Competition is fierce for startups and with so many leading causes of startup failure (insufficient financing, poor planning, not enough marketing, lack of understanding of customers’ needs), wouldn’t you do whatever you could to avoid common pitfalls like these?
Finances are a major contributor to whether or not a startup survives. Because technology is always changing, it’s imperative that you are able to be flexible to turn on a dime. And that means you need the funds to update your platform or add new products, whether it comes from VCs, a line of credit, or a small business loan.
But what happens if you personally don’t have great credit? Won’t that impact your appeal to investors or banks? And if you just launched your startup, you don’t yet have business credit…so how can you build it?
Understanding Business Credit Scores
Just like you have a personal credit score, you also have a credit score for your startup. Now, if your business is brand new (and particularly if you’re running it as a sole proprietorship or partnership), lenders and investors will look at your personal credit score, since you ultimately will be responsible for paying any financing back yourself, if the business can’t afford to.
Your business credit score is typically a number between one and 100 that indicates how stable your business is, and how likely you will be able to pay back financing. Just like with your personal credit score, a higher number qualifies you for a larger loan at a better interest rate.
So what factors into your score? Your credit utilization ratio, for one. This is how much credit your business is currently using, divided by how much credit you have available. If you have a business credit card with a limit of $10,000 and you’re using $2,000 of it, your credit utilization ratio would be .2.
Other factors that impact your score include whether you have any delinquent payments on credit accounts, how long your credit history is, whether you have bankruptcies or judgments, how large your company is, and any risk factors in your industry that may impact your ability to pay back financing.
Important to Note with Regards to Business Credit
You might have proudly bootstrapped your startup and have no plans to get financing in the near future. That may end up being true, but it’s better to plan that you will take out a loan or line of credit, even if you don’t end up needing it.
Consider building your business credit like insurance. Take a few easy steps to increase it, and if one day you decide you do need financing, you’re in a good place to get it. Otherwise, you could end up paying far more in terms of interest rates because you didn’t take precautions to ensure that your credit was solid.
Now let’s look at some strategies to increase your business credit, no matter what it is right now.
1. Have a Strategy
Yes, you need a business and marketing plan when you launch your startup, but you also need a financial strategy. Beyond simply having a budget for startup costs and growth, you also need to see the bigger picture.
If your startup thrives the way you hope it will, how could you take it to the next level in a year? Three? Even if you’re seeing a nice profit margin at that point, you may want to get financing to expand operations, add another location, or invest in research and development for new products.
Knowing what you would do with an injection of cash helps you stay focused if and when you seek it. VCs and angels, naturally, want a well-developed plan for how you would spend their investment, and banks want the same. Even if financing is a long way off, now is the time to assess what it would look like when you get it.
2. Have a Separate Business Checking Account
In the early days of launching your startup, it may seem easier to just use your personal bank account for business expenses, but over time, this won’t help your business credit score. Keeping these two intertwined makes it difficult to file taxes, and should you be audited by the IRS, it will be quite a headache.
Open a business checking account (and a savings account, as well) at the start so that your finances are completely separated from your personal accounts. Use accounting software to categorize expenses so that filing taxes is easier, and so that you can run profit and loss statements easily to keep tabs on where your money is going.
3. Choose the Right Business Structure
By incorporating or forming an LLC for your startup, you essentially remove yourself personally from being the responsible party for much of the financial and legal aspects of your business. Should your startup ever be sued, your personal assets will be safe from being taken to cover legal fees. That’s not the case if you operate as a sole proprietorship.
Most investors want your startup to be a corporation, so whether or not you anticipate seeking funding down the road, setting up your business structure now will pave the way if you do.
4. Know Your Financing Options
The startup world talks a lot about venture capitalists, but the fact is: most startups don’t get VC funding. It’s a crowded marketplace, and there’s only so much capital to go around. While you might think your technology is earth-shattering, the VC you pitch might have heard a similar idea yesterday.
Venture capital comes with strings. While you will get funds you can apply to your startup, you also get partners who may want to have a say in how you spend those funds. Investors are essentially buying equity in your company, and that gives them some rights that you might not be comfortable with in the long run.
Another option to consider is a line of credit. You will be approved for a capped amount, and then you can dip into that credit whenever you need it rather than getting a lump sum at one time. A line of credit is ideal for short-term working capital needs, and typically your startup doesn’t need to be in operation very long for you to qualify for one. Some lenders will approve lines of credit for businesses in operation for just six months.
In terms of small business loans, there are several options. One is an SBA-backed loan, though some of those require the business to have been running for several years. Other loans, provided by private lenders, require no credit check and instead base approval on recent invoices for your startup. These will likely charge a higher interest rate but can be helpful in a pinch.
Then you have business credit cards. While these may have the highest interest of all financing options, you may be able to find a card with 0% APR for a limited time that would provide you the fantastic opportunity to not only get access to interest-free funds but also build your credit as you pay off the balance.
5. Stay On Top of Your Credit Score
As you start to use credit, your business credit score will increase. Monitoring your score can help you spot any discrepancies and report them before they tarnish your credit.
There are three primary agencies for business score reporting: Dun & Bradstreet, Equifax, and Experian. One benefit to using Dun & Bradstreet is your startup will be listed in its company database and you will be given a free DUNS number, which some institutions, like the U.S. government, require before hiring a vendor.
While each credit bureau will have a slightly different scale for reporting, in general, there are three tiers of business credit:
- Scores 49 and below: Business takes more than 120 days to make payments; high risk.
- Scores between 50 and 79: Medium risk; may have some delinquent payments.
- Scores between 80 and 100: Low risk; payments made within 30 days.
You probably can guess which you will fall into based on your startup’s financial health, but make a point to check your score once a quarter (or get automated monitoring updates via email) to ensure that your score is where you expect it, and that it’s slowly inching up the scale.
Should you see, for example, an alert that you have a delinquent payment (and you know you paid the invoice on time), you can report the discrepancy to the credit bureau, along with evidence to support your claim.
6. Pay Bills on Time
This sounds simple enough, but startup founders are often swamped with work, and it’s easy to let an invoice slip through the cracks. If you don’t have an accountant, put the due date on your calendar so that you don’t forget it.
And strive to pay bills before they’re due. That gives the payment time to hit the account and eliminates the risk of being reported as delinquent on your credit report.
There’s a bonus to paying bills early: some vendors will discount your invoice if you pay early!
7. Diversify Your Credit
While you might assume that opening multiple credit accounts would work against you, it actually can help build your business credit. The more credit you have access to, the lower that credit utilization ratio.
It’s wise to have different types of credit at your disposal. So open a business credit card, open credit accounts with your vendors, and maybe get a line of credit as well. Even if you don’t need them, use them and pay off the balance before interest rates kick in so that your credit score grows.
Just a note: if you want a Dun & Bradstreet Paydex score, you’ll need credit lines with at least three of the vendors you work with, so talk to the company that provides you with bottled water, office supplies, or maintenance about setting up a trade line.
8. Make Sure Your Lender Reports to Credit Agencies
Not every lender reports to a business credit bureau, so factor this in when seeking financing. It makes more sense to take out a loan with a company who will report it to a credit agency so you get “credit” for it, even if you end up paying a little more than you would with one who wouldn’t report it.Simply ask before applying for financing whether the lender reports to credit agencies.
9. Get Your Clients to Pay You on Time
Seems a funny way to build your credit, but when you get paid on time, you can pay your own bills on time. We’ve all had clients who drag their feet about paying invoices on time, and this can seriously impact your own cash flow.
There are two strategies for getting clients to pay on time: one is to charge a late fee for invoices paid after 30 days, and the other is to offer a discount for early payment. Most people don’t like paying extra on invoices, so will opt to pay on time or early, which gets you cash when you need it.
10. Set Money Aside
As your startup becomes more successful, you’ll see more revenue. It’s important to save some of it for a rainy day (or a broken computer). Having cash on hand to pay for unforeseen expenses can keep you from having to take out costly financing or charging something to a credit card with a high interest rate that you can’t pay off right away.
Make a goal to set aside a certain percentage of your profits each month. This nest egg will be your insurance against the unpredictable.
Building your business credit won’t happen overnight, but if you instill these easy practices into your startup’s structure, you will see that number increasing over time, giving you the ability to be picky about the types of financing you take on. Essentially, having a high business credit score gives you options for your startup, rather than forcing you to take costly financing when you’re backed into a corner.