At the early stages of any venture, financing is an ever-present need. Whether you require it to add to the business’s capital or to cater for its daily operations, savings and investor’s money may not always be enough. You will need lending institutions to help with the finances.
Unlike large established companies, a startup is yet to become stable. This means that the venture may be lacking collateral, a credit history, enough cash flow, or proof of its ability to pay back the loan. These are all requirements to get a business loan approved.
You may easily get funds from alternative and small business lenders. But in most cases, small lenders may not provide sufficient funds to meet the business’s needs at such a time of growth.
In the case of startups and small-sized companies and businesses, commercial banks will be keen on the credit rating of the owner to determine whether or not they will lend the business, how much they will lend them, and at what interest rate.
Let’s understand the term credit score, which is also known as a credit rating, and why it is a major player in determining credit qualification.
What is a Credit Rating?
A credit rating is a numerical representation of your ability to pay back a loan. The three-number digit is an indication of the level of risk involved in giving you a loan. A high number shows you are unlikely to default while a low figure shows you are a risky borrower.
The number is computed from data existing from your credit report such as credit history, frequency of applying for credit, balances, and amount of credit used out of the provided limit. Any time you default, make a late payment or file for bankruptcy, there is a drop in the credit score.
So where does the link between personal credit and business credit stem from?
Its Legal Structure
A major distinction between the various forms of business is the liability to loans and other obligations.
In the case of a general partnership and an enterprise that is under sole ownership, the partners or owner are personally liable for all the liabilities the business carries. They can face legal charges for broken contracts, unpaid loans, and debts.
In a limited liability company and corporation, the law in most countries treats the business as an individual, separate from the owners. The business is capable of owning property, suing, and getting sued. In case of default on debt, no action can be taken against the owners, but the entity is held liable.
General partnerships and sole proprietorships are easy to form, and most small businesses take this structure. Lenders, therefore, have to be careful when offering financing to these enterprises. They need to be sure that in case the business is incapable of paying the loan, the owner can step in and make the payments.
A Tie between Enterprise Finances and the Owner’s Finances
Even in cases where the enterprise is legally separate from the owners, the owners get involved in the enterprise’s finances. This is due to the fact that small businesses unlike more established enterprises do not easily access credit from lenders because of the high risk involved.
Here are several situations where personal and business finances are intertwined.
- a) Some owners take up loans under their name to finance the operations of the firm. Due to the firm’s inability to acquire business loans under favorable terms, most owners opt to fund their businesses using home-equity loans. Compared to business loans, home-equity loans and lines of credit are more accessible than business loans.
- b) Consumer credit cards offer an easier alternative for firms to finance their daily operations, and most owners opt for the method. A report by Intuit indicated that small businesses, at the time of the study, owed about $150 billion in consumer credit card debt.
- b) In some cases, lenders request for security in the form of assets. Most startups and small enterprises may lack valuable assets that can adequately act as security. Business owners, in such cases, opt to use personal assets as security for the business loan.
- c) Business owners personally guarantee the unsecured loans that their firms take. A personal guarantee is a promise to pay back a realistic instant cash loans in case the enterprise fails to meet payments. It is a written agreement that allows the lender to pursue the assets of the guarantor in case both the business and guarantor default on payments.
The interconnection between personal finances and a small business’s finances is undeniable. When the business is unable to meet its obligations, the owner steps in. For this reason, the lender needs to be sure that the owner is in a position to adequately cover the debts in case the need arises.
As an enterprise owner, how do you ensure that your credit does not affect the business’s ability to obtain financing?
Improve your Credit Score
Before the business grows and becomes stable, lenders are always going to look at your credit score as a determinant in obtaining credit for your business. As the owner, you can help the business in its financial struggles by ensuring that your score is good enough.
Here is what you should do.
- Pay your bills on time. This includes your student loan debt, auto loans, rent, and utilities.
- Keep the balances on your credit cards low. A low credit balance keeps your credit utilization ratio less than the recommended 30%.
- Check the accuracy of your credit report regularly and dispute any discrepancies you find.
- Do not apply for new credit unnecessarily. It creates hard inquiries that negatively affect your rating.
- Keep the unused credit cards open. It keeps your credit utilization ratio low.
- Let the old debts such as student loan and auto loan remain in your report, but only as long as you made the payments on time and in full. It will increase your score.
Build an identity for Your Business
If your business is a sole proprietorship, incorporate it. It does not just lift the burden of the legal liability off your shoulders, but it also improves the chances of finding new investors.
Obtain a tax identification number, open a new bank account for your new business corporation, a business phone number, and obtain business credit cards.
Work with an attorney to ensure you take all the steps, pay all required fees, and file all necessary paperwork with the right local and state authorities.
In the case of a general partnership, converting the business into a limited liability company is the best option. Changing it into a limited partnership may fail to have the desired result of having no legal liability to the business’s debts. This is due to the fact that at least one general partner is required to run the enterprise.
In case of failure of the business, separating your business and personal credit protects you from losing assets or using personal finances to pay off loans and debts. According to Small Business Association (SBA), half of the small businesses do not survive past the first five years.
Small enterprises will always need to borrow credit, and this is the task of banking institutes – to finance these businesses. The only problem is that there is a high risk involved in financing a new business.
For this reason, these lenders will not just check the enterprise’s credit history and performance, but the owner’s as well.
If your personal credit is poor, then the chances of obtaining funds for your venture are low. To prevent this, ensure your credit rating is high and if possible, give legal identity to your business.
By doing this, your credit performance will not affect your enterprise’s financing, and failure of the enterprise will have no adverse impact on personal finances.