Operating Leases: The Financial Tool most Small Businesses Overlook
Are you evaluating financing options for a major capital expense? You should strongly consider an operating lease.
While there are thousands of resources available to help decide whether debt or cash is ideal for any particular team, a third path is often available but rarely discussed. It allows for many of the benefits of leasing, like You can secure monthly payments, predictable expenses while avoiding many of the challenges like debt sensitivity, depreciation accounting, and property tax considerations.
Debt financing vs. Operating leases
In a standard debt transaction, often called a “finance lease,” you would take a loan from an investor, and use the cash to buy a piece of equipment outright. Instead of spending your cash up front, you would spend your investor’s capital and pay them back over time (with interest). You would own the entire asset and record a fixed asset and a debt obligation on the balance sheet, offset by debt payments and depreciation expenses over time. This isn’t far from a classic home mortgage transaction.
Operating leases present a few key differences:
- Ownership: In an operating lease transaction, the investor owns the equipment, not you. Any depreciation, property tax, or other ownership considerations are usually handled by the lessor.
- Residual: The lessor is required to take a residual position in the asset, meaning a portion of the asset isn’t technically being financed. This can help lower monthly payments, and is required from a regulatory perspective. For example, if you were leasing a 3D printer with a useful life of 20 years on a 10-year operating lease, after the 10 years is up that machine would still carry some value. That value is held on the balance sheet of the bank, and thus it isn’t part of the financing cost.
- Balance sheet treatment: The lessee under an operating lease doesn’t record traditional “debt” on their balance sheet. Instead they record an operating lease liability and a smaller right of use asset, which is not depreciated.
- Duration of lease: An operating lease usually spans a much shorter period than a finance lease, and is required to be shorter than 75% of the useful life of the asset.
- End-of-term optionality: At the end of an operating lease, the lessee generally has the option to purchase the equipment for its fair market value, or return the equipment to the investor. The lessee also generally has the ability to add up to two pre-negotiated early buyout options (EBOs).
Why most small businesses haven’t heard of operating leases
Operating leases require some legwork on the part of the investor. To determine the proper residual position, the investor uses an asset management team to precisely calculate the future value of the asset, and that means cost. Investors need to stay profitable, so they hesitate to finance smaller transactions or riskier lessees on an operating basis.
Because of the additional overhead, operating leases have historically only been offered to large corporations, whose transactions are large enough to support the additional cost without throwing off the economics of the lease.
Today, the rapid evolution of software and data are driving disintermediation, which is starting to lower the cost of each transaction for the investor. That means smaller companies who might previously have been ignored are now able to fill out an online form, upload their POs and machine specs, and secure financing on a much more automated basis. This is good news, as it means operating leases are growing more and more accessible every day.
Beyond that, companies are moving more quickly, and avoiding long-term structural cost. That means fewer teams are making long-term debt purchases where avoidable. Technical advances in equipment are driving shorter cycles, and companies are looking to stay lean, following closely behind the ever-changing production landscape.
Advantages of operating leases
Your accounting and finance teams will always need to review the decision to pursue an operating lease, but there three key advantages to keep in mind:
One of the most important advantages of operating leases is that they provide multiple avenues to ownership, or disposal of an asset.
Every operating lease gives you the option to either return the asset, or purchase the asset for fair market value (FMV) at the end of term. This optionality allows the borrower to regularly replace equipment if necessary, but the FMV purchase option can create upside risk in the purchase price if the machine has a higher-than-expected value at the end of term.
To mitigate that risk, an operating lease can be structured with up to two early buyout options (EBOs). EBOs can take place at any set date within the lease, up to 12 months from the end-of-term. They provide a way to measure your cost of capital (by totaling your rent payments and buyout to measure IRR), as well as protection from the FMV risk.
Operating leases aren’t considered traditional ‘debt,’ and so they may not interfere with covenants placed on the lessee by other lenders. On top of that, because the asset isn’t technically owned by the lessee, there’s no balance to depreciate, and no property tax for the lessee to pay. Talk to you accounting and tax teams if you’re not sure which situation is preferable.
The monthly payments in an operating lease are technically operating expense, not capital expenditure, and this can drastically simplify the accounting behind the purchase.
Lower monthly payments
Because an operating lease is technically a partial financing (with the investor taking a residual position), you get the benefit of a lower monthly payment even though the term on an operating lease may be shorter than in a debt transaction.
Disadvantages of Operating leases:
In a finance lease, you own the asset outright from the beginning. This allows you to do whatever you want with that asset, within limits. You can often move it between facilities, change or upgrade the equipment, or even scrap it in some cases, so long as you pay down your obligation.
In an operating lease, you have much less flexibility to change the asset that is being leased. For highly customized equipment, or machines that might be changed over time, debt financing may be the better option.
Debt financing generally comes with specific rules that allow the buyer to pay down their obligation all at once, or refinance at any time. This can reduce interest expense, or provide an option to refinance whenever the rate environment is favorable.
In an operating lease, payments are generally expected through the end of the financing term, and refinancing can be difficult outside of the EBO points or end-of-term because of the more rigid payment structure.
Important terms and considerations
Not all operating leases are structured the same. Like any financing arrangement, It’s important to work with your investor or broker to land on the best possible structure for your business. This will help protect the economics of your deal, and avoid having the investor take advantage of your company for lack of asking. A few considerations include:
- Residual positions: Residual positions can be flexible, and they’re often the big determining factor in monthly payments. Ask your investor how they’ve determined the residual position, and get a second opinion if you think it could be advantageous.
- Lease terms: While there are limits to the length of an operating lease, the general timeframe ranges from a short period of months, all the way up to 10 years or more. Like a mortgage, the longer the term, the lower the monthly payment. On the other hand, shorter terms provide a path to lower total interest paid.
- Buyout options: EBOs are an important mechanism for protecting against FMV risk, and should be requested unless you plan on returning the equipment at end-of-term.
- Interest rates: Investors generally operate within approval ranges to land on the interest rate your business will end up paying. Try comparing offers from multiple lenders, or directly asking what can be done to reduce the rate in a given transaction. Often times, simply asking about rates can be enough to create some upside, which can lead to meaningful savings over the life of a deal.
More tools: more flexibility
While operating leases may not be perfect for every purchase, they’re one of many important tools that can be used to finance your ongoing capex needs. Operating leases provide a path to (optional) ownership that helps keep cash under control and accounting uncomplicated. Because of the changing nature of manufacturing and ever-increasing tech infrastructure behind lending, more and more businesses are able to take advantage of the benefits of operating leases.
There are quite a few resources available to help you determine what may be right for your business. I recommend taking a look at the Equipment Leasing & Finance Association and the Corporate Finance Institute for more information if you’re looking to dig deeper into the technical details.