By Alex Ormond
I’ve wanted to write this post for a long time. Of the hundreds of business owners – either current or potential – that I speak to regularly, nearly half tell me they will make the mistake that I discuss in this post without knowing how it can affect their personal finances. In fact, you might consider this post as a public announcement as the ease of making this mistake along with its long-term impact on your personal financial well-being is shocking.
I’m talking about using a personal line of credit to finance your business. On paper, this process doesn’t sound catastrophic, dangerous, or worrying. In fact, it sounds logical and simple.
The typical thought process that individuals share with me is this: you are passionate about starting a business or buying an existing one, you have a good credit history, and the bank has given you access to a line of credit. It’s sitting there waiting to be used, and you realize it’s an easy way to fund your dream entrepreneurship – be it buying computers, equipment, paying a salary, or whatever your line of credit is is even buying a business. You can simply take the money out of your personal line of credit and transfer it to your company. Easy!
In reality, however, this simple transaction can hurt your personal financial well-being, limit your personal access to credit, put you in a vortex of high interest rates, and give you years of below par creditworthiness.
A warning story
A few years ago I met David (name changed) and his wife for coffee. David was interested in buying a ski equipment store where he worked from its then owner. Both David and his wife were in their early 30s, had no children, but wanted to start a family soon and the dream of buying and running a business was very attractive to them.
During the course of our conversation, I asked David if he and his wife had any savings, to which he replied, “No.”
As you can imagine, skiing is a very seasonal sport. During the summer months, business dries up, revenue generation is uneven, resulting in an unbalanced cash flow for the company and its owner. I expressed this concern to David about his personal financial situation and the fact that his wife planned to stay home and not work.
The combination of the seasonal nature of the business, coupled with David’s limited savings and his wife’s desire to have a family, led me to recommend to David that he was not ready to buy the business. I advised him not to buy the store as I feared it might get in the way over his head.
About a year later David called me. He mentioned that he bought the business and needed a business plan that would support his application for a short-term loan to fund operating expenses and bridge the seasonal cash flow shortage the business had encountered. When I asked David how he funded the purchase of the business, he told me that he had taken nearly $ 50,000 off his personal line of credit to buy the inventory and rented the retail space from the previous owner who owned the physical building still heard.
Needless to say, I got worried. I asked David what rate he was paying on the credit line. He replied, “9.5%.” It was then that I realized that David committed the mortal sin of mixing his personal finances with those of his business. He took out a very expensive line of credit to buy a very seasonal business that he couldn’t afford to pay with fixed costs that he couldn’t afford to pay. By maximizing his personal line of credit, David had lowered his credit score to a level that unfortunately made him ineligible as a business owner on the majority of business loans.
As I spoke to David and explained my view of the situation to him, I felt his heart sink. I advised him to do a credit report to get his own score: it had gone from nearly 740 to below 630. In addition, he owed the bank $ 50,000 that he had borrowed from the line of credit, with an annual interest rate of nearly 10%.
The previous owner of the business had built up cash reserves to provide the business with liquidity in the off-season. David didn’t have such savings. He ultimately sold the company, paying back approximately $ 35,000 of his personal line of credit in the process, and taking a year to repay the rest while pursuing a career in restaurant management.
Other items from AllBusiness.com:
Why banks offer lines of credit
Lines of credit are a great tool for short-term needs but should never be used to fund long-term liquidity shortages in your personal life. For banks, credit lines are just another way of earning interest. They provide them to you, of course, and hope that you take advantage of the easy money and not pay it back anytime soon. The longer your credit line is used, the more interest income the bank receives.
I fully understand that there is a time when you need to dive into your line of credit for personal reasons, sometimes even for extended periods of time. That’s what they were designed for; However, you should never be tempted to use the funds on your personal line of credit to support your business – here is why:
Top Reasons Why Your Personal Line Of Credit Should Be On Hold On Your Business
1. Your personal financial well-being must always come first. Never put your personal finances at risk to keep your business going. You don’t have to do this for a successful business, while a failed business should exit and you should keep going.
2. There are other sources of finance for businesses. If your business needs financial assistance, suitable tools such as loans and investor finance are available. You can also use business lines of credit, but never use personal lines of credit.
3. What if you fail? As in David’s story, if your business fails, you can be ready to repay your personal line of credit.
5 things you can do instead
1. Start a business that requires minimal up-front costs. This can include consulting, marketing, SEO, web design, coaching, teaching or affiliate marketing. The possibilities are endless.
2. Start or buy a business where company assets can be used as collateral. Whether you’re buying a dental clinic or starting a food truck (as an example), companies with fixed assets (which can be resold if the business goes down) tend to attract better funding options as lenders offer specialized loans for equipment, inventory, etc.
3. Make sure you have personal savings. You need to make sure you have a personal financial safety net in case your business gets into tough times and it is your only source of income.
4. Apply for business loans – not personal loans – to help you run your business. There are numerous options available to small businesses in need of operational, equipment, or liquidity shortages.
5. Save and lend your savings to your company. Your personal line of credit is not yours – it is a loan to you from a bank; Hence, it is dangerous and unwise to use it to fund your business. Instead, take the time to save some money. When your business falters, borrow from yourself (as an individual) to your business.
CONNECTED: 22 mistakes entrepreneurs make when approaching investors
About the author
Contribution by: Alex Ormond
Alex Ormond is the founder of BizPlanShark, a small business consultancy that for the past 10 years has helped small businesses and entrepreneurs improve strategy, operations, and finances with only $ 50,000 to $ 1.5 million in funding. Through BizPlanShark, Alex leverages his corporate marketing, strategy and business development career to help entrepreneurs benefit from the quality and style of advice normally reserved for large budget firms. Using Alex’s strategies, his clients have selected companies like Ulta and Sephora, franchised some of the most successful cosmetics and consumer goods companies (INGLOT Cosmetics, Rylko) and founded numerous startups in Canada, the US and Europe.
Company: BizPlanShark
Website: www.bizplanshark.com
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