Do You Need Excellent Credit to Start a Business?
When Richard Branson started Virgin Records (now the Virgin Group conglomerate), he did what most entrepreneurs do: He used his personal savings, borrowed from relatives and patched together enough funding to pay his bills during the difficult months. He had many of the characteristics of successful entrepreneurs, but what he did not have was excellent credit.
Many entrepreneurs do not have good credit. Some start a business because they were laid off and don't have many alternatives. Some start a business when opportunity strikes, rather than when their personal financial situation is in good condition. Some go through divorces and personal bankruptcies that can ruin their credit.
If you are starting a business and have a poor (or nonexistent) credit history, here are a few tips that should help:
1. Forget big banks as sources of funding. In the past, obtaining bank financing was based on the four Cs of credit: credit history, cash flows, collateral and character. Today, this is no longer true for most large, well-known financial institutions. They care little about three of the four Cs-and instead tend to focus purely on credit history in making lending decisions to small-business applicants. This is because consolidation in the banking industry has driven banks to automate their credit decision processes and minimize the labor involved in getting to know credit applicants face to face. If you have a great business idea but poor credit history (such as a credit score below 650), you will not get any money from banks. Even if you have a great business idea, a strong character and relevant work experience, you are not likely to get any money from big banks if your credit score is not above the 600 to 650 range.
There is one notable exception to this rule: home equity loans. If you are willing to secure your business loan with personal equity in your home, you will have plenty of options even if you have poor credit. But be very careful about relying on home equity loans too early in the life cycle of your business. Cash flows for startups are notoriously difficult to forecast.
2. Differentiate your personal credit from your business credit. While large banks focus on your personal credit score, smaller community lenders and business-friendly banks will focus on a combination of your personal credit score, business credit score and other factors associated with the viability of your business.
Your personal credit score is determined by several factors, including the outstanding debt balance on personal credit cards, the number of open lines of credit accounts, bill payment history and late payment history. Your business credit score is determined by similar factors but is linked to the tax ID for your business, not your Social Security number. This important difference can help you get your business off the ground.
If your personal credit score is damaged, you should seriously consider getting a separate tax ID number for your business as soon as possible-whether you are incorporated or not. If you do not want to spend the money to incorporate your business, you can still get a tax ID number from the IRS even if your business is a sole proprietorship, an LLC or a partnership. Talk to your CPA for information on how to do this. It's very simple to complete the relevant form (form SS-4) and send it to the IRS. You can apply online at the IRS site.
In addition to getting a tax ID number, it is important to ensure that your business is distinct from your personal identity. You should consider getting a separate business address (not a post office box), a separate bank account, an official corporate name registered with local authorities and a separate telephone listing. While these administrative chores might seem minor, they are critical in distinguishing you from your business.
3. Build your business's credit score. Once you have a tax ID number and a legal identity for your business, you can start building your business's credit and establishing a means to qualify for trade and credit lines from suppliers and sources of capital.
A growing number of data companies currently track business credit. For example, Equifax has recently developed the Small Business Financial Exchange which provides participating banks with a business credit report. (Click here for a sample.) This report contains information on your business's performance on open lines of credit, including credit cards, installment loans and even loans between relatives, friends and business associates that are reported to Equifax. If you are able to keep these loans on track by making your payments on time, you can establish a strong credit rating for your business.
There are several other data companies that collect financial information on your business. D&B's PAYDEX score is among the most famous. This score allows your suppliers to know the likelihood that you will be delinquent on a payment. Specifically, the score measures the extent to which payments to your existing vendors have been made on time over the past 12 months. However, keep in mind that most small vendors do not report to D&B. To maximize the likelihood that your business's PAYDEX score is high (more than 70 out of 100), you should focus on paying large vendors who are likely to submit information to D&B.
If you do not have strong personal credit, you should pay special attention to ensuring that you build a good business credit history with companies like Equifax and D&B.