There are many ways to fund a startup, from term loans to revenue-based financing to venture capital. Each type of funding comes with its own rules and tradeoffs; and, truth be told, what’s good for one business may not be right for another.
A business line of credit is one option that can be a good way to fund working capital for a growing startup with fluctuating cash flows.
Many in the SaaS startup community are so focused on angel investing and venture funding that they aren’t as familiar with these more traditional banking products. The reality is a business line of credit can be an excellent option for bootstrapped SaaS companies that are pursuing steady, stable growth and need non-dilutive capital at reasonable rates.
Here are the basics about this kind of debt financing.
What is a startup line of credit?
A line of credit is effectively a startup financing solution that can be readily tapped at the borrowers’ discretion. It it a flexible alternative to equity or venture debt, providing startups with working capital as a cushion to pay for regular business operations. With a line of credit, startups can save money with lower interest expenses and advance or draw on the line when they need the money.
How a business line of credit works
A business line of credit works kind of like a credit card: You get approval to borrow up to a particular limit, and then you only pay interest on the portion of that approved funding you actually borrow. There are two types of business lines of credit:
Secured lines of credit
Unsecured lines of credit
Secured lines of credit typically offer higher limits and better rates.
Lines of credit vs. credit cards
A line of credit is different from a credit card in several ways that make it a more useful mainstay for doing business. Lines of credits usually come with higher limits and lower rates than credit cards. And they allow you to access the funding in cash, so you can make payments that require liquidity, such as lease payments, payroll, and payments to particular vendors.
With a business line of credit, you are able to keep borrowing again and again, then repaying again and again, as long as you don’t exceed your credit limit in total borrowing at any one time. As such, a business line of credit can be good for companies that have occasional needs, variable costs, or “bumpy” revenue streams.
How are lines of credit structured?
A line of credit helps finance working capital needs. This generally means financing accounts receivable (AR).
Here's one example of how a business line of credit can be structured:
Revolving: Businesses can draw on the line (meaning get capital) and pay down the line (giving back capital) multiple times during the life of the line of credit.
Maturity: Lines of credit will mature in one year. They may be extended for additional years – we expect many will be.
Draws: Businesses can draw twice per month. Some lines of credit may offer companies the ability to draw more times per month.
Draw Notice: Businesses will need to provide the lender a minimum 3-days notice to make a draw on the line.
Minimum Monthly Payment: Businesses will be required to make a payment each month they have an outstanding balance. The minimum payment amount will be for all accrued interest from the prior month plus 5% of the outstanding principal. This is similar to a credit card — each month you must make a minimum payment of interest and some principal. And just like a credit card, customers may re-draw principal that they have repaid.
Pricing & Rates: The total amount of combined interest and fee income is 15-30%.
A. Facility Fee: On the first payment date, the lender will charge a Facility Fee of 1% of the committed amount of the line. If the line is renewed for another year at maturity, the lender will charge a new Facility Fee of the same amount.
Example: If in January the lender originates a $500,000 line of credit to Company A, they will collect a $5,000 fee at the February payment date. The company can make this payment in cash, or it can be added to the balance of the line of credit.
B. Interest Rate: The interest rate on the outstanding balance will generally be 1% below the total rate. This is because of the 1% facility fee.
Example: If a company has a minimum risk rating of 16%, then the lowest line of credit pricing the lender can offer is a 1% Facility Fee and 15% interest on the outstanding balance.
C. Floating Interest Rate: Interest rates will be floating, (based on the Prime Rate) with a floor (minimum interest rate).
How does my startup qualify for a line of credit?
In general, most lenders will require you to have been in business for several years — and at the very least six months — and to have built up some steady revenue streams during that time, usually at least $25,000 in annual income. You may need to have a good credit score to quality. And to get approved for a high credit limit, you will likely have to provide collateral to secure the lending, such as property of some kind.
The application process for traditional banks is more time-consuming, usually involving an in-person visit, versus online lenders that allow you to apply online. Whether you apply to a bank or an alternative lender, you’ll need to provide basic information about your business — tax returns, bank account info, and financial documentation like a profit-and-loss statement and a balance sheet.
Where can my startup get a line of credit?
With a little legwork, a SaaS company in need of flexible funding will be able to find a lender to provide a line of credit. Banks and credit unions usually offer lines of credit, but these traditional institutions aren’t always the right match for SaaS companies.
SaaS businesses are often rich in intellectual property, but low in physical property, which can be a roadblock to getting approved for a high credit limit from a bank that demands the usual forms of collateral.
SaaS companies can more easily qualify for unsecured lines of credit with lower limits, particularly from online lenders that are interested in innovation and expanding the availability of capital to nontraditional applicants. Borrowing from an online lender will often come with higher interest rates compared to a line of credit with a traditional bank, so be sure to compare offers and fully vet the terms of your agreement before signing anything.
A few banks and institutions work to accommodate SaaS business or even lend exclusively to them. Silicon Valley Bank, for example, works with tech companies in growth mode. Tech banks often require your startup to partner with them in other ways in order to qualify or receive their lines of credit — a venture capital raise with them, for example.
Learn more about debt financing for startups
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