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Is a Line of Credit the Right Solution for Your Startup?
Running into cash flow problems from time to time is part the process of running a startup. Sales growth is never orderly and can happen in spurts. These inconsistencies can be hard to manage and often leave you cash-strapped, without enough money to pay suppliers or employees or to expand.
When companies run into cash flow problems, most owners apply for a business line of credit. In my experience, most owners underestimate the difficulty of getting a line of credit. And, in most cases, a line of credit is not always the best solution.
What is a line of credit?
A line of credit is a product that allows you to draw funds against a set credit limit. Whenever you need money, you make a draw request from the lender. After making a draw, your company has to make regular payments to repay the balance. You pay fees on the outstanding amount; however, some lines include additional fees.
Most commercial lines of credit have restrictions concerning how you can use them. Obviously, you can use them only for business expenses. Companies use lines of credit to pay suppliers or regular expenses, to take new opportunities, or to deal with cash flow shortfalls.
A revolving business line of credit can actually work much like a credit card, though they are more complex. For more specific details on how commercial lines of credit work, read this longer explanation.
Getting a line of credit is difficult
One of the problems with lines of credit is that getting one is difficult, especially for new businesses. Lines of credit have stringent qualification requirements. Lenders provide loans only to companies and business owners who have assets, cash flow, and a good credit score. If you don’t have these, getting a line is nearly impossible.
Lines of credit are also not directly available to pure startups. Companies must have two years of trading history and must be profitable. They must prove to the lender that they can repay the line.
However, there are ways around this requirement. Lenders can provide business lines of credit that are secured by the owner’s (or major shareholders’) personal assets. If the business defaults, the owner pays.
Even if you do manage to get a line of credit, keeping it can be difficult. Lenders often add covenants to their business loans. You must comply with these covenants in order to keep the line of credit active. Some covenants include:
- Complying with certain financial ratios
- Paying the line in full every so often
- Keeping a minimum net worth
- Advising a lender of material changes
The role of the Small Business Administration
The Small Business Administration (SBA) has a program that helps small business owners get a loan or line of credit. The SBA does not offer loans. Instead, it provides guarantees to lenders as a way to entice them to offer a line of credit to small businesses.
Most business owners misunderstand what the guarantee provides. The SBA guarantees 85% to 90% of the line of credit to the lender if the loan defaults. The lender is expected to try to collect from the business and the owner (if personal guarantees were involved) first. In this case, it’s good to think of the SBA as offering second- tier protection to the bank in case you default.
Lines of credit have two main advantages over other alternatives. They can be very flexible, as long as you use them within their limits. This flexibility allows you to deal with occasional cash flow problems.
Lines of credit are also less expensive than other alternatives. Therefore, they can work with businesses that have low margins.
However, lines of credit also have disadvantages. As I mentioned earlier, they are hard to get. Lines of credit are an option only if you or your company has assets and a trading history.
A greater disadvantage is that it’s hard to get an increase if you need more funds. This limitation can create a serious problem if your company is growing quickly and you have reached your credit limit.
What problem are you trying to solve?
Before jumping into a line of credit, determine your true objective for getting financing. Do you have a stable business and are simply looking for the cheapest financing? Then a line of credit is probably your best bet. If you have a growing business and need the most flexible option, then consider alternatives. However, these alternatives are more expensive than a line of credit.
Few startups actually qualify for lines of credit. As every founder knows, finding money to run a business is difficult. However, there are some options, especially if the startup has traction and has developed a customer base.
The following three financing options are easier to get than a commercial line of credit and offer more flexibility:
1) SBA Microloan
One SBA option that I like is the Microloan program, which is a part of the 7(a) loan program. Microloans are specific to small businesses and are offered up to a maximum of $50,000. What makes Microloans attractive is that they are much easier to get than conventional SBA-backed lines of credit. They also come with financial and business consulting services designed to help new entrepreneurs.
2) Invoice Factoring
Companies often look for a line of credit because they have cash flow problems. These problems are often the result of commercial clients taking 30 to 60 days to pay invoices. Small companies, especially growing ones, can’t afford to wait that long for payment. Factoring solves this problem by financing your slow-paying invoices. This financing provides immediate working capital to operate the business.
Qualifying for factoring is easier than getting a line of credit. You can get the line in a week or two. Most importantly, startups can qualify as long as long as they work with reliable clients. Factoring lines are flexible and are designed to grow with your sales (learn more).
3) Asset based lending
Larger startups that can’t get a line of credit or can’t meet banking covenants should consider an asset based loan. Assets based loans allow you to finance the assets of your balance sheet. Assets include invoice accounts receivable, inventory, machinery, and real estate.
In most cases, your greatest asset is your accounts receivable (invoices). Asset based loans allow you to finance your receivables in a structure that is similar to a line of credit. This arrangement provides liquidity to operate the company. In cases where machinery and real estate are financed, asset based loans resemble term loans (learn more).