Why Your Startup Needs a Line of Credit

Many clients working 9-5 jobs dream of owning their own businesses. As their accountant, you realize their idealized view is not the reality. Regardless, many people take that big step and start their own businesses. Some start small and grow to big operations. Other clients buy into a franchise. Some consult or setup a store on eBay. As their accountant, you know there’s a business opportunity for you too. One of your first conversations should be about establishing a line of credit (LOC) for the business.

The Corporate Veil

Your client might not see the need to establish a second financial relationship with a bank. They might feel it’s a small-scale operation. They will either have little or no expenses or they can self-fund the operation. You have counseled them to incorporate as an “S” or “C” corporation. They like the idea of limited liability and the protection of their personal assets. They might not understand merely incorporating doesn’t meet all the criteria for separation. They need a parallel financial structure.

The Rationale for the Line of Credit

Your client will go through a period when they are spending money while not bringing in revenue. Later, they will have peaks and valleys in their revenue. Suppliers won’t be sympathetic. They want to be paid on their terms.

Your client should sit down with the bank where they have setup their business checking account. (You got them to do this immediately after incorporation.) They should discuss setting up a modest line of credit, which the bank treats as a commercial loan. There are several advantages:

1. Available credit facility. Your client can access funds as needed without needing to return to the bank to request a more structured loan. That takes time.
2. You are new. You are setting up the line of credit while your business is getting started. If you waited until you had a cash crunch and needed money in a hurry, your bank might not be eager to lends. As another business owner explained: “Get it setup now when you don’t need it because when you really do need access to cash, the bank might choose not to lend.” This might require a personal guarantee, but there’s more potential reward than risk, because the initial LOC is often small.
3. Establish your creditworthiness. The LOC is designed for short-term borrowing, a way to smooth over the peaks and valleys in revenue. You borrow when you need the cash and pay down the LOC once money comes into the business. Your good behavior builds up your credit history over time.

Other Steps Relating to Finance

Your client might need more advice on separating their business finances from their personal finances:

1. Business credit card. Even a small business will incur expenses. Your client will take prospects to lunch. They will purchase supplies at the office supply superstore and stamps at the post office. They need a separate credit card in the business's name to separate these purchases from personal expenses.
2. Business auto insurance. Your client probably used their own car to get to that lunch or drive to the office supply store. What if they had an accident? Their standard auto insurance policy likely doesn’t cover them for accidents while using the car for business. They should buy a policy through their insurance agent providing this protection.
3. Reimbursing business expenses. Business travel using your own car means you can be reimbursed based on the distance traveled. Currently, it’s 56 cents per mile. This can add up. Your client needs to keep records for out-of-pocket expenses they claim from the business. This might be settled up monthly and paid by check.
4. Lending money to the business. Now the time has come to reach into your own pocket. It’s a problem bigger than the LOC can handle. In a low interest rate environment, the client’s savings might not be earning anything. They decide to loan money to their business. This can’t be as simple as moving money or cash between accounts. Their needs to be a document, like a simple letter explaining the amount of the loan and other details. Your client may be writing to themselves, but there needs to be the paper trail.

The separation of business finances from personal finances is critical in protecting the client from personal liability. They might have a separate checking account for the business. You file taxes for both the business and personal entities. They need an obvious separation of each set of finances. It’s a concept accountants understand, clients less so.