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Ideas for Financing a New Embroidery Company
Because the area of financing can be confusing, yet crucial to the success of any business endeavor, let’s look at some do’s and don’ts of financing as pertains to the embroidery industry.
The “Do’s and Don’ts”
- Do your homework.
- Do a market research study for your area.
- Do all of the work necessary to create a comprehensive business plan.
- Do decide which equipment best serves your needs to complete the business plan.
- Do spend about 1,500 hours preparing projections and proposals.
- Do contact every financial institution within a 2,000-mile radius.
- Do send up offerings to whichever heaven you prefer.
- Don’t let the seemingly endless process deter you from your goal of owning your selected equipment.
- Don’t take it personally when, after reviewing all of your thoughtfully prepared work, they hand you your hat and coat and boot you through the door.
- Don’t take no for an answer!
Welcome to the wonderful world of financing. Once you have decided on the type of embroidery equipment, the direction of your new venture and the location for your shop, then comes the how. The how is the money part.
There are three ways to purchase equipment:
Even if you are in a position to pay cash, sometimes it’s more prudent to hang onto 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 as much stability as possible in a prospective loan customer.
Here’s another reason to consider holding back some cash: You may need an operating loan a few months down the road, and if everything. you have was already applied toward the machine, there won’t be any cash reserve to reassure the bank.
Unless the financial institution has a lot of experience dealing in the embroidery business, it will know nothing about re-sale values, and will discount your equipment’s worth severely upon consideration for a loan.
So, if you can’t-or choose not to-pay cash, you still have two possibilities: 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 that portion of the equipment that the bank doesn’t own.)
You create an equity interest in the machine and therefore add to the asset column on your balance sheet. With each payment, that equity increases. You also create 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 to the asset column. Naturally, there has been some depreciation on the equipment, but it rarely approaches its value at the end of the finance term. In our business, equipment maintains an extremely high value over the years. So do try to own the equipment whenever possible and practical.
Another advantage of financing is that generally you can find lower interest rates from banks and credit unions than from leasing companies. In many cases, leasing companies borrow money from the same lending institutions that you might 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 is using its own money, the interest rate is often about the same as that charged by smaller leasing companies. It is possible to shop around for more favorable interest rates on leases if you currently own a business, and have operated it for at least two years. If you have sterling business credit, you may be able to obtain a fairly good rate from a company that does its own funding, rather than one that brokers funds on your behalf.
Some advantages of leasing are lower entry costs, tax benefits (ask your accountant), and the fact that it is sometimes easier to qualify for a lease program than to qualify for conventional financing for such a large amount. The disadvantages are higher interest rates and, sometimes higher payments. Also, at the end of the lease period, you don’t automatically own the equipment. Let’s look at these factors more in-depth.
One of the biggest advantages of leasing is lower entry costs. Whereas a bank is typically looking for a 20% or 30% down payment, a leasing company is usually looking for the first and last payments, and maybe one additional month’s payment as a security deposit.
In some cases, a deal with which a leasing company is not comfortable can be strengthened by an additional capital deposit. For example, what if instead of providing first and last payments, plus an additional month’s payment as security, you offer a security deposit equivalent to six monthly payments? Or maybe one year’s payments? An easy way to provide such a security deposit is to post a certificate of deposit from your bank. If you have such an investment, you can pledge it to the leasing company as security on your lease, and still earn and receive the interest. The leasing company is covered, your security requirement is minimal, and you still receive the interest.
One concern here is that in some cases, when pledging a large amount of money on a lease, the transaction becomes a purchase rather than a lease and may be treated differently from a tax standpoint. The primary reason that you would want the lease to be viewed by the IRS as a true lease, rather than a financed arrangement, is that monthly lease payments are deductible as a business expense. Loan payments are not deductible-only the interest paid each year is deductible. Of course, on 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 results in a capital gain. This is a complex area, and each situation is different. Talk with your accountant about which avenue best suits your situation. If you don’t have an accountant, consider consulting one on such major issues as this.
At the end of the lease term, you have the option of turning the equipment back to the leasing company, or paying from $1 to 10 percent of the original cost of the equipment (or its fair market value) to purchase it. Be careful here, because if the purchase residual is too low, the IRS may look at the transaction as a financed arrangement or purchase, rather than as 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 business and know the resale value of equipment.
You are going into business with every expectation of succeeding, but the bank or leasing company is looking at it from the viewpoint that if you should fail, it must limit its exposure on the downside. How much can it get for the machines if you can no longer make the payments? A leasing company that doesn’t know embroidery equipment might assess a re-sale value on a machine at 10 cents on the dollar, whereas a company experienced in this business would use a valuation of 50 cents on the dollar.
If your proposed equipment package includes digitizing 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 software value is usually limited to between 20 and 50 percent of the total lease package.
No matter what you do, make sure that you are well prepared when you approach a financial institution about a loan for your machine. Be sure you can confidently answer all questions. Those questions will undoubtedly 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 sort of general rule in the banking or leasing business that no matter how many documents the customer brings to a first and second meeting, a loan cannot be transacted until the customer has been to the office at least three times! Kidding aside, there is no alternative to being prepared, and it may take a lot of legwork to find the deal that works for you.
Other sources that are emerging in the world of finance are government programs and the economic development council (EDC) programs. Do not overlook these possible sources of machine financing. Small Business Administration loans administered through the 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 that are referred to 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 transaction total. The balance of the deal is split between the EDC and a participating bank. The bank usually loans its half at 2 percent over the prime interest rate, while the EDC provides its funds at 2 percent under prime. Here, you just may have the ultimate deal. Your down payment responsibility is only 15 percent, and you are borrowing at prime. (Donald Trump can’t borrow at prime!) Terms are usually 4 or 5 years and there is no prepayment penalty for early payoff.
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 of the avenues available before jumping into a deal that might not be right for you. The long-term financial wellbeing of your new business is at stake. Take some time to find a arrangement that works best for you, so that the equipment you eventually buy will be a true pleasure to own.
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