Technology leasing has gotten a black eye recently due to the sensationalism surrounding the Toronto City Hall computer leasing inquiry. Colorful characters, mayoral politics, juicy perks, and allegations of over-billing gave the story huge media play, but let’s not overlook plain old sloppy lease work, which unfortunately is fairly common.
2004 and 2005 should be robust years in technology spending, and the lease versus buy question is going to be on the table once again. After the post-Y2K spending drought, Forrester Research reports that 2003 spending in North America was up one per cent versus the predicted one per cent decline and that the 2004 US spending projection has recently been revised to a five per cent increase from four per cent. If the life cycle of modern technology is about three to four years, then we are due for a bonanza period of acquisitions and upgrades.
Professional Purchasing Minefields
The financial decisions surrounding the computer acquisition process, to buy or to lease, operating leases, capital leases, etc., are best left to the internal “numbercrunchers.” They have in-depth knowledge of potential tax benefits and opportunity costs of capital, and can make the best decisions on how the deal should be financed.
After the finance department has spoken, and if leasing is the preferred alternative, using all factors known today, the professional purchaser must protect the company from leasing terms that may expose the users to future pitfalls during upgrades,resulting in higher total costs of ownership down the road.
Let’s concentrate on the most abused and misunderstood area of leasing where omissions in the original contract often lead to problems: the upgrade or the lease rollover.
Never leave future lease rates to be mutually agreed upon and reflective of future market conditions without some benchmark. It is likely you are going to upgrade the equipment during the term of the lease; if you bought enough capacity to last three years, you’ve over-bought capacity that you will not need for 18 to 24 months. But when you upgrade, the leasing company owns the equipment and you can’t upgrade without their permission, so you are locked into leasing any upgrade through them. Upgrade time is a bad time to find out that the new lease rate is pegged at four or five percentage points over the original rate.
In your original leases, tie any future lease rates to some common and mutually acceptable benchmark that reflects an appropriate cost of money to the lessor when it once again invests on your behalf. The three-year mortgage rate, bond rate or interest rate of a major bank should be agreeable to all parties.
Let’s take a closer look at the operating lease or residual-value lease, which is still the most popular lease option for computer acquisitions. The leasing company’s mantra is “leave the risk of technological obsolescence with us,” but in fact the only time this benefit accrues to the customer is when the customer doesn’t modify or upgrade the equipment for the entire term of the lease, and returns the equipment to the leasing company.
As an example, suppose the purchasing department does a fantastic job of negotiating and gets a $1,000,000 purchase price on the computer equipment. The leasing company wins the business with a great lease rate of five per cent and a 15 per cent residual value in the equipment. The monthly payments are based on $850,000 and a five per cent lease rate. The leasing company is taking a risk of $150,000 if the computer is worthless in 36 months when they get it back – if it ever goes back!
Fair Market Value
Typically, at the end of the lease the lessee can either return the equipment or purchase it for fair market value (FMV), which is never defined in the agreement in favor of the leasing client. You can expect the leasing company to want to make a profit of 15 to 20 per cent on the $150,000 it invested over the three years; expect FMV to be at a minimum $170-180K, regardless of what the equipment is actually worth on the open market. If returning the equipment is not feasible, you may be limited to paying the leasing company the requested amount, or to re-leasing for a new term based on that amount.
The fair market value will certainly be negotiable. However, you would be well advised to cap the amount in the original lease to lower your future risk with an opportunistic lessor. Having the option to retire or replace the equipment also puts the client in a much better negotiating position. Keep in mind that the advantage is minimized if you leave the decision until the last few months of the lease term, so plan to start evaluating your options six months prior to the end of the lease.
December is the busiest month for technology deals, and with good reason. The majority of businesses operate on the calendar year, the vendors are offering hefty discounts while scrambling to make their year-end sales targets, and clients are trying to ensure their budgets are 100 per cent utilized. Traditional lease terms of 24, 36 and 48 months will have lease termination dates falling on December 31, two, three and four years out. But swapping out old equipment, installing a new system and reloading all the applications is a dangerous and unnecessary risk just prior to a month-end, quarter-end and year-end processing run.
This poor timing once again shifts the FMV negotiation leverage to your lessor. Also, even if you are willing to take the risk and can find the personnel to do the installation work and testing, they’re not going to be happy with all the extra work during the holidays. Time the leases to expire when the replacement equipment can be obtained at the highest discounts but also when your resources are better able to handle the workload.
Upgrades and Rollovers
When you upgrade the equipment you either make the upgrade portion coterminous with the original lease schedule or you break and rollover the original lease into a replacement lease. The former can result in high monthly payments depending on how many months remain on the original lease. The leasing company is not compelled to take any risks on the upgrade portion so assume the client pays out the total upgrade value over the remaining term. The upgrade to more capacity, additional functionality or later technology has increased the value of the system and exposed the client to a higher FMV purchase price. The leasing company’s exposure on returned obsolete equipment is reduced as the upgraded technology is worth considerably more on the resale market. The client’s alternative of returning the equipment is less appealing as it is now worth more and is still fairly recent technology. Following the upgrade the FMV negotiation leverage now all resides with the lessor.
The rollover alternative will typically incur a financial penalty while taking the present value of:
- the remaining monthly lease payments, plus
- the lessor’s original investment ($150,000), plus
- some or all of the profit (15 – 20 per cent) they assumed they’d make on that investment.
Add the cost of the new upgrade and the total becomes the amount upon which to base the new lease. Once again the lessor is under no obligation to take another residualvalue risk or provide you with the competitive lease rate that was offered during the original competitive bid. The client may now find himself in the awkward position of paying a higher lease rate to finance the remaining dollar value of the original equipment, the upgraded portion, the lessor’s profit and the penalty over a new lease term.
The Devil is in the Details
One similarity in all technology deals is the asymmetry of knowledge. The vendor has done hundreds of deals and the client relatively few. Moreover, the client must constantly look for the “devil” in the details in a dynamic marketplace where change is the only constant. Leasing can play a key role in facilitating the acquisition of essential and expensive business systems to achieve a competitive technology advantage. But to benefit, the buyer needs to think through to the end of the lease and anticipate change during the term.
You must have alternatives at any point during the lease term to protect your interests, and those alternatives will only be present if you negotiate them into the original transaction. If you are not getting the right lease terms then don’t sign, and if you haven’t built in alternatives, and find yourself with unattractive technology leases, consider your next lease an opportunity to do better.