12 Things Startups Should Know About Equipment Financing
Equipment financing is a great option for businesses that require expensive equipment.
- November 3, 2019
- Startup Business Loans
- 8 min read
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When you’re looking into financing your new startup, you don’t always need a lot of working capital or cash, but you might need an expensive piece of equipment instead. A restaurant can’t get off the ground without some commercial kitchen appliances, and a landscaping company needs mowers, trimmers, saws and more to do its job. Equipment financing is one way to ensure you have access to the resources required to launch your new company.
Equipment financing can be a great option for many new and existing businesses. But they come with their own set of pros and cons. Read on to find out the 12 key things startups should know about equipment financing.
Equipment financing involves a loan or lease that is used to fund the purchase of or use of equipment for your business. Unlike with general business loans, which can be used for a variety of purposes, you can only use the equipment loan funds secured for the business equipment approved by the lender or financer.
The limitation on what you can spend equipment financing on exists because the equipment is usually used as collateral for the loan. The lender provides the money to purchase the equipment at agreed-upon terms, which generally includes periodic payments that include interest and principal over a fixed term. If you don’t make the monthly payments, the lender can repossess and sell the equipment to recover some of its losses.
Equipment financing comes in two broad categories:
They both work very similar to how loans and leases work in the auto industry.
Equipment loans require you to agree to payment terms, including the length of the loan, the amount to be paid monthly and an interest rate. At the end of the loan period, if you’ve fulfilled all your payment obligations, you own the equipment. This is a good option if you want to own the equipment outright, want to purchase used equipment or want to purchase and modify equipment.
Equipment loans usually cover up to a certain percentage of the price of the equipment. For example, if you are opening up a restaurant, you’ll need appliances like ovens and refrigerators. If the total cost of the equipment is $80,000 and you’re approved for an equipment loan equal to 75 percent of the equipment’s cost, then the loan amount will be $60,000. Your out of pocket expenses on the restaurant equipment is, therefore, $20,000.tr
Equipment loans are different from equipment leasing. In an equipment lease, you pay the rent periodically to the equipment’s owner for use of the equipment over an agreed-upon duration of time. At the end of the leasing term, the equipment is returned to the owner if you discontinue the lease.
Other options at the end of the lease term include renewing the lease, upgrading the equipment and renewing, or sometimes buying out the equipment. What’s more, the qualifications for equipment leasing are usually less strict than for an equipment loan. If the equipment is necessary for your business, however, the endless payments on leased equipment without the prospect of future outright ownership may prove a more costly option.
Qualifying for equipment financing depends on the requirements laid down by the lender. Most lenders review a set of general requirements when making a decision on equipment financing. The important thing to keep your eye on when you apply for equipment financing is both the qualifying requirements and the terms of the financing, which can vary considerably depending on the equipment loan lender and your personal or business’s credit history.
Your personal credit score is a crucial factor when applying for equipment loans, especially if when starting a brand new business that doesn’t yet have a credit history of its own. If you’re not sure what your current credit score is, you can find out online through a “soft pull,” a credit inquiry that doesn’t affect your credit score.
As with most types of lending, the higher your credit score, the more likely you are to get approved. A better credit score also usually entails better loan terms.
Another key piece of criteria often required by lenders is a comprehensive, well-written business plan describing your business and outlining future growth potential. Lenders may want to know the number of years you’ve been in business and annual revenue, both of which you should put in your business plan. Business plans provide prospective lenders with a detailed layout of the business they’re putting their money into, which helps them weigh the risks and benefits of funding your business.
In addition to your business plan, another critical piece of information lenders may require is a balance sheet or cash flow statement. These statements identify the revenue your business is bringing in and expenses your business is paying out. Your personal finances are important to lenders since your personal financial habits will inform your habits as a small business owner, especially if you’re starting a new company with no history of business. So, in addition to financial reports on your business, you should get personal financial statements and all relevant financial information in line for lenders to review. It’s not a bad idea to hire a qualified accountant when applying for an equipment loan to make sure all your financials and paperwork are in order.
There are a variety of options available for obtaining equipment financing. You can acquire equipment loans from places ranging from traditional banks and national lenders to smaller specialized equipment lenders. Traditional lenders, including big banks, usually have stricter underwriting requirements, but better interest rates and terms. They may be more suitable for established businesses with strong cash flow and assets.
Specialized lenders are generally more flexible with their underwriting requirements. However, the interest rates and terms tend to be less favorable compared to business equipment loans from a traditional bank. Specialized online lenders, like Seek Business Capital, are often more suitable to startups or businesses that do not meet the minimum credit and asset requirements of bigger, traditional banks and lenders. The option you choose will depend upon the qualifications of your business as well as the loan type that best suits your needs.
In addition to equipment loans, small business owners can also consider obtaining the money needed to purchase equipment via a personal credit cards and business credit cards, as well as invoice factoring or financing, or angel investing. Each have their pros and cons regarding terms, turnaround time and qualification requirements. However, these alternative methods of funding can be great options if you’re having issues with traditional lenders.
There are many reasons and circumstances that make equipment loans an appealing option for entrepreneurs. At first glance, you might think it’d be better just to pay cash for essential equipment, thus avoiding starting your new business with debt. But while that seems like great logic on the surface, depending on how much cash you actually have on hand, trying to avoid equipment financing completely could put your new business at risk.
Cash flow is a pressing concern for any business owner. Purchasing business equipment naturally makes an impact on your cash flow. Equipment loans, however, can actually help cash flow issues because an equipment loan allows you to spread the cost of the purchase out over time. This enables you to hold some of your cash in reserve, which can come in handy with all the uncertain costs that arise when running a business.
Another basic reason to seek out equipment loans is because you simply don’t have the cash to purchase the equipment needed to run your business. Some equipment necessary for your business can be quite pricey — as much as thousands or even tens of thousands of dollars. Most startups don’t have that kind of extra capital lying around, so you’ll have to borrow it from somewhere.
What’s more, you might have enough cash to purchase basic equipment, but you want premium or more capable machinery. The bottom model isn’t always the best choice for your business, even if it’s the cheapest. Equipment loans might let you make the most appropriate investment in your products and processes.
Equipment financing is sometimes easier to obtain than other types of business funding, including SBA-backed loans or angel investing. That’s because equipment financing is less risky for the lender since the equipment acts as collateral. For the same reason, equipment financing, like truck loans for example, may come with better rates and terms than other types of small business loans.
Another benefit of equipment financing is how many options you might have. Several lenders work exclusively with this type of loan, but you could also get financing from traditional banks and specialized or alternative lenders.
Equipment financing also spares you a difficult situation that often arises with business loans. In order to qualify for a business loan from certain lenders, you may be expected to put up collateral that you already own, such as real estate or vehicles. They might even require a personal guarantee, which could intertwine your personal assets with the terms of repaying the loan. Fortunately, this generally isn’t the case with an equipment loan. Most of the time, alternative and online lenders will be satisfied with using the equipment you’re purchasing as collateral for the loan without personal financial commitments. By using the equipment as collateral, you significantly reduce your financial risk, as does the lender.
Perhaps the biggest disadvantage of equipment financing — especially for a purchase — is that you might need to come up with a sizable down payment. Down payment requirements vary; whether or not a down payment is required depends on the lender, your own credit history, the business’s credit history, the type of equipment and how much you need to finance.
Equipment depreciation is a major factor that the equipment lender will consider. For example, if you want to finance $20,000 for equipment that’s likely to depreciate $5,000 a year, the lender is taking on fairly significant risk. If you don’t make any of the payments, they can repossess the equipment, but they may only be able to sell it for $15,000, which is a loss of $5,000. Lenders often require down payments on equipment loans to reduce that risk.
Depreciation of equipment also affects you as the business owner using it. Equipment financing for equipment that depreciates quickly, requires significant maintenance or becomes obsolete too soon could prove very expensive to your business. With equipment such as this, equipment leasing may make more sense.
Equipment loans — whether you lease or purchase — are probably going to be a financial fact of life for your business if expensive machinery is required in your processes. Luckily, it’s a form of business financing that is relatively easy to get and works well with many business budgets.
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