Borrowing and the value of money

When most business owners finance equipment, they first try to figure out whether it is best to use their bank, assuming that is an option, or an alternative lender, like a typical leasing company.

The reality is that they are trying to find the path of least resistance along with the lowest cost of accessing funds. Spoiler alert: These two are rarely related.

Every customer I talk to, unless it is a startup, has a commercial banking relationship and along with it some form of operating line. It’s no secret that a bank always has the lowest cost. This is because the cost of funds for a deposit-taking institution like a bank these days is less than 1 per cent, so banks can put out money 100 basis points above the Canadian prime rate and still turn a very good profit. On top of that, a typical bank will ensure it is in an extremely secure position, so it is not uncommon for it to want a security that’s three or more times as valuable as what it is lending.

Normally, all of the borrower’s assets are secured with a General Security Agreement (GSA). However, it is the nuances of the GSA that cause some confusion for many business owners. A GSA is the document that provides a lender a security interest in a specified asset being pledged as collateral.

In the event the borrower defaults, the pledged collateral can be seized and sold. The GSA is presented and signed when an account is opened and gives the bank the first option for all current and future assets of the company.

The key word here is future. Growing companies accumulate assets, such as new machinery and equipment, but because the GSA includes the future assets, even if they are purchased with cash, they still become part of the bank’s security.

Asset-based lenders encounter GSAs when providing additional lease financing for a new piece of equipment but want to use an existing piece as collateral in lieu of a deposit. This requires a waiver from the bank.

The waiver is a simple document, which waives the bank’s interest in a particular asset. It is required because the GSA names this equipment as security for the bank.

A borrowing scenario

This situation came up earlier this year when a customer of mine desperately needed some new equipment. The customer is a well-established business with a strong balance sheet. To save time it bought a new machine outright to get it on the shop floor and making money as quickly as possible.

This manufacturer figured it could arrange the financing later and was shocked to find out a condition of my approval called for a waiver from its bank.

The waiver was necessary because the moment the equipment was paid for with company funds, it became an asset of the company and, therefore, part of the bank’s security.

What made it even more frustrating for my customer was the bank did not want to provide the waiver until it had updated financial statements for the company and personal financial information from the owner.

Eventually it was sorted out, but it did take time, effort, and some additional aggravation, all to use money that never was the bank’s in the first place.

Net worth calculation

Another difference between banks and alternative lenders is that banks first look at the amount of financing requested and to see if it fits the equity box of the company. Specifically, banks look at the company’s total net worth, which by definition is the difference between assets and liabilities, but in a business context net worth is also known as book value or shareholders’ equity. This difference is the company’s retained earnings.

A bank will think the transaction fits if the money left in the company is a minimum of three times the amount of the transaction size. So if you were looking at a $100,000 purchase, a typical banker would expect the retained earnings in the company to be about $300,000.

However, in the manufacturing industry, this type of evaluation becomes problematic because machinery is expensive and usually purchased when an opportunity for growth comes along but has not yet shown up on a financial statement.

An alternative lender looks at this transaction much differently.

For this type of lender, all that is normally required is a security guarantee from the company and/or the guarantee of the company and its shareholders. Most importantly, it is very rare that there will be a request for a GSA.

For the same $100,000 transaction, alternative lenders expect the company to have retained earnings of only $100,000.

This means that transactions from an alternative lender are approved for more money than what could be done at a typical bank.

However, because alternative lenders don’t require as much security, the transaction is risker so it is not priced the same as it would be from a bank. The difference between what a bank offers and that of a prime credit leasing company could be as little as a few hundred basis points, but it does exist.

In today’s competitive environment, everyone is trying to ensure that they borrow at the lowest possible cost, but understanding how different institutions review applications, along with their security requirements, is extremely important when making your ultimate selection.