Rod McHenry, the financial vice president of a document imaging company, thought he had great cause for celebrating. He had signed an unbelievable $370,000 lease proposal covering computer servers, wo...
Rod McHenry, the financial vice president of a document imaging company, thought he had great cause for celebrating. He had signed an unbelievable $370,000 lease proposal covering computer servers, workstations, software and other networking equipment. McHenry believed he had snared an incredible lease rate, capping off weeks of negotiating an acceptable equipment price with the equipment vendor. The proposal guaranteed a lease closing and offered a return of the 2% ‘commitment fee’ paid by McHenry’s company if the leasing company failed to give credit approval within two weeks. Little did McHenry know that signing this proposal would lead his company into the ‘Twilight Zone’ of equipment leasing. Ultimately, his firm would fork out more than $15,000 in legal fees seeking lessor performance, only to learn that the lessor was already insolvent and mired in several similar lawsuits.
Like McHenry’s employer, thousands of U.S. companies lease equipment each year, many of them without careful attention to potential blunders. Rod McHenry became victim to one possible pitfall, but there are several areas deserving careful attention.
Falling For the Lowest Rate
One potential pot-hole facing many would-be lessees is basing their lease decision solely on the lowest monthly payment. Even on the face of it, making a decision based on the monthly payment makes little sense. First, these amounts give only a partial picture of total lease pricing. An accurate discounting of cash flows using a present value analysis, including up-front lease payments, monthly payments, security deposits and fees can often change the outcome of the lowest lease bid. Making sure that each lease proposal is reduced to a present value calculation guarantees that you will be comparing apples to apples. Even if you make accurate price comparisons, pricing all by itself fails to consider several important factors – ones that might save you a bundle in the long run and keep your firm from blundering. To avoid pitfalls in this area, list and evaluate your top priorities for a leasing arrangement. Consider factors such as: choosing the right leasing partner, balance sheet considerations, tax considerations, choosing the right form of lease, avoiding severe lease terms, and getting enough lease flexibility.
Failing to Check Lessors’ References and Financial Condition
As Rod McHenry discovered, perhaps the area with the greatest potential for a misstep is lessor selection. Failing to investigate and make a wise choice of leasing partner can result in transaction delay, misrepresentations, nonperformance, unexpected fees or even fraud. Like many industries, equipment leasing encompasses many players with varying degrees of experience, specialization, integrity and financial strength. In selecting the best leasing partner, get sufficient information from bidders to perform an effective reference check. If possible, also obtain financial information from bidding lessors to evaluate their financial condition. Obtain Dunn and Bradstreet reports on each bidder. Ask for and check customer, vendor, bank and trade references. Perform an Internet news and message board search to make sure the bidding lessors are not the subject of any unresolved problems or scandals. Most reputable lessors belong to one of the major equipment leasing trade associations (ELA, EAEL, UAEL, or NAELB). Call the appropriate association for a reference. Lastly, ask around. Check with your attorney, accounting firm, banker, friends and associates who are able to make recommendations based on past experiences.
Not Fully Understanding the Lease Agreement
Failing to read and understand the major terms and conditions of the equipment lease can cost your company a bundle. While most lease agreements include similar terms and conditions, there can be noticeable differences. For example, most agreements cover the lessee’s responsibility to pack the equipment and ship it to the lessor at the end of the lease, if the lessee chooses to return the equipment. Some leases require the lessee to have this done by the last day of the lease, perhaps depriving the lessee of a week or more of use. Also, some agreements require the lessee to pay for equipment de-installation, packing and shipping to any destination within the US, which can be costly. You can save money by negotiating many of these points. Read the lease agreement thoroughly, get legal advice if necessary, and negotiate points that can save you money.
Making the Wrong Choice Between Fair Market Value and Bargain Purchase Leases
High on the list of potential leasing blunders is choosing the wrong form of lease for your planned use of the equipment. Failure to choose wisely can result in significant additional lease expense. Equipment leases fall into two broad categories: 1) leases designed to pass ownership of the equipment to the lessee at the end of the lease (bargain purchase/capital leases) and 2) leases intended to allow the leasing company to retain ownership of the equipment (FMV or operating leases).
If you plan to keep the equipment beyond the term of the lease, it is generally cheaper to enter into a bargain purchase/capital lease. During the lease, you pay the lessor a rate of return plus the cost of the equipment. At the end of the lease, you receive the equipment title for a nominal payment. If the equipment is subject to rapid obsolescence or if you feel confident that you will return the equipment at the end of the lease, a FMV or operating lease might prove advantageous. What you are getting in a FMV or operating lease is the flexibility to kick the equipment out at lease end. Additionally, this form of lease can lower your lease rate as the lessor passes a portion of the anticipated residual value back to your firm in the form of lower payments. If your firm has reason to minimize liabilities appearing on the balance sheet, perhaps due to bank financial covenants, an operating lease might be appealing. In these lease situations, balance sheet concerns may trump the desire to obtain the lowest lease rate. In choosing a lease form, look at the period of intended equipment use, the potential for equipment obsolescence, balance sheet considerations, income tax considerations and any other factors that might influence lease choice.
Failing to Evaluate Vendor Service - Equipment Lease Arrangements
Entering into a ‘hell or high water’ equipment lease involving proprietary equipment required for a multi-year service (such as alternative energy or telephone services) can lead your firm into a situation ripe for blunder. Even under the best of circumstances, a ‘hell or high water’ equipment lease (one requiring non-cancelable payments) entered into in connection with a service arrangement carries a certain degree of risk. In many cases, the lease is provided by a leasing company independent from the service provider or later sold by the service provider to a lessor. The potential pitfall results from the possibility that your company might get stuck making lease payments for equipment it can no longer use, should the service provider fail or cease to offer the service. The best protection against this potential pitfall is to avoid these types of arrangements. If you must enter into such an arrangement, make sure the service provider is financially sound, reputable, and has a long track record of providing excellent service. Also, since these transactions always carry some risk, make sure that an abrupt interruption in the service will not have a material negative impact on your company or cause financial hardship.
Ignoring End-of-lease Notice Deadline
While not a deadly blunder, failing to give timely notice at the end of your lease can create significant additional lease expense for your firm if you plan to return the equipment. Many leases have provisions that require the lessee to notify the lessor of the lessee’s decision to return the equipment at the end of the lease. If you violate the notice period, the lease kicks into an often unfavorable automatic renewal period, usually one to six months. If you intend to return the equipment at lease end, make sure your firm gives notice on time. It can save your firm a bundle in avoidable lease expense.
Underestimating Time Required to Close Lease
Not allowing enough time to go through the lease planning, proposal, approval and documentation phases can result in extra cost. A rushed process can lead to poor lessor selection, approval delays, documentation miscues or poorly negotiated lease terms. Except in small ticket transactions (under $ 75,000 to $ 100,000) where personal guarantees of the principals are involved, most lease transactions take at least three weeks or more to close. While some of the time is consumed in the bidding and credit review processes, much of it can be eaten up by administrative matters. Obtaining insurance certificates, filing UCC financing statements, reviewing and negotiating the lease agreement, all contribute to the time it takes to get to a lease closing. The best way to manage the lease closing process and to save precious time and money is to plan ahead. Make sure you establish criteria for the lease you are seeking, prepare a package containing information all bidders would want, obtain a lease closing list from each lease bidder, and respond to all requests/questions raised by bidding lessors on a timely basis.
While equipment leasing pitfalls can not always be avoided, you can take steps to prevent snags that can cost your firm a mint. Plan ahead and do your homework before launching the lease bidding process. Give high priority to selecting an experienced lease provider with high integrity and good expertise. Also, with lease transactions that represent significant obligations for your firm, engage a competent attorney to help you review and negotiate the equipment lease.
George Parker is a Director and Executive Vice President of Leasing Technologies International, Inc. (“LTI”). Headquartered in Wilton, CT, LTI is a leasing firm specializing nationally in equipment financing programs for emerging growth and later-stage, venture capital backed companies. More information about LTI is available at: www.ltileasing.com.