When entrepreneurs look for money for their startup or growing small business, I’ve learned there’s a right way and a wrong way to go about it. Some companies borrow at the wrong time, or for the wrong reasons.
Here’s my take on the right way for a small business to borrow. A good loan or business line of credit:
Has a goal. If you’re borrowing money in a panic because “the business is out of money,” that’s probably not going to work out well. Have a clear plan for how the borrowed funds will be used — a way that will generate cash to pay off the loan. Will more working capital allow you to do more marketing, or take advantage of a limited-time deal on inventory at a better margin? Have a clear sense of how this loan or credit line will help the company grow and give it the capacity to manage this debt.
Keeps your personal credit separate. Sometimes, small-business owners have let business-related debt pile up on their personal credit cards or lines of credit. Getting a properly structured business loan can pay off these damaging debts, or just keep debt from hurting your personal credit rating.
Builds up your credit. To get the best rates, you should be aware of your credit rating and work actively to improve it. That means building a low debt-to-income ratio, having few inquiries on your credit score, and keeping your utilization of lines of credit low. This last one is the number-one mistake I see small business owners make — you want to keep utilization down, as this one factor accounts for a whopping 30 percent of your FICO score. The factor that matters here is whether the line of credit reports to your personal credit or not. Simply put, if the business line of credit is reporting to your personal credit report, then it affects the utilization calculation. If it doesn’t report to your personal credit, then it does not affect this important FICO calculation — and a good FICO score is critical to securing capital at the most favorable rates. Businesses can build up their credit rating by using a new loan or line of credit wisely. Done right, a business loan can help improve your credit profile with Dun & Bradstreet, Experian Commercial, and Equifax Business — the important rating agencies for businesses.
Is cash-flow friendly. That means the monthly burden of servicing this debt doesn’t drain your company of too much cash. For instance, if we both borrow $50,000, and my monthly payment is $1,000 and your monthly payment is $9,000 (which is what you might well pay from using some specialty business lenders!), then my loan is far more cash-flow friendly. Cash flow is the lifeblood of your company — cash flow is huge. Make sure any debt you take on doesn’t choke off your cash flow too much and endanger the business’s survival.
Minimizes interest expense. An inexperienced borrower without a perspective may think getting the best rate is the most important thing — but doing that at the expense of cash flow or your credit rating may not be worth it. Yes, you want the lowest rate, but not in a loan that might hurt your personal credit or have too high of a monthly payment.
Maximizes tax benefits. An common example of how entrepreneurs mess this up is when they use personal credit cards for business expenses and then carry a balance. It’s more difficult to track, document as business-related, and successfully deduct business expenses on your taxes when they are mixed in with personal expenditures. A business line of credit, on the other hand, has a clear write-off of interest as a business expense.
Shows ‘skin in the game’ to investors. If you are seeking angel investor or venture-capital funds, you can use a small business loan to demonstrate your personal commitment to the venture. The more you show you are personally invested in your business, the more interested investors will be in your company.