For CEOs, it seems as if requests for new phone systems, computers, copiers and networking equipment are an everyday occurrence. Certainly, a continuous investment in office and communications equipment is necessary in order for a company to remain competitive.
How to finance capital equipment can be a major decision for CEOs. Many choose leasing as a preferred method. Each leasing company has its own lease agreement. So knowing the most advantageous terms in a lease agreement is vital when it comes time for the CEO’s selection.
“Equipment leasing can be an attractive and flexible alternative means for a business to acquire equipment rather than paying cash or borrowing money,” says Sandra L. Shippey, partner with Procopio, Cory, Hargreaves & Savitch LLP. “There are some pluses and minuses in lease agreements that CEOs should be aware of before they sign on the dotted line.”
Smart Business spoke with Shippey about the advantages of leasing and what CEOs should know before signing a lease agreement.
What type of contract is an equipment lease?
An equipment lease is generally a ‘net’ lease where the lessee agrees to lease the equipment from the lessor for a noncancelable fixed term of years, and the lessee must pay rent, taxes and insurance and agree to maintain the equipment throughout the lease term. At the end of the lease, the lessee either returns the equipment to the lessor in the condition required by the lease, purchases the equipment pursuant to a purchase option contained in the lease, or renews the lease for an additional term.
What are the advantages of leasing equipment versus purchase or direct financing?
- Preserves working capital: Generally, lease financing is 100 percent financing, so there is often no down payment required from the lessee, which will result in the lessee preserving working capital. This is particularly beneficial to emerging companies that want to conserve their limited cash resources.
- Lower rates: Often, the lessee will pay lower rates for a lease than a loan because the lessor, as the owner of the equipment, will be able to take advantage of accelerated depreciation tax benefits and pass on at least some of the tax savings from those tax benefits to the lessee in the form of reduced rent. Again, this will help a business conserve its working capital through the life of the lease.
- Fewer covenants: Generally, loan transactions contain significant restrictions on management’s decisions and contain financial and other restrictive covenants on the business itself. Usually, but not always, equipment leases contain less restrictive business and financial covenants.
- Flexibility in structure: An equipment lessor can provide many different types of leasing structures that will provide flexibility to a potential lessee such as reduced lease payments in the early years with higher lease payments in later years as the business grows to increase cash flow; options to upgrade the equipment during the lease term; different purchase options from mid-term early purchase options to end-of-term purchase options at a price equal to the equipment’s fair market value or a predetermined fixed amount; and renewal options.
What should CEOs be aware of when reviewing a lease agreement?
Usually, a lease proposal or term sheet will be provided by a potential lessor that describes the basic structure of the lease that will be documented in more detail in the actual equipment lease agreement.
Lessees should be particularly aware of the following issues that are generally negotiable.
First, review the proposed structure including the lease term, rental payment amount, amount of casualty and termination values, and minimum insurance requirements so that the structure adequately meets your business requirements.
Second, note whether any purchase options or renewal options are offered and whether you might want to put any limits on fair market value purchase options and renewal options.
Third, see if any business or financial covenants will be applicable so you can determine whether they will be acceptable from a business perspective.
Fourth, notice if any tax indemnification will be required from you.
Fifth, see if you are allowed to self-insure against any risks, which is important if this is currently part of your strategy.
Finally, find out the required return conditions for the equipment and whether they are acceptable from a business standpoint.
With such a competitive market, it may be possible for CEOs to negotiate successfully on many of these points and achieve the best terms for their business.