Dec 4, 2023

The Startup Founders Guide to Lines of Credit in 2024

Arc Team

Go-To-Market

Startups often find themselves facing a myriad of challenges, with securing adequate funding at the forefront. One of the easiest forms of financing to qualify for during the infancy of a startup is a line of credit. In this guide, we break down the key things you need to know about a line of credit so you can make a more informed decision. Ready? Let’s dive in!

Lines of Credit - The Basics

What a line of credit is (and isn’t)

A line of credit, also known as a “business line of credit’ is a form of flexible debt financing for startups. Lines of credit are most similar to credit cards, in that the startup can draw funds as needed and pay down the outstanding balance, unlocking more credit.

Also like a credit card, lines of credit come with a minimum monthly payment on the outstanding balance which includes the interest charge, however, the APR (or interest rate) is often much lower than a credit card which makes it more attractive to high-growth startups.

But unlike a credit card, a line of credit doesn't have annual fees, though lenders may charge origination fees, monthly maintenance fees, or both. A line of credit also typically offers a much higher credit limit compared to a credit card, especially for newly incorporated startups.

The advantages of lines of credit for startups

Highly flexible - Startups can strategically use the funds from a line of credit as needed, whether to cover operational expenses, invest in growth opportunities, or manage unexpected financial challenges.
Smooths cash flows - Lines of credit act as a buffer against cash flow gaps, ensuring that essential operations can continue uninterrupted even during lean periods.
Cost-effective - Opting for interest-only payments offers short-term financial relief, allowing startups to allocate resources more efficiently.
Establishes creditworthiness - Responsible use of a line of credit can contribute to the establishment and enhancement of the startup’s credit profile, paving the way for future financial endeavors.

The disadvantages of a line of credit for startups

Vulnerable to interest rate fluctuations - Lines of credit typically come with a variable interest rate structure, meaning that as rates rise so does the cost of capital.
Can negatively impact financial health - Mismanagement of credit (including missed payments) can adversely affect a startup’s overall financial health and ability to access credit in the future.
Risk of default - Failing to manage credit responsibly can lead to severe consequences, including default and damage to the startup’s financial reputation. It can potentially appear on the founder’s credit report if the line of credit comes with a personal guarantee.

How lines of credit work

Lines of credit are dynamic financial tools that can benefit startups by providing them with a flexible and accessible source of funding. Unlike traditional loans that offer a lump sum upfront, lines of credit allow startups to draw funds as needed, up to a predetermined credit limit. We’ve outlined the key components that define how lines of credit work below.

Revolving nature

The key aspect of a line of credit is the revolving nature of the credit: the available credit is replenished as the startup repays the borrowed amount. This revolving structure is particularly advantageous for businesses with fluctuating cash flows or seasonal variations, offering them a financial safety net when they need it most.

Interest accruing

Lines of credit accrue interest based on the terms set by the lender, and this interest can be either fixed or variable. Fixed interest rates remain constant throughout the life of the credit line. Variable interest rates, on the other hand, are subject to market fluctuations and may change periodically based on an underlying benchmark, such as the prime rate.

Monthly repayment

Lines of credit typically involve monthly payments on the outstanding balance. Some lines also require a minimum monthly payment, ensuring that startups remain disciplined in their financial management. As startups repay the borrowed amounts, they free up additional credit for future use, fostering a cyclical and sustainable approach to funding.

Multiple forms

Lines of credit come in two basic forms: secured and unsecured. Secured lines of credit require collateral, such as business assets or property, reducing the lender's risk and potentially resulting in more favorable terms. Unsecured lines of credit, on the other hand, do not require collateral but come with higher interest rates and lower credit limits.

The average interest rate for a line of credit

The average interest rate on a line of credit can vary based on several factors, including the financial health of the startup, the creditworthiness of the startup, the lender's policies, and prevailing market conditions. As of December 2023, typical interest rates for a line of credit ranged from around 8.50% to 20%. Besides the headline interest rate, lenders may also charge origination fees, draw fees, maintenance fees, and closing costs.

Criteria for Startups to Qualify for a Line of Credit

Qualifying for a line of credit is a pivotal step for startups seeking financial flexibility. Lenders evaluate several factors to assess a startup's eligibility. Here are some of those factors:

Demonstrated Revenue - Lenders prefer startups with a proven track record of consistent revenue. Demonstrating a reliable income stream reassures lenders about the business's financial stability and its ability to meet repayment obligations.
Stable Cash Flows - Lenders assess the startup's cash flow to ensure it can comfortably manage debt obligations. Positive and stable cash flow is a key indicator of a business's ability to handle credit responsibly.
Collateral (for Secured Lines) - If applying for a secured line of credit, startups must offer collateral, such as business assets or property. Collateral serves as security for the lender, reducing the risk associated with the credit extension.
Debt-to-Equity Ratio - Lenders assess the startup's debt-to-equity ratio to evaluate its financial leverage. A balanced ratio indicates a healthy financial structure and enhances the startup's creditworthiness. Generally, a good debt-to-equity ratio is around 1 to 1.5.

Common Terms When Applying for A Line Of Credit

Here are a few of the common terms you may come across while applying and after qualifying for a line of credit. The “repayment terms” include the interest rate, repayment period, and monthly payment.

Credit Limit: The maximum amount that a startup is authorized to borrow.
Fixed Interest Rate: A constant interest percentage applied to the outstanding balance throughout the credit line's duration.
Variable Interest Rate: Subject to market fluctuations and may change periodically based on an underlying benchmark, such as the prime rate.
Draw Period: The duration during which the startup can access funds from the line of credit.
Repayment Period: Follows the draw period and is the timeframe within which the startup must repay the borrowed amount, also known as the “loan term”.
Minimum Monthly Payments: The required payments that contribute towards both the principal amount borrowed and the accrued interest. In some cases, the line of credit comes with an interest-only period, during which you only pay interest.

Tips for Successful Line of Credit Usage

Utilize Funds Strategically - Exercise discretion in using the funds. Prioritize spending on initiatives that contribute to business growth, such as marketing campaigns, inventory expansion, or capital investments.
Monitor Your Cash Flows - Keep a close eye on your cash flow. Regularly review income and expenses to ensure that the business has sufficient liquidity to meet ongoing financial obligations and service the line of credit.
Avoid Over-Borrowing - While the line of credit offers flexibility, resist the temptation to over-borrow. Borrow only what is necessary to avoid unnecessary interest costs and potential strain on future repayments.
Establish a Contingency Plan - Plan for unexpected circumstances. Having a contingency plan in place ensures that your business can navigate challenges without jeopardizing your ability to meet credit obligations.
Communicate with Lenders - Maintain open communication with your lenders. If you foresee challenges in meeting repayment obligations or need adjustments to the terms, proactively discuss these matters with your lenders.
Consider Refinancing When Appropriate - If you find that the terms of your line of credit are no longer favorable or if you've improved your creditworthiness, explore the possibility of refinancing to secure better terms.

Commonly Asked Questions About Lines Of Credit

How is the credit limit for a line of credit determined?

Credit limits for a line of credit are determined based on the startup’s financial health, credit history, and overall creditworthiness. Lenders assess the company's revenue, cash flow, and profitability to gauge its ability to meet repayment obligations. A strong credit profile, a history of timely payments, and a stable financial performance can contribute to a higher credit limit.

Secured vs. unsecured lines of credit: which is better?

Choosing between a secured and unsecured line of credit can be a tough decision. Secured lines of credit, require collateral such as assets or property but come with lower interest rates and higher credit limits. Unsecured lines of credit, offer greater flexibility and less risk to a startup’s assets but come with higher interest rates and lower credit limits.

How long is the approval process for a line of credit?

The approval process duration varies among lenders. Generally, it can take anywhere from a few days to several weeks. The speed of decision-making depends on factors such as the complexity of the application, the completeness of documentation, and the lender's internal processes.

Online lenders and fintech platforms often provide quicker decisions, sometimes within a day, leveraging technology to streamline the approval process. Traditional banks may take longer, as they require extensive documentation requirements and a thorough review process.

Can the credit limit associated with a line of credit be increased?

Credit limits are not static and can often be increased over time. This typically depends on the business's financial performance, revenue growth, and overall creditworthiness. Lenders may review the business's financial statements, payment history, and credit utilization to assess the feasibility of a credit limit increase.

What happens if you default on a line of credit?

In the unfortunate event of default, lenders may impose penalties, such as late fees or increased interest rates, the business's credit rating may be negatively impacted, affecting its ability to secure future credit, and for secured lines of credit, the lender may seize the collateral provided.

Are personal guarantees required for a line of credit?

Depending on the size and age of the business, lenders may require a personal guarantee, especially for smaller or newer businesses. A personal guarantee means that the business owner(s) personally assume responsibility for the debt.

How much money can be accessed via a line of credit?

Lines of credit offered to startups by banks or online lenders can range from $10,000 to $500,000 or more. The specific amount depends on factors such as the business's revenue, creditworthiness, and time in operation.

What documentation is needed for a line of credit application?

The documentation required for a line of credit application typically includes:

Financial Statements: Both business and personal statements.
Business Plan: Outlining the company's objectives, financial projections, and growth strategies.
Tax Returns: Personal and business tax returns for the preceding years.
Credit History: Business credit history (if applicable).
Bank Statements: Providing insight into the business's cash flow.
Legal Documents: Depending on the business structure, legal documents such as licenses and registrations.

Wrap-Up - Raising a Line of Credit in 2024

Given you’ve made it this far, we’re going to assume you’ve either started the process to raise a line of credit or are thinking about doing so. As covered above, lines of credit are highly flexible debt instruments that grow with companies from start-up to scale. They can be used to cover operational expenses, invest in growth opportunities, or manage unexpected financial challenges. They can also be used to help protect against cash flow gaps and establish a startup’s credit profile. That said, they do come with risks, as they are susceptible to interest rate fluctuations and if the monthly repayments are not kept up, there is the possibility of default.

Ultimately, we believe that they are the perfect fit for most high growth startups. If you’re interested in a line of credit, get in touch with us!