In considering the best deal structure, think of what your needs are at the end and the beginning the lease. Not thinking about the end at the beginning may come back to bite where it hurts, in your bank account. So here are five points in brief to consider when financing equipment or software. Begin with the end in mind.
1. What to do at the end of the lease? There are three basic end of lease options:
a. Own the equipment- You have paid for the equipment in full or $1 payment to own it.
b. Pay fair market value at the end of the lease (FMV) or Return the Equipment – The FMV could be anywhere from 10-30% of the original cost of the equipment. I recently had two clients that did not consider the end of the lease at the beginning. The first client had a FMV buyout cost of $119k on a forklift but did not have the cash and the original finance company would not re-fi the deal. Yep, it came back to bite them in their bank account. Another client was going to go with the manufacturer’s financing company for a 2019 mechanic truck that cost $114k with 30% FMV option. They were not considering the $34,200 that would be due at the end of the lease. In the end, I was able to provide the financing structure that met their needs as they both clients wanted to keep the equipment.
c. Monthly Contract Continuation. You continue paying the lease on a monthly basis. This can buy you time while you decide to buy something else. Beware though of evergreen clauses!! An Evergreen Clause allows for an agreement to continue for a defined period if the existing agreement is not renegotiated or properly cancelled within a specified time. Typically, an Evergreen Clause takes the following form in a contract: Each Term shall automatically renew for subsequent period of the same length as the initial Term unless either party gives the other written notice of termination at least (30) days prior to expiration of the current term. You don’t want evergreen clauses in your agreements! In fact, check all of your current leases for these clauses!
2. How much to put down! – Down payment can vary widely from $0 to 30% down depending on your overall credit profile (i.e. TIB, credit scores, comp credit). However the less you put down the more financing cost will be incurred. Balance down payment with your today and planned cash need during the term of the agreement. As the old saying goes, “Cash is King!”
3. Term. – How long do you want to finance the equipment? Typical terms are 24-60 months. The longer the term the smaller the payment and you will incur most overall financing costs. But longer terms will be easier on your cash flow. Get creative with the terms! If it will take two to three months to make or save money from your purchase, ask for a 2-3-month deferred payment plan. Or if your cash inflows will be uneven in anyway, ask for a seasonal or skip payment plan. The goal is match the cash inflows with the cash outflows.
4. Payment and Net Cash Flows. You want to make sure that the net cash flows make sense for your budget. For example, you may have a lender that will give a very low rate, but it may require a large down payment (d/p) and large equipment buy out option (say 30%) at the end of the lease. Recall the examples above. Whereas another lender may have a higher interest rate while not requiring a down payment or any buy out cost at the end of the lease. So focus on ability to support the monthly payment from cash generated from use of the asset and the overall net cash flows considering d/p and cost at the end. A cash shortage is no fun!
5. Net Cost of the Buying the Equipment is Tax Deductible. – Don’t forget you will deduct the interest and depreciation the equipment or software purchases on your tax returns. See your tax advisor on options such section 179 of the IRS tax code.
Bringing it all together! The number one benefit of equipment financing is retaining cash in your business for current operations. Evaluate all of the points discussed above in the lease/loan agreement. Shop down payment, payment amount, terms and end of lease options that meets your total cash needs rather than rate; that’s the smart play.
About the author:
Julius Talley is a CPA with a MBA from the University of Notre Dame. He has over 25 years as a Chief Financial Officer and sources capital for business, municipalities and non-profit organizations. He brings capital to his clients from a network commercial financing sources for equipment purchases, lines of credit, letters of credit, term loans, inventory and P/O financing. Connect with him on LinkedIn or contact him at email@example.com.