A line of credit is a type of financing that allows startups to access capital as needed up to a set limit. Unlike a business loan that provides a lump sum of cash upfront, a line of credit offers flexibility since you only take what you need, when you need it.
Lines of credit are usually offered by banks and allow startups to withdraw money, repay it, and withdraw again in what works like a credit card. So it operates as revolving debt that doesn’t have a set monthly repayment schedule.
This form of financing is extremely useful for startups that have uneven cash flows or need working capital to cover short term funding gaps. For example, a tech startup entering a rapid growth phase may need to scale up operations quickly before its revenue catches up. Or an ecommerce business may need extra cash ahead of the holiday season to stock up inventory. Lines of credit allow startups to access capital for these situations without taking out a large loan.
In this comprehensive guide, we’ll cover everything startups need to know about getting and using a business line of credit including:
- How lines of credit work
- Types of lines of credit for startups
- Costs and fees to expect
- Qualification and application process
- When to use your line of credit
- Maintaining a line of credit responsibly
- Repayment rules and consequences of default
- Other funding options to consider
Let’s get started.
How Do Business Lines of Credit Work?
A line of credit has a set credit limit and allows businesses to withdraw funds as needed. Similar to a credit card, as you make payments towards your balance, it frees up credit for you to continue utilizing up to the approved limit.
Lines of credit will have a variable interest rate set by the lender, usually tied to a benchmark rate like the prime rate. So the cost of borrowing may fluctuate over time. There may also be origination fees charged upfront when setting up the line of credit.
While loans provide a lump sum payout, lines allow more flexibility in how much and how frequently capital is accessed. That’s why they are a better short-term financing option for startups with uneven capital needs.
With proper planning, lines of credit allow startups to scale up operations smoothly during times of rapid growth and manage cash flow gaps. The trick is responsible utilization and repayment within your budget to avoid spiraling into unmanageable debt.
Types of Lines of Credit for Startups
There are different types of lines of credit offered to startups based on use cases, terms, and eligibility. Common options include:
Working Capital Lines Best for everyday business expenses and near term operating costs. Offers most flexibility in use of funds.
Startup Lines
Specialized lines that provide higher limits to qualified startups in the early stages of building their business. Requirements focus more on the founders and growth plan vs financial history.
Inventory/Equipment Lines Used to finance purchasing inventory and equipment. The purchased assets usually serve as collateral for these specialized lines.
Bridge Loans
Designed to bridge short term financing needs in anticipation of major capital raises such as seed funding or Series A. Helps startups avoid premature large equity dilution.
Government Backed Lines SBA loan programs provide access to government guaranteed lines of credit that are easier to qualify for.
When researching business lines for your startup, look for ones that match both your use case for financing as well as eligibility criteria you can meet.
Comparing the Costs of Startup Lines of Credit
The cost structure of lines of credit typically has two components:
Interest Rate This is expressed as a variable percentage rate tied to a benchmark like the prime rate. So your borrowing costs may rise and fall over time. Expect rates from 6% to 18%.
Origination & Maintenance Fees Fees charged to open, renew or access the line of credit. Can include application fees, annual fees, balance inquiry fees etc ranging from 1% to 5% of the credit limit.
Depending on the lender, there may also be early termination and late payment penalties to watch out for. When comparing line of credit options, calculate the total cost of fees and potential interest payments based on factors like:
- Credit limit needed
- Expected usage and repayment period
- Chances of paying off balance in full each month
- Interest rate and annual/monthly fees
- Your credit worthiness level (determines rate offered)
Online lenders now offer lines of credit with easy applications, faster approvals, and lower rates. This expands options beyond traditional banks.
Qualifying for a Startup Line of Credit
Compared to regular business lines, requirements to qualify for startup focused lines are more flexible andforward-looking. Still, almost all lenders will want to review factors like:
- Time in business
- Projected revenue growth
- Founder/management expertise
- Funding raised
- Cash burn rate
- Personal credit scores
- Assets for collateral
For startups with under 2 years of operating history, the criteria focuses more heavily on the strength of your business projections, market opportunity, leadership team, and current investor backing.
Essentially lenders need to see a strong growth trajectory ahead for your startup to justify extending credit. Quickly growing startups also represent a lower risk vs stagnant businesses.
Startup founders with excellent personal credit scores above 720 have the best shot at qualifying for competitive rates too. So work on building your personal creditworthiness in parallel.
Streamlined Applications for Startup Credit Lines
What business founders love about the new generation of online lenders is the dramatically simplified loan applications.
Using technology and algorithms, alternative lending platforms like Credibly and Fundbox automate most of the decision making process. All you need to do is complete a basic application online that asks for details like:
Years in business, location, industry, and entity type
Founder/owner personal details and background Credit score and financial statements Revenue and projections
Funding sources and debt
Requested credit amount
After reviewing thousands of small business loan applications, the platform can rapidly analyze eligibility and risk to provide near instant pre-approval decisions.
If eligible, you also get matched with best lender offers based on your unique profile. This saves the headache of proposal research and loan shopping.
So in many cases, startups can submit a single application that gets them matched with multiple lender terms for a credit facility in just 24-48 hours. That kind of speed can be invaluable when short term financing is needed urgently like covering payroll before a big funding event.
Using Your Line of Credit Strategically and Responsibly
With easy access to lines of up to $250K these days, it helps to strategize exactly how much you really need before applying. Over estimating your credit limit often leads first time borrowers to accumulate more debt than necessary or responsible.
Remember that while lines offer easy access to capital, what you withdraw must also be repaid with interest eventually. So follow a strategic plan on how credit will be used and repaid instead of treating it like free money.
For example if you need to cover $50K of equipment purchases for a pilot program over the next 6 months, apply for a line large enough to fund that expense instead of defaulting to the maximum limit allowed.
Build a realistic repayment plan into your projections as well factoring in potential business growth, interest costs, and cash flow from operations or funding events. Covering at least interest payments monthly is key to staying current on your facility.
Then implement a strict policy on line of credit use cases, caps per use case, and approval chain of command. For example only authorize senior managers to initiate draw downs when essential for costs like:
Emergency operating expenses unable to be covered from revenue Limited to $15K per instance with CEO approval
Inventory purchases for proven products with big orders
Limited to $35K per new SKU with VP Operations approval
Critical contractor fees for period until Series A closure Limited to $20K total with CFO approval
Standardizing the pros and cons analysis before each withdrawal ensures you stay disciplined in using credit only when truly necessary vs just convenient. Review utilization often and adjust credit limits down if the approved line is too tempting.
Following best practices in credit management makes lines of credit powerful tools. Used irresponsibly, they can quickly snowball into dangerous debt burdens.
Maintaining Good Standing on Your Startup’s Line of Credit
To keep your line active and charging the lowest interest rates, you must maintain ‘good standing’ by:
- Making at least the minimum payments due each month This covers monthly interest charges at minimum. Late fees apply for missed payments.
- Not exceeding your set credit limit
Usage and unpaid balance cannot exceed your approved limit before repayment. - Paying down full balances aggressively Most facilities require the full balance to be paid off every 180 days or less.
Defaulting on your repayment obligations can put your line of credit into bad standing or default status fast. Penalties for this include:
Frozen credit line Higher default interest rates of 25-36% charged Accelerated maturity of the balance
Termination of the loan facility
Negative credit reporting
So be vigilant about monitoring account activity via online banking and automated alerts on factors like:
Available credit remaining
Outstanding balance Total interest paid to date
Minimum monthly payments
Maturity dates upcoming
Set calendar reminders on key dates and reconciliation checkpoints too. Depending on utilization patterns, aim to pay off the full balance one to two months to avoid ballooning interest costs.
Many founders also arrange a personal loan facility as a backup to cover business line payments in a worst case scenario. The key is avoiding missed payments by monitoring cash flow budgets diligently.
What Happens Upon Defaulting on Startup Lines of Credit?
Defaulting on your startup’s line of credit repayment has serious consequences including:
- Credit Facility Termination: The bank or lender will revoke access to the credit facility upon default. Any outstanding balance owed becomes payable immediately as a lump sum.
- Collections & Legal Action: For unpaid balances, the lender can pursue legal action to attempt collections through means like wage garnishment or liens. Expect harassing calls and lawsuits until resolved.
- Personal Credit Damage: Your business credit score and personal credit scores will be severely impacted making future borrowing very difficult beyond predatory terms.
- Higher Interest Rates:
Defaulting categorized you as high risk. If you manage to secure financing again, expect very high interest rates of 25-80%. - Business Relationships Strained: Vendors, customers, and partners may revoke credits terms or refuse to work with you if they view your business as unstable from a default crisis.
So before signing up for financing, make sure you read all default clauses and fine print properly to understand the consequences. Monitor accounts actively and have open communication with lenders at the first sign of issues making payments. Explore options like interest only payments or payment deferrals to cope with temporary hardship.
The bottom line is honoring the legal repayment obligations you take on to avoid business catastrophe.
Comparing Business Lines of Credit to Alternative Funding
Beyond lines of credit, tech startups also use alternative financing options to fuel growth including:
Invoice Factoring/Financing Selling outstanding invoices to an investor provides immediate cash and outsources collections. Fees range from 1-5% per invoice. No collateral required.
Revenue Based Financing
Investors provide growth capital to be repaid as a percentage of your startup’s future revenue. Rates start from 5-10% with caps. No collateral required.
PO Financing External financing helps pay your suppliers directly. Repaid after client pays invoice. Rates from 1-5% per PO. No collateral required.
Peer to Peer Loans Borrow from a pool of retail investors via fintech platforms. Offers enhanced automation and better rates for borrowers.
Crowdfunding Loans Raising capital from retail investors through regulated platforms like SeedInvest and CircleUp. Good for community engagement.
Angel & Venture Capital Selling equity shares to accredited investors in return for growth funding. Best for high return potential startups tackling big markets.
Each form of startup funding has its own pros and cons related to cost, dilution, operational impact, repayment risk and more. For immediate working capital needs, lines of credit offer advantages like:
- No revenue sharing or equity sold
- Interest rates competitive vs other options
- Repeating access to minimize applications
- Flexibility in withdrawing as much as needed, when necessary
- Often quicker to secure than equity fundraising
The catch is lines of credit must be actively repaid versus alternative capital that may only take a % of revenue or equity piece in return. So the risk of non payment penalties is much higher with lines of credit.
Ultimately startups are best served by pursuing a mix of funding sources to minimize risk and dilution. Just be strategic in leveraging credit only for the right purposes so debt burdens don’t overwhelm your operations.
Getting Started with Applying for Startup Lines of Credit
If a line of credit makes sense to supplement your tech startup’s funding strategy, here are tips for getting started:
- Review Eligibility Criteria Thoroughly Check what FT or PT operating history, revenue minimums, projections and other criteria the line of credit product calls for before applying.
- Prepare Required Documentation Financial statements, business plans, projections, ownership details etc needed to complete the application.
- Build Your Founder Credit Profile
Having excellent personal credit helps secure the best startup line of credit rates so monitor your score. - Pick Lenders Wisely
Check reviews and compare costs, limits, terms across banks and alternative lenders carefully before applying. - Model Repayment Capacity Upfront
Based on intended use cases and limits, ensure your budgets actually support repaying principal + interest. - Set Internal Policy for Credit Use
Standardize the guidelines on what scenarios warrant withdrawing funds before getting access.
Following these best practices will help first time applicants secure a startup friendly line of credit optimized for their funding needs while ensuring responsible usage and repayment.
Key Takeaways on Startup Lines of Credit
Getting familiar with the pros and cons of lines of credit allows startups to make an informed decision on utilizing them as part of their funding mix.
Here are some key parting tips:
⚫ Be Strategic About Limits & Usage Right size your credit access and clearly define cases eligible for withdrawals.
⚫ Closely Monitor Accounts
Set alerts and check balances often to avoid unwanted fees or bad standing.
⚫ Pay Down Fully Every Few Months
Avoid interest ballooning by fully clearing balances before maturity.
⚫ Have a Backup Repayment Plan
Model for revenue but have a plan B if cash flows fall short of projections.
⚫ Upgrade Terms Over Time As your business matures, access larger limits at better rates based on financial track record.
Used right, lines of credit provide startups invaluable and accessible capital to smooth out uneven cash flows during the turbulent early stages of growth.
Apply conservatively and continue raising funding via equity or revenue sharing to minimize business risk from debts. Thriving startups judiciously layer complementary forms of capital.
Over time proceed towards rounds like Series A that accelerate business success on more favorable terms than debt financing.