Benefits Of Equipment Leasing For Startups

Startups optimize everything, including Equipment Leasing. What drives a startup to take equipment on lease?

My decade long journey in equipment leasing has also given me the opportunity to observe how startups approach and evaluate equipment leasing. And I have learnt a lot from them.

1. Efficient Way To Raise Capital

Startups by definition generally share the following traits – a huge cash burn, ongoing losses in the near term, successful equity raise, healthy cash balance, innovative business model, high valuation etc. A sure shot mix for a conservative banking system to not extend any open credit facilities!

In this scenario many startups have successfully leased equipment and saved significant amount of capital which would have otherwise gone in buying the equipment.

This has been possible because equipment leasing companies understand the intrinsic value of the equipment and extend credit against the same even though the financials of the startup may not be strong enough.

I have seen deals where the startups would give significantly high Bank Guarantee to reduce the credit risk and avail of Equipment Lease. One would wonder why did the startup lock capital in a Fixed Deposit and issue a Bank Guarantee to avail funding when it could simply have used the money to buy the equipment.

Most startups ensured timely lease rental payments, and once seasoning was established for a few months, they could convince the funders to significantly lower the Bank Guarantee for taking more equipment on lease.

Once further track record of payments was established, even rival leasing companies came forward to offer higher limits!

2. Help In Increasing Valuation

Once I was discussing the commercials of an equipment lease transaction with a very successful founder.

He knew that the leasing rates were high since he was not ready to give any collateral but he had very sound logic.

He reasoned that though the lease rates were high, it would help him delay his next round of funding and in the meantime his valuation would continue to grow. And when the funding did finally happen, he had enough cash to close the running lease deals as he had very smartly insisted on some favorable early termination clauses while entering the lease transactions.

This is probably one of the smartest ways I have seen a startup use the equipment lease product.

3. Lease Of Low Depreciation Equipment

Leasing of equipment which have depreciation rates between 10-15% as per the Income Tax Act are generally disadvantageous to the Lessor and advantageous to the Lessee.

The Lessor has to treat the rentals as an expense but the corresponding lower depreciation means the Lessor has to pay higher taxes. It is reverse for the Lessee.

A startup can have a back to back tie up with wealth management teams from financial institutions who help them tap into Family Offices, HNI’s and Ultra HNI’s. These high net worth people willingly buy the lease receivables at rates exceeding 20% annually.

Startups are comfortable borrowing at such rates. Though the rates are high, they are still acceptable, as there is no need for any collateral. 

Even though these startups may be loss making presently, they know that once they become profitable, the rentals would be tax deductible anyway.

4. Monetize Existing Equipment

Several startups have also used the equipment leasing product as a way to monetize their existing equipment by doing sale-and-lease-back transactions.

A sale-and-lease-back allows them to free up much needed liquidity and at the same time allows them to write off the equipment faster.

A sale-and-lease-back may not be an easy choice for many startups as the collateral demanded may be higher but its still worth exploring.

However, startups must be careful as to which Equipment Type is being considered for a sale-and-lease-back transaction.

5. Manage The Profit & Loss Account

A few years ago I came across a unique transaction. A “Unicorn” wanted to lower their overall expenses as they were under tremendous pressure to declare profit in their books.

Instead of purchasing the equipment, they structured it as a lease with lower payments in the initial years thereby lowering the expenses.

They were able to declare profit and went on to raise capital at higher valuations later!

However, such a transaction is not advisable.

Conclusion

There is a very thin line between a well structured equipment lease transaction and one executed poorly.

Startups who have the right team and advisors have been able to use the equipment leasing product very successfully.

Time Value Of Money – Part I

A understanding of the Time Value of Money and the inter relationships between IRR, NPV, XIRR and XNPV are the basic building blocks of finance.

When Albert Einstein was once asked what mankind’s greatest invention was, he replied: “Compound Interest”. There’s even one claim that Einstein called compound interest the “8th Wonder of the World.”

These are also the first step to decipher equipment leasing. As we go along, we will look at different equipment, lessor landscape, leasing regulations including how to differentiate between an operating lease and a finance lease. And all this will require that we first master this blog.  

We will often compare apples and oranges! And this understanding of Time Value of Money and its associated formulae will help us do this smoothly.

This is Part 1 of a 2 part series on Time Value of Money.

1. Time Value of Money

Time Value of Money simply means that money now is worth more than the same absolute value in the future.

To take a simple example – Rs. 100 today is more valuable than the same Rs. 100 in the future.

Additional Reference Material

2. Simple vs. Compound Interest

“Simply” put, when calculating compound interest, interest is applied on interest over the period of compounding. 

Where:

P = Principal
i = Annual Nominal Rate of Interest (In many places you will see “r” instead of an “i“, both mean the same)
n = Compounding periods per year
t = Tenure in years

Please see the first two sections of the attached excel which explain Simple and Compound Interest with examples.

Real World Fact: The more the number of times money is compounded, the higher is the future value. Often you will notice that banks and financial institutions lend money with monthly compounding but borrow (read “create fixed deposits”) at quarterly compounding. So they earn more and pay less!

Additional Reference Material:

[download_after_email id=”1979″]

Effective and Nominal Rates of Interest

Effective Rate of Interest is just the annual equivalent rate taking account of compounding.

The difference in both causes a lot of confusion and more so because IRR and NPV use the Nominal Rate and XIRR and XNPV use the Effective Rate. So we must know how to reconcile these two.

The two relevant formulas in MS Excel are:

  • =Effect(Nominal rate, no of compounding periods) – This will convert the Nominal Rate into the Effective Rate.
  • =Nominal(Effective Rate, no of compounding periods) – And this will do the opposite.

Additional Reference Material:

Amortization Schedule

This is one of the first things a student of finance and commerce learns.

It simply shows with each compounding period how the interest gets accumulated and how the principal gradually reduces as the installments of a loan or are paid off.

This is also the format in which you generally receive your bank and loan statements.

3. Net Present Value

Net present value is the present value of the cash flows at the required rate of return of your project compared to your initial investment.

Where:

CFt = Net Cash Flow in the period t

I have calculated a simple example in the same excel. Please refer Columns M and N. Note there is only one cash in-flow in Column P. Generally we will have more than one.

I have again calculated the NPV in Column N rows 4, 5 and 6 using the mathematical formula.

Row 4 – By taking the Annual Nominal Rate
Row 5 – By taking the Monthly Nominal Rate
Row 6 – By taking the Annual Effective Rate

I am sure you note that all give the same result. If the correct formula is used with the correct rate then this is expected. But in a complex excel, if a wrong combination is used, it can really be difficult to find the mistake!

The understanding of these subtle differences is extremely critical.

We must also understand here how MS Excel works:

    1. Every excel row is a 30 day compounding.
    2. Which also means Excel assumes a 360 day year and not 365.
    3. NPV and IRR formula use Nominal Rates with 360 day year.
    4. XIRR and XNPV use Effective Rates with 365 day year.

For a live example please download another excel from my post Operating Lease vs. Finance Lease.

Additional Reference Material:

4. Internal Rate of Return

The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.

Let us move to Column P in the same excel now.
There are only two cash flows, one “outflow” at the beginning of the period and the other “inflow” at the end. IRR will be the rate which will make the NPV of these cash flows together as ZERO. We have already calculated that in Column M and N above in the NPV section. Note that in Cell P14 we have multiplied the IRR by 12 to give the Annual Nominal Rate otherwise we get the Monthly Nominal Rate.

Few Common mistakes to avoid:

  1. Don’t leave a blank row in between – If you do so, excel assumes that row does not exist. Play around while deleting some of the Zero’s between cells P17 to P27
  2. Don’t forget to multiply by 12 to get the Annual Nominal Rate.

Real World Fact: What the banks quote to you when you got to take a loan is generally the Annual Nominal Rate.

Additional Reference Material

Conclusion

This covers the minimum basic we need to know regarding Time Value of Money. Compound Interest is the base and IRR and NPV are the two most popular formula in use.

Part 2 of this series covers XIRR and XNPV and how they relate to IRR and NPV. It also covers NPV Factor and Days 360.

Time Value Of Money – Part 2

Part 1 – Time Value of Money of this series covered a basic introduction to the concept of compounding and looked at IRR and NPV in detail.

Here in Part 2, we pick up from there and examine XIRR, XNPV and the relationships of all these formula. We also look at NPV Factor and Days360.

The excel worksheet accompanying this post is available in Part 1 of the series or can be downloaded from here again:

[download_after_email id=”1979″]

5. Extended Internal Rate of Return

where:

r = Effective Rate of Interest

The problem with IRR formula is that it can only give the Annual Nominal Rate when the cash flows are evenly spread across many months. But it does not help if the cash flows are spread unevenly on different dates.

XIRR allows us to do that. Combined with the NOMINAL() function, we get the IRR!
Please see cell R14 just above the XIRR in cell R15.

Fun Fact: One interesting observation is if you change the start date from 01 January 2021 to 01 January 2020 the XIRR will change. I first created this excel with 01 January 2020 and just could not understand why the rate was not coming to 10.47%. It took me a while to understand that the year 2020 was a leap year and had 366 days which was reducing the effective rate. What I want to stress is, that even after years of practice, you will keep on getting confused but if you understand the fundamentals well, you will eventually be able to reconcile.

Additional reference material

6. Extended Net Present Value

XNPV solves the same problem with NPV as XIRR solves for IRR.

You will notice a interesting difference though.

In NPV we do not include the first row of outflow. If there is a inflow on the same date as the outflow, it is separately added outside the NPV formula. We will see examples later. But for XNPV we include the first row also since that also includes the first reference date for the outflow from when the interest starts accruing.

7. NPV Factor and Days360

There will be many instances where we will not want to use the IRR, NPV, XIRR or the XNPV but will require to use a more generic compounding formula.

We will then resort to NPV Factor. In the formula for compound interest (P x (1+ i/n)^(n x t)) – P, the portion inside the inner bracket is also referred to as the NPV Factor.

Actually the formula we want to use here is:

(1+i/12)^(no of days / “days with the year divided in 12 periods”)

or to say in layman terms:

(1+i/12)^(“no of times compounding happens”)

a. NPV Factor using (1+i/12)^(no of days*12/365)

 

Let us have a look at Columns V, W, X and Y.

In the formula section (1+i/n) we are taking n = 12 which means we are compounding the interest 12 times in the year. So for the formula to work correctly we have to divide the year into 12 equal periods. Now since a standard year has 365 days, to get one compounding month we divide 365 by 12 and the result is 30.41667 which is a little more than 30.

So instead of writing (1+i/12)^(no of days / 30.41667) we write (1+i/12)^(no of days * 12/365)

b. NPV Factor using (1+i/12)^(no of days/360)

 

Please see cell X18, the resulting Future Value is 110,624.21

The FV increases because you are now compounding over 12.16 periods (365/30)

c. NPV Factor using (1+i/12)^12

 

This is done just to cross check and show you that for a year the compounding needs to happen 12 times. Needless to say that this works here because we have an exact one year period.

d. NPV Factor using (1+i/12)^(no of days/30) with DAYS360

 

This is an interesting one. The result is correct and it is so because we calculate the number of days using the function DAYS360() which considers a year to have 360 days. And with a 360 day year, a division by 30 gives us 12 which is the correct times we need to compound.

Fun Fact: For a very long time I handled the relationship for one of the largest global technology companies who used DAYS360 in their leasing deals.

8. Conclusion

What we have covered in the two parts of this Time Value of Money series should be good enough for understanding equipment leasing. These formulae help us understand how the time value of money works in practice. 

Even the other formulas like PMT, NPER, PV, PPMT, IPMT etc. use the same underlying logic as explained above and should be easy to understand.

I would also like to reemphasize – the inter relationships between these formulae is something we will find very important.

Additional Reference Material:

Know Your Lessor!

Lessors come in all shapes and sizes and which one is right for you depends a lot on their background, focus area, access to funds, equipment expertise etc.

We can broadly classify them as those that are regulated (Non Banking Finance Companies licensed by the Reserve Bank of India) and those that are non-regulated (the business model does not require any special licensing). 

Let us look at the different types and understand their strengths and weaknesses.

A. NBFC's - Regulated by the RBI

Leasing entities which are registered as an NBFC (Non Banking Finance Company) are regulated by the Reserve Bank of India. An NBFC registration has both advantages and disadvantages. A regulated NBFC definitely though, is a more resilient structure.

1. Original Equipment Manufacturer (OEM)

Many OEM’s across equipment categories have their own NBFC to finance the equipment they manufacture. These entities are generally the best for leasing if you have chosen to buy equipment made by them. They can almost always provide the best rates.

When leasing equipment from other OEM’s, they may have restrictions around the value and the type of equipment that they can include in your deal.

2. Independent

There are many independent NBFC’s which lease equipment. 

Compared to the non NBFC’s, an NBFC can give better interest rates but can be more conservative in taking higher Residual Value positions.

A lot depends on whether it is an NBFC focused on a particular equipment type or is a larger NBFC where equipment leasing is just one of the many business lines.

A focused NBFC is generally expected to be smaller, with limited capital raising capability (read higher interest rates), but quick in decision making and with deeper expertise in equipment life cycle.

A larger NBFC with many business lines may not have the desired focus on the equipment leasing vertical, may be conservative on Residual Values and slower in decision making but may not have any capital challenges (read lower interest rates).

B. Non Regulated - Non NBFC

1. Original Equipment Manufacturer

Some of the OEM’s do not want to get into the regulatory hassles of forming an NBFC but can still lease their equipment if they are careful about compliances. For Operating Lease they do not need any special regulatory clearance and can also carry out some Finance Leases provided they stay within the regulations.

Please check my post highlighting the differences between an Operating and a Finance Lease. 

2. Independent

Non regulated independent lessors are generally very aggressive and understand the Residual Market better than most other players. They are vendor agnostic and can be very quick. However, they may have limited access to funds and their interest rates can be high.

Lessors with Residuary Accounting model or Leveraged Lease model belong to this category. They also have the advantage of access to multiple sources of capital.

3. White Label

This is setup where the OEM does not do any leasing in its own books but has a dedicated team which identifies and negotiates lease terms with its customers and facilitates the lease with any of the lessors it has a tie up with.

This model is easy to set up and does not require any separate compliances but the OEM is dependent on the Lessor-Partners to a large extent.

4. Renter

Renters are different from a leasing company in their working style. The major differences are:

  1. The lease contract periods and the lock-in periods are much shorter.
  2. The lease contract either does not exist or is much simpler.
  3. They are completely dependent on their own funds and borrowings.
  4. They are the quickest.
  5. Their rental rates are the highest.
  6. They generally serve a customer base with a lower credit risk profile.

A Quick Snapshot

Here is a quick snapshot of the key attributes to help you decide which type of Lessor is right for you.

Conclusion

It’s obvious, that as a Lessee, if you are aware of the business model and the strengths and weaknesses of your Lessor, it can help you get the best equipment leasing deal.

Sometimes you may have unique requirements. Let’s say you are evaluating an equipment sale and lease back transaction. In that case it will be important to find a Lessor who can provide you with the correct solution.