this privilege only if you have excellent credit. However, the line comes with a personal guarantee from the owner. If the line defaults, the bank can sue the owner for their personal assets. As you can imagine, such lawsuits can drag out for some time and make your life miserable.
If the lender wins, the lender can use the judgement to attach your assets for repayment. They can attach your home, bank accounts, and garnish your wages. Still feel like it is really an “unsecured” line? Didn’t think so. Ultimately, banks have a way to collect. Otherwise, they would not lend.
Lines of credit are not perfect either
While lines of credit offer some flexibility, they have one major drawback which makes them unappealing to some startups. Getting your line of credit increased is difficult, especially early on.
Imagine this scenario: your company manages to get a line of credit and starts growing the business. You use the line to pay suppliers, which allows you to sell more to clients. Soon enough, you reach the line’s limit. Sounds like a good problem to have, right?
Not really. Most lenders will increase your line only after you have had it for while. Even then, they will ask you for a business justification and will repeat part of the underwriting process.
So, if you shot through your limit within five months because you are very successful, too bad. Getting an increase will be hard and will take some time.
By the way, I don’t mean to sound negative about lines of credit. I think they are a great product. I know many successful businesses that use them.
The problem is that many new entrepreneurs have serious misconceptions about them. I just want you to understand that they are not perfect and they have limitations.
If you are looking for a line of credit, consider the SBA 7(a) loan program which helps entrepreneurs get business financing. Their program makes getting a line of credit a little bit easier for folks that need them.
If you are looking for other alternatives, consider reading “Finding Money to Start a Small Business,” where I list 13 options that you can use to finance a new and growing business.