Small Business Financing Structures and Sources of Funds
This section describes the range of financing structures and sources of funds open to a typical small business.
- Commercial Loans are commonly used to finance energy projects. They may be unsecured (known as “signature loans,” “good faith loans,” or “character loans”) or secured by certain assets of the business or owner(s). This differs from a secured loan in the residential market, which implies taking a security interest in the real estate of the borrower. Typically, secured loans reflect the reduced risk to the lender by having lower interest rates. Traditional lenders will look at business history, company assets, and cash flow to decide whether or not to approve a loan. Newer or financially challenged businesses may not qualify for a loan without providing substantial tangible collateral. For example, many banks require compensating balances to be held in their institutions, place restrictive covenants on the operations of the business until the loan is paid in full, and will not lend 100% of the cost of the asset (the clean energy project). Large, national banks tend to look for larger clients and loans, while local community banks are often more flexible when it comes to loans for small businesses. Some credit unions also offer business loans to small businesses.
- Equipment Leasing is often referred to as “creative financing” because leases can be structured to address the particular tax strategies and cash flow needs of the lessee (borrower). For financial reporting purposes, leases fall into one of two categories: capital or operating. Capital leases are reflected on the lessee’s (borrower’s) balance sheet, while operating leases are considered “off balance sheet” financings. (At the time of this writing, the current classification is being reevaluated by the Financial Accounting Standards Board. The expected outcome is that operating leases will be included on balance sheets.) More information on operating leases is available in the Financial Accounting Standards Summary of Statement No. 13 (FAS 13).
- A Tax or True Lease is a lease with a true “fair market value” purchase option, essentially a long-term rental agreement. It may be reflected on the balance sheet for financial reporting purposes, yet it may qualify as an expense item for tax reporting purposes. In addition to tax considerations, most leases can be structured with uneven payments that reflect the timing of energy savings of the installed equipment. Also, unlike most bank/traditional loans, leasing can provide 100% financing. When dealing with clean energy projects that offer state or federal tax credits (which can only be used by taxpaying, profitable organizations), operating or true leases may be a way to separate ownership from the use of the equipment. In this way, the value of the tax credits may be reflected in lower lease pricing to the user.
- Equipment Sales Agreements are financing contracts in which the seller keeps the title of the equipment and the right of repossession (should the buyer default) until the buyer finishes paying for it. From an accounting perspective, the buyer treats the asset as if he/she owned it, depreciating the asset and expensing interest payments. Many large equipment vendors offer financing programs to help promote the sale of their equipment. That is often handled through captive financing companies (a finance company generally owned by a manufacturer and occasionally a large distributor) at attractive rates. Captive finance companies may have the advantage of offsetting some of their financing costs by using the profit margin in the sale of the item, resulting in lower rates. The financing structures they commonly use are equipment sales agreements, lease financing, and for large projects power purchase agreements, energy service agreements, and performance contracts (see Commercial Property-Assessed Clean Energy Financing for information on the financing of large commercial projects).
Less Attractive Alternatives for Clean Energy Financing
Some businesses have a line of credit established with their banks. That is best used for short-term working capital needs like inventory purchases, and is not recommended for the purchase of longer term assets such as energy efficiency and renewable energy projects. Small business owners might decide to take out a home equity loan to obtain the funds needed for a clean energy project. While the interest rates and terms will be attractive, putting one’s home at risk will not appeal to many small business owners. Credit cards are another option; however, they tend to be expensive sources of long-term capital and are not recommended for clean energy projects.