Funding a business acquisition with equipment financing

There are many ways to finance the purchase of a small business. The most common method includes using an SBA 7(a) loan along with a mix of seller financing and investor equity.

However, many deals are structured differently. Sometimes, SBA lenders refuse to fund a loan based on the industry, customer concentration, or asking price. Other times, the seller may refuse to issue any promissory note.

In order to come up with the sources of fund to close, SMB operators will need to explore other options for funding the deal -- either private lenders, all-equity, etc. One common way to fund a deal that includes a lot of equipment is using equipment financing.

We see this a good bit in the logistics space, where the customer concentration or size of the deal may remove SBA financing from teh table.

What is Equipment Financing?

Equipment financing is the process of getting a loan, lease or a sale leaseback backed by a business's equipment to fund the deal. Equipment financing can be used to purchase almost anything a business needs, aside from real estate and intangible assets. It is important to note that real estate is NOT a part of equipment financing. There are other financing options for the purchase of real estate (building, land, etc.). In addition, intangible assets (trademarks, goodwill, etc.) can be purchased using other financing options.

Equipment financing is an overarching term used interchangeably with an equipment-backed loan, equipment lease and equipment sale leaseback. Below are the pros and cons of each type of equipment financing:

Equipment Loan: An equipment loan is structured similar to a loan you would take out on your own home. The equipment loan is fully collateralized by the piece of equipment it is financing. Moreover, an equipment loan may require personal guarantees depending on the longevity and credit worthiness of the business. A large down payment is sometimes required to obtain an equipment loan. Although, an equipment loan does allow a business to take ownership of the asset and fully depreciate it on its income statement. Typically, an equipment loan has term lengths between 5 and 7 years.

Equipment Lease: An equipment lease is where a business or person (“Lessor”) leases out a piece of equipment to a business (“Lessee”). Here, the Lessee pays periodic (monthly, quarterly, annually, etc.) payments (lease payments) to the lessor for use of the equipment. Minimal cash is needed upfront and the interest rate charged is typically baked into the lease payment. A lease payment is analogous to a rent payment. Therefore, a lease payment decreases a businesses taxable income.

Equipment Sale Leaseback: A sale leaseback is a bit more complex, but is often used in situations where a business needs immediate cash flow. What happens in a sale leaseback is that a business sells equipment to a buyer and then the buyer immediately leases that piece of equipment back to the seller. Oftentimes, the piece of equipment is never physically transferred to the buyer. The buyer and seller simply transfer ownership and cash for the piece of equipment.

Bear in mind that depending on the current interest rate environment, decreasing or increasing, and inflation, disinflation or deflation, one financing option may be preferred over another. 

Now that we have a solid understanding of what equipment financing is and the pros and cons of different types of equipment financing, let's turn our attention to common terms in equipment financing, specifically for an equipment lease.

What are Common Terms in Equipment Financing:

Equipment Description/Funding Amount: This section details the piece or pieces of equipment that are a part of the equipment financing agreement. Details include a valuation of the equipment and its current fair market value. Each agreement is specialized based on the lessor/lessee preferences. Below is a snippet of the equipment description section of an equipment financing agreement.

Financing term: Typically details the length of the financing term. Below is a snapshot of the financing term section of an equipment financing agreement.

Financing Factor: Part of the equipment financing agreement specific to leases and sales-leaseback. The financing factor is a percentage of the funding amount. Below is a snapshot of the financing factor section of an equipment financing agreement.

Fees: This section is quite variable and is often used as a mechanism to slightly increase or decrease the purchase price of equipment. Three common fees written in an equipment financing lease agreement include closing fees, annual fees and underwriting/deposit fees/costs. Below is a snapshot of the fee section of an equipment financing agreement.

Equipment financing agreements in general are quite easy to understand once you have seen or reviewed a few of them. However, at first glance, it can be quite difficult to understand an equipment financing agreement. Therefore, it is imperative to discuss with your attorney, business advisor or accountant before signing any equipment financing agreements.

How is Equipment Financing used to buy a Business?

Equipment financing, particularly in an equipment-heavy business, can be a great financing option to acquire a business. Purchasing a business through equipment financing allows the buyer to finance an acquisition that may otherwise be outside of the "credit box" for most lenders. This can lessen the amount of equity that needs to be raised from investors.

Equipment financing is an alternative to SBA financing. It is easier to receive equipment financing than SBA financing due to SBA financing requirements. However, depending on the business, equipment financing could be more expensive than SBA financing and if payments are missed then the business could be forced into bankruptcy. Below is an example of an amortization schedule for SBA financing and equipment financing.

SBA Financing

Equipment Financing

As is evident, the SBA monthly payment is less than the equipment financing monthly payment. Economically, this makes sense because the equipment financing often has a much shorter term than an SBA loan (e.g., 4-5 years vs. 10-years). Additionally, equipment financing is typically more expensive from an interest perspective.

The upside of equipment financing, however, is that it does not take into account the cashflows of the business or the equity injected into an acquisition. This makes it a good candidate for financing deals that otherwise are unbankable.

After reading this post, you should be able to have a solid understanding of what equipment financing is, common terms in an equipment financing agreement, and economic reasons for why an SBA loan will have lower monthly payments compared to equipment financing.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.