Editor’s Note: Daniel Pische is a Senior Vice President at First American Bank and a member of their Senior Loan Committee. Daniel is a regular speaker at SBA conferences and serves on the U.S. Department of Commerce’s Trade Finance Advisory Council. To find out more about his work, connect with him on LinkedIn. First American is a member FDIC bank.
When small brewery owners prepare to expand, they spend considerable time scouting and designing new locations, selecting the brewing equipment, and considering new distribution opportunities to support the increased capacity.
As a lender, I believe that owners should also spend time becoming well-educated borrowers. Doing so will put their companies in the best position available to obtain the necessary funding for expansion.
In doing so, it’s important to get inside the mind of an underwriter.
When I prepared the craft brewery lending guidelines for First American Bank, I set a few basic requirements for how we would approach the craft beer industry. First, we view the category as specialty manufacturing. This allows us to conceptualize the capital intensive requirements posed by the equipment and inventory. Second, we understand that many breweries, via their taprooms, also participate in the costly world of hospitality.
So how might someone in my position approach the funding for your brewery expansion?
In many cases, it’s possible the individual underwriter will not be intimately familiar with the brewing industry, which means you must prepare your business and loan application in anticipation of facing headwinds.
Nevertheless, there are a wide variety of financing options available to small brewers. The following is an outline of four financing methods for owners to consider.
For startups, leasing is one way to secure equipment on a per-piece basis without the presence of an established lender who has to finance each phase of expansion. In some cases, equipment manufacturers, together with leasing companies, can offer financing solutions to provide a comprehensive solution for growing breweries.
When considering an equipment lease, it is important to speak with your accountant to determine if a lease or an outright purchase is most advantageous from a tax perspective. Leases historically have allowed for the write-off of payments, compared to depreciation (accelerated or otherwise) under a traditional purchase.
“There are some nuances under the Tax Cuts and Jobs Act related to the amount of depreciation deduction allowed in a lease versus buy scenario,” said Bob Denninger, partner at the accounting firm of Plante Moran in Chicago. “Furthermore, companies need to assess the amount of interest they are allowed to deduct due to the new limitations on interest expense under 163(j).”
Under the terms of some lease agreements, the expense of the loan (effective to the interest expense) is rolled into the lease itself. In doing so, the savings normally recognized by paying off a loan early are lost under such a structured lease. If your brewery is able to prepay the lease or finds itself in a position that requires the retirement of the lease, the associated savings may not be present.
Small Business Administration (SBA)
In addition to entrepreneurial development, government contracting and small business advocacy, the SBA has several loan programs aimed at providing small-to-medium-sized companies access to capital. Two of the most popular programs (SBA 7a and SBA 504) are a great fit depending on the size and type of project.
While the SBA has several loan programs that could theoretically accommodate a brewery expansion, the 7a Program is the most applicable and often the best fit. It is highly versatile and can accommodate most any type of term loan need — from equipment to taproom buildouts.
For that reason, it is the most commonly available SBA program and is offered by both banks and non-bank lenders alike. The loan process for an SBA 7a loan is standardized across all lenders, which allows a borrower to approach multiple lenders for the same project in an effort to identify the best fit. Many lenders have delegated authority (also known as PLP or Preferred Lender Program) on the SBA 7a program, which allows them to make the approval decision in-house. This designation can be extremely beneficial from an underwriting perspective as it eliminates the secondary approval of the SBA, a process that can take several weeks.
When evaluating if the 7a program is the right fit for your project, a general rule of thumb is that it is best for projects costing under $1 million. For projects over $1 million, your lender should also be considering the SBA 504 program which is outlined below.
While the 7a program is commonly available due to its flexibility, the ability for lenders to sell off a portion of their loan (75 percent in the case of the SBA 7a program) also drives many banks and non-bank lenders into the program. It should be noted, however, that there is nothing inherently wrong with an SBA lender selling off the loan. In fact, the process can be relatively seamless as the issuing bank will continue to service the loan. Outside of a prepayment restriction that can be imposed once the loan is sold, there is little that changes as a result of the sale.
Nonetheless, I have some concerns over the sale of SBA 7a loans, mostly related to the terms some lenders choose to offer borrowers on loans they look to sell. Commissions are paid based on the yield of the loan (interest rate) and its duration (amortization).
While it is simple to understand how a higher interest rate and a longer amortization would yield a larger commission — both serve to increase the amount of interest earned on the loan — the area that receives considerably less attention is the frequency at which the loan reprices. Under most commercial term loans, the lender will fix the interest rate for a period of several years at a time. Should an automatic repricing take place, it is indexed and is negotiated ahead of time. This is done so the bank can adjust the terms of the note to match its cost of funds and the interest rate to the market at the time.
A term loan used to fund an expansion should not reprice monthly or quarterly. When that language is written into a loan structure, it is done simply to maximize the return for the lender.
While the SBA 7a program is one of the best programs available for expanding breweries, it is important to be an educated borrower and understand nuances as you seek the right loan for your business. As you meet with lenders, it’s worth asking if they intend to keep your loan in a portfolio or sell the guarantee, as it may influence the terms offered. If the lender’s answer is anything but “we portfolio our loans,” they likely intend to sell it.
The SBA 504 program is similar to that of the 7a program in that it can support a combination of equipment and real estate under one loan. However, unlike the 7a program, the SBA 504 program does not involve the issuance of guarantee to the lender. Instead, a series of loans are aggregated into a bond issuance that allows the borrower to obtain a 10-, 20- or 25-year fixed interest rate on a portion of the project.
Due to the costs associated, we believe the best use of the program is on projects with a cost in excess of $1 million and those including a combination of real estate and/or equipment. Under the program, the equity component required of a borrower is reduced to as little as 10 percent.
Compared to most conventional requirements of 20 percent, this results in a significant reduction in the capital contribution required by the business. Using the SBA 504 program, the lender will issue a pair of loans, the first for 50 percent of the total project costs, and the second for between 35 percent and 40 percent of the total costs. Once the project is complete, the SBA will issue a bond that pays off the interim note and grants the borrower with a fixed interest rate for the duration of that loan. This is the only commonly available program that can extend that length of a fixed interest rate.
A word of caution regarding 25-year amortizations: While the appeal of a reduced payment is obvious, the resulting increase in interest expense is considerable. Take for instance a $1 million loan that is amortized over either 20 or 25 years. At an interest rate of 4 percent (currently well below market rates), the 25-year amortization will result in a 10 percent reduction in the monthly principal and interest payment due to the bank. While certainly a benefit in the short-term, the same 25-year amortization will result in a 29 percent increase in the overall interest expense incurred by the borrower over the term of the loan. As interest rates increase, the monthly savings provided by the 25-year amortization will be reduced, while the overall interest cost of the loan will remain at a 30 percent premium over the traditional 20-year amortization.
When evaluating an expansion opportunity, if your brewery is not in a position to cash flow the debt without a 25-year amortization, you should really evaluate if the company is healthy enough to undertake the debt.
For large-scale projects, those in excess of $2 million, tax-exempt financing may allow for considerable savings on interest expense over the term of a loan. Under an industrial revenue bond, a bank will work together with an issuing body to authorize the bank to issue a bond through the municipality. Functionally, this loan is similar to a commercial mortgage and is most commonly issued with a 20-year term. While issued through the municipality, the bond does not result in any cost or risk to the taxpayers, which makes it an attractive way to bring business to the sponsoring municipality.
Once issued, the bank will not incur any tax on the interest income derived from the loan. This savings is then passed through directly to the manufacturer in the form of a permanent reduction in the interest rate of the loan — one that is equal to the tax rate of the bank. This reduction can fluctuate depending on changes to federal tax rates (as we saw most recently in 2018).
At present, the interest rate savings range between 23 percent and 29 percent depending on the bank and its tax rate.
Industrial Revenue Bonds are not without their challenges, however. For a lender to issue one, a local sponsor must be identified. Depending on where the brewery is located, the availability of a sponsor can vary. The process also carries considerable upfront legal expenses that can add $80,000 to $120,000 in additional closing costs. In order to evaluate the viability of a project, the upfront costs are weighed against the interest rate savings to calculate a recapture. On most projects, the legal costs are recaptured between 18-and-22 months, leaving the remaining term of the loan to benefit from the reduced interest expense.
Given the unique nature of tax-exempt financing, consulting with your accountant and attorney can be a good start for evaluating the viability of the structure for your brewery.
Preparing for the Loan
Regardless of the size and scope of your expansion, there are a number of areas that you can focus on to put your brewery in the best position possible to obtain the loan you need
The level of financial reporting required by a lender will depend on the type of loan and the amount being borrowed. This requirement ranges from corporate tax returns to accountant prepared compilations, and accountant reviewed and audited financial statements. As you prepare for your expansion, consider whether your accounting and bookkeeping match the scope of the upcoming project.
As a brewery begins operations, its accounting needs are relatively simple, and typically only a corporate tax return will be required. As a brewery expands and begins producing more beer, the reporting expectations placed on the brewery by a lender will change.
Having a level of accounting that is in line with the expectations of the lender will aid in the underwriting process. Moreover, an accountant who specializes in brewing and specialty manufacturing can serve as a vital asset for the expansion and operations ahead.
When it comes to capital-intensive projects such as brewery expansions, cash flow is the first area that an underwriter will examine. They want to evaluate how a company will make payments on existing loans, as well as the new debt associated with a project. Given competition within the brewing industry and the rapidly changing landscape, I am leery of expansion efforts that rely heavily on projections.
Nevertheless, having detailed projections assembled before engaging with lenders is a critical component of the underwriting process. Included in the projections should be a detailed debt schedule containing the terms of all existing obligations as well as assumptions on the debt service for the new loan.
Having proactive stress tests in place is also advisable. However realistic the projections are, have contingencies in place. This extends to additional methods of raising capital should unforeseen circumstances unfold.
Once the expansion is complete, brewery owners should discuss the benefits of a cost segregation analysis with their accountants. Cost segregation allows a brewery to more accurately estimate the useful life of the various components of the project in order to depreciate those assets on the appropriate schedule.
“When investing in a significant build-out or expansion, many of your assets will default to very long depreciable lives for tax purposes,” said Denninger. “With a cost segregation study, you can potentially accelerate depreciation by categorizing the costs of the build-out into buckets of assets with shorter useful lives, thus reducing your tax liability in the initial years.
“This process allows a brewery to pull-forward their depreciation expense so they can realize the tax savings sooner. This allows a brewery to minimize their tax liability earlier into the project and help recapitalize the company following the expenditures associated with the expansion.”
As you consider the financing that is right for your business, seek out the type of partner you hope to obtain in the process. An expansion is an excellent opportunity to evaluate your lending partner as you seek a loan structure that best meets the needs of your brewery.
Given the complexities of expansion, brewers should seek a financing solution that is tailored to their needs, rather than a standardized product that is “selected” due to your industry. Focusing on a standardized loan product, rather than one designed to meet the needs of your expansion, can result in oversights that could carry considerable correction costs.