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.
IT
Spending on the Rise
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.
Lease
Rates
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.
Residual
Values
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
