When you are starting your own business, it may be challenging to find financing, forcing you to rely on your own personal credit to get started. However, you may not realize that by paying for business expenses such as inventory, equipment, and utilities with a personal credit card or from your personal checking account, you are mixing your personal and business credit, and potentially putting your personal assets at risk. Starting a business is a risky endeavor by itself, and it would be a great mistake to compound that risk by making liable the assets you and your family depend upon.
The good news is, building your business credit history is not as difficult as you might think. The best way to start is to cleanly separate your business from personal credit as early as possible.
Separating personal credit from business credit
A great first step to separate personal credit from business credit is by incorporating your business as a separate legal entity. Whether the legal structure is a corporation or a limited liability company (LLC), you can create a separate legal entity with its own assets and liabilities. This shields your business from any personal liabilities and, unless legally provided for (in the case of personal guarantees on a bank loan), also shields your personal assets from the activities of the business. Importantly, once you have incorporated, you can start building business credit that will be used to determine the creditworthiness of the company—which is separate and distinct from an individual's personal credit.
Running your business as a separate legal entity and paying its bills through a bank account or credit card associated with this legal entity helps both your personal credit as well as the credit of your new business. First, paying bills through separate bank accounts associated with your business starts the process of building your business' credit history. Second, should your business encounter financial or legal difficulties, a corporate entity will provide your personal assets with some level of legal protection. For more information about different business structures or to form yours, visit LegalZoom.com.
Maintaining superior business credit
As a small business owner, it is imperative to establish and maintain superior business credit for business growth, since it is required for obtaining external financing, as well as to build trusting relationships with vendors, suppliers and even your customers. The development of good business credit is a gradual, iterative process. As you start to pay your business bills with a business credit card, you start the process of building your business credit history, which eventually increases your chances of obtaining more credit in the future. More credit equals easier access to capital to grow your business and build a strong cash flow position. Therefore, building strong business credit is something that is absolutely necessary for the health and future growth of your business.
The conundrum of personal guarantees
Once business credit is established, owners should try to refrain from offering personal guarantees in order to obtain financing. The primary reason a business owner works so hard establishing business credit is to separate the business from the owner's personal credit. Many business owners fail to realize that they have given personal guarantees as a requirement for obtaining credit cards or business lines of credit. To ensure this doesn't happen, you should try, whenever possible, to be clear with potential financiers that you will not provide personal guarantees to secure financing.
By definition, a personal guarantee is a contractual, personal assurance provided by a borrowing entity that a loan or agreement taken by the entity will be repaid. In the event that the loan cannot be repaid, a personal guarantor has to personally come up with the funds to repay the deficiency. Signing a personal guarantee as a principal of a company is essentially co-signing for a business. As an officer of a corporation, when you sign a personal guarantee, no matter what your corporate structure is—LLC, corporation, S corp—you become personally liable.
When personal guarantees can't be avoided
That said, some lenders or programs, such as the Small Business Administration (SBA) are going to require a personal guarantee as a matter of policy. When you are starting out, even as a corporation or LLC, if you have no established business credit or collateral, a lender will most likely require a personal guarantee. So what is a small business owner to do? Take the steps necessary to establish your business profile as soon as possible. Robust profiles need to include payment history, updated ownership information, verified core demographic data, and a record of all public filings.
You've earned it, use it
Once you have established your business profile, stand your ground when you are seeking favorable terms for financing, including the ability to finance without a personal guarantee. You often have the option of finding an alternative bank if your existing bank is asking for a personal guarantee before approving financing for your business. Leverage your credit report in your negotiations—do not simply assume someone at a lending institution has looked at it. If there is still a requirement for a personal guarantee, set specific personal collateral rather than an open personal guarantee and set timelines for when the personal guarantee is terminated. Lastly, you can ask for an appropriate higher interest rate to avoid a personal guarantee.
Establishing your business as a separate legal entity and paying its bills through business bank accounts and company credit cards, which are separate from your own personal finances, is strongly advised for both financial and legal reasons. Financially, paying for business expenses with business accounts or credit cards helps build your business credit history, which can only help your business' ability to obtain favorable credit in the future. From a legal perspective, keeping your personal and business finances separate decreases your personal liability.
For more information on Dun & Bradstreet Credibility Corp. products and services, visit www.DandB.com or call 1-855-444-3093 to speak with a credit advisor.
