An Equipment Leasing Primer
SCORE Counselor and Leasing Company Executive
Almost all businesses need some type of equipment in order to operate. Whether it is simply a requirement for telephones, office products and furniture or highly technical and expensive production equipment such as printing presses, machine tools or MRI scanners, business cannot succeed without the necessary supporting equipment. How such assets are acquired is up to each company, but many turn to equipment finance and leasing to provide what is necessary to operate and produce income.
Many business owners have some familiarity with leasing. Perhaps their accountant has advised them to lease their car. Frequently, their first introduction to leasing involved their acquisition of a copy machine for their office. In fact, whether a Fortune 100 corporation or a sole proprietorship, a large number of individual businesses already utilize financing or leasing. Statistically, according to the Equipment Leasing & Finance Association of America, eight out of ten American businesses lease some or all of their equipment. This amounts to over $600 billion annually and represents approximately one-third of all productive assets acquired during a yearly period. Given that the probability that a business will need to consider leasing as an alternative means of equipment acquisition at some point, the purpose of this article is to discuss the reasons a company may lease, the basic lease types, the main components of the lease document and the questions a lessee should ask before signing a lease contract.
In this economic environment, leasing as an alternative funding source takes on even greater importance. One of the significant reasons why companies lease their equipment and software is that leasing provides 100% financing. There is generally no initial cost outlay required. This provides an out-of-pocket benefit over most bank financings, which often require down payments. Of perhaps greater benefit is that leasing permits bank lines of credit to remain intact and to be used for working capital requirements, which are the appropriate uses for financing that is geared to short term needs.
Once a decision to consider leasing is made, there are several important questions that need to be examined by the business owner, generally in consultation with an accountant. These include the tax treatment implications of the type of lease to be utilized, the nature of the equipment to be leased and its intended ultimate disposition and the terms and conditions of the lease agreement along with a complete understanding of all costs associated with it.
In general, two types of transactions are prevalent and both equipment vendors offering financing alternatives as well as leasing companies who may be contacted directly will generally offer both. The first type of lease, commonly called an “installment lease” or “$1.00 option lease” provides that ownership of the equipment passes to the lessee at the end of the lease term for a nominal payment, usually $1.00. The second type of lease provides that equipment may be returned to the lessor at lease termination, or the equipment may either be purchased for fair market value or the lease extended based upon fair rental value. In the first instance, the equipment is capitalized on the books of the business. Interest may be expensed and the equipment depreciated. In the latter instance, the equipment is capitalized by the lessor and the business may expense the rental payment. Consultation with tax counsel is vital in assessing the best program to meet individual needs.
Finding a Leasing Source
Often, the manufacturer or dealer of the equipment being considered may work closely with a leasing partner and will present lease alternatives during the equipment sales process. These programs are frequently quite attractive. Because of the volume of business provided to the leasing company by the vendor, a below-market rate may be available. In some instances, the vendor may even “buy down” the rate to permit structures such as deferred payments or a low interest rate to be available. Just as one would shop several dealers if acquiring a new car, it is always wise to consider a few alternatives to assure the most favorable terms are available. A good way to do this if you have not worked with a leasing company in the past is to contact the Equipment Leasing & Finance Association of America (“ELFA”) in Arlington, VA for a referral. ELFA members represent the leading U.S. leasing companies and are pledged to a high standard of integrity. The ELFA web site (www.elfaonline.com) permits you to search for a leasing company and also provides a page which lists important questions to ask as you move through the lease process.
The first part of the process, to which reference has been previously made is to determine how the equipment will be utilized and for what length of time. This is critical in allowing the financial advisor to help decide the type of transaction that would be most appropriate. The next series of questions that need to be addressed are based on what happens during the term of the lease. The lease is a “hell or high water” transaction, meaning that it provides for an uninterrupted stream of payments over a fixed period of time. This calls into question several possibilities. What happens in the event the equipment is damaged or destroyed? The lessor is entitled to full recovery of their obligation, so the business needs to ensure that the equipment is adequately insured. If a blanket insurance policy is not already in place, many leasing companies can provide insurance coverage for an additional fee. What happens if the business wants to change or upgrade the equipment during the lease term? Depending on the lease structure, the residual value of the equipment may be utilized to offset some of the remaining cost of the lease in the upgrade to new equipment. What are any additional obligations of the business in the transaction? Taxes, including sales, use or property taxes, are the responsibility of the lessee. Depending on the jurisdiction, sales or use tax are either added to the initial transaction cost or are collected over the term of the lease. Normally, any maintenance costs beyond the standard equipment warranty are paid directly by the physician separately from the lease. However, depending on the equipment and the vendor, there may be a possibility of bundling extended maintenance contracts into the lease. What are the end of term options and what are the lessee’s requirements in relation to them? If the lease has a fair market value provision, there may be notification requirements which the lessee must follow if the equipment is to be returned.
Read the Document
There are a number of additional questions which should be addressed with the lessor prior to entering into a contract in order to assure that full disclosure of all responsibilities and costs are understood. The requirement to understand end of term provisions can help avoid additional financial liabilities at lease expiration. The lessor has the right to anticipate that certain payments will be made at specific times. If the lessee fails to notify the leasing company of the intended return of the equipment, the lease may be extended until such time that return is accomplished. It is fair that that a continued monthly rental is provided for in the lease. Depending on the nature of the equipment, it may be equitable for the lease to extend for a three month period, due to the time required to refurbish and remarket the equipment. The businessman should carefully read the lease contract to ensure that the requirements do not provide for an automatic renewal for a period longer than three months.
All costs should be disclosed by the leasing company. Frequently, there will be an initial charge for the processing of the lease application and the lease documents. The leasing company should be asked to disclose this amount. The lessor should also be asked if there are any end of term fees for equipment disposition. Unless the equipment is being delivered in stages, the lease should be for the term specified. Make certain that you are not responsible for any interim rent. If the lease calls for a sixty month term, it should be for sixty months from the date of completion of installation and acceptance of the equipment. If the leasing company only bills on a monthly basis and you accept the equipment on any day other than the first of the month, they may ask you to make additional payments for the period between those two dates. You should know this information up front in order to deal with it before lease commencement.
While this article may make it appear that equipment leasing is a difficult process, the reality is that obtaining lease financing is very often easier than other types of financing. In particular, if your planned acquisition is less than $150,000 or so, obtaining credit approval may frequently be accomplished in a matter of minutes, without the requirement to fill out extensive application forms or to provide detailed financial information. Most equipment leasing companies utilize a credit scoring mechanism under which transactions may be approved based upon a credit bureau or D&B report and time in business. This permits the decision regarding the equipment and the financing to be made almost simultaneously. You will also find that the lease documentation is usually less onerous than financing through the use of a bank loan. Most leases are one-page documents written in plain English, making your review of the contents easily understandable.
The purpose of this article is to familiarize the businessman who has not utilized leasing previously to gain some basic knowledge so that, in concert with the recommendations of a financial consultant, a decision that is in the best interests of the practice may be made. With that support and with the due diligence that should be a part of any financial process, the leasing experience should be a pleasurable and rewarding one.
This article was written by Alan N. Frankel, a SCORE volunteer and President of Lighthouse Capital Corporation, a consulting company to banks, leasing companies and equipment manufacturers. Mr. Frankel has been involved in the equipment leasing industry for forty years and served as President and COO of two public leasing companies prior to becoming a consultant.