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:

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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:

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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.

Operating Lease vs. Finance Lease

Equipment Leasing is essentially Renting. A Lessor, who owns the equipment, gives it to the Lessee, who uses the equipment for a defined period, in return for periodic payments.

Renting, in common parlance, is for a shorter term of few months where there may or may not be a lock-in period whereas equipment leasing is generally longer, between 2 to 5 years, and with a lock in period.

If the Lessor provides additional support and services the lease is classified as a Wet Lease, otherwise it’s a Dry Lease.

Several factors determine whether a lease is an Operating Lease or its a Finance Lease. Let us explore those factors in this post.

Simple Process Flow

Definitions

The Classical definitions as per InD AS 116 are as follows:

A lease is classified as a Finance Lease (FL) if it transfers substantially all the risks and rewards incidental to ownership of an underlying asset.

A lease is classified as an Operating Lease (OL) if it does not transfer substantially all the risks and rewards incidental to ownership of an underlying asset.

Ind AS 116 also goes on to add:
“Whether a lease is Finance Lease or Operating Lease depends on the substance of the transactions rather than the form of the contract.”

I just cannot stress enough how important the above statement is. How a particular transaction is classified, has many ramifications.

This will be a recurring discussion as we navigate equipment leasing!

Distinguishing Between OL And FL

Accounting Standards have given us a few indicators regarding how to distinguish between the two. There are 5 major indicators to suggest that a transaction is a Finance Lease.

1. Full Payout Test

If the present value of the minimum lease payments almost recover the fair value of the equipment, the transaction is a Finance Lease.

This is the first and the most important test which everyone resorts to. And actually most of the organizations just classify the lease as an Operating Lease or a Finance Lease based on this one test.

Let us understand the key terms here in a little more detail:

  1. Present Value – For arriving at the present value, the interest rate used for the discounting is either the interest rate implicit in the lease, and if not readily determinable, it can be the Lessee’s incremental borrowing rate. The Implicit Rate of Interest is – “The rate of interest that causes the present value of (a) the lease payments and (b) the unguaranteed residual value to equal the sum of (i) the fair value of the underlying asset and (ii) any initial direct costs of the lessor.”
  2. Minimum Lease Payments – They include all fixed payments but exclude any Security Deposit or Processing Fee. In-substance fixed lease payments are payments that may, in form, contain variability but that, in substance, are unavoidable.
  3. “Almost recover” – How is this ascertained? If the present value is less than 90% of the fair value of the equipment, the transaction can be classified as an Operating Lease. Now this figure of 90% is mentioned in the US GAAP but we don’t have any such number in India. We just follow the global norm.

For the Lessor the discounting rate can only be the implicit rate in the lease!

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2. Transfer Of Title Test

An equipment lease will be classified as a Finance Lease if at the inception it is known that the Lessee will get the ownership of the underlying equipment at the end of the lease term.

3. Bargain Purchase Option Test

An equipment lease will be classified as a Finance Lease if the lease provides an option to the Lessee to buy the equipment at the end of the tenure at a bargain purchase price which is expected to be substantially lower than the fair market price at that time and which the Lessee is reasonably certain to exercise.

4. Lease Term Test

An equipment lease will be classified as a Finance Lease if the lease term is for the major part of the economic life of an equipment. The threshold here is generally taken as 75% but it is not explicitly defined anywhere.

5. Equipment Is Specialized Test

An equipment lease will be classified as a Finance Lease if the equipment is of specialized nature which only the Lessee can use without major modifications.

Ind AS 116 goes on to add other situations where the lease can be classified as a Finance Lease.

  1. If any cancellation losses are borne by the Lessee.
  2. If changes in fair value of residual asset are borne by the Lessee
  3. If the Lessee can continue the lease for a secondary period at a substantially lower rent.

And lastly it goes on to say that all of the above may not always be conclusive and there may be other features which may help in deciding if the lease transfers substantially all the risks and rewards.

From the above it is clear that the Accounting Standards have gone to great lengths to help us understand how a lease needs to be qualified.

Why Is This Distinction Important

The question we must ask ourselves is why is this distinction important.
It is important because certain accounting and regulatory aspects depend on this classification.

Accounting – Operating Lease and Finance Lease are accounted for in different manner in the books of accounts. It can have a great impact, especially for equipment which are under lower depreciation rates as per the Income Tax Act.

An interesting development is the concept of Synthetic Leases in India. These are Finance Lease transactions structured and shown as an Operating Lease. We will cover Synthetic Lease in another post.

Ind AS 116 has tried to address this issue by proposing the same accounting standard for both Operating and Finance Lease for the Lessee. But it only succeeds partially.

NBFC Classification – Anyone can give equipment on Operating Lease. There are no restrictions. But if a Lessor is giving equipment on Finance Lease, beyond a certain threshold, they have to look at the RBI Act which says that where the financial assets of the company are more than 50% of the total assets and the financial income generated by the company is more than 50% of the its total income, then the company is required to register itself as an NBFC.

Whether a Lessor decides to operate as an NBFC or not, has a significant impact on its competitiveness. Read more about it on my post Know Your Lessor.

Conclusion

Equipment Leasing can become a complex transaction. The Accounting Standards have gone to great lengths to explain and cover everything.

But there are still many grey areas in the Operating Lease vs. Finance Lease debate. This has greatly influenced how the equipment leasing industry has developed. Understanding the basic classification criteria is our first step as we navigate through the equipment leasing landscape.

Equipment Types

Equipment leasing can be an efficient way to acquire equipment provided you know what equipment to lease and on what terms. First and foremost, that requires a deep understanding of the equipment itself.

Let us try and understand what makes different types of equipment good or bad for leasing.

Various Equipment Classes

In India Equipment Leasing is slowly gaining traction and there are certain type of equipment which you can acquire on lease. Some such equipment are:

– Aircraft
– Automobile
– Commercial Vehicles
– Construction Equipment
– Technology Equipment
– Healthcare Equipment
– Plant & Machinery
– Furniture & Fitout
– Renewable Energy

Worldwide however it is possible to lease the following type of equipment also:

– Farm / Harvesting
– Fitness Equipment
– Cleaning Equipment
– Aesthetic Devices
– Food Processing
– Surveying & Testing
– Industrial Tools

A good question to start with is what type of equipment are good candidate for leasing? There must be some attributes which can help both lessors and lessees decide for which type of equipment, leasing is a good strategy.

In the below table, I have tried to map several attributes of different equipment.

A rough legend for the above table:

But these attributes really do not seem to help us decide on what equipment should we lease!

Residual Value

Equipment Leasing is all about one thing – Residual Value.

Generally speaking, any equipment which has a good residual value at the end of term and which is easily movable should be leasable.

For such equipment, leasing is a win-win acquisition or financing option. The Lessee gets to use the equipment for a period of its choice, at a lower cost, conserving its cash flows and with great administrative and operational flexibility. After the lease term is over, the equipment then goes in the secondary market and is used by other companies who derive benefits out of its residual value.

Thus, equipment leasing is a great way to share equipment and derive maximum value out of it.

Is Residual Value A Good Indicator For A Lease?

At first glance it seems obvious that true operating lease is possible where both the Lessor and the Lessee understand and agree that the equipment has Residual Value.

But is it so? Let us take see examples.

Construction Equipment – It fits the bill. Construction Equipment definitely has a good residual value if we consider a true operating lease for a 3 to 5 year tenure. They are also easily moveable. But if you analyze the industry and specifically the NBFC’s who are into financing of Construction Equipment, you will hardly see any of them offering true operating lease for a tenure ranging from 3 to 5 years.

Shriram Transport Finance, Mahindra Finance, HDB Financial Services, Sundaram Finance, Tata Capital etc. are all mostly offering a loan to acquire Construction Equipment.

Commercial Vehicles and Farm Equipment – We take the same line of thought as for Construction Equipment and again you will observe that the larger NBFC’s hardly offer a true operating lease for these equipment.

The same once again applies to Plant & Machinery and Healthcare Equipment though these are relatively difficult to move.

Even though most of the equipment have good residual value, these do not seem to be popular with leasing companies. Why is this so?

The Real Criteria For True Operating Lease

Leasable equipment is that equipment for which the Lessor perceives a higher Residual Value than the Lessee.

Let us look at another table below:

Let us examine some more equipment categories here.

Automobiles – Automobiles are one of the most leased category of equipment worldwide. They are a fast depreciating asset.

Technology & Office – Again a fast depreciating equipment class and an essential tool for any industry now. Automobiles and Technology Equipment both experience very rapid technological change and the Lessees tend to replace them quickly. The Lessors of these equipment have a deep understanding of these equipment and access to a well developed secondary market.

Commercial Vehicle, Construction Equipment, Plant & Machinery, Healthcare Equipment, Farm Equipment are all classes for which the Lessee associate a much higher Residual Value till the very end of their economic life.

And since the Lessee has a higher perceived Residual Value as compared to the Lessor there is no true Operating Lease.

Airplane and Solar / Wind Power Generation Equipment – Both are very long lasting equipment with the key difference that Airplanes are of course made for movement whereas it is very difficult to move Solar / Wind equipment once installation is done.

Furniture & Fitout – A very interesting equipment class. Very difficult to move but with much shortened economic life in today’s times.

The below graphic is a simpler way to visualize the Residual Value difference.

Conclusion

A clear understanding of the inherent attributes of the equipment and more importantly, how its Residual Value is differently perceived by the Lessor and the Lessee are important to create the correct leasing product which benefits both the Lessor and the Lessee.

Fractional Equipment Leasing – An Analysis

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Many people have reached out to me over the last few weeks and have asked me about Fractional Equipment Leasing. Fractional investing seems to be catching on in many asset classes including Real Estate and Equipment of all kind. 

Personally, I believe, fractional equipment leasing in the current model is not advisable for investors. 

The Current Fractional Equipment Leasing Opportunity.

Let me explain the basic construct first.

There is an anchor Fintech who, on one hand, will aggregate individuals promising a pre-tax return of 20% plus. This anchor Fintech will then use the money raised from the investors to lease equipment to many startups in the rental space who rent anything from laptops, bikes, electric vehicles, furniture and other assets to individuals and corporates.

The legal structure will consist of creating a LLP (Limited Liability Partnership) of the investing individuals as partners and then leasing the assets through this LLP to the rental startups (Lessee).

Sample Analysis Of A Term Sheet

I took a term sheet of one of the deals on offer. Here is what I understood. For an initial investment of INR 100,000/-

An investor will get around Rs. 1,21,581 post tax on an investment of Rs. 1,00,000/- over a 36 month lease term. Out of which, Rs. 21,581/- is realized in the 36th month on liquidation of the Residual Value at the agreed valuation. Which means the upside is only Rs. 21,581/- and is realized at the end of the term whereas the potential downside is loss of a significant portion of the investment if the startup fails anytime during the term.

Also the investors receive their money back on a monthly basis and they have to deposit that money again every month to keep earning interest. This effectively lowers the interest earned on the investment.

On the other hand, the effective rate which the Lessor is paying is way lower since the entire lease rental they pay is tax deductible! 

Comparative risks

Let’s analyze the risks associated with Fractional Equipment Leasing in greater detail. 

I have also tried to look at similar aspects of Venture Debt and Fractional Real Estate investments for a little better understanding however I must admit I am no expert on these.

1. General

a. Repayment structure

Your entire upside is tied up in the Residual value. This means that your entire upside is realizable only at the end of the term.

  • Venture Debt: Payment is equated or even if structured, it has other safeguards built in.
  • Fractional Real Estate: Payment is equated for only the interest portion in the form of rental.

b. Risk perception

The banking and investment world places these startups in high risk category.

As a leasing professional I have had the opportunity to lease equipment worth millions of dollar’s to many startups in India  and I can tell you that all such leases were initially backed by a 70% to 100% Bank Guarantee or some other solid collateral. All funders demand similar collateral.

Please look at my post How Startups Benefit From Equipment Leasing to understand more.

  • Venture Debt: They have specialist teams who understand the risk. They have the expertise to assess and monitor the same. They negotiate for additional equity, warrants and other instruments to gain from the upside if the startup succeeds.
  • Fractional Real Estate: They have specialist teams who understand the risk.

c. Financial Credit Rating

Credit rating institutions like ICRA, CARE, FITCH provide financial ratings which reflect the financial health of organizations. I am reasonably sure that none of the Lessee to whom these Fractional Equipment Leasing companies are leasing equipment have any credit rating. The anchor Fintech is also unlikely to have an experienced team to assess and monitor the risks.

  • Venture Debt: They have specialist teams who understand the risk.
  • Fractional Real Estate Not Applicable.

d. Exit options during the term

If you want to liquidate your investment during the lease, there is only one option which is to approach other investors who may agree to buy your share. But if even one Lessee defaults, you can expect a scenario where all investors across other investments may rush to liquidate with no one willing to buy.

Closest example is maybe the recent plunge in bond prices of a large finance and leasing institutions which enjoyed a strong AA credit rating till a few years back.

  • Venture Debt: Depends on deal structure.
  • Fractional Real Estate: Similar risk but with underlying real estate the likelihood of everyone wanting to liquidate together will be remote.

e. Other covenants

There does not seem to be any collateral except the underlying asset. There is a small security deposit which is not enough to even cover the Residual Value.

  • Venture Debt: Equity shares / warrants or other guarantees.
  • Fractional Real Estate: Underlying real estate itself is a big safety net.

f. Skin in the game

When lending money, a bank will always insists that the borrower puts in his own equity also which is a good percentage of total funding required. If we look at this from the Lessee’s perspective, they are putting a small security deposit.

But what we should not miss is that the anchor Fractional Equipment Leasing promoters are practically putting in nothing. 

If anything goes wrong, they are simply not liable at all. They hardly have any skin in the game!

  • Venture Debt: They ensure borrower pitches in with good collateral.
  • Fractional Real Estate: No skin in the game by the Fintech.

g. Source of funds

The investors in a Fractional Equipment Leasing company are generally salary holders or small businessmen. I do not expect them to have a very high risk taking capacity. 

I think they will be better off doing a bit of research and investing money in stocks of few blue chip companies which can give them similar 15-18% returns over next few years. Its not difficult to narrow down on such opportunities with tremendous amount of analysis available on the internet. 

  • Venture Debt: Large PE Funds, Family Offices, HNI’s. Essentially sources which have much higher risk taking capacity.
  • Fractional Real Estate: HNI’s and above.

2. Equipment

a. Underlying Equipment and Secondary Market

The only collateral the investors have is the underlying assets. All these assets are generally highly depreciating meaning the value falls rapidly over time. Some like charging stations etc. are either too niche, custom made or innovative and may not have any resale market at all. The anchor Fintech may not have any expertise on managing these equipment or access to a ready market to quickly liquidate them at a good price. In case of a default by the Lessee, these factors will play a major role in how much money you recover.

  • Venture Debt: Depends on the deal structure.
  • Fractional Real Estate: Real Estate which is a very strong collateral.

b. Ease of repossession in case of default

Repossession is nearly impossible as the equipment are low in value, more in quantity and are further distributed over a large number of users spread across a wide geographical area. The anchor Fintech also may not have any requisite legal and logistical expertise to deal with these challenges. Again, in case of a default, it is unlikely that anything will be recovered at all. 

Please see the Talwalkar case study below.

  • Venture Debt: Not Applicable.
  • Fractional Real Estate: Comparatively much easier as the underlying real estate is owned by the investors and the regulations are better.

c. Appreciation potential of underlying assets

As mentioned earlier these are generally highly depreciating equipment which rapidly lose value over time.

  • Venture Debt: Not Applicable.
  • Fractional Real Estate: Real estate is a comparatively much safer investment.

3. Legal

a. Legal Structure

The leasing structure is actually a finance lease in substance but projected as an operating lease. 

With more than a decade spent in equipment leasing which includes interacting with the biggest of audit and law firms and finest of consultants on all matters related to equipment leasing, I can say with certainty, this structure is a finance lease.

There are regulatory requirements for doing a Finance Lease transaction and non compliance has serious implications.

The liability is on the investors who are partners in the LLP. I don’t think a retail investor is either aware or ready to get into these troubles.

  • Venture Debt: The structure is legal.
  • Fractional Real Estate: The structure is legal.

b. Compliances with GST, Income Tax and other regulations

Any business today has stringent compliance requirements which include having several licenses, periodic GST returns, Income Tax returns etc. Violations are strictly monitored and are punishable with penalty and in some cases imprisonment. As a partner in a LLP the investor is directly responsible even though the investor may not be a designated partner. 

  • Venture Debt: Compliances are part of regular business.
  • Fractional Real Estate: Compliances are lesser and easier.

c. Operational Creditor

The lease is being booked as an operating lease in the books of your LLP, in case the Lessee defaults, the courts will treat your LLP as an operational creditor.

Under current Indian IBC and NCLT laws, this brings its own challenges as Financial and Operational Creditors are treated differently.

  • Venture Debt: Depends on deal structure. They are also likely to structure the deal to ensure that in case of a default they get preference for any repayments.
  • Fractional Real Estate: Operational creditor but only the rental is at stake and not very difficult to take possession of the underlying real estate.

d. Lease Agreement

The operating lease agreement I have seen is not at all in line with similar agreements in the equipment leasing industry. It is full of loopholes which puts the Lessor (the LLP and the investors) in a very weak position.

This also raises serious questions on the expertise of the anchor Fintech in other areas including credit assessment, LLP formation and management, operational setup etc.

The Talwalkar's Case Study

I think a very public and appropriate case to recall here will be that of Talwalkar’s. 

This famous fitness chain enjoyed a very high credit rating of AA till few years back. One of the lenders to Talwalkar’s was Tata Capital who leased fitness equipment to them in 2018 valued around INR 36 crores. Talwalkar’s however defaulted on the lease payments in 2019 after which Tata Capital swiftly approached the courts to repossess and sell the leased fitness equipment.

We should be aware of the following points and compare with the current Fractional Lease offerings.  

  1. Talwalkar’s enjoyed a very high credit rating and could avail of huge direct loans from banks unlike the Lessees here.
  2. The lessor, in this case Tata Capital, had deep expertise to analyze such deals unlike an anchor Fintech offering Fractional Equipment Leasing.
  3. The equipment was spread only over the fitness studios of Talwalkar’s unlike in many cases here with the equipment being more widely distributed across individual renters of these Lessees.
  4. Many of these fitness studios were taken on rent where I believe the landlords would have denied permission to remove anything till their pending rent was cleared.
  5. It would be near impossible to sell such used equipment and in such numbers. Even storing them after repossessing would entail a cost.

There are many other such instances of large and well established Lessors being unable to either repossess or sell off the equipment in case of a default by the Lessee. 

Startup Risk

The Lessees here are some of the most successful and exciting startups and are run by the best our country has to offer. They are constantly innovating and creating new business models. Most are already very successful and will probably give 20x to 100x returns to their investors.

The optimist in me says these startups are already successful, already have a comfortable fund raise and a proven business model and will of course not default. But when I look into the mirror, the conservative finance person I see, has different views.

A startup is a startup and we need to understand that a Private Equity player or a Venture Debt company understand the huge risks they are taking and therefore ensure that they structure the deal in a way that they also share the profits and valuations if the startup succeeds.

The Fractional Equipment Leasing investors are taking the same risks but are not getting similar benefits.

Conclusion

The financial and credit risk associated with the Fractional Equipment Leasing opportunity seem to be very high. On careful analysis it seems the returns are just marginally higher than a investment grade AAA / AA rated bond but the risks are way higher. It is important that the investors understand these risks.

The bigger concerns however, are the compliance and the legal risks.

As an ordinary individual you may not have the patience, the resources and the experience to handle these issues if things go wrong.