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When startups consider financing options, the usual suspects are debt and equity financing. However, there are alternatives to the traditional approaches. Leasing can, under certain circumstances, function as a form of financing. This article will explain in which circumstances leasing operates as a form of financing and also evaluate the advantages of this.
What is Financing?
We commonly use financing to refer to how a business funds its long-term capital. This is also called the business’s capital structure. It describes the permanent source of funds a business uses to generate returns for its shareholders and other investors.
Startups will use different capital structures depending on where they are in the growth cycle. Nearly all startups will use a large portion of equity, which refers to funds injected by shareholders. Some may also use debt financing such as:
- traditional bank loans or loan notes; and
- hybrid financing options like convertible debts.
This cheat sheet outlines what you should be aware of in your lease agreement.
What is Leasing?
In the most general sense, leasing refers to an agreement where a business pays a provider a fixed fee to use a piece of property, such as a vehicle, airplane or machine.
Leasing comes in two forms:
- finance leases; and
- operating leases.
Let us explore examples of each.
Finance Leases
Suppose your startup requires a piece of machinery that will cost £500,000.
You may enter an agreement with a bank, where the bank purchases the property from the seller and then agrees to let you use it in exchange for a monthly fee. Your startup will pay this fee over 20 years. At the end of the term, your startup can acquire the machinery for a nominal price.
While leasing the machine, you are responsible for insuring it and maintaining it.
Operating Lease
Suppose your startup needs access to a piece of equipment for at least five years. However, you are unsure if you will need it afterwards. Therefore, you agree with the equipment manufacturer to hire the equipment for five years. You pay a monthly fee to use the equipment for five years. After this, you may renew the lease if you wish, but there is no obligation.
While you lease the equipment, the manufacturer insures it and agrees to repair or replace it if any defects arise.
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Leasing as a Form of Finance
A finance lease is a form of financing in that if the financing lease was not an option, you would have to borrow the money to purchase the machinery (without purchasing it outright). The effect would be the same:
- you would make a series of payments to repay the loan;
- you would incur credit costs in the form of interest;
- at the end of the loan’s term, you would have an unencumbered title to the machinery subject to any other loan agreements.
This alternative arrangement is known as asset financing.
However, finance leasing differs from asset financing because asset ownership remains with the lessor, the party leasing the equipment to you.
Importantly, operating leases are not a form of financing. Rather, they are an expense that does not confer you with the benefits and obligations you will find with financial leases.
Further Considerations
Historically, finance leasing had two main advantages compared to other kinds of financing:
- certain tax laws made it financially more advantageous in certain circumstances; and
- from an accounting perspective, businesses did not have to declare financial leases as liabilities on their balance sheet.
Nevertheless, there are certain inherent advantages to finance leasing compared to traditional debt financing.
| Ease of Access | Most loans require you to grant security over your assets in exchange for the loan amount. Alternatively, asset financing means the bank will take charge of the asset you borrow money for. You may not qualify for these loans if your startup has insufficient creditworthiness. However, finance leases, by their nature, mean that the lessor does not need to take security over the equipment or your assets. This is because the lessor retains ownership over the equipment. |
| Cost | For similar reasons, negotiating a financial lease is quicker and more straightforward. This often means that the costs and fees associated with the lease are less than what your startup would incur under a loan agreement. |
| Flexibility | There is a ready-made market for lessors leasing valuable equipment to businesses. As a result, many financial lease agreements contain provisions that allow your startup to vary the lease terms if the equipment becomes obsolete. However, this may come at an increased cost. |
| Cash-flows | You can think of the payments you make under the financial lease as consisting of the asset’s cost spread out over the agreement period plus a premium similar to interest. At the end of the agreement, you will typically have paid for the asset, which entitles you to take ownership of it. This is often better than under a loan, where you may owe a large sum at the end of the agreement. |
Key Takeaways
A financial lease, as opposed to an operating lease, is a form of financing startups can use to acquire the use of valuable assets like cars, ships, airplanes and equipment. The advantages of finance leasing, such as ease of origination, cost-effectiveness and flexibility, and more manageable servicing terms, can make them more advantageous than traditional debt financing.
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