Art Beroff and Dwayne Moyers
Where’s the Money?, Winter, 1999
RESUME: EQUIPMENT LEASING
Definition or Explanation: Equipment leasing is basically a loan where the lender buys and owns equipment and then “rents” this equipment to a business at a flat monthly rate for a specified number of months. At the end of the lease the business may purchase the equipment for its fair market value (or a fixed or predetermined amount), continue leasing, lease new equipment or return the equipment.
Appropriate For: Any businesses at any stage of development. For start-up businesses with no revenues, “small ticket” leases, those of $150,000 or less, are feasible on the personal credit of the founders or owners — if they are willing to make the monthly payments.
Supply: Abundant. Of the billions of dollars individual and institutional investors pour into the capital markets each month, a good hunk find their way to leasing companies which use these funds to purchase equipment on behalf of small businesses. With more and more money pouring into the markets, leasing companies are flush with capital, eager to do business, and respond to competition with lower monthly rates.
Best Use: Financing equipment purchases. Also leasing can finance the soft costs often associated with equipment purchases such as installation and training services.
Cost: Lease financing is generally more expensive than bank financing, but in most instances, it is more easily obtained than bank financing.
Ease of Acquisition: Easy for leases under $150,000. An application for a small ticket lease is generally no more complex than a credit card application. Leases for more than $150,000 will require detailed financial information from the business and the leasing company will conduct the same credit analysis which a conventional bank would.
A CASE IN POINT
When Phil and Meg Kensey took over Royal Laundry, which provides laundry services to institutions, the company was breaking even on sales of approximately $500,000. With some focused marketing efforts, the potential which the couple saw in the business quickly materialized with customers such as Electronic Data Systems, American Airlines and a large hospital group. “Our customers,” recalls Phil Kensey, “were offering us lots of opportunities to grow with new services and a higher level of volume.”
To take advantage of this demand, the Kenseys needed new equipment and lots of it. The dry-cleaning machines, automated folders and high speed irons which they needed totaled about $500,000.
Phil says he tried to get a bank loan but was summarily rejected by national, regional and local lending institutions. “Even though the business was almost 10 years old when we sought the loans, in the eyes of the bankers it was technically a start-up since we recently purchased it. None of them were willing to finance a company that was less than 2 years old.” And even if they found a bank, the Kensayzzs personal guarantee, which would be required, wasnzzt worth much. “We put everything we had into buying the business,” says Phil , “We were cash poor.”
Enter Jim Lahti, president of Affiliated Corporate Services, Inc., a Lewisville, Texas, equipment leasing company. Lahti took a real interest in what the Kenseys were trying to accomplish, and over the course of two years, structured approximately seven leases that got Royal Laundry the equipment it needed. With the added capacity and new services, annual sales at Royal mushroomed to $2.8 million.
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A Good Deal: When you take out a lease for equipment, the entire lease payment is deductible as an expense. When you take out a loan to purchase equipment, only the interest portion of your payment to the lender is deductible as an expense.
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SIDE BAR: LEASING BY THE NUMBER
Companies of every size use leasing. Commercial airlines lease jets. Caterers lease tables, chairs and chafing dishes. So how do the professionals who serve these diverse businesses segment the market? Basically, the leasing business is segmented into three distinct markets.
Small Ticket Leases: $100,000 or less.
Middle Market Leases: $100,000 to $1 million.
Large Ticket Leases: $1 million and up.
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ADVANTAGES OF LEASING
Equipment leasing is big business. In fact, it is the single largest source of financing for businesses, totaling more than $180 billion annually at last count. The dollar volume of equipment leases exceeds the annual dollar volume of commercial loans. It exceeds the dollars raised through the issuance of bonds or the sale of stock. Leasing is bigger than commercial mortgages. And perhaps best of all, because of the high volume of lease capital which is available, equipment lease financing is readily available for small businesses.
Here are some of the most important competitive advantages of lease financing.
• 100 percent financing. With leasing the lessor (i.e. the company which purchases, then rents the equipment), finances 100% of the cost of the equipment being purchased. In fact, lessors often finance some of the soft costs associated with the purchase of new equipment such as training and installation.
• Easy Application and Rapid Approval Times. Most applications for leases under $150,000 are a single page in length and approvals can occur within 24 hours.
• Tax treatment. In general, the tax implications of leasing can be quite complex, and could be the subject of a book in itself. However, for small ticket leases, which are in most instances are so-called capital leases, the tax treatment is very straightforward an very favorable. The business leasing the equipment writes off the entire monthly payment as an expense. Conversely, when a business takes out a loan to buy [italicize buy] equipment — i.e. places it on its books as an asset — the company can only deduct the interest portion of the payment, plus a depreciation expense.
• Flexible terms. Most leasing companies can structure the term of the lease to fit a certain monthly payment which the business owner is able or willing to make.
NOT A BANK
According to Jim Lahti, who is also the president of Oakland, CA-based trade group United Association of Equipment Leasing, the distinction between an equipment leasing company and a bank run deep. “When the bank makes a loan, you have some discretion over the proceeds. And if you buy equipment with the loan, you own the equipment, depreciate it, and pay the bank back. But with a leasing company, we buy and own the equipment, and rent it to you. So one of the primary differences is ownership.”
Another big difference is orientation. “What makes the leasing company more adventurous than a conventional lender,” Lahti says, “is that we do not labor under the same federal regulations as a bank, and we do not have the same audit trails as a bank.” To underscore this difference, Lahti says that his firm will lend up to $75,000 on a so-called “app only” basis. By this he means that the loan underlying the lease can be approved on the basis of information provided in the lease application, which is generally no more complex than an ordinary credit card application. Lahti says there are leasing companies that will do deals up to $250,000 on an app only basis.
Finally, whereas most banks are geared up for credit analysis — a detailed study of a businesseszz financial position, and assessment of itszz ability to repay a loan — leasing companies are not. Says Lahti, “We all take the path of least resistance and try to figure out ways to make loans even faster.”
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A Good Deal: Leasing companies will also frequently finance the soft costs that come with equipment purchases such as training, installation fees, service contracts, and even consulting fees you may have paid to get help figuring out which piece of equipment was right for you.
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IMPROVING YOUR CHANGES OF GETTING A LEASE
One of the reasons a small ticket lease is comparatively easier to land than a traditional loan is the widespread use of credit scoring systems by leasing companies. Banks are starting to use credit scoring systems for business, though most still utilize credit analysis [italicize analysis]. Under the credit analysis model, businesses are analyzed for their ability to meet a monthly payment and to pay off a debt. This analysis is time consuming and expensive. In fact the same credit analysis which goes into a $2 million loan, is also applied to a $200,000 loan — a fact which makes applying for a small business loan difficult and time consuming.
But under the credit scoring model, business are analyzed not so much on their ability to repay a loan, but on the probability [italicize probability] that they will repay a loan. In fact, says Lahti, for leases under $100,000, a leasing company may simply credit score the business ownerszz personal credit and check trade and bank references to reach a decision.
And as a general rule, for leases more than $100,000 but less than $150,000, the leasing company will credit score the business, and its owners, and ask for a full set of financial statements. Overall however, the application process is streamlined with the actual application still just a page long, in most cases. When leases get over $150,000, Lahti says that would-be lessors will face the same kind of scrutiny and analysis which they would face with almost any commercial lender.
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Donzzt Forget: A lease can be a superior alternative to a term loan because the leasing company will finance 100% of the equipment, whereas a bank will most often require a sizeable down payment for any major asset purchases which they are financing.
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SIDEBAR: ADDING UP YOUR CREDIT SCORE
Credit scoring streamlines the credit process because it looks at relatively few variables out of many which constitute a companyzzs full financial picture. Each variable is scored, and the credit decision making is done either by computers or clerks. Often times, the credit scoring models are adjusted over time to reflect a lenderzzs experience. As these models evolve, many lenders regard their credit scoring system to be proprietary and a trade secret. Below are the main criteria which are evaluated in a credit scoring system.
Time in business
Lesseezzs industry
Type of equipment
Bankzzs rating of lessee
Trade creditorzzs rating of lessee
Personal credit bureau reports of the principals
Landlord rating
Quality of the vendor supplying equipment to be leased
Structure of the lease
New or used equipment
Credit reports of outside reporting agencies
Source: The Leasing Professionalzzs Handbook
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So, what are the red flags which appear in a credit score that might cause your would-be lease not to be approved?
• Personal credit problems. Past delinquencies, slow payments, or nonpayments will reduce your overall credit score.
• A high number of credit inquiries. If a lot of lending institutions are scoring your credit, it could be a sign that you have made too many credit applications and are carrying too much debt.
• Lengthy payments on trade credit. If you stretch out the payments to your vendors to 90 days, it will come home to roost when you fill out a equipment lease application.
• A high number of NSFs. If you continually write checks that are returned for nonsufficient funds, it will seriously undermine your credit score.
• Lawsuits and judgments. Never a good sign for a lender.
• Frequent change in banking institutions. “If you change banks often,” says Lahti, “youzzre not doing yourself any favors.” Most lenders, he says, like to see at least two years of history with the same institution.
• Being a bad tenant. If your landlord thinks youzzre a lousy tenant, it cause a lessor to think you will be a lousy lessee.
• Exotic equipment. The harder it is to resell whatever equipment you are leasing (which is what will happen if the whole deal goes south), the lower your score.
If your credit score comes up poorly, Lahti says that most leasing companies will take steps to make the deal doable. “In the trade we all this structuring,” he says.
Popular “structuring” techniques include down payments on equipment, additional guarantors (i.e. other people or institutions which will pay off the lease if the original lessee runs into financial difficulty), and anteing up additional collateral in the form of real estate, publicly traded stock, letters of credit and of course equipment a company already has on hand. “If you already have equipment on your floor, I can use it as additional collateral. In fact if you need working capital, we can buy your equipment [for a lump sum] and lease it back to you. ”
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Shop Talk: The “residual” is the value of the equipment at the end of the lease period. Oftentimes the lesee has the option to purchase the equipment for its residual value.
P.S.: The “lessee” is the entity taking out the lease and the lessor is the entity granting the lease.
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SCORING THE LEASE
There are ways to gauge how expensive or cheap lease financing is. To do this, you must know the residual value of the equipment you are leasing. The residual value is the value of the equipment at the end lease, which the lessee would have to pay to purchase it. For instance suppose you lease a $12,000 warehouse forklift for $300 per month for three years, and at the end of the lease, the value of the forklift is $4,000. If you buy the forklift for $4,000, your total cash outlay is $10,800 (36 payments x $300) plus $4,000 for a total of $14,800. Since the forklift cost just $12,000 new, the difference between the original price and the total cash outlay is the implied financing cost, in this case $2,800.
If the residual was higher, say $5,000, and the payments remained the same, $300, the resulting financing costs, $3,800, would be much higher than in the previous scenario.
Lahti says that such an analysis represents a good starting point for analyzing a lease, but that other factors must come into play as well. “The, flexibility to extend or modify a lease, search and documentation fees, speed of approval, the ease with which you can upgrade to new equipment, are all features that must be taken into account when weighing one lease against another.
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Donzzt Forget: If you are leasing equipment, you donzzt own it. Therefore you can make a case that the lessor pays for repairs and taxes.
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LETzzS MAKE A DEAL
Finding an equipment leasing company is easy. Almost any equipment which a business could conceivably need offers a lease option. Though itzzs not apparent at first glance, the company offering the lease financing is not the same one that is selling the equipment. What happens is that the company selling the equipment simply makes a direct referral to a leasing company with which it does business.
Itzzs a good idea to get a quote from the leasing firm which is referred by the company that wants to sell you the equipment. The quote should be competitive. After all, the company selling products, wants to sell as much as possible, and they surely donzzt win any points by referring a leasing company which gouges its customers. But it also pays to get another quote as well. Usually, the company selling the equipment has more than one leasing company on hand, or ask a friend or business associate.
As a final point, when looking for a leasing company you should understand whether or not you are talking to a broker — who simply structures deals, then gets them financed through any of the leasing companies he or she works with — or a leasing company which is actually putting it own funds on the line.
Therezzs nothing wrong with brokers. The situation is analogous to working with an independent insurance agent. He or she might have intimate knowledge of the marketplace, and knows where to go to get the kind of insurance, or lease which you need, and in theory at least, generates savings in excess of his or her fees. But with brokers, as in many other walks of life the same advice applies: Buyer beware.
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Taking Action: To find a leasing company, call or write the United Association of Equipment Leasing for a referral. The address is 520 Third Street, Suite 201, Oakland, CA 94607. 510-444-9235.
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