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Kapitus secured line of credit small business lending

Pros and Cons of a Secured Business Line of Credit

September 23, 2022/in Alternative Financing, Featured Stories, Financing/by Vince Calio

If your business needs to have fast access to cash, having a business line of credit (BLOC) in place can be invaluable. Before you apply for one, however, one of the first questions you need to ask is whether a secured or unsecured business line of credit is for you. Both options come with pros and cons, so it’s crucial that you carefully consider which is best for you.

What is a Line of Credit?

Secured and unsecured lines of credit are types of financing that give your business the flexibility to borrow funds at will with pre-agreed upon payback terms and credit limit. Whether you need cash to meet a business emergency or to meet payroll during the offseason, you can use the borrowed money to finance any aspect of your business that you see fit.

Secured and unsecured lines of credits, however, have different risk profiles for the borrower, so they usually come with different limits and interest rates.

What’s the Difference?

A secured BLOC is a form of financing that requires collateral to ensure that you pay back the borrowed amount, while an unsecured line of credit does not require collateral.

An unsecured line of credit typically requires a high FICO score, a certain number of years in business (usually at least two years) and a strong cash flow. This type of line of credit normally ranges between $10,000 and $100,000, depending on the needs of the borrower, and comes with a variable interest rate often pegged to the prime rate plus several percentage points.

A secured line of credit, while typically reserved for business owners with lower credit scores, requires borrowers to put up valuable assets as collateral. That collateral can include real estate, equipment, present and future invoices and inventory. If you operate a pass-through business, you may even have to put up personal assets such as your house or personal savings. That said, however, a secured line of credit does have distinct advantages:

#1 Secured Lines of Credit Usually Offer Lower Interest Rates

The Federal Reserve has hiked interest rates five times so far this year with more probably coming, so cost of capital is a major concern for borrowers. Since a secured line of credit is collateralized with tangible assets, the lender takes on much less risk when providing this type of loan, so therefore, depending on your FICO score and the amount of collateral you put up, there’s a good chance that the interest rate on a secured BLOC could be lower than an unsecured one.

#2 Your FICO Score can be Lower

Almost all lenders consider a high credit score to be one of the most important qualifications for financing, so if your FICO score is below 650, trying to secure a loan may be a frustrating experience. Since a secured BLOC is backed by assets, your chance of getting approved with a lower credit score is far higher than if you were applying for an unsecured line of credit.

#3 You Could Secure a Higher Line of Credit

A secured line of credit could come with a higher limit than an unsecured one.

While not in all cases, an unsecured BLOC usually tops out at $100,000 to limit the risk of the lender. Even for small business owners with great credit who are able to get approval for an unsecured BLOC, they often have to put up collateral if they want a limit exceeding $100,000. Depending on the value of the collateral being put up, a small business owner is more likely to obtain a higher limit with a secured BLOC than an unsecured one.

#4 Secured BLOCs May Have Longer Repayment Terms

Securing your line of credit brings a host of benefits, and one of them is that your repayment term will usually be longer than with an unsecured BLOC. Putting up real estate as collateral can be especially beneficial, as the lender may increase the repayment term and the limit since the value of real estate usually increases over time. In some cases, the repayment term on an unsecured BLOC can be up to 10 years, whereas with an unsecured BLOC, it is usually far less.

Cons of a Secured BLOC

While a secured BLOC does have its advantages, there are also potential drawbacks to consider before applying for one:

#1 You Risk Your Most Valuable Assets

To get approval for a secured BLOC, you need to put up valuable collateral. These can include your home or a highly valued piece of property. If your business relies on expensive pieces of equipment such as tractor-trailers or medical devices, or the future payment of invoices, those assets could be put up as collateral but would be at risk if you fail to pay off your debt. Therefore – just as you would with a personal loan – it is crucial that you make sure you can meet the repayment terms before you take out a secured BLOC.

#2 More Paperwork is Involved

You’ll probably need to consult with an attorney when applying for a

A secured line of credit will involve a lot of paperwork, as well as advice from a business attorney.

secured BLOC. That’s because you will need an expert to hash out the terms of repayment, especially if calamity hits and you are unable to pay back the amount you borrowed. An attorney can negotiate terms of what assets you will have to surrender in case you default on payments.

#3 Interest Rates Vary

While the interest rate on a secured BLOC is generally lower than an unsecured one, the rate will still be variable, meaning that it will fluctuate as interest rates fluctuate. This underscores the importance of making sure you understand the exact terms of the secured BLOC before you take one on.

A BLOC is not a Credit Card!

There is a common misconception that a line of credit is like a business credit card, but don’t be mistaken – the two are not the same. Yes, they both provide a line of credit and only charge interest on the amount you borrow. However, a line of credit ideally should be used for bigger, foreseeable expenses than a credit card since the interest rate is typically lower, and in some cases, you won’t get the cash from a line of credit for 24 hours. Plus, lines of credit have term limits and different repayment terms than a credit card.

A business line of credit is a great tool if you need to get new office furniture or appliances, if you need cash for a business emergency, or if there is unexpectedly high demand for one of your products and you suddenly need to purchase more inventory. On the other hand, a business credit card is handy for sudden cash needs, such as picking up the tab for a business meal, or if your flight gets canceled during a business trip and you suddenly need to pay for a hotel room. Business credit cards also offer perks such as travel miles, but generally charge a higher interest rate than a BLOC.

Carefully Weigh Your Options

A secured BLOC can give you great benefits if you need access to cash to grow your business or for an emergency. However, you need to carefully consider the terms of this type of financing, and like you would with your personal finances, you shouldn’t spend more than you need to.

The Ins and Outs of Equipment Leasing

January 28, 2020/in Alternative Financing, Financing/by Wil Rivera

Suppose you need expensive equipment to run or grow your business. If you pay cash for it, your employees’ paychecks would bounce. Equipment leasing might be the rescuing you need.

1. What is Equipment Leasing?

Equipment leasing is a payment strategy accounting for around one-third of all equipment in use, from desktop computers to jumbo jets. “Evidence suggests,” according to the Commerce Finance Institute (CFI), “that an origin of leasing may have started… in the ancient Sumerian civilization.” Leasing has since evolved into an accessible financial resource.

The CFI defines an equipment lease as “a contract for the use of a piece of equipment over a specified period of time where the user of the equipment becomes the lessee and agrees to make periodic payments to the lessor of the equipment with specific end of term options.” In other words: you’re renting the equipment. Unlike renting a home, for example, the opportunity to buy the equipment outright when you enter the lease, is typically an option.

The accompanying illustration provides a breakdown of the categories of equipment leased today, and their share of the leasing universe. In the following pages we will explain when, why and how it is done.

https://www.elfaonline.org/data/market-trends/facts-about-industry-sectors (NEED TO CREATE AN IMAGE FROM THIS ARTICLE – BA)

2. When Should Your Business Lease Equipment?

Before you begin to think of different ways you can bring in new equipment, whether by leasing, borrowing or even paying cash, give the idea a reality check. Ask yourself the same questions that a leasing company or a lender will probably ask you:

Will the equipment meet an important business need that’s currently unmet?
Does the cost of continuing to use the equipment I already have, in repairs and/or inefficiency, justify the price of acquiring new equipment?
Is now a good time to get new equipment due to special “deals” in the market?
How does the new equipment fit into my overall business plan?
If I wait a little longer before bringing in new equipment, might more advanced models become available that will give my business more bang for my buck?
What is my expected return on investment?
Do I have adequate free cash flow to enter a lease agreement without needing to sacrifice more urgent spending priorities today or down the road?

Another important consideration pertains to your company’s tax situation. With an “operating lease,” you are unable to take advantage of an important tax code provision known as Section 179. That benefit is available to companies using a different kind of lease known as a “capital lease.” It’s also available to companies that buy equipment through borrowing.

If you haven’t payed a lot of business taxes lately and don’t expect to soon, you won’t get the full benefit of Sec. 179. It could make sense to use an operating lease. That way, the lessor—the company you lease the equipment from—gets that tax benefit. This helps you because the lessor takes into account the tax benefits factors when deciding how much to charge.

3. What’s The Difference Between Leasing Equipment And Financing Equipment?

When you lease equipment, you’re essentially renting it. Equipment “financing” means you buy equipment with money borrowed from a lender. You own the equipment. There are advantages and disadvantages to both approaches.

A third way to obtain business equipment is buying it outright without borrowing or leasing.

4. What Are The Pros And Cons of Equipment Financing?

Equipment financing pros:

If you have a strong balance sheet and profitability, you might be able to obtain a very competitively priced loan to purchase the equipment at a lower total cost than leasing. Having the purchased equipment as collateral for the loan already makes the loan less risky for the lender than an unsecured loan. A strong balance sheet makes you more attractive to lenders.
Depending on your financial strength, you might be able to borrow all of the money you need to buy the equipment without a down payment.
As the owner of the financed equipment, you may be able to claim tax benefits such as Sec. 179 and deductions for loan interest.
With a loan, you have the option to pay the principal balance off if you want to–without penalty. This allows you to reduce the total interest you pay, and ultimately, the cost of getting the equipment.
If you own the equipment and can pay off the loan, you can dispose of the equipment at your discretion leveraging equipment financing.

Equipment financing cons:

Borrowing to purchase equipment could limit your ability to borrow for other purposes, if lenders believe you’re assuming too much debt.
An equipment loan appears as a liability on your balance sheet.
Depending on the size of your down payment for the equipment, the lender might need more assets to secure the loan than just the equipment being financed, possibly including personal assets. The equipment might depreciate faster than the amortization schedule for paying off the loan.
The equipment could be obsolete before you pay the loan off.

5. What Are The Pros and Cons of Equipment Leasing?

Equipment leasing pros:

For companies of average or even sub-par financial standing, equipment leases are generally easier to obtain than loans.
It is often easier to obtain equipment via leasing without having to put any money down, than with a loan.
The only “security” you need to pledge is the equipment itself—which technically isn’t yours anyway since you’re borrowing it from a lessor.
Leasing equipment is known as “off balance sheet financing.” At least with an “operating lease,” the liability associated with your lease obligation isn’t reported as a liability on your balance sheet. Also, lease payments are treated as operating expenses–and tax deductible.
At the end of the lease term, which should coincide with the time you want to replace old equipment with newer models, selling or otherwise disposing of it isn’t your problem. You just return it to the leasing company. This is helpful with high-tech equipment which becomes obsolete more quickly than other equipment, and thus more difficult to sell.
Flexibility is a hallmark of leasing. There are many ways to structure a lease agreement.

Equipment leasing cons:

Because the leasing company is typically assuming greater credit and technology obsolescence risk rather than a lender making a loan to a financially strong company, lease payments often have a higher built-in cost structure than loans.
You are obligated to make all of the payments prescribed by the lease contract. You typically cannot pay it off ahead of the original schedule. Or if you can and want to, you would incur a large financial penalty.
Many lease agreements place the burden on you to pay for certain repairs and maintenance services.

6. What’s Involved In Entering An Equipment Lease Agreement?

The first decision you’ll face, after you decide on the equipment, is what kind of a lease agreement suits your needs. You’ll probably have several options, you just need to figure out which is best for you.

What can you really afford? While a leasing company makes its own judgments about that, you might want to be more conservative in the appraisal of your financial capacity. This will give your company plenty of breathing room for future financial needs.

Another task associated with entering an equipment lease agreement is which leasing company to work with (see Section 10). Some equipment manufacturers have their own “built-in” leasing companies. But, you owe it to yourself to be sure you’ve found the best deal before signing on the dotted line.

The final step in the process is persuading a lessor that you’re the kind of company with which it wants to do business. That may involve turning over reams of financial documents, along with good explanations of why you need the equipment and what it’ll do for your business. The process is like applying for a bank loan. However, it will probably be less rigorous since you aren’t borrowing money. You’re simply paying rent on property that you don’t own.

7. What Are The Main Categories of Equipment Leases?

There are two basic kinds of equipment leases: capital and operating. With a capital lease, you’re treated (for tax purposes) as the owner of the leased equipment. That means you can take depreciation deductions or, if you’re eligible, a Section 179 deduction. With an operating lease, you are treated more as a renter than an owner, and not eligible for that tax benefit. The only tax benefit is that lease payments are tax deductible.

Under Section 179 of the Internal Revenue Code, you are able–in 2019–to take a deduction for up to $1 million in equipment acquisition by purchase or through capital leasing. There are strings attached, however. You’re only eligible if a) you don’t acquire more than $2.5 million of equipment in that year (although you might still be eligible for a partial deduction) and b) the equipment is used at least 50% of the time for your business.

The Section 179 deduction is phased out dollar for dollar, for every dollar your equipment acquisitions exceed $2.5 million. For example, if you acquire $2.7 million in equipment, your maximum Section 179 deduction would be $800,000. The kinds of equipment eligible for deductions are restricted.

Any of the following criteria must be met in order for a lease to be treated as a capital lease.

You automatically become the owner of the leased property at the end of the lease term.
You have the option to purchase leased property at a subsidized price.
The lease term is long enough to cover at least 75 percent of the “useful life” of the equipment.

8. What Are Some Subcategories Of Leases?

Under a capital lease, there are several subcategories. The most expensive (in terms of monthly payments) is the $1 buyout lease. You have the option to buy the leased equipment for $1 at the end of the lease term. In effect, you’re buying the equipment over the lease term, since the lessor is prepared to turn it over to you at that time for the price of $1.

This type of lease may be the easiest to qualify for as the lessor is getting more money from you. You might not want to use a $1 buyout lease unless you plan to buy the equipment, and expect to use it for years to come.

Another common capital lease is the 10 percent option lease. As the name suggests, it gives you the option to buy leased equipment for 10 percent of the original value when the lease is up. Your monthly payments might be lower than the $1 buyout lease since you’re only paying for 90 percent of the equipment. Yet, the interest rate the lessor uses to calculate the payment might be higher, because it’s assuming the risk that you’ll decide not to buy the equipment at the end of the term.

A variation on the 10 percent option lease is the 10 percent “purchase upon termination” (PUT) lease. You’re obligated to purchase the equipment for 10 percent of the original equipment cost when the lease is up. This is more of a financial risk to you, thus giving you lower monthly lease payments. Of course, you have to come up with the cash simultaneously.

What are the terms?

Terms for a standard operating lease, in which there are no special tax benefits (beyond writing off lease payments), is the FMV lease. It gives you the option of purchasing leased equipment for its fair market value (as set by the lessor) at the end of the lease term, return the equipment or renew the lease. It’s an operating lease because it’s more like a simple rental arrangement. Lessors set approval standards highest for FMV leases.

A fifth lease category, known as a TRAC (Terminal Rental Adjustment Clause) is a hybrid contract. Depending on specifications, it can be a finance or an operating lease. They’re used primarily for commercial vehicle leases and are a good loan option for the trucking industry.

9. How Much Does Equipment Leasing Cost?

The cost of leasing equipment varies. These are the factors determining the cost:

The value of the equipment
The competitive state in the market of lessors that specialize in companies like yours
The interest rate environment
The way credit and obsolescence risk are allocated between you and the lessor
The assigment of which party gets the tax benefits

Also critical is your credit history. In a perfect world, the stronger your credit score is, the lower your lease payments will be. You can find lease payment calculators online to give you ballpark numbers for your own leasing situation.

10. How Do I Decide Which Equipment Leasing Company Is Right For Me?

When you start looking for an equipment lessor, you’ll find four kinds:

A company that just puts together equipment leases.
A “captive”: a subsidiary of a company making costly equipment.
A financial institution offering equipment leasing among a variety of other financial services.
A lease broker, who helps you find a suitable lessor.

Considering the long-term financial commitment involved, shop around. Your best bet might be a leasing company that specializes in working with companies like yours, and / or specializes in the kind of equipment you want to lease. Getting competitive terms is important, but so is the strength and integrity of the leasing company.

Should I Use Purchase Order Financing? When Does It Make Sense?

July 29, 2019/in Alternative Financing, Financing/by Albert McKeon

There is a great deal of misinformation and erroneous assumptions around purchase order financing. You know what a purchase order is but how do you finance it? This is so-called asset-based lending but a purchase order is not an asset. In short, your question is, “should I use purchase order financing and, if so, when?”

Scenario

You are ecstatic that you just landed a huge order from a corporate customer you have been chasing for months. You and your team celebrate this seminal moment in your company’s history. The next day, however, you feel a pit in your stomach. You realize the money your firm has in the bank and the small credit line you can tap are not enough to fulfill even half of this order. You run through the scenarios. You could cancel the order, but you know you will not get an opportunity like this again. You could divide the order in half and wait on pushing the second half until you get paid for the first. Although this is not as poor an option as cancelling, it is not good. You could request a deposit or require that the order be pre-paid, but you remember that your controller already made this request. The response was that the firm would consider it in the future but not right now. You believe that they want to make sure your firm is viable enough to handle orders of this size.

Since you are hitting a mental wall with your options, you convene with your team to brainstorm. You discard accounts receivable financing because you would have to work out an arrangement with your bank to exclude the A/Rs from this customer. That may be doable, but you will not actually have a receivable until you invoice your customer AFTER the product comes in from the manufacturer. Your vice president exclaims, “I wish we could finance the purchase order itself!” Something in that statement resonates with your controller and she googles “purchase order financing” and voila! You discover it does exist.

What exactly is purchase order financing?

Before we go any further, it is important that you understand both what purchase order financing is and what it is not. Purchase order financing is essentially an advance provided to you on a specific customer’s purchase order to purchase readily available inventory or manufactured goods from a supplier. Hence, this is potentially a viable option if you are a reseller or distributor or if you outsource all of your manufacturing. Typically used for a sizable order, your PO financing firm will either advance funds directly to your supplier / manufacturer or issue a letter of credit or payment guarantee to release funds when the goods are delivered. The PO financing then collects payment directly from your end customer, thus acting as an invoice factoring firm.

Basically, the PO financing firm acts as a substitute for you, ensuring payment to the supplier / manufacturer so that you can fulfill your order. PO financing is not a general inventory financing option for you as it does not allow you to buy and hold inventory to sell later. It requires a specific purchase order for a specific customer. Your PO financing firm will need a copy of both the signed PO from your customer and your signed purchase order to the supplier.

What PO financing provides

The PO financing option allows startups and other rapidly growing or cash-restricted firms to accept large, new orders for their products from credit-worthy customers. According to Entrepreneur magazine, “Purchase-order financing can be beneficial to small businesses because it relies mostly on the company that has placed the order with the startup, and not the startup itself.” Although most PO financing firms require the goods to be shipped directly to the end customer, there are some that will allow shipment to a third party warehouse and even to your facility for light assembly, packaging and distribution. In these cases, according to Entrepreneur, “purchase-order financing often covers a large portion of the requisite supplies (needed to produce those goods), and sometimes even all of them.” Furthermore, the PO financing process is often much easier to navigate – and more straightforward – than traditional bank financing.

How does it work?

The PO funder obtains a copy of your customer’s purchase order and your purchase order with the supplier / manufacturer. After analysis, the PO funder agrees to finance your customer’s purchase order.
The PO funder sends payment or issues a letter of credit directly to the supplier or manufacturer.
The supplier receives the letter of credit or outright payment from the PO .
The supplier fulfills the order and ships the goods directly to the customer specified in the purchase order.
The customer receives the order from the supplier and receives the invoice from you.
The customer pays the invoice directly to the PO funder. If the customer pays immediately, the PO funder accepts the payment, takes out its fees, then remits the remaining gross profits from the sale to you. If the customer has terms (typical for large corporations and government entities), the PO funder factors the invoice – buys the invoice at a discount – and provides you with the funds, less the discount.
The customer remits full payment in 30 days to the funding company. The funding company releases any reserves to you that had been held.

If your company does light manufacturing such as assembly, printing and/or packaging, additional steps will be necessary as the inventory and supplies will be delivered to you then you will deliver the finished products to your customer. This increases the risk to the PO funder and hence, increases the fees.

Benefits for Your Company

If your customer has a strong credit history and has a record for prompt payment, and if you have a reputable supplier or manufacturer, your lack of business longevity or your weak credit profile will matter little, if at all, to a PO funding company. As outlined above, only the administrative components of the transaction, the purchase order and later, the invoice, rely on you.

When asking yourself, “should I use purchase order financing”, consider this. According to Forbes, “purchase order financing provides “sufficient working capital to cover payroll and start-up costs for a new contract.” This funding can also provide you with negotiating leverage to obtain better terms and pricing from suppliers. “Taking the calculated risk of a working capital loan that enables the small business to accept a job and grow is often critical to succeeding in government contracting” and other arenas.

Risks for the Funding Company and Associated Fees

In purchase order financing, there is no interest rate quoted. Instead, you pay a discount rate and fees. This means that you receive less than 100% of the amount the customer pays on the invoice, typically 1.5% to 6% less or, put another way, 98.5% to 94% of the invoice. This embedded interest rate captures the higher risk that purchase order financing typically has for the financing firm. The risks vary. The supplier / manufacturer may not deliver the product. (This risk is greatly reduced if a letter of credit is used.) Your customer could refuse delivery or refuse to pay because of issues with the product. Furthermore, your credit worthy customer could have financial issues. If you take delivery of the product, the risk is even higher as more could go wrong. Thus, rates for light manufacturers that process and repackage the inventory are generally higher, at least initially until a strong track record is created. The PO funder will not get paid in all these scenarios, which drives up the risk and hence, the rate.

The answer to the question, “should I use purchase order financing” is multi-layered. It depends on what type of firm you have, what your growth stage is, and what your current sources of funds are. Be aware of the risks but fully understand the benefits. According to Medium, if you can monetize your inventory by eliminating or reducing what you actually hold onsite, this will allow you “to sell more goods, grow the company, employ more people and feed more families.” Purchase order financing provides an asset-based form of working capital that, if used wisely, ultimately allows you to invest in your firm and its future.