Is bad credit bad for small business startups?

Blemished credit can limit your entrepreneurial success, but it doesn't have to stop it

By Tamara E. Holmes

With roughly 600,000 businesses launching every year, entrepreneurship is, for many, part of the American Dream. But for those with bad credit, the prospect of business ownership may seem more like a fantasy than a viable option.

While it's true that bad credit can hurt your chances for raising money, financial resources are still available for those who are willing to look for them.

Paula Frendel of Mahwah, N.J., discovered the perils of starting a business with blemished credit last year when she launched her personal training firm, Perfect Results By Paula. At first, she imagined helping clients burn fat and build muscle in her own fitness studio, but attorneys' fees for her divorce "put me into over $100,000 of credit card debt," the 57-year-old says. As a result, she had neither the money nor the credit to buy or rent a business space of her own.

Frendel's credit situation led her to miss out on other opportunities. Without access to a credit line, she couldn't afford some large expenditures, such as the $2,000 she'd need to complete a certification program that would have netted her free advertising and promotional opportunities to expand her business. Instead, she says, "I've had to grow it much more slowly."

But the obstacles did not stop Frendel from putting out her shingle. Since she couldn't afford a business space, she worked with clients out of her home. To buy the minimal amount of equipment she needed, she borrowed money from relatives. "What I have been able to put into the business has been successful," she says.

The best place to start a search for financing is through loans backed by the Small Business Administration. "SBA loans are designed exactly for borrowers with less than perfect credit," says David J. Hall, a spokesman for the SBA. In addition to a credit score, such loans take into consideration such factors as the business's viability -- meaning you have to have a business plan -- and any collateral the borrower has. "However, the SBA would not decline guaranteeing a loan based only on the lack of collateral," Hall adds.

While the SBA doesn't provide the funds directly and leaves the lending criteria up to the banks, it guarantees 90 percent of the loan if the borrower defaults, making the loans less risky to lenders. As a result, SBA loans tend to have looser requirements. Someone with bad credit and a good business idea would be more likely to qualify for an SBA loan than a traditional business loan, Lehman says. Business development centers that work with the SBA are the best source of information about lenders who offer SBA loans, but even SBA loans are harder to come by than in years past. In fact, roughly half the number of SBA loans were approved in 2009 than in 2008.

Thinking outside the bank
Another financing option that has become more prevalent during these tough economic times is microlending. Microlenders solicit small donations and investments from people and funnel those funds into loans for businesses. "Different microlenders work with different types of credit situations," says Laura Kozien, a spokeswoman for Accion USA, a microlender based in New York. For example, Accion USA requires a 575 credit score to receive a business loan, while Prosper, a microlender based in San Francisco, requires a credit score of 640.

Typically, microlenders let investors sift through prospective borrowers to find business owners they want to invest in, but beyond that, they differ in the details. Prosper, for example, lets investors bid on the return they want (or interest rate they'll pay) for filling a particular loan, while Redwood City, Calif.-based Lending Club sets the interest rate and lets investors determine whether they will fund the entire loan request or a portion of it. Some, such as Accion USA, will even report your loan repayment to the credit bureaus, which can help you build your credit rating. 

If microlending and traditional bank or SBA loans don't pan out, entrepreneurs should look into funding opportunities with those who know them best -- family members and friends, says Lehman. Just as you would with an outside lender, spell out to family members what you're trying to do and what they'll get out of the deal if they lend their financial support.

"You have a selling job to do," says Lehman. "Say, 'I'm opening a store, and this is what it's going to take.' Even offer them a piece of the action, saying, 'If you lend me $20,000, I'll give you a percentage of the total.'"

Find a way to formalize the agreement, perhaps by issuing a promissory note with details on when and how you'll pay the money back. Another tool that could be helpful is ZimpleMoney, a website that helps track the payback process of loans issued by family members and friends.

Regardless of the method you pursue to raise money, don't borrow more than you need. A rule of thumb suggested by American Express is to take on only debt that directly contributes revenue to your business. So it might make sense to borrow money to hire key staff, but it would be a mistake to borrow to buy a better computer when your current PC still works. The key to starting a business with bad credit is being flexible enough to build slowly, and as your credit rating improves, taking advantage of new avenues of funding.

"Even if you don't have much, you can still grow a business from it," Frendel says.

See related: Small business credit card comparison chart, NSBA: Small businesses hurt by credit card terms, How to keep a small business credit limit from being cut, Pros and cons of using social lending for consolidation

Published: June 24, 2010

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