Business Finance 101 – Negotiating To Lease Or Buy Equipment

When it comes to acquiring new equipment for business, do you use your own money or the bank’s (do you lease, rent, use a chattel mortgage? What’s smart?)

Scenario

Let’s say we have a recently-established private company which traded at a loss during its 16 months establishment period but has now turned the corned to profitability and is experiencing increasingly strong cashflow and currently has $100,000 in cash at bank. It is purchasing its business premises via a mortgage of $750,000 and its directors are now considering the purchase of a new piece of business equipment valued at $82,500, but are finding a less-than-helpful reception from their bankers.

As a general rule its smart to conserve your own cash and to use the bank’s money to finance equipment over the term during which it is intended to earn an income (sort of like paying wages to a good worker who will make you more each month than you’re paying them).

However, when you strike a combination of strong cashflow and low deposit interest rates, it pays to widen the assessment to include a couple of other scenarios, not the least of which is that of exploiting the unique bargaining ability that cash provides when buying for products that may not be selling strongly elsewhere.

Calculations¹

• On the cash on deposit in your working account, the bank is likely to be paying you up 3%-4.5% (see infochoice for current rates).
• On the property mortgage you’re likely to be paying the bank around the 6% mark.
• On a business overdraft you’ll be paying the bank between 8% and 11% (the majors can be charging 50% over the second tier lenders).
• On a fully drawn equipment loan you pay 8% to 15%, but let’s say 12% for this exercise (at the time of writing 15.64% was Westpac’s current car loan rate, though Arab Bank Australia looked worth investigation as a less-thought-of option for business asset finance.)
• Using an offset account for your cash on hand would effectively earn you 6% (if offset against your mortgage interest); 8.5% against a business loan; 11% against an overdraft; and, if used to purchase equipment outright instead using asset finance, anything from 12% to 15%.
• If you are not off-setting your cash on hand on a daily basis, then it may be earning you 3%-4.5% (though it this era it’s not unusual for banks to pay nothing or very little on business deposits). So, you are effectively “losing” 8% to 12% in interest earnings (or excessive interest costs, depending on how you look at it).
• To any equipment finance arrangement add an establishment fee ($200) and a monthly account fee ($7.00) which, over a 5 year term total $620 or, on an $82,500 purchase, adds another 0.7% to the cost of the money – ie, it adds .7% to the real interest rate).
• Then there are factors such as Director’s Personal Guarantees, and the impact of liabilities or on-going cash-drain purchases on your future borrowing capacity.

Using Cash

So, let’s look at actually using your own cash to buy the equipment.

1. Firstly, set the scene: Let your seller know that while their equipment makes good commercial sense right now, you are experiencing less than a warm reception at your bank, and that it’s looking increasingly like you may not be able to purchase their equipment. Sad, but there you go. Don’t be too passionate about acquiring their equipment, but make it clear that it does make good sense to do so, and that you could really put it to work and make additional profits from it. If only . . .
2. Now shut up, and watch your salesrep go into overdrive to try to solve your (sorry, their) problem.
3. Listen to each solution with great interest but, if any entails your taking finance, regretfully reject it (shaking your head slowly explain that you don’t want to provide security; you don’t want to compromise your borrowing ability because you have a real estate opportunity emerging; you don’t give guarantees as a matter of principle; etc)
4. Take the conversation to the brink of “no sale” – then (sharp intake of breath) “dare” to consider purchasing the equipment outright. No banks, no third party, no messy paperwork. Just you and your seller – and a pile of cash. But the price – the price is a problem. And that much cash, in one lump, that’s a problem as well. But the equipment, you do truly think it’s the right choice. What a dilemma. Who could solve this? (Realise that you now represent the salesperson’s pot of gold: A motivated buyer with the means! Never underestimate the power of this negotiating position.)
5. As your seller goes into overdrive to raise Lazarus from the dead and snatch this lost sale back from the jaws of Hell, start working your way down your mental concessions checklist, always ready to trade one concession for another. After all you’re a reasonable person, right? Some of the concessions you’re looking for might be:
   • A price reduction. The seller has a margin in the deal. Your aim is to trim that to the point where it’s still a worthwhile deal for them, but where it has absolutely no fat in it.
   • Terms. Gee, it would be risky from a cashflow point of view for you to pay $72,500 (your new agreed buy price) all in one go, but you could shuffle things around and afford to pay them in 10 equal payments over the next 10 months. “If your company retains title to the equipment until I make the last payment could we do that?” (That’s effectively an interest free loan with a guarantee. Value to you around $3,200 in interest over the term. Cost zero!)
   • Service Agreement. Most sophisticated equipment will be accompanied by the option of a service agreement. The cost of delivering this service may come out of a different budget to sales and sellers are often very willing to make concessions on other people’s money! Now’s the time to cut the deal of a lifetime on a Service Agreement.
   • Extended warranty. This has only an “opportunity cost” to the seller. If their equipment is first-class it cost them nothing. If it’s less than perfect, the value to you in years 2, 3 and 4, for example could be substantial.
   • Training. If you make the stretch and prioritise your precious cash away from other commitments and towards them, could they see their way clear to providing your team with extra training, manuals, on-line support – whatever?
   • Marketing support. This usually comes out of a different department’s budget back at the supplier end, and salespeople are often happy to use this resource to close a deal, since it is not usually accounted for against their margin or budget. So, look for contributions in the form of advertising subsidies, referalls from the supplier’s website to yours, marketing material. In other words, explore what they have that you could use to promote their equipment more effectively and so have it earning its keep quicker.
   • Accessories. What accessories are available? Don’t be swept away by a bargain and take an accessory that is essentially useless to you. But, if the accessories can be used to turn an extra dollar in your hands, then this is the ideal time to negotiate on them. Your supplier will already have their profit (albeit somewhat reduced) in the equipment itself and so any accessories are likely to represent additional (incremental) profit to them. Squeeze hard enough and they may even be prepared to sell accessories at cost if they feel that this will secure the main deal.
   • Consumables. If the equipment consumes materials or components, this is the ideal time to be bargaining for a keenly priced fixed agreement on this future expense item.
6. Finally, at the time of writing this article, as part of a federal government economic stimulus package, there was a 50% tax concession available for business equipment purchases, which had the potential to powerfully alter the numbers.

Keeping Score

Let’s say you were successful in gaining some or all of the concessions above, what would they be worth?

1. Price reduction: $10,000
2. Terms: $3,200
3. Extended Warranty: $5,000
4. Training: $2,000
5. Marketing support: $2,000
6. Accessories: $1,000

Total: $23,200

Add to that a possible 50% Tax Concession ($36,250) in the current environment and as George Burns said on his 98th birthday when talking about the Hollywood Country Club Lifetime Membership he had purchased at a 30-year old actor, “it’s starting to look like a good deal”.

Offset that against the opportunity cost² of using your own money for this purchase (you could have earned around $13,000 by simply saving the same sum over 10 months and leaving it in the bank for the balance of 5 years) and it seems an option worth working on.

So, is there a way of using your cash so that it would return you better value than holding onto it while borrowing the bank’s money?

Justifying the Equipment

Bear in mind that a useful rule of thumb when purchasing business assets (particularly equipment that you personally desire or admire) is to look at it as having to earn “a dollar a day per $1,000 of its cost”. So, in our case above, at $82,500 the equipment would have to have the potential to earn an additional Gross Profit of at least $82.50 seven days a week even to be considered for purchase.

Using that perspective, could you create a marketing plan around the equipment to ensure that not only did it pay for itself, but that it did so multiple times over every day? If you have such a plan, and you are confident that it can be made to work, then you’d have to ask yourself why you wouldn’t buy this equipment right now!

Learning More

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If you would like to talk to us at any time to gain more detail about any of the concepts or skills dealt with here, you will find a very warm welcome when you make contact.

¹This article was written in mid-2009 and while interest rates change the considerations it contains are timeless.
² Opportunity cost is equal to the income you could have earned using your own money in another way.