Shopping for Equipment and Spending Capital Smarter
By Andrew Nere and Angela Caraglio
Today’s winery requires a large and varied amount of equipment to operate successfully. And like most business owners you are wearing 10 different hats, and doing 10 different jobs. So when machinery breaks, a tank cracks, or the life has been squeezed out of that tractor for as many seasons as possible, the time has finally come to invest in new equipment.
Purchasing equipment for a business is essential yet the process is often convoluted and extremely stressful. As a B2B service provider, our customers often come to us flustered and overwhelmed with the purchase decision process. While every business will have different priorities and circumstances when it comes time to acquire new equipment, how a business pays for it will have a significant impact on the businesses bottom line.
We recommend breaking down the considerations into various steps:
- Equipment Longevity and Obsolescence
- Matching Principal
- Operating Budget
- Financing Plan
Equipment Longevity and Obsolescence
The need for equipment can come about for many different reasons. Examples include the need to replace broken equipment, update existing equipment, or purchase new equipment for increased productivity. It is crucial to determine the useful life of the asset. Then, always try to match life of the asset to the term of the payments.
Ask yourself the following questions…
…Will this piece of equipment last my business for 10 years or does this need to be purchased again in 16 months?
…Is the equipment reliant on technology upgrades?
…Is the equipment category constantly evolving and new models are being released? (Think drones for crop monitoring.)
…Are there significant operating expenses associated with the equipment not included in the initial purchase?
…Does the equipment allow my business to open new revenue centers?
…What is the likely resale value of the equipment if my business no longer needs it?
The answer to some of the questions above will help you start to create an idea of a monthly budget for the acquisition and it’s true value. An example may be adding a Point of Sale System to a tasting room where the technology and software will likely need to be upgraded every 3 years. For this to be worthwhile, are the on premise sales soaring or are they taking a back seat? Another likely scenario for a small to medium production sized winery is; the addition of a bottling line to the quiver of equipment. The winery is producing more, however each of its 5 vintages can be bottled in a week and therefore the bottling line will only be utilized 5 times per year. The remaining 47 weeks it sits there unused – not contributing to the businesses bottom line. The question to consider is whether it makes more sense to purchase or hire a mobile service.
As you start to think about budget, it is important to review one of the basic guidelines in Accounting; “The Matching Principal.” Simply defined, this principal guides a company to match the expense of the equipment to the same period as it provides your business revenue.
Let’s use gasoline for your car as an example. When you first purchased your car you didn’t purchase all the gas you’ll use over the next 5 years simultaneously. Rather, you purchase the gas as you use it, as it provides transportation over the life of the vehicle. The same is true for your equipment, pay for the asset as it provides you a benefit and, as closely as you can, over the life of that equipment.
So, when considering budgeting alternatives keep in mind the benefit that piece of equipment will provide for your business and over what period of time. While as closely as you can, try to match the expense of the equipment to the revenue it produces for your business.
Business budgeting can be accomplished in a number of ways. It is necessary for an owner to take an honest look at their business and establish priorities. Like assessing the impact the equipment will have on the Income Statement. For instance, will the equipment provide direct additional revenue (French Oak versus American Oak barrels and casks) or does the equipment create a net savings (bottling in house vs. outsourced).
In situations where the addition of equipment removes or reduces an existing labor expense, be sure to factor in all supplementary expenses. Consider the reduction in workman’s comp insurance, employee benefit expenses, payroll taxes, etc. Where the equipment will require additional resources, be sure to factor incurring expenses into the budget.
Next let’s assess what additional expenses, if any, will arise out of the actual equipment use. Will there be significant ongoing maintenance or service expenses? Does the equipment installation require electrical, pad, or other infrastructure improvements? What are the additional power and/or fuel requirements and associated costs?
Once you have taken a moment to assess all of the variables you’ll have a much better picture of the entire project and be in a better position to assess the most important question of all, how to pay for it.
The Next Step – Financing the Purchase
Let’s change the topic to purchase options and financing! In the following section we will share and compare the most common Capital Budgeting alternatives; cash, equity (investors), and debt (bank and non-bank alternative financing).
Spending your company’s hard earned money
To pay cash for an equipment acquisition is usually what first comes to mind. A large percentage of business owners prefer to avoid debt as much as possible. While this is certainly a position that creates a level of comfort, it requires heaps of available cash to accomplish. Additionally keep in mind paying cash can be considered a form of financing, just your business is the lender.
When paying cash you are converting a liquid asset (cash) into a long term asset. So, it is important to consider how the depletion of your cash will impact your business. Some things to think about are seasonal cash needs, and maintaining a reserve for unexpected emergencies. Too often we have customers come to us in a crisis where they are equipment rich but cash poor.
Heading to the Bank
The traditional bank loan has been a mainstay of equipment financing for over a century. However, bank loans are notoriously difficult to obtain. By some reports, the rejection rate by traditional banks is as high as 70%! The reality is that the great recession really put banks out of the risk business. If you are fortunate to have a business that does not need to borrow (see cash financing) then a bank loan is probably an option. For most businesses they simply will not qualify.
However if they do, it is often under a Small Business Administration (SBA) loan product. The SBA loan mitigates a portion of the risk for the bank as they are provided a partial guarantee from the federal government. Nonetheless this is a long and laborious process that involves a significant amount of paperwork. So, while the end financing rate may be attractive this process is difficult for a business owner with any sort of time constraint.
Keep in mind, most bank loans will come with a requirement for a significant down payment, often as high as 10-20% of the equipment cost. And, bank loans usually only cover the equipment itself and do not include the installation, shipping, tax, and other “soft costs.”
Using a Business Credit Card
A Business Credit Card is a fantastic tool for financing routine expenses. Racking up reward points is a great side benefit, but credit card use should be reserved for the acquisition of short term asset or business incidentals. To avoid the steep rate most cards carry, you’ll want to complete pay off in the same billing cycle, typically 30 days, thus making credit cards a poor choice for acquisition of longer lived assets.
Even with an introductory teaser rate, most cards will have a rate in the 14% – 29% range. Most cards are revolving credit facilities, only the minimum interest payments are often paid, leaving the debt open for extended periods. Also, note that most business credit cards are simply a personal credit card with the businesses name on it. As such, the debt on the card most likely reports to your personal credit bureau and is a personal liability. This may potentially impact a business owner’s personal ability to borrow in the future.
Seeking an Investor
We cannot deny that scoring a deal on Shark Tank seems like finding the pot of gold at the end of a rainbow. To receive the capital your business needs and have no debt – sounds compelling. However, the reality is that equity financing is most often the most expensive form of financing.
Setting aside the passion and love many owners have for their businesses, the goal is to produce a profit. So, if you give up a piece of your business, what is that cost going to look like over the life of the equipment? Let’s take a $100K example for a grape harvester. Let’s assume the company is a small business worth $1Million so the investor is given 10% of the company in return.
Fast forward 10 years, and the business is currently valued at $5Million. That 10% stake is now worth $500K. The cost of your equity financing grew a whopping 400% (or 40% annually)! This is a great deal for the investor, not so much for you.
Independent Financing (Lending) Companies
There is also a well established equipment financing industry in the US that accounts for over $1 Trillion in annual financing (according to the Equipment Lease Finance Association or ELFA). This “non-bank” industry is comprised of both equipment financing and equipment leasing companies. Given that banks traditionally approve less than 30% of their business applicants, this sector finances a significant portion of the equipment businesses need to be successful.
There are significant benefits when financing with an independent company, including speed of approval, limited or no financial information required, and the ability to structure custom payments and terms. For companies that have less-than-perfect credit, an independent is often the best solution as the credit windows are often significantly larger.
An Equipment Lease is a very popular financing alternative. Under an equipment lease, the financing company (Lessor) is the technical owner of the equipment while the equipment user (Lessee) pays a monthly payment for the use of the equipment. Thus, the leases operate far more like a rental, and may convey potentially significant tax and financial advantages. Even though these leases operate like rentals, the equipment is typically not returned at the end of the term. Also there is typically a pre-defined option to purchase the equipment that is clearly specified at the time the lease agreement is signed.
Equipment Finance Agreements (EFA) are another alternative financing structure offered by many independents. The EFA operates very much like a loan in that the business acquiring the equipment is the owner of the equipment and the financing company is a secured party. However, there are differences from a traditional loan.
Whether a business utilizes a Lease or an EFA there are significant additional benefits to both products including:
- Rapid credit decisions, usually measured in hours instead of days.
- Limited financial products, many offer programs up to $250,000 with only a 1 page application.
- Low or Zero down payment programs.
- Seasonal payment programs to match seasonal cash flows.
- Deferred payment programs that delay the start of payments up to 6 months while equipment starts producing revenue for the business.
Whether a Lease or an EFA, financing is by far a more flexible alternative.
Given that every business is unique, make sure to first consider all of your needs and an equipment purchases’ impact on your business. Next seek a financing plan and financing partner that can custom tailor your program to meet these need. For more information visit Innovative Lease Services, Inc. online at www.ilslease.com or give us a call at 800-438-170.