While this has always been a common question for business owners looking at their funding options, it’s about to get even more popular. Wells Fargo recently announced that they are no longer offering personal lines of credit, shutting down accounts over the next few weeks to streamline their product offerings.
So what does news about personal lines of credit have to do with business lines of credit? A lot, because many small businesses owners use personal lines of credit for their business. Oftentimes it’s easier to get one. Consumers tend to have a job, house, and other assets. Many business owners have better personal credit than business credit, making them attractive clients to banks issuing personal credit lines.
Whether you’re evaluating your funding options or are one of those credit-displaced entrepreneurs, I’m going to give you the honest answer to the question of whether you should get a line of credit for your business:
Absolutely. Speaking as a recovering investment banker turned business owner myself, if you are able to get a line of credit from your bank, you should do it. It is the cheapest source of funding, and it’s versatile and flexible. It’s easy to draw on when you need it and you can simply leave it alone when you don’t.
How Can I Prepare to Get a Line of Credit?
There are plenty of resources about how to get a line of credit and what you need to do so. What’s not as available is how to plan and prepare for the application. There are a few factors to be mindful of if you decide you want to apply. Be prepared for these conditions:
- It takes time. From application to approval it could be a three to six month process. That’s not counting the time it takes to prepare and gather all the materials, bringing us to the next point.
- You have to be profitable. Your profit-and-loss and balance sheet will need to reflect that. You typically need to have three years of financial statements with either recent profitability or a very clear path to profitability for a bank to consider your application.
- You’ll need to provide a personal guarantee. You’ll also need to provide a personal net worth statement listing out all your personal assets and liabilities. (This is pretty standard and is likely also required for any alternative finance options you might consider.)
- You’ll need professionally prepared documents. Your CPA or accountant will need to prepare three years worth of financials. Determining the limit on your line of credit is done on historical financials, not forecasted growth.
One special note on that last point. The limit is set based on historical financials, so if you are growing quickly it won’t take long until that line of credit can no longer keep up. Asking for a higher limit is an option but it will take time for the bank to consider it so it’s also a good idea to make sure you have other sources of funding available to you.
More than confirming that you should indeed apply for a line of credit, the main point of this post is that there are many ways to fund your business out there and they are not mutually exclusive. You can – and should – have multiple sources of funding that complement each other well. If you and your accountant or bookkeeper can determine your financial needs and goals together, you’ll be well on your way to finding that ideal mix.
How Multiple Funding Options Drive Growth
I’ll give you an example of a situation I’ve seen happen over and over. Say you’re a business owner facing a common cash flow challenge: cash is slow to come in from accounts receivable, and what is coming in has to be spent on operating expenses. Then an opportunity for a major project comes up, or an existing customer wants to deepen their relationship with you, which requires you to buy materials or hire contractors with cash you don’t have. It would be a shame to have to turn down the opportunity to grow. I’d also be remiss if I didn’t mention that poor cash flow situations like this are highly stressful for business owners. However, by finding and using complementary financing options, you can easily solve this problem.
In this case, you could use your line of credit on normal expenditures like inventory, payroll, and marketing. While you’re growing you could use another financial tool designed for using quickly, like credit cards, a merchant cash advance, or invoice financing to fund more purchase orders. By having options for fast, flexible financing, you can get the cash to fund new work so you can grow without going into debt – or have more options ready in case your line of credit application doesn’t get approved.
Why Banks Deny Business Lines of Credit
Even though business lines of credit have a 73 percent approval rate, there’s always the possibility of banks denying a line of credit. That approval rate is a bit misleading because it doesn’t consider what percentage of the money requested is actually approved. If you request $500,000 but only get approved for $10,000, is that really helpful? It’s an unfortunate (and again, stressful) situation, but by maturing and growing your business and taking advantage of different financing options, you can still get funded. Below are some of the common reasons this happens. Any one of these by itself could cause an entrepreneur to get denied:
- Too new. There’s not enough of a track record yet to make a decision.
- Not profitable. Your financial statements show the business has only been breaking even or losing money. Perhaps you hit a speed bump after years of profitability. Now you have to start over to prove the business’ ability to generate profits
- Lack of assets. No “hard” collateral for a secured line of credit. An example of this is a consulting company or any company where your assets are people and not equipment or vehicles.
- Too small. It’s the same amount of work for a banker to process a large loan as a small loan but they make more money on the large loan so they would prefer that. If you’re not big enough to be meaningful to them the bank will likely push for you to use your personal line instead of applying for a business line of credit.
Actions to Take Next
If you do want a line of credit, don’t wait to get started. Once you finish gathering documentation and completing your application, you won’t hear much from the bank until they have a decision, so you’ll have time to line up other financing.
Invoice factoring in particular isn’t based on your own credit, but rather the credit of your customers, making it useful if you haven’t built up enough business credit yet. Unlike a line of credit or other financing options that create debt, factoring doesn’t require repayment (since the fee comes out of the invoice amount) and takes the work of handling accounts receivable off your plate.
The bottom line is that business lines of credit are a flexible, low interest financial product, but it’s not the only one out there that can help your business succeed. Explore all your available options and choose a funding mix that supports your goal for the short and long term.