Five Financing Sources

There are many sources of financing available to gift business owners. In this column, we will focus on five options that are available for major equipment acquisitions and capital additions or improvements. They are: equity, conventional bank financing, Small Business Administration 7(A) guaranteed loans, Small Business Administration 504 loans, and leasing. We will look at the basic parameters of each, as well as some advantages and disadvantages of each.

If you are looking to undertake new construction, a major expansion, or the acquisition of another gift business, equity is an option. The primary advantage of equity financing is that it provides a source of capital without a specified repayment agreement.

The typical gift business owner already has much of his or her personal net worth tied up in the business, which necessitates going to outside sources for additional capital. In accepting equity capitalization, you give up a portion of the ownership of your business in exchange for access to capital. From then on, the equity investor shares in the profits.

Some equity investors want to become directly involved in the day-to-day operations of the business. This might not be all bad. Fresh opinions from a co-owner can be helpful, especially when it comes to macromanagement; the opposite can be true if the investor decides to micromanage your business.

There are two important points to remember with regard to equity financing. First, don't give up more than 49 percent of the ownership in your company. Second, try to negotiate a buyback agreement that will allow you to repurchase the stock from the equity investors after a certain period of time.

Unlike equity financing, conventional bank financing involves no co-ownership. Banks are cash flow lenders and will focus primarily on the historical performance of your store when considering a loan request.

The biggest advantage of a conventional bank loan is the relatively low cost of the money. Bank interest rates typically range from prime to prime-plus-two-points (the current prime rate is around 7 percent). Some banks also are willing to provide fixed rates. Another advantage of conventional bank financing is that you maintain control of your business and of the asset being purchased.

The biggest disadvantage of conventional bank financing is the relatively short repayment term. The typical terms are three to five years for working capital loans, five to seven years for equipment loans, and 15 to 20 years for real estate loans.

In the Small Business Administration (SBA) guaranteed loan program, a commercial bank actually extends the loan to the small business, while the government-sponsored SBA provides a guarantee of repayment for a certain percentage of the loan amount (usually 75 to 80 percent).

An SBA loan has three key advantages. First, because the SBA assumes most of the credit risk, commercial banks are generally willing to consider riskier deals than they normally would. Second, the repayment terms are usually more favorable: up to seven years for working capital loans, up to ten years for equipment loans, and up to 25 years for real estate loans.

The primary disadvantage is the relatively high cost of the financing compared with that of conventional bank loans. For term loans, the SBA charges a guaranty fee on a sliding scale: 3 percent on the first $250,000, 3.5 percent on the next $250,000, and 3.875 percent on the remaining guaranty amount.

The maximum rates that can be charged are prime plus 2.25 percent for loans of less than seven years and prime plus 2.75 percent for loans of seven years or more. Many banks also will do fixed-rate SBA-guaranteed loans.

The other disadvantage of an SBA loan is the amount of paperwork involved in obtaining one.

The SBA's 504 Certified Development Company (CDC) Program is designed to provide growing businesses with longer-term financing for major capital expansions. 504 financing can be used for both real estate additions and equipment acquisitions. The SBA describes a CDC as "a nonprofit corporation set up to contribute to the economic development of its community or region."

The typical 504 transaction involves a 10 percent down payment from the business owner, a 50 percent loan from a conventional bank, and a 40 percent SBA guaranteed debenture arranged by the CDC.

Specific uses for a 504 loan can include purchasing land, modernizing existing facilities, or purchasing machinery and equipment. 504 loans cannot be used for working capital, inventory, or debt refinancing. The collateral requirements are usually tied directly to the assets being financed. Personal guaranties from the owners are also required.

There are three basic advantages of 504 financing packages. First, the down payment requirement is only 10 percent. Second, the overall cost of the money borrowed is relatively low. Third, the maturity period can be as long as ten years for an equipment loan and as long as 25 years for a real estate loan.

SBA 504 loans have three primary disadvantages. First, the paperwork and documentation requirements are extensive. Second, it can take several months to get approval for an SBA 504 loan. Third, the fees on an SBA 504 loan are high compared with the fees for conventional bank financing.

You can learn more about the SBA and its loan programs at www.sba.gov.

There is a growing trend among small businesses toward the leasing of significant fixed asset purchases such as vehicles and computer systems. With a lease, the leasing company actually owns the equipment. You make a monthly payment based on the present value, lease rate, and residual value. At the end of the lease, you are generally given the opportunity to buy the equipment at the specified residual value.

The advantages of leasing are numerous. Little or no down payment is required, there is a good deal of flexibility in monthly payment requirements, and you will still have the option of seeking conventional bank financing.

The biggest disadvantage of leasing is the interest rate charged. It is not unusual for lease rates to be 3 to 5 percentage points higher than borrowing rates. For example, if you purchased a truck and took out a $50,000, five-year loan with a 9 percent rate, your total interest outlay during that five-year period would be $12,275. The total interest outlay on a $50,000, five-year lease at 12 percent would be $16,733. With a conventional bank loan, you would save $4,458 in interest costs over that five-year term.

The other major disadvantage of leasing is control of the asset. As the owner of the asset, you have more control than you do if you lease the asset: For example, you could sell it without having to wait for a finance term to expire.

Arranging financing for expansion can be a significant challenge for any gift business owner. But there are a number of options to explore, so you should be able to find a source of financing that meets your needs.