Buzz

Sources of Capital - Leasing Companies

Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser and D. L. Sonny Williams


Introduction

LEASING COMPANIES

When a company leases equipment, it benefits from the asset's use, not its ownership. As a result, the company does not consume capital that can be used for expansion, growth, or other resource acquisition. Leases are made based on the value of the asset and the credit quality of the borrower. [1]


Leasing companies can be independent finance businesses or units of banks. They provide capital by procuring equipment for their clients in exchange for a commitment of a series of payments. Some leasing companies focus on specific industries and have special programs tailored for certain types of equipment, while others are broad-based in scope. Those with industry specialization sometimes have the ability to be more aggressive in pricing given their understanding of the equipment values and paths to liquidation or resale. In some cases and depending on the amount of the lease, leases are easier to obtain and less sensitive to the customer's creditworthiness, particularly when the equipment being leased is ordinary.

When considering leasing as a financing alternative, ask the following questions: [2]

  • How long will your company need to use the equipment?
  • What does your company intend to do with the equipment at th end of the lease?
  • What is the tax impact of a lease, given the company's tax situation?
  • How will the lease impact your tax situation?
  • What are the company's expected future needs, and how does the lease fit into a total financing plan?

Types of Leases

For financial reporting purposes, leases can be divided into two categories: capital leases and operating leases. An operating lease is a short-term lease or usage agreement that allows the company (lessee) to acquire use of an asset for a fraction of the asset's useful life. This type of lease is accounted for by the lessee without showing the asset or liability (for the lease payment obligations) on the balance sheet. The lessee accounts for rental payments as an operating expense on the income statement. [3] For example, a company may enter an operating lease to rent a computer system for a year. Operating leases should appear as a note to the balance sheet to disclose the annual amount of minimum rental payments for which the company is obligated, the general terms of the lease, and any other relevant information. The benefits of an operating lease include the reduced risk of asset obsolescence (for technology equipment) and off-balance-sheet financing, allowing a company to effectively borrow additional long-term capital without negatively impacting its debt-to-equity ratio.

An operating lease must possess all of the following elements to meet Financial Accounting Standards Board (FASB) rules:

  • Lease term is less than 75 percent of estimated economic life of the equipment.
  • Present value of lease payments is less than 90 percent of the equipment's fair market value.
  • Lease cannot contain a bargain purchase option (i.e., less than the fair market value).
  • Title does not pass automatically to the lessee at the end of the lease term.

A capital lease is a direct substitute for the purchase of an asset with a term loan. It is a noncancelable contract to make a series of payments in return for use of an asset for a specified period of time. It transfers substantially all the benefits and risks inherent in the ownership of the property to the lessee. Typical terms transfer the asset to the company at the end of the lease or allow the company to purchase the asset for a minimal price. Interest and depreciation are expensed as payments are made against the capital lease. A capital lease tends to generate expenses sooner than an equivalent operating lease.

In both operating and capital leases, there is usually some type of deposit required. It is sometimes in the form of prepayment of the first and last payments.

Venture Leasing

Venture leasing companies generally provide equipment for start-up and emerging growth companies. There tend to be two types of venture leasing:

  1. The first type is offered by traditional leasing companies that have targeted venture capital-backed businesses and have tailored their marketing and product structure. In this case they do not seek an equity position in the lessee. These firms usually require a minimum level of venture funding to be invested and full financial disclosure. The transaction is usually structured as an operating or true lease for 18 to 36 months, and is for equipment that is essential to the operations of the business.
  2. The second type is offered by a venture leasing company that seeks an equity stake in the lessee, typically in the form of warrants or options. The lessee has generally received venture investment and is evaluated based on its growth potential. Typically there is no deposit required with regard to the lease transaction, and it is structured for a three- to four-year term. As in the prior paragraph, full financial disclosure is required.

When negotiating with a venture leasing firm, the concept is to seek a lower interest rate and lower payments in exchange for warrants, given that the strike price of the warrants is appropriate. In an ideal situation, the warrants will be at or above the current equity valuation. Venture leasing can be a less dilutive financing alternative than raising additional venture funds.

Sale Leaseback

A company can unlock or reallocate existing capital by selling existing assets to a leasing or finance company with an agreement to lease those same assets over time; this is referred to as a sale leaseback arrangement. This technique is useful for companies that have already invested in certain fixed assets and need to shift the use of that capital.

It is also a viable technique for companies that have equity in real estate. A typical mortgage will enable an owner to extract 50 to 80 percent of the equity for higher return uses, where a sale leaseback will likely yield close to 100 percent. There are possible tax advantages to a sale leaseback transaction versus a traditional mortgage or other financing alternatives; we counsel a company to evaluate this impact as part of the decision process. Sale leaseback transactions offer the advantage of creating off-balance sheet financing at a price that is likely less than mezzanine.

Some venture leasing firms will do a sale leaseback arrangement with early stage companies that have already invested in fixed assets. This may be an alternative for asset-intensive venture-backed companies that are between rounds and need additional capital to meet their next milestones, yet do not want to further dilute the founders' shares by accepting a premature round.

What Can Be Leased

  • Agricultural, forestry, fishing equipment.
  • Amusement games and machines.
  • Banking equipment.
  • Computer hardware and software.
  • Construction equipment.├┐
  • Electrical equipment.
  • Industrial and manufacturing equipment.
  • Materials-handling equipment.
  • Medical equipment.
  • Mining, oil, and gas extraction equipment.
  • Office equipment.
  • Printing/publishing equipment.
  • Restaurant equipment.
  • Telecommunications equipment.
  • Transportation equipment and vehicles.
  • Vending equipment.

Read more about the Sources of Capital in the Encyclopedia of Private Equity and Venture Capital


[1] Henry Frommer, Intellectual Property Leasing and Its Implications for the Leasing Industry (Wells Fargo Leasing, Inc., 2002), 21.

[2] Steve Cooper, "Choose Leasing" Entrepreneur Magazine, November 1, 2004.

[3] http://pages.stern.nyu.edu/~adamodar/New_Home_Page/AccPrimer/lease.htm.


The above material is excerpted from:

The Handbook of Financing Growth: Strategies and Capital Structure by Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser and D. L. "Sonny" Williams.

To order the Entire Second Edition of, The Handbook of Financing Growth: Strategies, Capital Structure, and M&A Transactions, 2nd Edition

This material is used by permission of John Wiley & Sons, Inc.

Kenneth H. Marks, CM&AA,* is the founder and a managing partner of High Rock Partners, Inc., providing strategic consulting, investment banking, and interim leadership services to emerging growth and middle-market companies. As CEO he founded a high-growth electronics company and, led and sold a technology business to a Forrune 500 buyer. As adviser, he has worked with managers and board members ro develop and implement growth, financing, turnaround, and exit srrategies in over two dozen companies. Marks' past positions include president of JPS Communications, Inc., a fast-growth technology subsidiary of the Raytheon Compnny, and president/CEO of an electronics manufacturer that he founded and grew to $22 million.

Mr. Marks created and teaches an MBA elective titled "Financing Early Stage and Middle-Markct Companies" at North Carolina State University; and created and teaches "Managing Emerging Growth Companies," an MBA elective, at the Hult International Business School in Boston (formerly the Arthur D. Littlc School of Management) in connection with Boston College's Carroll School of Management. He is the author of the publication Strategic Planning for Emerging Growth Companies: A Guide for Management (Wyndham Publishing, 1999).

Mr. Marks was a member of the Young Presidents Organization (YPO); the founding YPO Sponsor of the Young Entrepreneurs Organization (then YE0 and now EO) in the Research Triangle Park. North Carolina Chapter; a member of the Association for Corporate Growth: and a member of the board of directors of the North Carolina Technology Association. Marks obtained his MBA from the Kenan-Flagler Business School at the University of North Carolina in Chapel Hill.

Larry E. Robbins is a founding partner of Wyrick Robbins Yares & Ponton LLP, a premier law firm locared in the Research Triangle Park arca of North Carolina. He is a frequent lecturer on the topics of venture crlpital and corporate finance and serves on the boards of directors of entrepreneurial support organizations, technology trade associations, and charitable and arts organizations. Mr. Robbins receivcd his BA, MRA, and JD from the University of North Carolina at Chapel Hill. He was also a Morehead Scholar at UNC.

Gonzalo Fern ndez is a retired vice president and controller of ITTs telecom business in Raleigh, North Carolina. Subsequently he spent 15 years working as a finance executive for emerging growth companies and as an accounting and business consultant to other companies. He is a past president of the Raleigh Chapter of the Institute of Management Accountants. He received his BA in accounting from Havana University, Cuba. He wrote the book Estados Financieros (Financial Statements) (Mexico: UTEHA, third edition, 1977).

John P. Funkhouser has been a partner with two venture capital funds, and operated as chief executive officer of four companies in a variety of industries from retail to high technology. In his venture capital capacity, he was a corporate director of more than a dozen companies and headed two venture-backed companies. The most recent company he led from a start-up concept to a public company is a medical diagnostics and devices business. Mr. Funkhouser worked in commercial banking with Chemical Bank of New York, in investment banking with Wheat First Securities, and in venture capital with Hillcrest Group. He has an undergraduate degree from Princeton University and an MBA from the University of Virginia, Darden Graduate School of Business Administration.

D. L. "Sonny" Williams is a managing partner at High Rock Partners. As CEO, for over 25 years he led three global manufacturing/technology companies through major transitions; and as an adviser, he has worked with companies in numerous industries to create value and implement change. Mr. Williams has over 30 years successful operating experience in engineering, manufacturing, sales/marketing, and senior executive roles. His career is highlighted by having led the turnaround of three global manufacturing/technology enterprises ($50 million to $330 million in revenues in nine countries) over a 20-year span in CEO/president/director roles, serving the automotive, consumer, industrial, aircraft, and medical component markets. Mr. Williams' leadership accomplishments include successfully achieving dramatic lean enterprise-based cost restructures, low-cost country expansions/sourcing, and accelerated organic growth through strategic value proposition repositioning; complemented by leading eight acquisition/ merger/joint venture-related negotiation/lintegrations. Mr. Williams' value-creating experiences were magnified by successfully repositioning two of the corporate companies for investment-attractive management buyouts.

Mr. Williams received his BSEE from Kettering University and his Executive MBA from the Kenan Flagler Business School at the University of North Carolina, Chapel Hill. He is president of the Association for Corporate Growth (Raleigh-Durham chapter) and a member of the National Association of Corporate Directors.

John Wiley & Sons

Founded in 1807, John Wiley & Sons is the oldest independent publishing cormpany in the United Stares. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers' professional and personal knowledge and understanding.

The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and financial instrument analysis, as well as much more.

For a list of available titles, visit their Web site at http://www.WileyFinance.com/.


* The Certified Merger & Acquisition Advisor (CM&AA) credential is granted by Loyola University Chicago and the Alliance of Merger & Acquisition Advisors.