September 2011 Issue of Wines & Vines
 
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Barrel Leasing and Cash Flow

How to address your fast-depreciating oak inventory through finance

 
by Kerry Kirkham
 
 
duckhorn barrel room
 
The barrel room of Duckhorn Vineyards, St. Helena, Calif., highlights where an asset-based loan helped bolster the winery's working capital. Photo by Douglas Sterling
 
When it comes to securing loans in our recovering wine industry, lenders concede that though money is difficult to secure, it is still available at competitive rates. Fortunately, there are more options than ever in leasing barrels.

With the help of longtime wine industry finance veterans, Wines & Vines examined two lease types: capital and operating, along with the potential tax benefits of each.

We also explored examples of three different financing options: traditional bank loans, winery-specific leasing and barrel-specific leasing, all with the goal of protecting existing credit lines and freeing up precious winery cash flow.

Leasing demystified
In a lease, an equipment owner or lessor agrees to allow a client or lessee to pay to use equipment within a specified time period. Unless there is a buyout option, the lessee may be required to return the equipment to the lessor at the end of the lease period. Even though the lessor owns the equipment, the lessee is required to maintain and insure it as if it were theirs.

A lease differs from a loan in many ways. For one, a loan requires an initial down payment, whereas a lease typically requires just the first payment up front. For the same 100% financing advantage that is found in a lease, a loan requires additional collateral. In a lease the equipment itself is the collateral. A loan is financed according to its balance, and a lease is financed according to a specified time period that the equipment is to be used.

When considering a lease versus a loan, Bill Rodda, vice president and branch manager of American AgCredit, Santa Rosa, Calif., advised that the economic life of the asset must be taken into consideration. Rodda, who has worked with AgCredit since 1981, said, “Wineries typically do operating leases for barrels for a period of three years. Just like corks and bottles, barrels are a necessary component—you constantly have to replace them. We’re not talking about stainless steel tanks with leases that can sometimes run up to seven years. The answer lies largely in the real-life usefulness of the asset. Most people buy stainless steel tanks because they last for 20 years or so.”

Rodda said that barrel leases often have a $1 buyout at the conclusion of the lease contract. Therefore, wineries can take their barrels through their useful life and resell them themselves.

American AgCredit, founded in 1916, is a nationwide government-sponsored enterprise that is part of the Farm Credit System. To qualify for financing with American AgCredit, a winery client must grow grapes or have a long-term lease on a vineyard. Farm Credit Leasing services the loan and American AgCredit maintains the relationship between the client and Farm Credit Leasing.

Jerry Guffey, president of Mission Capital, Santa Rosa, Calif., has been lending to the wine industry for 15 years. Mission Capital specializes in financing for wineries that want to acquire equipment. Guffey explained two types of leases: operating leases and capital leases.

“With an operating lease, the lessor is the owner of the equipment and is entitled to take the depreciation on the equipment so they get the tax deduction,” Guffey said. Since the lessor takes the tax deduction, they require a lower lease payment. Guffey added, “Because we’re the owners, it doesn’t show up on the client’s balance sheet as a debt, since they are essentially renting the equipment. It shows up as an operating expense in what is called off balance sheet financing.”

Barrels can be sold back to the winery via a fair market clause, which is a form of a buyout in an operating lease. “The good news is the fair market value on barrels is not much, so operating leases work well on things like computers, barrels and other equipment that has a fairly short useful lifespan.” With equipment such as stainless steel tanks, where the fair market value can still be high years down the road, an operating lease may not be such a good deal.

With a capital lease, the buyout amount it’s not fair market value based, it is built into the lease at a fixed amount. “Typically there are two choices: a $1 buyout at the end of the lease or a percentage of the original invoice amount. The higher the buyout amount, the lower the lease payments can be,” Guffey said.

“The client owns the equipment and it appears on the balance sheet and they get to expense the depreciation as a tax deduction with a capital lease. But, then the lease payments tend to be higher because the lessor isn’t getting the tax break,” Guffey concluded.

Taxing matters
Jon Dal Poggetto CPA, managing partner of Dal Poggetto & Co. LLP, Santa Rosa, Calif., has been involved with the wine industry for his entire public accounting career, which spans 36 years. Dal Poggetto, who has worked with more than 200 wineries and vineyards, remarked, “I have seen a trend of more barrel leasing in the past seven years by wineries of all sizes.”

“Barrels are like automobiles, in that they depreciate in value very rapidly. Operating leases are a popular way to finance the use of depreciating assets. My own philosophy is to buy assets that have appreciation potential and lease assets that depreciate in value rapidly,” he said.

Dal Poggetto then touched on the tax implications of leasing. “Under current tax law, the operating lease does not provide a federal income tax deduction as rapidly as a purchase of barrels—either for cash or financed through debt or a capital lease—because there is 100% bonus depreciation available for new asset acquisitions made in 2011 and 50% bonus depreciation for acquisitions made in 2012. In addition, there is the Section 179 deduction available in 2011 and 2012. The state of California does not conform to these generous federal tax provisions, however.”

Further illustrating tax benefits of leasing, Dal Poggetto continued, “In an operating lease, the lease payments are expensed as they are paid and are all deductible for federal and state tax purposes. If someone entered into an operating lease Jan. 1, 2011, they would deduct 12 payments in 2011. If it is a three-year lease, that would represent 1/3 of the total payments under the lease. For simplicity, assume the total lease is for $36,000; they would deduct $12,000 in 2011.

“If they purchase the barrels, and the barrels have a cost of $32,000, they could expense the entire $32,000 in 2011 for federal tax purposes. For California tax purposes, they may be able to deduct $25,000— the Section 179 limit for California tax purposes—if they are profitable. Otherwise, they could depreciate the barrels under normal depreciation rules for California tax purposes.

“A capital lease is equivalent to a purchase; the asset is carried on the balance sheet, and a corresponding lease obligation liability is also recorded. As the lease payments are made, the lease obligation is reduced and a portion of the lease payment is treated as interest expense. The asset is depreciated, just as if it had been purchased, so the bonus depreciation and Section 179 expensing provisions apply for income tax purposes.” For this reason, the current tax rules are more favorable toward a purchase or capital lease.

Traditional bank
Silicon Valley Bank’s annual wine industry report recently concluded that the wine industry is expected to grow by 11%-15% this year over the previous year. Authored by Rob McMillan, founder of Silicon Valley Bank’s wine division, the report was based on Silicon Valley Bank’s in-depth survey of nearly 600 wine industry experts and insiders, third-party research and the bank’s perspective as a long-time observer of the wine industry.

When discussing the option of leasing barrel inventories with McMillan, he said, “Barrels are an ingredient rather than a capital expenditure. It’s almost like buying grapes every year. There are a couple of leasing companies that have come into the business that will do operating leases for barrels.”

“The practical reality is: You finance your barrels as an operating line with a bank or finance out as cash. Many wineries have a formula line that includes an advance rate on their bottling line, case inventory and barrels,” McMillan said. However, to exercise this option, the winery must not have any operating debt.

GE Capital, a general mid-market financing company based in Norwalk, Conn., lends to a wide range of industries. According to Lisa Tibbits of GE Capital, the 75,000-case Duckhorn Vineyards, St. Helena, Calif., took an asset-based loan, from which the borrowers can take the proceeds and use them for working capital needs. “Cash flow loans are not collateralized the way asset-based loans are. They’re based on your businesses cash flow, how much your business is making after expenses,” she said.

As insurance against unfavorable exchange rates, Silicon Valley Bank also provides forward currency hedges to lock in euro rates. So if you’re buying barrels in euros, you can lock in a favorable exchange rate for use at a future date.

When shopping for a traditional lender, McMillan advised seeking out banks that are experts in the wine industry. “If you have to explain risk to your lender, who ends up being a partner, then you really don’t know how your partner is going to respond in a negative environment,” he said. Silicon Valley Bank typically services wineries with an average price point of $33 per bottle, with case production ranging from 400-15,000 cases per year.

Wine industry-specific leasing
Although Jim Taylor, lease manager at Hansel Leasing, Santa Rosa, Calif., said Hansel Leasing could lease barrels to wineries of any size, many of their winery clients are composed of small family-owned operations. Most of the barrel leases Taylor sees run in the $50,000-$100,000 range. “Our forte is anything $15,000 and above,” he said. Since wineries have varying oak programs, typical barrel leasing terms range from two to four years.

When discussing the benefits of barrel leasing, Taylor highlighted the fact that leasing barrels can preserve a line of credit. “As most can tell you, lines of credit are difficult to get and maintain. If you have a line of credit, you probably don’t want to put it into a depreciating asset such as barrels,” he said.

With the financial industry tightening up, lenders require more information than in years prior, so be prepared to be highly scrutinized. Even if you’ve been in business for several years, in addition to a complete business credit application Hansel Leasing requires two years of financial statements such as balance sheets, profit and loss statements, one bank and three trade supplier references, personal credit information on the principals with tax returns and financial statements and the listing and pricing of the barrels you wish to lease.

Though there’s money available at competitive rates, Taylor said the principal or principals of the project would have to have a very strong financial position. “It helps if they come from a related industry that shows a track record of business practices. We are not actively out there soliciting startup wineries.”

Hansel Leasing, which is a division of Hansel Auto Group, approves credit, creates the contract and services the lease. Statements come from Hansel, and the winery pays Hansel, which is a locally owned company that does its own underwriting. This can present a variety of options for a winery’s specific needs. “Each lease is underwritten separately based on the needs of the client. We don’t have a checklist we go down. Each lease is individual,” Taylor said.

Taylor has observed that most wineries keep the barrels at the end of their lease. However, if that’s not your winery’s goal, a barrel-specific leasing company with resale services may be an intriguing option.

Barrel-specific leasing
H&A Financing & Services was founded 10 years ago in France. With offices in Spain, H&A is undergoing an international expansion and has recently established offices in San Francisco and Santa Rosa. They are a barrel-specific leasing outfit that facilitates the loan, while Bank of the West services it. H&A is strictly a financial partner with no allegiance to any specific cooperage.

H&A Financing’s European roots can come in handy when sourcing barrels abroad. Jon Pelleriti, CFO of Healdsburg, Calif.-based Wilson Artisan Wineries, which comprises six wineries, has been in contract with H&A Financing for the winery’s first leasing cycle. Wilson Wineries is currently leasing between 150 and 170 French and American oak barrels. “H&A has a good relationship with the European coopers. Working directly with coopers, they could speak with them and get invoices, facilitating a smooth business transaction. Since they are new to the area, it was a good financing opportunity for us, and we were their first American customer,” Pelleriti said.

Contract flexibility and post-lease service set H&A apart from other barrel leasing options. Charles A. Alvarez, sales director at H&A Finance, said, “Lease contracts are totally flexible. Rate and payment are the keys to the negotiation. Once the contract is signed you can remove barrels from your inventory and resell them yourself or via the H&A Network. There are no penalties or documentation fees for changes.”

As hinted by Hansel Leasing, H&A’s lowest limit for lease considerations is $15,000. Their typical winery clients finance barrel inventories to the tune of $150,000 for a span of three years.

Though wineries have the option to keep their barrels at the end of the lease, through H&A Network, barrel inventories can be presold at an agreed-upon minimum resale amount via an established network—even before the leasee racks out of them. “On a given date, when the barrels have reached their useful lifespan in your cellar, a truck pulls up and takes your barrels away,” Alvarez said. The funds from the barrel resale can be rolled into the next barrel lease so you can avoid paying taxes on what would otherwise be seen as profit.

H&A also offers an online barrel inventory management system to help track oak assets and inventory, details of the lease contract, barrel orders and barrel resale. All data can be accessed online and exported to an Excel spreadsheet.

The icing on the barrel leasing cake is that some coopers may be more willing to offer a discount on barrel purchases when working with a bank or leasing company.

François Peltereau-Villeneuve, president and CEO of Seguin Moreau, Napa, Calif., remarked that though barrel leasing is more common in Europe, “On a case-by-case basis, depending on various criteria, if winery comes cash in hand with immediate payment instead of paying the usual net 30 or 60, we would consider a 1% to 3% discount.” In this case, it takes qualifying for money to save money. The resulting savings could apply toward the interest on your barrel lease.

 
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