A Catch-22 (def) is a logical paradox wherein you find yourself in need of something which can only be had by not being in need of it.
When you are starting a business or investing to break through to the next level (sales, volume, support, equipment, etc), that’s when you need cash most. The irony is that ‘no one’ wants to bank on you and your business when you need money but they come out of the woodwork ready to lend you as much money as you want, once you do breakthrough to success and don’t need their money anymore. Doesn’t that fit the definition of a Catch-22?
Whether it’s the booming market we had in the 1990s or a much tighter market like we are recovering from now, small business and sole proprietors in particular are generally locked out of the capital markets.
Resourceful, determined business owners often turn to their credit cards to fill their company’s equity gap. But research findings from a study: The Use of Credit Card Debt by New Firms, http://www.kauffman.org/research-and-policy/use-of-credit-card-debt-by-new-firms.aspx, released by the Ewing Marion Kauffman Foundation confirm some worrying consequences:
- “Startup firms with continuing high balances have reduced likelihood of success”
- “Credit card debt reduces the likelihood that a new business will survive its first three years of operation”
The study suggests that, during many firms’ first few years of operation, their credit card debt increases and then eventually stabilizes to manageable levels; while firms with high credit card debt close-up, and successful firms start paying off their debt.
It’s no surprise that more than 50% of all new businesses rely on debt financing when they begin operation. The size of the business is not a factor. There are many sources you can pursue for funding your business; however, a solo business owner is rarely eligible to apply for any of that funding. Then again, most of us are not interested in putting our family home at risk. Nor do we have wealthy investor relatives to bankroll the business.
When you look around for quick equity to invest, credit cards become very appealing as a means to self-fund a small business or sole proprietorship.
- Credit cards help you manage finances
- Credit cards streamline payments
- Credit cards are easier to get than a traditional bank loan or government business grant
- Credit cards smooth revenue streams – especially in the startup’s early stages when expenses exceed revenues.
- Credit card companies never come back and ask you how you spent the money.
In the Kauffman Foundation study, about 58% of the surveyed firms relied on credit cards to finance their first year of operations.
The study results found that every $1,000 increase in credit card debt increases the probability a firm will close by 2.2 percent.
While it’s relatively easy to get a credit card with a line of credit for your business, you should keep in mind a few caveats:
- Credit card interest rates are extremely high
- Credit card companies are very unforgiving about late payments and over limit expenditures
- If you intend to fund your business with credit cards, it is easier to get approved before you start your business, preferably while still employed by someone else.
- Because this kind of debt financing is so expensive; you must plan, budget and monitor your spending very carefully monthly if not weekly.
If you use credit cards in your business, how much of a balance do you carry?
By the calculation above, if you carry $2,000, you have a 4.4% probability of closing this year, so on this scale, you are in good shape. But if you carry a credit card balance of $15,000 (x 2.2%/$1000) that’s a 33% probability you won’t be in business by the end of the year!
If that sounds like your business, or if you were considering going deeper in debt to fund operations this year, think carefully how you intend to generate revenues to cover expenses AND pay down that debt.
To avoid a credit and borrowing catch-22, an alternative option is to self-fund your business with credit cards. That way, you don’t have to ask for approval or permission from anyone. But keep your eyes open and recognize you are taking on all the risk yourself.
