Should you fund your startup business with a credit card?
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Dear Your Business Credit,
I launched a small technology startup with a friend last year. We pooled our savings to get started, but are running out of money to keep developing our software. We're still at least six months away from getting the product to market. Would I be better off borrowing some money on my credit cards for the time being or should I try to find an outside investor? -- John
We've all read articles about entrepreneurs who borrowed their startup money on credit cards -- and built wildly profitable businesses. The most obvious advantage of credit card financing is that it's easily available if you already have good credit and cards in your name.
However, for many entrepreneurs, using credit cards as a main form of financing is very risky. If the business fails, they will be saddled with debt for which they are personally responsible -- regardless of whether they have taken out business or personal credit cards. This is because both types of cards typically require a personal guarantee.
"Credit cards are supposed to be short-term debt," says Nat Wasserstein, chief restructuring officer at Lindenwood Associates, a crisis management firm based in New York City and Upper Nyack, N.Y.
One reason you should restrict them to short-term purchases is that it's not cheap to borrow on them. The average annual percentage rate on credit cards is just below 15 percent as of early 2013, while interest on loans up to $25,000 that are backed by the U.S. Small Business Administration can't exceed the prime rate (currently 3.25 percent) plus 4.25 percent (bringing the total to 7.5 percent).
Using credit cards can also be a crutch that leads you to sloppy financial habits at your business. "You lose the monthly discipline -- or never develop the monthly discipline -- of paying down a line of credit," says Wasserstein. 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 money is tight. That forces you to maintain adequate cash reserves.
Wasserstein says that your situation "almost screams" that you should be looking for long-term capital instead. "It should probably be equity," he says. It is also worth looking at hybrid debt instruments, such as loans that can convert to equity, he says.
Certainly, selling a stake in your company to early-stage private investors -- known as angels -- usually means you'll have more cooks in the kitchen. They will typically want to have some say over how the business runs. That can benefit you, if they bring valuable business knowledge to the table, but it can backfire if you end up clashing. "The main risk of equity is adding another human element you don't really know," Wasserstein says.
There's also the risk of giving away 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.
There's a third option to consider. I've come across some entrepreneurs recently who have opted to take on part-time or full-time jobs for a while to raise some funding, so they don't have to borrow or sell equity. If you have a lot of energy and few outside demands on your time, this approach may work for you.
However, Wasserstein believes there's a high risk of getting distracted from your main business if you don't give it your all. You'll need to look at your situation to determine if this is a suitable solution for your business.
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