Since the area of financing can be confusing, but crucial to the success of any business venture, let’s look at some financing do’s and don’ts as it relates to the embroidery industry.
The “Do’s and Don’ts”
- Do your homework.
- Do a market research study for your area.
- Do all the work necessary to create a complete business plan.
- Decide which team best suits your needs to complete the business plan.
- He spends about 1,500 hours preparing projections and proposals.
- Contact all financial institutions within a 2,000 mile radius.
- Send offerings to heaven that you prefer.
- Don’t let the seemingly endless process stop you from your goal of owning your selected piece of equipment.
- Don’t take it personally when, after reviewing all your carefully prepared work, you are handed your hat and coat and thrown out the door.
- Don’t take no for an answer!
Welcome to the wonderful world of financing. Once you’ve decided on the type of embroidery equipment, the address of your new business, and the location of your shop, then comes the how. The how is the money part.
There are three ways to buy equipment:
- Money
- Finance
- Rent
Even if you’re able to pay cash, sometimes it’s wiser to keep as much cash as possible and finance anyway. This provides more back-up capital for the start-up period. What lenders are really looking for is the greatest possible stability in a prospective loan customer.
Here’s another reason to consider holding on to some cash: You may need an operating loan a few months down the line, and if all. already applied to the machine, there will be no cash reserve to reassure the bank.
Unless the financial institution is highly experienced in the embroidery business, they won’t know anything about resale values and will severely discount the value of your equipment when considering a loan.
So if you can’t, or choose not to pay cash, you still have two options: finance or lease. These options also have their own advantages and disadvantages. Let’s start with the advantages of financing. First, you own the equipment (or at least the part of the equipment that the bank does not own).
You create an equity interest in the machine and therefore add it to the asset column on your balance sheet. With each payment, that equity increases. It also creates a liability on the balance sheet, but with each payment the liability decreases. At the end of a three- or four-year period, you own the equipment outright, so 100 percent of its value goes into the asset column. Naturally, there has been some depreciation on the equipment, but it rarely comes close to its value at the end of the financial term. In our business, equipment holds extremely high value over the years. So try to own the equipment whenever possible and practical.
Another advantage of financing is that you can generally find lower interest rates at banks and credit unions than at leasing companies. In many cases, leasing companies borrow money from the same lending institutions that you may approach. In order for the leasing company to make money, it adds a percentage to the interest rate of the transaction. Even in cases where the leasing company is so large that it uses its own money, the interest rate is often similar to what smaller leasing companies charge. You may be able to seek more favorable interest rates on leases if you currently own a business and have operated it for at least two years. If you have business credit in sterling, you may be able to get a pretty good rate from a company that finances itself, rather than one that negotiates funds on your behalf.
Some advantages to leasing are lower entry costs, tax benefits (ask your accountant), and the fact that it is sometimes easier to qualify for a leasing program than conventional financing for such a large amount. The downsides are higher interest rates and sometimes higher payments. Also, at the end of the lease period, you do not automatically own the equipment. Let’s look at these factors in more depth.
One of the biggest advantages of leasing is lower entry costs. While a bank typically looks for a 20% or 30% down payment, a leasing company typically looks for the first and last payment, and perhaps an additional month’s payment as a security deposit.
In some cases, an agreement that a leasing company is not comfortable with can be strengthened with an additional capital deposit. For example, what if instead of providing your first and last payment, plus an additional month’s payment as security, you offer a security deposit equal to six monthly payments? Or maybe a year’s payments? An easy way to provide such a security deposit is to issue a certificate of deposit from your bank. If you have such an investment, you can pledge it to the leasing company as security for your lease and still earn and receive interest. The leasing company is covered, your security requirement is minimal, and you still receive interest.
One concern here is that in some cases, when a large amount of money is committed to a lease, the transaction becomes a purchase rather than a lease and may be treated differently from a tax standpoint. The main reason you would like the IRS to treat the lease as a true lease, rather than a financed arrangement, is that the monthly lease payments are deductible as business expenses. Loan payments are not deductible, only interest paid each year is deductible. Of course, in an outright purchase, there are different tax benefits, such as investment tax credits. These can be significant, however they must be repaid when the equipment is sold because the sale creates a capital gain. This is a complex area, and every situation is different. Talk to your accountant about which pathway is best suited for your situation. If you don’t have an accountant, consider consulting one on topics as important as this.
At the end of the lease term, you have the option of returning the equipment to the leasing company or paying between $1 and 10 percent of the original cost of the equipment (or its fair market value) to purchase it. Be careful here, because if the residual value of the purchase is too low, the IRS may consider the transaction a financed purchase or arrangement, rather than a lease.
Another point to remember is that we are talking about leasing embroidery equipment, not automobiles or farm equipment. Some leasing companies specialize in certain types of businesses and know the resale value of the equipment.
You are going into the business with every expectation of success, but the bank or leasing company is looking at you from the point of view that if it fails, you must limit your exposure to the downside. How much can you get for the machines if you can no longer make the payments? A leasing company new to embroidery equipment might assess a resale value of a machine at 10 cents on the dollar, while a company experienced in this business would use a valuation of 50 cents on the dollar.
If your proposed equipment package includes scanning equipment, you should ask about the prospective leasing company’s policy regarding software. Most leasing companies place a limit on the dollar amount of software value in a deal. This varies widely, but the value of the software is generally limited to between 20 and 50 percent of the total lease package.
No matter what you do, make sure you’re well-prepared when you approach a financial institution to apply for a machine loan. Make sure you can confidently answer all questions. Those questions will no doubt include some of the following: Do you have a business plan? What experience do you have in owning a business? Why do you think your business will be successful?
There must be some kind of rule of thumb in the banking or leasing business that no matter how many documents a client brings to a first and second meeting, a loan cannot be arranged until the client has been in the office at least three times! Jokes aside, there is no alternative but to be prepared, and it may take a lot of legwork to find the deal that works for you.
Other sources emerging in the world of finance are government programs and Economic Development Council (EDC) programs. Don’t overlook these potential sources of machine financing. Small Business Administration loans administered through banks can be difficult to qualify for, but those who qualify are rewarded with low interest rates and favorable terms.
There are other programs available in some areas from regional or municipal economic development councils known as Revolving Loan Funds. Here’s how they work: the borrower is required to provide from his own funds in the amount of 15 percent of the total transaction. The balance of the agreement is split between the EDC and a participating bank. The bank typically lends its half at 2 percent above the prime rate, while the EDC provides its funds at 2 percent below the prime rate. Here, you may have the best deal. Your down payment responsibility is only 15 percent and you are borrowing at your prime. (Donald Trump can’t borrow at the best rate!) Terms are usually 4 or 5 years and there is no prepayment penalty for prepayment.
Financing your own equipment may not be fun, but it is a necessary part of getting into the embroidery business. Be resourceful and investigate all available avenues before jumping into a deal that might not be right for you. The long-term financial well-being of your new business is at stake. Take some time to find the arrangement that works best for you so that the equipment you ultimately buy is a real joy to own.
