Financing Process for Small Businesses
When designing a finance program, grantees should bear in mind that from the small business borrower’s perspective, obtaining financing is a two step process:
- Choosing the underlying financing structure (e.g., loan or lease)
- Deciding upon the source of capital to be used.
Often the source of capital will determine the type of financing structure used. For example, a borrower may wish to expense the financing payment for tax purposes, which implies entering into an equipment lease and working with a leasing company (see Section titled Equipment Leasing below). Banks, in turn, generally prefer to issue loans. Because the grantee becomes the source of capital, the grantee has control over the choice of financial structure to be used.
Different types of financing structures may have distinct tax and financial reporting consequences for the borrower. For example, small business borrowers often want “off balance sheet” treatment for their energy efficiency projects. “Off balance sheet” treatment means that the energy project and financing do not appear on the balance sheet as an asset or liability, and the small business owner can deduct the entire financing payment as a business expense. This deduction reduces the business’ profit and, consequently, its tax liability (which is based on net profits).
Borrowers with restrictive covenants in place with their current lenders may find that adding debt to the balance sheet changes their financial ratios. Restrictive covenants are clauses in the lending document that impose restrictions on the borrower by the lender. Commonly found in bank loans, they may include keeping minimum balances on deposit with the lender, defining minimum working capital requirements, maintaining certain financial ratios, limiting the sale of assets, etc.
Different financial ratios can result in higher interest rates on existing loans, can limit borrowing capacity, and can even prompt a lender to call in existing loans. That is why for certain borrowers, keeping the asset off the balance sheet is important. However, for an asset to pass the economic test needed to obtain off balance sheet treatment, it must retain its value over the term of the financing. With few exceptions, energy efficiency equipment or retrofit products do not have much resale value and do not qualify for off balance sheet treatment. Imagine trying to repossess and resell insulation added to a building’s roof or walls, or removing and remarketing a recently installed lighting system.
The alternative is to show the asset (e.g., the clean energy project) and corresponding liability (loan) on the balance sheet, and depreciate the asset over its useful life (the period set by the Internal Revenue Service during which the asset is expected to be used).