Why startups do better with business debt than with personal credit

A small business owner walks into a bank and asks to borrow money so she can make significant improvements to her property. What kind of financing is best for this situation, a business line of credit or a term loan?

Initially, the business owner sought a line of credit.

“We really coached them that it makes more sense to put this into your existing building term loan,” said John Blossey, vice president and senior credit officer at Dart Bank, a mid-Michigan lender that specializes in providing a full line of business loan solutions. “These are long-term, structural improvements that are improving the value and maintaining the effective life of the property, so this would make more sense to be stretched out.

“It would have hampered cash flow if we had expected them to repay that in a year (using a line of credit). There were enough improvements to the property that long-term was the best option.”

A new study on financing businesses has found that new ventures taking on business debt survive longer and generate higher revenues than ventures financed on personal credit. So then, what kind of business debt should you talk to your bank about?

Two common vehicles for small business financing are term loans and lines of credit:

A business line of credit meets short-term needs for capital, like when you’re waiting on receivables from the job you just finished and you need to make payroll and cover other expenses in the meantime. Like a personal credit card, a business line of credit is designed to be used and paid off, then re-used and paid off again and again. It helps bridge a gap in cash flow and only accrues interest when there’s a balance.
A business term loan provides a lump sum of cash to cover an expense that will generate value over the long haul — new equipment, for example, or a building expansion. Like a personal mortgage or auto debt, a business term loan carries a fixed monthly repayment schedule over a number of years. It reduces the impact of the expense on your cash flow by spreading out the cost over the long term.
So which is best for your business?

“The biggest thing it comes down to is how long you’re looking to use whatever it is you’re borrowing the money for,” Blossey said. “You match the loan with the life of the asset.”

Say a business owner has an opportunity to buy additional inventory at a reduced cost, enabling him to enter the busy season with more product at a great price. In this case, a business line of credit is best because the hope is you’re going to sell that inventory and turn it into revenue quickly.

You then can take the revenue and pay off the balance on the line of credit. It’s cheaper than a longer-term loan, and you only pay interest on what you use.

According to a study published recently in the Journal of Corporate Finance, start-ups with business debt perform better than those financed with personal credit. If the debt is in the name of the business, then the venture tends to survive longer and have higher revenues than if the debt is in the name of the business owner, researchers found.

“If you go to borrow $100,000 from the bank to start your business, the bank’s evaluating your business. And then after he makes the loan he’s got skin in the game, so he’s going to monitor you and mentor you,” said Rebel Cole, a Florida Atlantic University finance professor and co-author of the study.

“So, it makes sense if you can get a business loan that you’re going to have superior outcomes. And that’s exactly what we find.”

It’s also important for businesses to take on debt in the name of the business to establish a credit history and public track record that can make it easier to finance and grow the business into the future, Cole said.