Rod McHenry, vice president of finance for a document imaging company, thought he had great reason to celebrate. He had signed a whopping $370,000 lease proposal that covered computer servers, workstations, software, and other network equipment. McHenry believed he had obtained an incredible lease rate, which culminated weeks of negotiating an acceptable equipment price with the equipment supplier. The proposal guaranteed the closing of the lease and offered to return the 2% “commitment fee” paid by McHenry’s company if the leasing company did not approve the credit within two weeks. Little did McHenry know that signing this proposal would land his company in the ‘Twilight Zone’ of equipment leasing. Ultimately, his firm shelled out more than $15,000 in legal fees seeking the landlord’s performance, only to learn that the landlord was already insolvent and embroiled in several similar lawsuits.
Like McHenry’s employer, thousands of American companies lease equipment each year, many paying no heed to potential blunders. Rod McHenry became the victim of a potential pitfall, but there are several areas to pay special attention to.
Fall in love with the lowest rate
One potential pitfall many prospective renters face is basing their leasing decision solely on the lowest monthly payment. Even at first glance, making a decision based on monthly payment makes little sense. First, these amounts provide only a partial picture of the full lease price. Accurate discounting of cash flows using present value analysis, including advance lease payments, monthly payments, security deposits, and fees, can often change the outcome of the lowest lease offer. Making sure that each lease proposal is boiled down to a present value calculation ensures that you’ll be comparing apples to apples. Even if you do accurate price comparisons, pricing alone fails to take into account several important factors, which could save you big in the long run and prevent your business from making mistakes. To avoid pitfalls in this area, list and assess your top priorities for a lease agreement. Consider factors such as: choosing the right leasing partner, balance sheet considerations, tax considerations, choosing the right form of lease, avoiding harsh lease terms, and getting enough lease flexibility.
Failing to check references and financial condition of landlords
As Rod McHenry discovered, perhaps the area with the greatest potential for missteps is in landlord selection. Failure to research and choose a leasing partner wisely can result in transaction delays, misrepresentations, default, unexpected fees, or even fraud. Like many industries, equipment leasing encompasses many players with varying degrees of experience, specialization, integrity, and financial strength. When selecting the best leasing partner, get enough information from bidders to perform an effective reference check. If possible, also obtain financial information from bidding lessors to assess their financial situation. Get reports from Dunn and Bradstreet on every bidder. Request and verify references from customers, suppliers, banks and businesses. Do an internet search for news and messages to make sure that the landlords making the offer are not the subject of any unresolved issues 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 referral. Lastly, ask around. Check with your lawyer, accounting firm, banker, friends and associates who can make recommendations based on past experience.
Not fully understanding the lease
Not reading and understanding the main terms and conditions of equipment leasing can cost your business dearly. While most lease agreements include similar terms and conditions, there can be notable differences. For example, most agreements cover the responsibility of the lessee to pack up 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 tenant to do this before the last day of the lease, perhaps depriving the tenant of a week or more of use. In addition, some agreements require the lessee to pay for the removal, packaging, and shipping of the equipment to any destination within the US, which can be costly. You can save money by trading many of these points. Read the lease carefully, get legal advice if necessary, and negotiate the points that can save you money.
Making the Wrong Decision Between Fair Market Value and Bargain Purchase Leases
High on the list of possible leasing mistakes is choosing the wrong form of lease for the planned use of the equipment. Failure to choose wisely can result in significant additional lease expenses. Equipment leases fall into two broad categories: 1) leases designed to transfer ownership of the equipment to the lessee at the end of the lease (bargain purchase/equity leases) and 2) leases designed to allow the leasing company to retain ownership of the equipment. equipment ownership (FMV or operating leases).
If you plan to keep the equipment beyond the lease term, it is generally more economical 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 title to the equipment for a nominal payment. If the equipment is subject to rapid obsolescence or if you are confident that you will return the equipment at the end of the lease, an FMV or operating lease might be advantageous. What you get with an FMV or operating lease is the flexibility to retire the equipment at the end of the lease. Additionally, this form of leasing can lower your lease rate since the lessor passes a portion of the anticipated residual value back to your business in the form of lower payments. If your company has reason to minimize liabilities on the balance sheet, perhaps due to bank finance agreements, an operating lease might be attractive. In these lease situations, balance sheet concerns can trump the desire for the lowest lease rate. When choosing a form of lease, look at the expected period of use of the equipment, the obsolescence potential of the equipment, balance sheet considerations, income tax considerations, and any other factors that may influence the choice of lease.
Failing to Evaluate Provider Service: Equipment Leasing Agreements
Entering into a “hell or high” equipment lease involving proprietary equipment required for multi-year service (such as alternative energy or telephone service) can put your business in a position ripe for blundering. Even under the best of circumstances, a “hell or high” equipment lease (one that requires non-cancellable payments) made in connection with a service agreement carries a degree of risk. In many cases, the lease is provided by a leasing company independent of the service provider or later sold by the service provider to a lessor. The potential pitfall arises from the possibility of your business being locked up in lease payments for equipment it can no longer use, should the service provider fail or stop offering service. The best protection against this potential danger is to avoid these types of arrangements. If you must enter into such an agreement, make sure the service provider is financially sound, reputable, and has a long history of providing excellent service. Also, since these transactions always carry some risk, ensure that an abrupt interruption in service does not have a material negative impact on your business or cause financial hardship.
Ignoring the End of Lease Notice Deadline
While not a deadly mistake, failing to provide timely notice at the end of your lease can result in significant additional rental expenses for your business if you plan to return equipment. Many leases have provisions that require the lessee to notify the lessor of their decision to return the equipment at the end of the lease. If you violate the notice period, the lease enters an often unfavorable automatic renewal period, typically one to six months. If you intend to return the equipment at the end of the lease, make sure your company notifies you in time. You can save your business a lot in avoidable rental expenses.
Underestimating the time needed to close the lease
Not allowing enough time to go through the planning, proposal, approval and documentation phases of the lease may result in additional cost. A rushed process can lead to poor landlord selection, approval delays, documentation errors, or poorly negotiated lease terms. Except for small ticket transactions (less than $75,000 to $100,000) where the principal’s personal guarantees 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 consumed by administrative matters. Obtaining certificates of insurance, submitting UCC financial statements, reviewing and negotiating the lease all contribute to the time it takes to get to a lease close. The best way to manage the lease closing process and save valuable time and money is to plan ahead. Be sure to establish criteria for the lease you are seeking, prepare a packet that contains information all bidders would want, obtain a lease closing list from each lease bidder, and respond to all requests/questions raised by bidding landlords timely.
While equipment leasing pitfalls can’t always be avoided, you can take steps to avoid pitfalls that can cost your business a mint. Plan ahead and do your homework before starting the lease bidding process. Make selecting an experienced leasing provider with high integrity and good experience a high priority. Also, with lease transactions that represent significant obligations for your business, retain a competent attorney to help you review and negotiate the lease of the equipment.