Structuring the deal
In general, equipment can be financed through a variety of leasing agreements, such as operating, tax-oriented and finance leases, or by securing a loan. Leases are traditionally used, and beneficial, when the equipment in question has a high obsolescence factor—that is, when it needs to be replaced within two to three years. In the life science industry, for the most part, equipment has a very long, useful life, so a loan structure rather than a lease usually makes the best dollars and sense.
An equipment loan, unlike a lease, can be used to finance diverse categories of equipment as well as soft costs. Soft costs that are often included in the funding mix are tenant improvements, shipping and software. One of the most important things to keep in mind when negotiating the terms of a loan agreement is that the equipment should be the sole source of collateral. Avoid contracts that have restrictions on other parts of the business or balance sheet. A basic equipment loan should not include financial covenants or blanket liens on other company assets, such as intellectual property or receivables.
Other negotiable terms in an equipment loan are total loan amount, interest rate level, duration of the take-down period (the time frame in which the borrower can draw funds), minimum funding amounts, length of the payback period, and timing and level of any warrant participation. Additionally, a request by the lender for an option to invest in future private equity rounds is a negotiable item. In the current market, typical terms would include single-digit interest rates, a 36–48-month payback.
The ease of securing an equipment loan and the flexibility of the terms are based on a variety of factors. The amount of a potential borrower's cash on hand, in conjunction with its cash burn rate, historic and projected, are of paramount importance to a lender, as it is indicative of the borrower's ability to repay the loan. Therefore, it is best to secure a loan when funds are plentiful. Lenders also take into account committed cash from investors, grants and sales; previous equity rounds and the quality of the investors; and the company's stage of development, industry sector and management team. All of these components need to show strong momentum, which is essential to obtain follow-on venture capital, and gives the lender comfort that the company will be well-positioned to pay back the loan.
A company that augments its equity with debt can extend its cash runway by as much as six months, a significant period of time for a company working to reach milestones and hustling to secure new equity rounds. Equally important is that debt can increase the total cash on hand by 30–50% at the most critical juncture—when a company is negotiating follow-on equity several months before it runs out of cash.
Lease or buy?
Leasing has two primary benefits: (i) it protects against equipment obsolescence (as long as the term is short) and (ii) it preserves cash on a monthly basis. Leasing rather than buying is practical for companies that will realize a competitive advantage by always having state-of-the-art equipment for purposes such as computing and screening. It should be noted, however, that if a company chooses to extend a lease beyond the initial term or to purchase the equipment at the end of the term, it is likely that the total cost of leasing will surpass the expense that would have been incurred from an outright purchase.
Negotiating leases on many individual pieces of equipment is time-consuming and daunting, therefore it is almost always in the best interest of company to enter into a Master Lease Agreement instead of single leases. An MLA allows multiple pieces of equipment to be acquired under one agreement.
Pitfalls of borrowing
Putting a debt facility in place has many advantages, but, as with any business transaction, there are a few common pitfalls that all companies should be aware of when planning to borrow:
Agreeing to overreaching collateral terms. Be wary of lenders who require financial covenants or blanket liens on company assets, such as intellectual property and accounts receivable. Using only the financed equipment as collateral should be sufficient.
Waiting too long to borrow against equipment. Because the equipment should be the sole collateral, you will get the maximum financial leverage from it when it is new and has a higher value. Entering into a loan agreement several months or years after the purchase date is, therefore, not optimal.
Waiting until you are low on cash to request financing. It is much easier to put a loan facility in place while you have money in the bank. You will have more negotiating power on terms and conditions if you seek debt shortly after an equity raise, and borrowing at that time will still provide adequate runway extension.
Financing terms longer than the useful life of the equipment. Quite simply, if it is likely you will need to swap out a piece of equipment in a few years because of obsolescence, it is not prudent to enter into a loan agreement that extends beyond that timeframe.
Borrowing from a financing firm that may not react well to cash swings. It is highly beneficial to work with a firm that knows your industry. Because it is commonplace for a life science company to receive new cash just when the till is running out, business agreements with lending firms that understand this cyclical nature of equity rounds will eliminate tensions and surprises.
Seeking financing on specialty equipment. It may be difficult to secure a loan for customized equipment such as molds or assembly line machinery used to produce highly specialized or unique products. This equipment may have little resale value in the event of a loan default, and will not be as attractive to lenders as collateral that has a broader use.
Companies can benefit greatly by using their equipment to secure debt financing. It gives them an extended cash runway and more time to negotiate their next equity round. Cash is king at every stage of growth.