Understanding sale leasebacks

The biggest struggle for Canadian manufacturers is managing cash flow.

This is an issue regardless of whether they are busy or slow, because maintaining enough money on a monthly basis to cover overhead can be a challenge even in the best of times.

Ways exist to unlock some funds that traditionally have been used to purchase equipment. There is no question that given the choice between an outright purchase of a piece of equipment or entering into a lease or loan, it is much more palatable for any manufacturer to pay for the asset in cash and avoid the cost of borrowing.

However, when a business is busy, the costs of people, tooling, and materials can put a lot of pressure on cash flow because all of these costs are incurred upfront, with the payment term normally being 30 or 60 days.

In other cases, unforeseen delays beyond anyone’s control can force manufacturers to keep people and material available while in a holding period. This can apply just as much pressure to on-hand cash.

The value of sale leasebacks

One option is entering into a sale leaseback transaction with a lender who understands both the equipment and the industry.

A sale leaseback is a transaction in which the title of the asset is conveyed, at an agreed upon price, to a financial institution in exchange for a lump-sum cash payment. The manufacturer then leases the equipment back on a long-term basis to retain exclusive possession and use of the asset, but no longer owns it. This type of financing works extremely well for good-quality, brand-name machine tools because, when maintained properly, they consistently hold their value.

An example of this is a customer of mine who leased a $200,000 vertical machining centre over a five-year term. The original lease was paid in full and, therefore, the customer assumed ownership of the machine.

On two separate occasions, using a sale leaseback, I paid this manufacturer a lump sum against that machine when it required working capital.

The point here is that even older machine tools (by the second of these financing deals the machining centre was more than 10 years old) maintain enough value that a lender with experience within the industry has no issues providing funds against the asset.

Determining asset value

Figuring out an asset’s value involves a number of factors.

From a professional standpoint, the Association of Machinery and Equipment Appraisers (AMEA) is the premier international organization for certified equipment appraisers. They specialize in appraising machinery and equipment, and I am very fortunate to be a member of this association.

A few of the most important aspects a certified appraiser considers while valuing a piece of equipment are:

Manufacturer and Class. There are many different builders of machinery and equipment, all of which have their place in the market. However, a high-end machine built in Japan, Taiwan, Korea, or Europe will hold its value better, because these machines are historically known to maintain tolerances over a long time, if properly maintained, and have a large install base.

Usage. This is very important because the same machine can be used to manufacture a variety of parts across numerous industries, and there are plenty of differences among manufacturing environments.

Two machines of identical age could have vastly different values depending on how they were used. An average machine tool is run 2,000 hours per year. However, the automotive industry is known to run machines much harder, in many cases two or three shifts per day, so two identical machines of the same age will be valued quite differently to account for the additional usage.

Condition. In the world of machine tools, this means preventive maintenance. The amount of maintenance a machine requires is related to its usage and the type of material being cut.

A piece of equipment that has been cutting aluminum, a light material that is very easy to machine will be in significantly better condition, and in turn worth more, than an identical machine that has been cutting cast iron, a very abrasive material that produces chips that are known to cause long-term damage to a machine’s components.

The sale leaseback scenario

Once value has been established, the next step is to ensure the asset is owned free and clear.

Because the asset itself is the main collateral for the sale leaseback, it is of utmost importance to ensure that the full title of the asset can be conveyed to the lender.

It sounds simple enough: You buy a machine tool and pay for it; therefore you own it and can, in fact, borrow against it. But if you have a relationship with a bank, there’s a good chance it has a general security agreement (GSA) covering all your assets.

A GSA provides the bank with a security interest in your inventory, accounts receivable, equipment, and other assets because, regardless of the service the bank provides, it will insist on being secured at a minimum three or four times against any possible losses.

Every piece of equipment purchased, even if it was paid for in cash, is automatically included in the GSA, so the bank has an ownership right to the asset. The transaction can still proceed as long as the bank provides a waiver to the sale leaseback lender, which essentially means the bank is relinquishing its interest in the specific equipment that is being used to raise the funds.

This is a routine ask of any bank because it has a GSA in place for all its clients. As long as the manufacturer isn’t in financial distress, and the relationship is still good, getting the waiver is normally a non-issue.

One of manufacturing’s biggest pain points is managing cash flow regardless of whether your company is in a position to take on larger orders and expand or is just trying to get through a tough stretch. It therefore follows that knowing all of the different places to source additional capital is information that could determine making it through or having to cut your losses.