Running a startup business is a challenging task. You may seldom come across cash flow problems from time to time as operational costs run high and sales may not always be smooth enough. Startup business is all about uncertainties and inconsistencies which are the reasons that they usually need emergency funds to sustain and grow. Such businesses usually require quick funding which can come from banks or private lenders. One of the popular ways to procure cash for their operational needs is by getting a Line of credit. Before you pick this option to fund your startup during its initial years, here is all that you need to know about it.
What are Lines of Credit?
Commercial lines of credit refer to a type of borrowing that enables you to draw funds against a pre-decided credit limit. Whenever your business requires funds, you can ask the lender to disburse the said amount within the credit limit. Once the amount is withdrawn, your startup needs to repay the balance by making regular payments so that you reach your credit limit once again. A majority of lines of credit have some restrictions about using them, such as you are allowed to use them only for business expenses. For startups, these credit lines are of great help as they enable them to pay their regular expenses, procure inventory, deal with cash flow shortfalls and even take new opportunities. To some extent, lines of credit are similar to credit card though their working is more complex and requires in-depth understanding so that you can use it to your best advantage.
What are the challenges that startups face while getting lines of credit?
Getting lines of credit may be a challenge, especially for startups. The reason is that they come with stringent qualification requirements. Lenders take into consideration factors such as business assets, credit score and cash flow of a business. In case your startup does not meet these requirements, the chances of getting a line are bleak. Some lenders even place a condition that only companies that have a minimum of two years of trading history and are profitable will be given a line. In addition, they need to prove that they are capable of repaying the line.
On the other hand, there are some alternatives if you are a startup looking for a credit line. Lenders may agree to provide one if you secure it with your personal assets. In case the business defaults, the debt will be repaid by the owner. This may not be enough as lenders usually add certain covenants to business lines for startups. You are obligated to comply with them so that you can keep the line active. The covenants may include compliance requirements for certain financial ratios, keeping a minimum net worth for the business and paying the line in full on a periodic basis.
Advantages and Disadvantages of Lines of Credit for Startups
Lines of credits have their own pros and cons that you need to consider for a startup business. They are a flexible financing option as you can avail a certain limit for business expenses and will be charged interest only on the amount that you have used. This makes it ideal for dealing with occasional cash flow problems and financial issues. Moreover, they turn out to be less expensive as compared to other financing options. For this reason, they are favorable for businesses with low margins.
At the same time, there are some disadvantages that make business lines unsuitable for startups. Primarily, it is tough for startups to fulfill the qualifying requirements for availing them. A trading history, high profits and valuable assets are some parameters that startups can rarely show to the lenders. Also, the business line is hard to increase when a startup needs more funds at any point of time. This can be a serious concern for startups that need to scale their resources quickly but have reached their credit limit.
A Final Word
Before you consider a line of credit as a financing alternative for your startup, there are some things that you should consider seriously. Start by determining your true objective, whether you will need it for sustainable growth or just meeting your day to day expenses. The latter is more apt for this kind of financing because it will definitely not be helpful for pushing capital growth. Ensure that you have a personal asset that you can provide as security because most lenders would want one. Lines of credit can be a good option for startups that are confident about their ability to repay them.