More than 80 percent of small-business owners use credit cards, according to the Federal Reserve. But some make the mistake of reaching for plastic too soon when starting up their businesses and reduce their chances for long-term success.
Nearly 60 percent of start-ups rely on credit cards for financing during their first year of business, according to a recent study from the Ewing Marion Kauffman Foundation, and for every $1,000 increase in credit card debt, a firm's chances of survival decrease by more than 2 percent.
What's so problematic about funding a start-up with a credit card?
It puts personal finances in jeopardy and increases stress. People often assume that small-business credit cards insulate the owner's personal finances from the company's. But that's just not true. Whether you use a business or consumer card, you're going to be personally liable for debt. So, relying heavily on a credit card for financing could significantly increase the pressure you feel. If things don't go as planned, you not only will default on your business debt, but you also will face serious ramifications on a personal level.
You will have limited funding. How much money you're able to glean from a credit card is largely a function of your credit standing and income. Many entrepreneurs are young and often at a disadvantage when it comes to those factors. And even if you've managed to garner high credit lines, they will likely be insufficient to cover the costs of getting a business up and running.
It's harder to weather tough times. Credit card debt is expensive: The average interest rate for a business card is about 15 percent. Given that you're unlikely to have much money in reserve, an economic downturn or lag in sales could prevent you from making even minimum monthly payments.
Given those problems, why do entrepreneurs repeatedly turn to plastic in their search for start-up funds?
Credit card funds are easier to come by. Getting approval for a credit card account usually is easier than qualifying for a bank loan, especially in the current economic climate.
Entrepreneurs are often reluctant to ask friends and family. They are too shy or proud to approach loved ones and acquaintances about investing in a budding business venture.
Entrepreneurs don't want to sacrifice equity to investors. This is perhaps the biggest reason that entrepreneurs are hesitant to bring on investors: They don't want to give up a slice of what could end up being a lucrative pie.
How can entrepreneurs avoid the perils of credit card funding?
The primary way is to seek investors early. By putting together a solid proposal -- complete with a detailed business plan and projections for both future revenue and potential return on investment -- you'll be putting your business in the best possible position to succeed.
If you fund your startup through equity rather than credit card debt, you won't have to waste crucial early-stage revenue paying down debt or the interest associated with it. More money will therefore go into making your business a success. And even if it doesn't pan out, there will be far less personal risk. You won't have to worry about catastrophic damage to your personal finances, which means you'll be able to bounce back more quickly.
Despite these caveats about using credit card debt to fund startups, it's important to remember that credit card use in and of itself is not a mistake. Not only will a credit card allow you to earn rewards on everyday expenses, but it also will help with cash flow because you'll have up to 55 days from the time you make a purchase until a payment is due. In addition, if you're a young entrepreneur, responsible use of a credit card will help you establish a positive credit history. That will be very important when your business has matured enough to move to the next level and seek a bank loan.
When you're choosing your credit card, make sure you don't fixate on those branded for business use. There's no reason why you can't use a consumer card for business, especially considering the fact that you'll be personally liable with either kind of card and consumer cards actually have better legal protections. Consumer cards are protected under the CARD Act -- a law that eliminated many of the unscrupulous banking practices prevalent prior to the Great Recession -- but business cards are not.