Should you use credit cards to finance your startup?

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Should you finance your business with a credit card?

 

As any entrepreneur knows, one
of the most challenging aspects of getting a new business off the ground is
having adequate cash flow for growth. Securing financing can be a struggle,
which is why many small-business owners turn to their credit cards as a
significant source of financing.

A recent
survey
of startup founders by U.S. Trust showed that 16 percent turn to
credit cards to start their business, with 37 percent of millennial owners
using plastic to finance their business.

There are plenty of successful
examples of entrepreneurs who built wildly successful companies by spending
smart on their credit cards (Hello,
Google
).

“I’ve heard a lot of stories
about startups that were floated on credit cards,” says Paul Downs, author of “Boss Life: Surviving My Own Small Business.”
“But that’s survivorship bias. No one pays any attention to the people who went
down that road and didn’t succeed. I’d imagine there are a lot more stories
like that than the huge success stories.”

Credit card financing, despite
its popularity among startup founders, does carry some risks. Here are the benefits, the drawbacks,
other financing options and what you need to know if you charge ahead:

The benefits

The most obvious advantage of
credit card financing is that it’s easily obtainable if you already have good
credit and credit cards in your name.

“Credit card financing is
low-doc,” says Dallas-based small-business funding expert Myra Good. Issuers “don’t care if you started your business yesterday. They’re looking solely at
your credit score. A lot of business owners like that.”

If you’re able to pay off your
balance in full each month, business credit cards also can provide lucrative
rewards. They typically have higher credit limits than personal cards, and business
credit cards often allow you to add employees as authorized users.

Credit cards also can be used as a strategic tool to manage cash flow.

Ken Wentworth, whose Wentworth Financial Partners offers part-time chief financial officer services, advises small-business clients to wait
until the due date on an invoice and then pay the invoice with a credit card.

That could potentially provide
you 60 days after a purchase until you need to pay for it, assuming a 30-day
invoice period and a 30-day credit card statement cycle.

Wentworth also has worked with
clients who use 0 percent interest credit cards with long introductory periods to provide startup funds for a new business.

“You can have interest-free
money for over a year, but you have to build the payments into your budget so
that it’s paid off before the introductory period is over,” he says.

See related: How business owners choose their credit cards

“If you’re someone who hates debt and is going to pay in full, go for a card that offers rewards. Sign-up bonuses can be very good on business cards.”

The drawbacks

For many entrepreneurs, using
credit cards as a main form of financing is risky.

If the business fails, you’ll
be saddled with debt for which you are personally responsible – regardless of whether you have taken out business or
personal credit cards.

That’s because both types of
cards normally require a personal guarantee.

If you’re using credit cards
for long-term expenses, it can be an extremely expensive way to access cash. The
average annual percentage rate on credit cards is 16.73 percent, which is around
double what you’d pay for a loan backed by the Small Business Administration.

Plus, using credit cards to
finance your business can foster sloppy financial habits if you’re prone to putting
off payments.

“If you don’t pay the card off
in full, that just compounds the cash flow problem,” says Krista Tuomi, a
professor at American University, and an expert on entrepreneurial finance.

When you take out a business
loan, in contrast, you need to set aside a certain amount every month to pay it
– and you don’t have the option of making a minimum payment when cash is tight.
That forces you to maintain adequate cash reserves.

See related: 5 loan options to fund your small business

“If you don’t pay the card off in full, that just compounds the cash flow problem.”

Other funding options to consider

Using a credit card may not be
the only way to raise capital to keep your business running. A few other
options:

Peer-to-peer lenders

This is an option to consider if you don’t have strong enough credit to get a bank loan.

In peer-to-peer lending, the money comes from investors who make money by receiving interest on the loan.

Prosper and Lending Club offer small-business loans. You can use tools on the sites to ascertain what your interest rate would be.

For example, a business owner with excellent credit seeking a $40,000 loan for his or her business on Lending Club might be offered an interest rate of 6.83 percent and an APR of 9.61 percent (which includes a one-time origination fee of 4 percent, or $1,600, collected out of your loan proceeds and used to pay Lending Club as a fee for its services).

A bank loan


You’ll go through a more rigorous credit check than you’d need for a credit card, and you’ll need to provide some sort of collateral to secure the loan. The bank also may require a business plan to evaluate your business potential.

For example, to qualify for a Bank of America Business Advantage credit line or term loan, you will need satisfactory personal credit (typically defined as a FICO score greater than 670), at least two years in business under existing ownership and at least $100,000 in annual revenue.

Sell equity


Angel investors may provide funding, but they also typically want some say
over business operations. That can benefit you if they bring valuable
business knowledge to the table, but it can backfire if you end up clashing.

There’s also the risk of giving
up too much equity in exchange for investors’ money. Getting good financial
advice is a must if you go this route, and that often means springing for a
lawyer with experience in startup financing.

Borrow against your receivables


If your customers pay you after you have worked with them, such as a
professional services firm, you may be able to borrow against your receivables.

If you go this direction, it is
important to understand that the company will deduct its repayment amount
directly from your business bank account in set amounts each week until the
loan is repaid.

This can leave you in a
situation in which you are low on cash for the duration of the loan, unless
your future cash flow is steady.

Crowdfunding


Running a campaign on a site such as Kickstarter or Indiegogo is another
option, particularly for product-selling entrepreneurs who are very
active on social media and can generate interest quickly.

Such sites rely on
donation-based crowdfunding, so you don’t have to repay donors, but it’s common
for companies to use the cash as pre-orders for products.

“I’ve heard a lot of stories about startups that were floated on credit cards. But that’s survivorship bias.”

If you charge ahead

Go for a small-business credit card, rather than a personal credit card.

A small-business credit card will
make it easier for record-keeping and tax purposes to separate your business
expenses from your personal charges.

The downside of business
credit cards is they don’t offer the same consumer protections offered by personal cards.

Shop around to find the best
card for your business
’s needs.

“If you think you’re going to
carry a balance from time to time, look at the interest rate,” says Gerri
Detweiler, head of market education at Nav, a credit service for small-business
owners.

“If you’re someone who hates
debt and is going to pay in full, go for a card that offers rewards. Sign-up
bonuses can be very good on business cards.”

See related: 7 rules for using credit cards to finance a dream



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