The Business of Buying: WHEN, HOW AND WHY TO LEASE EQUIPMENT

Jan 1, 1999 12:00 PM, Dan Daley

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Leasing business equipment and technology has become a standard way of life for a majority of American companies. An estimated 80% of all U.S. businesses lease some or all of their equipment; of the $563.1 billion spent by U.S. businesses on productive assets in 1996, $168.9 billion-30%-was leased.

The leasing of professional audio equipment gained popularity about a decade ago, as the upper end of the equipment market continued to climb in sophistication and price. The day of the million-dollar audio console was imminent.

Banks have been primary lenders to the studio industry for years, but as the stakes grew and the equipment and operations of the industry became more opaque to nonprofessionals, many banks became skittish at providing large loans to studios. A recession in the early 1990s didn't help, and a surge in the number of start-ups shortly thereafter-in part a by-product of affordable technology that saw many home studios moving into the commercial stage-presented lenders with potential customers with short credit and business histories.

Several leasing companies specializing in pro audio entered the scene during this period. The largest is Terminal Marketing, in the New York City suburb of New City, Westchester County. But in recent years the number of leasing companies has grown across the country. Banks remain a big player in the credit aspects of this business, but leasing specialists have been significant in helping many studios get started.

TYPES OF LEASES Most studios can't afford to make large capital purchases, such as consoles and digital recording systems, outright without adversely affecting cash flow. With a straight bank loan, the buyer owns the equipment (the lessor retains title to the equipment until the term of lease has run its course, usually between three to seven years), contingent, of course, on continuing to pay off the loan. And with low interest rates available, bank loans look attractive. However, many banks are reluctant to make loans on expensive technology; in the event of default, the bank simply becomes one more creditor, and even if certain items are pledged as collateral, banks are not in the studio business and are generally not happy about having to hold auctions to recover their money. Leasing, then, becomes an alternative.

There are basically two types of leases: the so-called "true" lease, in which there is a market-value buyout at the end; and the dollar-option lease, in which the entire cost of the equipment is amortized over the term of the lease, save for a token sum that varies according to state and local regulations. Most often it's $1; some states, such as California, require $101. The difference is critical to the IRS, and thus to lessees.

"Intent to own" is the rule that the tax people use in determining how and how much of a lease can be deducted from taxes. A "true" lease has the residual value of the equipment determined at the end of the lease term. As Chris Marchese, senior account executive at Commercial Credit, a pro audio leasing specialist in Irvine, Calif., explains, "There's no Kelly Blue Book for pro audio; you have to see what the equipment's value is at the time the lease expires based on what else is out there, because technology in this business changes so fast." But in a true lease, the entire payment-principal and interest-is deductible, treated as through it were a rental for tax purposes.

With a dollar-option lease, the fixed, token sum at the end-which is what allows it to technically fit the definition of a lease vs. a loan-is also construed as an intent to own by the IRS in most instances. The finances are thus treated the same as a loan: The interest portion of the payment is fully deductible, and the equipment is subject to standard depreciation schedules (usually over a period of five years, though not necessarily at an even 20% a year; check with your accountant).

The dollar-option lease is the one most often used in pro audio, and as explained, it's really more like a straight loan in the legal guise of a lease. "I don't even know why they call it a lease," observes Doug Pell, East Coast lease manager with J.G. Capital Corp., a 15-year-old leasing company in Manhattan Beach, Calif.

Aside from the tax benefits, a lease can be less entangling than a straight loan. The lessor retains ownership of the equipment, and that serves as its collateral. Default on payments, and they take the equipment back. "As lessors, we're not putting liens on other equipment or cross-collateralizing bank accounts or homes," explains Marchese. "Out interest is in the equipment."

TYPICAL LEASE Outlining a typical dollar-option lease for a hypothetical $300,000 console, Doug Pell calculates a $6,300.56 monthly payment on a five-year (60-month) lease. While the interest is arrived at by using a money factor, reverse calculations indicate a 9.5% annual percentage rate (APR), which Pell, a former studio owner who leased equipment from the same company he now works for, says is toward the lower end of what's available. Make the last payment along with the buyout payment, and the title is yours.

However, there are some other considerations, says Pell. On a $100,000 lease, for instance, cutting the term from 60 months to 48 months reduces the amount of interest payable over the course of the lease from approximately $35,000 to $27,500, without affecting the interest rate. This trade-off will cost the lessee slightly less than an additional $200 per month to a 60-month payment of approximately $2,250. "Everyone knows cash flow is king, and they've heard the horror stories of businesses going under because they can't pay their leases," says Pell. "But the truth is, if you can afford to squeeze out a little bit more money each month, you can reduce your overall term costs substantially. That's always worth considering in a lease."

Some key points to note in a lease agreement are the term (length); the interest rate (running around 11 to 12% for purchases under $100,000, less for larger purchases; also expressed as a "lease factor" or "money factor," a decimal-place inversion of the actual APR); nature of payments (monthly, quarterly, semi-annually); down payments (usually first and last month's payments, with a 30-day lag before regular payments begin); warranty pass-through (almost always, but ask; remember, you don't own the equipment, the lessor does); and having all of the rights and responsibilities of both the lessor and lessee spelled out clearly in writing (such as how late fees are computed). There is a growing trend toward writing lease agreements and other contracts in standard English rather than obscure legalese-if your agreement is less than clear on key points, have an attorney look it over.

CREDIT CHECK There is the "damned if you do, damned if you don't" aspect to the credit check. As Pell explains, "The studio industry is a mom-and-pop business. People often play games with their financials-they overstate losses and expenses so as to pay lower taxes. But if they're not showing profits, that can put them in between a rock and hard place when it comes to a credit review." This, he adds, is one of the reasons that argues in favor of using a leasing company that specializes in pro audio. "We and others tend to give more weight to someone's payment history than some of the other factors," he says.

Still, getting approved for a lease is a pretty straightforward process. Expect an application to ask questions about how long the business has been in operation, how it's structured (corporation, partnership, LLC, etc.), some basic personal information on the company principals (home addresses, phone and social security numbers, own or rent their homes), and references from banks, other lessors, members of the industry and vendors. If the studio is a relatively small business, the lessor may pull a personal credit history from a reporting company such as TRW, often going back three to five years, as well as check average bank balances over a year. "That's really just a thumbnail sketch," says Marchese. "In the process, you're also trying to get a feel for the person and his or her business. You have to go with gut instinct some of the time."

Gut instinct works both ways, and lessors have been hit by scams. Marchese cites South Florida's Dade County as one hot spot where a lot of pro audio lease fraud has taken place. In the typical scam, as he explains it, a prospective "client" is in league with an equipment seller on a relatively modestly priced piece of equipment, say around $30,000. "We can do the deal, but we don't require an actual inspection to see if the customer got the equipment," he says. "We do a verbal, asking the customer if it arrived and was working properly. If it is, then we release the money to the seller." However, often there's no equipment, just a bogus invoice. The lessor gets the standard first and last month's advance payments, and then nothing else. Buyer and seller disappear. Marchese says he's also aware that certain markets are oversaturated with studios and equipment at given times (such as Nashville is now). "That's not to say we wouldn't do leases in those situations," he says, "but we'd want to scrutinize the market a bit more than we might otherwise."

Customers need to stay alert, too. Not every leasing company hanging out a shingle has your best interests at heart. Lou Gonzales, who has leased all of his many consoles at Quad Recording in Manhattan (including a pair of SSL 9000J boards and an Axiom MT), recalls that his early leasing experiences were less than pleasant. "I definitely had problems when I first started leasing years ago," he says. "It was mostly a matter of not having the end-of-term buyout made clear from the start. There can be all sorts of hidden fees and costs. And also, don't forget that they still own the equipment right up until the end. Even if you've made the very last payment, if you forget to exercise the one-dollar buyout, to send them that last dollar, you could technically lose the equipment. And the really bad companies can 'forget' to remind you that you're at the end of the lease. But if you have a good leasing company, it can keep you in business."

EARLY TERMINATION One of the biggest bones of contention in equipment leasing is early termination. Lessors hate it, and many are reluctant to agree to it in the lease agreement. Some also impose penalties. In short, the way most lease agreements are worded, the lessee has to pay the full amount owed on the lease, including interest, whether the lease runs its full term or not. The lessee can try to find a buyer for the equipment, which would reduce the principal owed, but the leasing company makes its money from the interest. Marchese says that there is sometimes room to negotiate the cost of an early termination, but expect to find resistance to that from lenders in most instances.

But once a studio has entered the lease game, it can use early termination to its advantage under certain circumstances. Once a lease passes its halfway point, it can make sense to terminate early (as long as there are no additional penalties specified for doing so) and trade up to new equipment by using the residual value of the original piece of equipment as leverage. Let's use the hypothetical $300,000 console again. In year four of the five-year lease, the lessee still owes $151,200 of the $378,000 (including interest) original loan. If the original console has a residual value of $150,000, that can be applied to a new $300,000 console, giving the studio a much newer piece of technology for nearly half the monthly payments. "Some studios just keep on rolling leases over after they start," says Pell. "It allows them to stay with the newest technology. Others simply want to own it at the end of the lease term." The caution here is to choose equipment with the highest value-retention over time; that generally means proven technology. Adroit choices at one point can generate savings later.

SIZE MATTERS Most lease companies won't deal in numbers less than $10,000. Upper lending limits generally depend upon the financial credentials of the lessee. However, most lease companies also limit the term of any lease, regardless of size, when it comes to computer-oriented equipment and mass-production items. These include PC-based workstations and modular digital multitracks. J.G. Capital limits leases on these items to three years, citing low, sometimes negative, residual values.

Leasing can free up a studio's capital for other purposes, and allow a studio to move to the next level. It can also provide significant tax relief under the right circumstances. But in the end, remember that a lease is simply another kind of credit; and whenever you borrow money, remember that nothing it buys you is yours until that last dollar goes out the door.

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