What You Need to Know About Financing Your Business - Financing 101: Leasing as a Tool
When we think about financing our business, we usually think about bank financing and private equity before we get down to leasing, but this can be a big mistake. Sure, we don’t think twice about leasing our space, more on that later, but we don’t carry this line of thinking through to whether or not to there are advantages to leasing equipment or other assets that we need. For instance, if you use software from Microsoft or other business software companies you no longer buy the software outright, you buy a licence to use the software for a set period of time. This licence operates very much like a lease, in that, it lowers your up-front cost to secure the rights to use the software for a set period of time after which you have to renew the licence. Since the odds are in favour of you using this software beyond the licence term, it will eventually cost you more in total. In return for agreeing to this arrangement, you are assured of always having the most up-to-date version of your software without having to pay additional fees for the upgrades. The software companies get a more secure revenue stream. This licence arrangement is similar in nature to a lease, whereby for agreeing to pay more for your asset, you get some benefits in return.
Let’s first look at how leasing differs from bank financing. When you borrow money from a bank to purchase assets, they lend you the money, you buy the asset and the asset now belongs to you. When you borrow money from a leasing company, you buy the asset, but the asset still belongs to the leasing company until you make the final payment and in effect you have a licence to use the asset until that final payment is made at which time you now own the asset. You might think that this is a major strike against the leasing company but that’s not the case. Unlike a bank that can call your loan even if your payments are up-to-date (a very unlikely scenario unless your business is losing money), you have to be in default of payment or terms and conditions of your lease agreement (such as moving the assets out of the jurisdiction specified in the lease) before a leasing company can take back your assets. Also, since the leasing company own the asset until you pay for it, they are often willing to accept a lower down payment for the asset, which means that you can use the money you save from the larger down payment the banks would have asked for and apply it to your working capital. Payments are usually based on the life of the asset being purchased.
There are two classes of leases. They are capital and operating leases. Put in its simplest form, a lease is defined as a capital lease if you acquire ownership of the asset upon making the final payment. If you never acquire ownership, then it is treated as an operating lease. In actual fact, it is not that simple and if you are considering leasing an asset you should sit down with your accountant before you finalise your lease to make sure that you understand what category your lease falls into, as they both have tax implications. Why should I care you may ask? Well if it is a capital lease, then it is treated as if you have borrowed the money from a bank and the value of the asset and the accompanying liability appear on your balance sheet and may impact the margin and ratio requirements your bank have placed on any loans you have from your bank. If it is an operating lease, then it will be treated just like any other expense your business incurs in its daily operations.
Let’s look at how the lease works. You see a piece of equipment that you need to operate your business. Its estimated working life is 20 years. You decide that the best way to finance this equipment is to lease it and you approach the leasing company of your choice, although most equipment companies have arrangements with a preferred leasing company, and negotiate the deal. In this case the payments will like likely be based on the life of the equipment, however the lease will almost certainly be for 5 years. The way this works is that they will set a down payment and establish monthly payments over a 5-year period, at the end of the 5-year period there will be an amount outstanding and this will be added to the final payment as a balloon payment. This amount may be greater or less than the value of the equipment at that time, so you will need to carefully calculate whether or not you want to acquire, renew, or turn back the leased equipment. Your accountant can help you with this calculation.
There is no doubt that leasing is more expensive than borrowing from a bank, so what are the advantages. The main advantage comes down to cashflow, this is particularly important for early stage and rapidly growing businesses. Down payments as well as monthly payments tend to be less than their equivalents at a bank which assists cashflow. Against this, is the balloon payment at the expiration of the lease but remember you have had the use of the asset during the term of the lease and it has helped your business thrive and prosper during that time allowing you to be better placed to deal with this at the termination of the lease. An often-forgotten fact is due to the lower monthly payments you may be able to buy better, more expensive assets if you use leasing.
The disadvantages to leasing, in addition to the fact that you will actually pay much more for the equipment than if you borrowed the money through a bank, is the fact that you can not pledge leased assets as security for other loans, and it can impact the ratios your bank has set for your company in their term sheet.
Just a quick word on leasing premises. Before signing a property lease it is always a good idea to have a lawyer look it over. Some things to watch out for include: the renewal covenants and who has the right to decide on whether the renewal is offered and upon what terms, the ability to sublet or not, if you sell the business can you transfer the lease or is it up to the landlord whether or not the new tenant is acceptable. All of these terms and condition can severely impact your ability to make rationale decisions regarding the continuation or disposal of your business. Also watch out for clauses allowing the landlord to accelerate the lease if you default on payment. This clause grants the landlord the ability to claim the full unpaid value of the lease outstanding not just the amounts defaulted by the tenant.
Leasing is a valuable component of your financing mix and is one that should be seriously considered when building your financial plan. If you have any questions or require more information, do not hesitate to contact us at firstname.lastname@example.org.
The next blog in this series will look at factoring.