Credit cards are now among the most common small-business financing tools. Used carefully, they might even work
Like every good entrepreneur, we felt we'd ultimately be able to turn things around and go forward," says Stephen Brents, cofounder with his wife, Julie, of Brents Sportswear, in Fayetteville, Ark. But during an overseas expansion effort in the fall of 1996, the Brentses' sportswear-manufacturing business slipped into a cash-flow dive and didn't pull out. "We both had good credit, so we started taking cash advances on the credit cards to make payroll and taxes. We were robbing Peter to pay Paul," says Stephen.
That lasted for several months, while the Brentses made minimum payments on a half-dozen personal credit cards. Ultimately, they ran the cards up to about $150,000 and then crashed and burned in January 1997, after sales never picked back up.
Amazingly, the Brentses' credit didn't end there. "Right after we filed Chapter 7, we got a dozen approval letters from credit-card companies. The interest rates were very high, 18% to 21% with a $1,000 to $2,000 credit line. They said they could help us build credit back up," Stephen says, laughing at the irony of it all. "We threw them all away."
But plenty of other small companies are raking in those cards. In 1997, according to Survey of Small and Mid-Sized Businesses, by Arthur Andersen's Enterprise Group and National Small Business United, the top two methods of financing for small companies were bank loans and credit-card financing, which were used by 38% and 34% of the respondents, respectively. That's a mighty spike in credit-card use compared with the situation in 1993 when only 17% of businesses surveyed used plastic. According to the survey, 25% of the companies that use credit cards are using them "often or routinely," which means they're whipping out the cards--both personal and business--month after month for business purchases.
Here's how one West Coast manufacturer's routine goes. Typically, he could have expected to have a 30-day billing cycle with his suppliers, but they have agreed to charge his purchases on the day after the closing date of his credit-card statement rather than on the date he buys the goods. Say he makes a purchase on May 23. If he didn't use plastic, the payment would be due June 23. But with a statement-closing date of June 29, the supplier bills the card on June 30. The credit-card company bills the manufacturer on July 29, and he pays his credit bill on August 29. Presto! He stretches his payment to 90 days. On top of that, from the $1 million in yearly charges, he's earning enough frequent-flier points to pay for all company sales trips. Obviously, he'd rather remain anonymous.
Using credit cards is a riskier-than-usual way to finance your company. You have that huge bill to face every month, instead of several smaller ones that can be juggled. Once you max out, you can't pay your bills anymore. And the interest payments on carrying a balance can make a grown entrepreneur cry. Funding businesses with a card violates the consumer-cardholder agreement. Yet it's a standard practice for thousands of company owners.
A case in point: Paul C. Porter, chief operating officer, vice-president, and co-owner of Automation Inc., which makes Clean Shower bath cleaner, is pulling in more than $2 million in sales each month, and his company has had outside investors since 1995. But Porter also turned to credit cards. "My wife and I borrowed about $80,000 on about 25 different cards in 1995," he says. Automation is the latest in a long line of companies for Porter, including a Blockbuster franchise and an engineering consulting firm. "I've used credit cards for all of them," he says. "Now they're sending us so many applications, we just throw them away."
There are certainly no lack of opportunities for business owners to sign up for yet another credit card. Consumer-card issuers sent out 2.5 billion applications in 1997, and record numbers of consumer cards have been issued--450 million at last count (with the entire U.S. population numbering fewer than 270 million). In 1997 consumer credit limits--the total amount of credit issued--increased by about 25% over the previous year's figure. Not surprisingly, there has been an accompanying rise in personal-bankruptcy rates (which surpassed 1 million filings for the first time in history in 1996 and were expected to have exceeded that in 1997). But with credit limits as high as $100,000 on some premium cards and introductory rates as low as 3.9%, who's going to just say no?
"If you're going to start your own business," a consultant told Charlene Connell, "get as many credit cards as you can before you quit your job." Connell got 10, for a total credit limit of about $15,000, which she used for cash advances to make payroll. That was seven years ago, when she was struggling to make minimum payments. Today her company, Vital Resources Inc., in Cleveland, is a profitable computer consulting firm that made the Inc. 500 in 1996.
Happily, 60% of the companies using credit cards in Survey of Small and Mid-Sized Businesses say they pay the cards off monthly. "The worst thing is to make a late payment in the current environment," says Robert McKinley, president of RAM Research Group, publishers of bank-card publication CardTrak. Five years ago banks would let customers slide for 30 days and charge a small fee, McKinley notes. But since government restrictions were lifted last year, the bank can charge whatever it likes in late fees--and some charge up to $25, even if you're only one day late. "But the real risk is that if you do that twice in a 12-month period, you're considered a risky cardholder, and they bump you up to a punitive interest rate, about 25% to 30%. Late payments show up in your credit file, and banks are very nervous about signs of weakness right now."
It's a short hop from weakness to bankruptcy. We talked to dozens of successful entrepreneurs who grew their businesses on credit cards, and every one had seen comrades choke and die on the stuff. "For every person who tries this, one out of three might not succeed," says McKinley.
Despite all the horror stories, personal credit cards can be a fast, cheap, and easy way to finance a business. That is, if you're smart about them.
"It was cheaper than our Small Business Administration-guaranteed loan," says Sally Williams, a founding partner at Hellas International Inc., an olive-oil importer based in Salem, Mass. When it started, in mid-1995, the company received a $150,000 loan, which Williams and her two cofounders nearly doubled by signing up for 18 personal credit cards. They immediately maxed out some of the cards or took cash advances, and then put the cards in a drawer and created a payment schedule in the company business plan. "If you take the $7,500 in loan fees plus the 11.5% interest rate versus some good interest rates on the charge cards, the cards are about the same money or cheaper. Our average is about 13% on the cards. Plus our time is money too, and the amount of time on that SBA loan was huge."
Careful management of those cards is what kept Hellas from becoming enslaved to high interest payments. "Each month I review each interest rate and our budget for interest and principal repayment," explains Williams. "You have to really keep a tight control, watching your interest rates. When those low introductory rates expire, cards can jump up to 17%. I call, and 9 out of 10 times they'll drop it down to 13%. I have one at 11.65%. And I transfer balances when I have room freed up on a lower-interest card." (Williams urges extra caution on transferring balances--some companies charge very high fees for such transactions.)
The real secret to credit-card financing isn't just to juggle the cards and make the payments on time. It's this: parlay those personal credit cards into corporate-credit history. First, make the credit cards part of your financial plan. (Keep personal and business charges on separate cards.) Second, stick to it. Third, impress a bank with your financial management of the cards and earn a credit line.
It worked for Charlene Connell, who relied on her 10 credit cards while starting Vital Resources. "There were times I needed to make payroll and hadn't gotten paid for our services yet," she remembers. "After Friday payday, I would wait for Saturday's mail. If the checks didn't come, I'd run to the bank machine and get cash advances and deposit them, and then hope everything worked out with the floats. My 6-year-old daughter thought it was great how you drove up, pushed some buttons, and money came out."
Connell quickly racked up close to $25,000 in debt. "In the first six months I was making minimum payments. Then after generating more income, I could pay them off--and I took care of those cards before I took care of myself."
After a year and a half, Connell's accountant introduced her to a loan officer at a bank that had previously turned her down for a line of credit. "The bank said I hadn't been in business long enough. We were a little under a million dollars in sales," she says. What changed the bank's mind was Connell's excellent record of managing her personal credit-card debt. The bank awarded her a $25,000 line, the amount her history showed she needed. "And then I cut the cards up," she says. "I enjoyed that very much."
Even with rigid financial management, credit-card financing can have its downside. "I ruined my personal credit at the expense of the business," says Jeannette Lee, CEO of Sytel Inc., an information-technology consulting company in Bethesda, Md. Lee started the company in 1987, and her government clients sometimes took months, even up to a year, to pay her. She turned to personal credit cards to get by. "We were maxed out on 15 or 16 cards for about five years. We struggled to meet monthly minimum payments. It was an endless spiral--the debt increased exponentially. I only just paid off the last two of my MasterCards in 1996." Even now, when her profitable company has placed 64th on last year's Inc. 500 list and she pulls down a salary of $200,000, Lee's credit trouble dogs her. "I wanted to apply for a new card to consolidate the three I have, and I got some rejections," she says.
Despite card issuers' attempts to press small businesses to apply for another "product," like a corporate card or line of credit, those services are sometimes difficult to qualify for and more expensive to use. Our anonymous West Coast CEO says that his credit-card company is pushing him to switch to a corporate card, but he's loath to give up his frequent-flier miles. Card companies are rethinking their corporate-card policies, including the possibility of awarding cards to younger companies. (See "Credit-Card Issuers Want You," below.)
Still, the days of ready corporate credit for start-up businesses are far in the future. For the moment it seems that capitalizing with credit cards will remain a Faustian bargain. As Lee says, "it was horrible. Don't resort to cards because they're easy. Try any other financing first--friends, family, borrowing, anything. Credit cards are a last resort."
Phaedra Hise is a contributing writer at Inc.
Consumer credit cards are for personal use only," says Shelley Ehrman, vice-president of commercial-card services at NationsBank in Charlotte, N.C. "Buying inventory, for example, violates the terms of the agreement. So would taking a cash advance to meet payroll." Still, until recently, credit-card issuers paid scant attention to those types of purchases on the personal cards that so many small-business owners use to get their companies up and running.
Today a dramatic change is in the making. Credit-card issuers are no longer turning a blind eye to the use of personal cards for business purchases. Instead, they're aggressively pursuing small-business owners--an estimated $75-billion to $100-billion market--in the hopes of selling them on corporate credit cards. Not only can the issuers make more money from corporate cards--they charge annual fees, for instance, and demand extra fees for extra cards--but they're also more likely to hang on to customers longer if they can sign them up for corporate-card services. So it's no wonder that credit-card companies want to turn consumer cardholders into corporate cardholders. And technology is on their side.
Basically, credit-card issuers only recently have discovered what a gold mine small businesses can be. Traditionally, they regarded small companies as a high risk--and thus set up restrictions that excluded many businesses. Thanks to the expanded abilities of computers, issuers now have more sophisticated standards for evaluating risk. One of those technologies, often called credit scoring, can create risk profiles of cardholders. Using analysis software, the issuers can pick out the small-business customers from among their consumer cardholders by looking for heavy traffic in areas like midweek travel, car rentals, office supplies, computers, and copy-shop printing.
"We can keep and retrieve information very quickly to know what profile of borrower will repay the debt," says Kendall Spencer of Barnett Bank, in Jacksonville, Fla.
And credit-card issuers are tripping over one another to woo those low-risk small-company owners away from personal cards to an assortment of new business services. That means you may actually get a solicitous call from your American Express, Visa, or MasterCard issuer--they're all hawking small-business corporate cards. The card perks include discounts from popular vendors, concierge services, and financial consulting services, among other things. "We're taking credit cards beyond being a credit card," says Richard D'Ambrosio, spokesman for American Express Small Business Services.
Steve Abrams, senior vice-president of corporate products at MasterCard International, sizes up the small-business market: "It's a good-quality market segment, with low delinquencies, not as much bankruptcy, and less fraud compared with the consumer side."
Finally, some respect.
SPECIAL REPORT: HOW TO FINANCE ANYTHING