Dec 10, 2023

The Founder's Guide to Getting a Financing Lease in 2024

Arc Team

Go-To-Market

Financing leases - the basics

What a financing lease is (and isn’t)

A financing lease, also known as a capital lease, is a type of lease agreement where the lessee acquires the benefits and risks of ownership of the leased asset. It typically involves long-term commitments for assets such as machinery, equipment, or vehicles. In a financing lease, the lessor (the entity or company providing the lease) typically purchases the asset specifically for the lessee, who agrees to make a series of payments over the lease term.

Key characteristics of a financing lease include:

Transfer of Ownership: One of the distinguishing features of this form of lease, is the ability of the lessee to purchase the asset at the end of the lease term at its residual value.
Long-Term Nature: These are long-term agreements, that cover a significant portion of the asset's useful life (vs operating leases that exist over a smaller portion of the useful life).
Fixed Payments: The payments are fixed and cover the upfront cost of the asset, interest charges, and other associated expenses.
Maintenance Requirement: In most of these leases, the lessee is responsible for maintenance, insurance, and taxes related to the leased asset.

How financing leases work

Financing leases are most similar to car leases. The startup effectively pays a monthly fee to use the machinery, equipment, or technology, and at the end of the lease term, they have the option to purchase the asset. Like a car lease, the payments do NOT build equity in the asset.

However, unlike a car lease, the lessee is responsible for maintenance and repairs. Also unlike a car lease, with a financing lease, the term is based on the economic life of the asset, which varies from asset to asset, rather than the standard term of 24 or 36 months for car leases.

Common terms found in a financing lease agreement

Lease Term: The duration for which the lessee has the right to use the leased asset. Typically 90%+ of the remaining economic life of the asset.
Interest Expense: Some lease agreements are subject to an interest expense, which is the charge for the privilege of borrowing the money,
Lease Payments: The fixed payments made by the lessee to the lessor, covering the usage cost of the asset, interest, and potentially other expenses.
Residual Value: The estimated value of the asset at the end of the lease term, at which the lessee may have the option to purchase the asset.
Ownership Transfer: Specifies conditions under which ownership of the leased asset transfers from the lessor to the lessee.
Maintenance and Repairs: Outlines the party responsible for maintaining and repairing the leased asset (typically the startup using the asset).
Use Restrictions: Outlines any limitations on the use or modification of the leased asset.
Default and Remedies: Details the consequences of default by either party and the remedies available to the non-defaulting party.
Early Termination Clause: Specifies the conditions and penalties associated with terminating the lease before the agreed-upon term.

Assessing whether a financing lease is right for your startup

The key advantages of financing leases

Lower Upfront Costs - One of the primary advantages of financing leases is the ability for startups to acquire essential assets with a significantly lower initial capital outlay. By paying a fraction of the total cost as a down payment, startups can conserve their capital for other critical operational needs.
Preservation of Working Capital - By spreading the cost of acquiring assets over the lease term, financing leases enable startups to preserve their working capital. This preserved capital can be strategically allocated to areas that directly contribute to business growth.
Optionality - With financing leases, startups have the option (but not the obligation) to purchase the underlying asset at the end of the lease term.
Tax Deductions - Financing leases may come with tax benefits, such as interest rate and depreciation deductions.
Predictability - Financing leases come with fixed, predictable monthly payments which is useful for effectively managing cashflows.

The key disadvantages of financing leases

Higher Total Costs - One significant disadvantage of financing leases is the potential for a higher overall cost of ownership compared to an outright purchase. While the lower upfront costs may be appealing, the cumulative lease payments, including interest, can result in a higher total expense over the lease term.
Limited Ownership Rights - Financing leases often involve limited ownership rights for the lessee during the lease period, such as restrictions on modifications to the leased equipment without lessor approval.
Fixed Commitment - Financing leases often involve long-term commitments, tying businesses to the leased asset for an extended period. While this may align with the asset's useful life, it can become a disadvantage if business needs change, and the leased asset no longer serves a strategic purpose.
Fees & Penalties - Exiting a lease prematurely may result in penalties or additional costs.

Requirements to qualify for a financing lease

There are a handful of factors that lessors assess when determining the lessee's creditworthiness. We’ve outlined the key requirements below.

Creditworthiness Assessment - Leasing companies typically conduct a creditworthiness assessment to evaluate the lessee's ability to meet financial obligations.
Financial Documentation - Lessees are generally required to provide comprehensive financial documentation to support their lease application. This may include audited financial statements, demonstrating financial stability, and cash flow projections that showcase the ability to meet lease payments.
Asset Evaluation - Leasing companies evaluate the asset to be leased to ensure its suitability for financing. This process may involve an appraisal of the asset's value, an inspection of its condition, and an assessment of its expected lifespan.
Personal Guarantees - In cases where the lessee is a business entity, leasing companies may request personal guarantees from the founders. This commitment provides additional assurance to the lessor, indicating that the individuals responsible for the business are personally invested in meeting lease obligations.
Adequate Insurance Coverage - Lessees are typically required to maintain insurance coverage on the leased asset. This coverage often includes protection against loss, damage, and liability. Providing proof of adequate insurance is a standard requirement in financing lease agreements.

The application process for a financing lease

Admittedly the outline we’ve provided below related to the application process for a financing lease is basic. While most financing leases will follow this process, some will require additional steps and others will require less.
Initial Consultation: Schedule a meeting with the leasing company to discuss your business needs and explore available financing options.

Application Submission: Complete the lease application, providing accurate and comprehensive information about your business, financials, and the asset to be leased.
Creditworthiness Evaluation: The leasing company will assess your creditworthiness, considering factors such as financial stability and business performance.
Asset Appraisal: If applicable, the lessor may conduct an appraisal of the asset to determine its value and condition.
Negotiation: Engage in negotiations to finalize lease terms, interest rates, and any special conditions.
Signing the Agreement: Once satisfied, sign the lease agreement and adhere to any specified conditions.

Frequently asked questions (FAQs) about financing leases

How does a financing lease differ from an operating lease?

In a financing lease, the lessee assumes ownership rights and responsibilities, and the lease is structured as a financing arrangement. An operating lease, on the other hand, is more like a rental agreement, and ownership remains with the lessor.

What are the key benefits of opting for a financing lease?

Financing leases offer lower upfront costs, potential tax benefits, flexibility in asset management, preservation of working capital, and predictable cash flow management.

Are there any downsides to financing leases?

While financing leases offer advantages, there are potential downsides, including the higher total cost of ownership over the lease term, limited ownership rights during the lease period, and the possibility of higher interest rates.

Can I negotiate the terms of a financing lease?

Yes, negotiation is common in financing leases. Lessees can negotiate various aspects, including lease duration, interest rates, and flexibility in terms of upgrades or early buyout options.

What happens at the end of a financing lease term?

At the end of the lease term, lessees typically have the option to purchase the asset at a predetermined residual value.

Are there penalties for early termination of a financing lease?

Yes, early termination of a financing lease may result in penalties or additional costs. Lessees should carefully review the lease agreement to understand the conditions and costs associated with terminating the lease before the agreed-upon term.

Can a startup or small business qualify for a financing lease?

Yes, startups and small businesses can qualify for financing leases. While they may face additional scrutiny, providing a solid business plan, demonstrating financial stability, and fulfilling creditworthiness requirements can enhance their eligibility.

Can I include maintenance costs in the financing lease agreement?

Maintenance costs are typically the responsibility of the lessee in this form of lease. However, in some cases, lessors may offer maintenance packages or include maintenance costs in the lease agreement. It's essential to clarify these details during the negotiation process.

Can I sublease the leased asset to another party?

Subleasing is typically not allowed in this form of lease without the lessor's explicit consent. Lease agreements often include clauses that restrict or prohibit subleasing the asset.

Wrap-Up - Leveraging Financing Leases in 2024

Financing leases are an attractive option for startups seeking machinery, equipment, vehicles, and other high-ticket items to operate their business. They have lower upfront costs and potential tax benefits and can help startups preserve their working capital. However, they may come with a higher total cost of ownership over the lease term, limited ownership rights during the lease period, and potentially higher interest rates. If you’re interested in getting approved for a financing lease, get in touch with us.