When you’re launching a startup, there’s one very important question to answer: Where will you find the capital to get your venture off the ground and keep it afloat?
Personal and business credit cards are an option if you’re looking for convenience and flexibility as you cover business expenses and manage your startup’s cash flow. Loans can provide you with a lump sum of cash to meet your needs in the early stages of your business.
Credit cards and loans each have advantages and disadvantages. Weighing both sides can help you decide which type of funding makes the most sense for your startup.
Pros and Cons of Using Credit Cards for Your Startup
There may be fewer hurdles to approval. Applying for a personal or business credit card to fund your startup is typically a less intensive process than applying for a business loan. While a bank, credit union or online lender may ask to see a copy of your business plan and analyze your business’s financials, credit card companies focus more on your personal credit score and credit history.
You can establish business credit. “A major pro of using a credit card to fund your startup is that it helps build your credit in the process,” says Deborah Sweeney, CEO and owner of MyCorporation, which offers limited liability company and incorporation services for entrepreneurs.
Business credit cards typically use your personal credit score for approval, but your account history registers on your business credit report. If you observe responsible credit habits — paying on time each month and keeping your card balance low — you can improve your business credit score over time. An established business credit score and credit history can work in your favor if you apply for a business loan later.
Some cards offer rewards and benefits. Rewards credit cards can be invaluable if you’re trying to keep your startup budget as lean as possible. Earning cash back on office supplies or advertising, for example, is effectively like getting a discount on those purchases. You can use miles or points to book free flights, hotel stays and car rentals if you’re traveling for business.
The benefits extend beyond rewards with some cards. There are business credit cards that offer perks such as employee cards with no annual fee, complimentary airport lounge access, annual travel credits and anniversary rewards bonuses. Remember to keep the combined value of a card’s perks in mind, however, since some cards come with hefty annual fees.
You may have to offer a personal guarantee. Before applying for a business credit card, read the fine print to determine if a personal guarantee is required. A personal guarantee means you assume personal responsibility for any debt associated with the card. That can be problematic, says Janet Gershen-Siegel, writer and content manager for Credit Suite, which helps business owners build credit using their employer identification numbers.
“If the entrepreneur defaults, they could lose personal assets, plus their personal credit would suffer,” Gershen-Siegel says.
If you’re sued for an unpaid debt associated with a business credit card and a judgment is entered against you, the credit card company could attach your personal bank account, real estate or other personal property. The judgment would show up on your personal credit report, affecting your personal credit score.
That’s a worst-case scenario, but it’s a possibility to be aware of if your startup doesn’t take off and you’re not able to keep up with the payments to the card.
Competitive rates aren’t guaranteed. There are numerous personal and business credit cards that offer zero percent introductory rates on purchases and balance transfers. That can save your startup money if you carry a balance. But you’ll typically need to have a good credit score to qualify.
Having a card with a higher annual percentage rate could lead to trouble if you’re not paying in full each month.
“It’s a slippery slope into carrying a staggering balance, making minimum payments and going into credit card debt for the business,” Sweeney says.
As minimum payments mount, that could be a strain on what may already be a tighter cash flow for your startup if revenue isn’t flowing in steadily yet.
Pros and Cons of Funding a Startup With a Loan
The cost of borrowing may be lower. A key advantage of a loan compared with a credit card is that the interest rates may be lower, says Gershen-Siegel. Lower rates mean less expensive capital.
With Small Business Administration 7(a) loans, for instance, rates range from 7.5 to 10 percent. Rates for SBA microloans, which are designed for startups and businesses that need to borrow $50,000 or less, range from 8 to 13 percent.
If you’re getting a loan from friends and family, they may not charge you interest at all. And such loans may be easier to get than a bank loan or credit card, says BJ Lackland, CEO of Seattle-based small business lender Lighter Capital. The potential downside, he says, is that things can get awkward if you’re not able to repay the money they’ve lent you on schedule.
Gershen-Siegel says, “Defaulting on loans from family and friends can tank relationships.”
You can tap into more capital. A drawback of credit cards is that they usually don’t provide much capital, Lackland says. While he acknowledges that it’s possible to get a credit card with a high credit limit, it may not be enough to start and grow a business. Loans, on the other hand, can be more accommodating to a startup’s capital needs.
For example, the SBA guarantees loans ranging from $500 to $5.5 million. With term loans, which are repaid over a set term, it’s possible to find borrowing options online ranging from $1,000 to $1 million. That makes them better for covering larger expenditures and scaling your business in the long term.
By comparison, “a credit card may more be suitable for temporary cash needs, such as fluctuating levels of inventory or seasonal working capital,” says John Kraus, senior vice president of Tompkins Mahopac Bank in Brewster, New York.
You’ll need collateral. Most business loans require some type of collateral to secure the loan, Gershen-Siegel says, “and that means putting assets on the line.” That can include business equipment, real estate, business savings or personal assets. If your startup lacks those assets, getting a loan could be more difficult.
Then there’s the risk associated with default. Defaulting on a loan could mean losing those assets if your lender decides to sue for what’s owed.
Startup Funding Alternatives
Connect with angel investors. Angel investing can allow you to raise larger amounts of capital for your startup without taking on debt.
“Angel investors usually invest their own funds and therefore have skin in the game,” Kraus says. “Most angel investors have entrepreneurial experience and expertise and provide the necessary advice to help the business succeed.”
The caveat is that instead of repaying an angel investment like you would a loan, you give the investor an equity stake in your business. If an angel investor is expecting a certain return on investment, that can eat into your profits and make the cost of acquiring capital higher than it might be with a loan or credit card, Kraus says.
Raising money through angel investors can also be more time-consuming, says Lackland, as investors may hold out for startups that have the best prospects for growth. Depending on whether you’re pitching investors directly or fundraising through a platform like AngelList, it could take weeks or months to secure angel funding.
Raise capital from the crowd. Crowdfunding is a way to raise the money you need for your startup from everyday people and investors. Rewards and equity crowdfunding offer two different paths for fundraising.
Sites like Kickstarter and Indiegogo fit the rewards crowdfunding mold. Someone donates to your campaign, and you give them a reward in return, such as a free product sample.
“Product crowdfunding has taken off and can be a great way to fund a project if you have something that’s attractive to send customers,” Lackland says.
Equity crowdfunding involves exchanging equity for capital. Lackland says it’s better-suited for high-growth companies because extensive regulatory constraints make it difficult for most startups to take advantage of.
Consider Using More Than One Funding Option
Using both credit cards and loans to fund your startup is a way to enjoy the best of both worlds. Lackland recommends using your credit card for those expenses you can afford to pay in full each month, such as your rent or utility bills if you’re leasing office space. You can then reserve a loan for larger expenses, like buying equipment or developing your first product line.
“There’s no reason why various types of funding can’t be combined,” Gershen-Siegel says, since “some cards might have rewards, perks or good introductory interest rates, while some loans might have a longer grace period for paybacks.”
Meanwhile, angel investors or crowdfunding can bring something totally different to the table if you’re able to qualify for more funding than a credit card or loan could offer.
If you’re using multiple funding options, be sure to have a system in place for managing your startup’s financial obligations.
“For a new business owner wearing a lot of hats, it might be hard to keep up with so many payback schedules, funding campaigns or investor demands,” Gershen-Siegel says. “A startup owner’s best first hire might be an accountant.”
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Should You Get a Credit Card or Loan for Your Startup? originally appeared on usnews.com