In this article:
|Lessee as Loser|
“We’re a highly leveraged company and our cash is going to certain other key investments that were more pressing than software.” says John Manning, controller of Tecstar in City of Industry, Calif.
Tecstar’s situation isn’t unique. The company, a manufacturer of electro-mechanical equipment for the aviation industry, needed a new ERP package. At the same time, it wanted to conserve its working capital. The solution was to choose an emerging option in IT purchasing: software leasing. With financing provided by International Software Finance (ISF) (http://www.isfnet.com), Tecstar ultimately selected, and leased, the Made2Manage resource management package, prices at $4 per user, from Made2Manage Systems (http://www.made2manage.com).
Illustration: James Yang
Software leasing is a means of financing software. Essentially, it is just a loan, but the agreement is written as though the companies involved were arranging the long-term lease of a piece of hardware. The advantage for the buyers is that they can get their software more quickly, Manning explains. They don’t have to wait until their budgets catch up with their needs. In some cases, they can get better prices than they could by simply taking out a loan.
“Sure, we’re paying interest,” Manning notes. “But it is below prime. You couldn’t borrow money at this rate.” Rates will vary from vendor to vendor, but it isn’t unusual to find a leasing finance company charging as low as 7.5%. “It’s quite simple, really,” he says. “[Leasing] is definitely an alternative to consider for anyone who doesn’t have a lot of cash lying around,” he concludes.
Paying the rent
Software leasing, in some ways, “is a misnomer,” says Doug Wetzel, CEO and founder of ISF in Wilton, Conn. “It is really the financing of the license fees and services associated with a particular piece of software.” It works like this: the buyer and seller agree on the software package to be exchanged. If the buyer wants to finance the purchase price, the two then go to a leasing finance company, which may be part of the seller’s own operation or an independent company. Or they will go to a broker who (in theory at least) will act in their interests and negotiate with a leasing company. Once the deal is approved, the leasing company hands the software vendor a check for the full purchase price of the software.
“From the vendor’s point of view, it is really, really neat,” notes Michael Regentz, president of the Lotus Notes distributor Winchester Business Systems (http://www.wbsnet.com), “because what would otherwise be a 90-day invoice is paid off immediately.” In some cases, though not always, that can translate into discounts for the buyers.
Other advantages include preservation of working capital. Quite simply, without a down payment, costs are spread out over a multiple-year lease, enabling customers to keep more of their working capital liquid and up-front. This is particularly useful, notes Regentz, if a company is cash starved at the moment. “You want to leverage everything you can,” he says.
Software leasing is still relatively rare, though. “Less than 1% of software deals are lease,” notes Jim Geuisman, president of the software marketing consultant Market Share Inc. “Though that’s still a large amount of money.” Specifically, he estimates that $100 million worth of software is acquired via leases each year–a drop in the bucket compared to the some $40 billion of software that’s sold each year.
Why so low? Partly, says Geuisman, because so few people have known they can do it, or that it has any advantages over financing or outright purchase. Then, too, there is the fact that many funding sources–banks, credit companies, and so on–have been reluctant to structure loans for software as leases because used software has no resale value.
“Most users don’t know you can lease software,” adds Mark Bazrod, president of LPI Software Funding Group, a software lease finance company (http://www.lpilease.com). “People think you can’t because banks and other lending sources have traditionally been leery of software. They’ve said they’ll lease hardware, but not software.” After all, software isn’t a tangible asset.
But a number of the larger software vendors already have leasing programs of one sort or another. Sybase, for example, led the way in the DBMS market when it started leasing programs in the 1980s. Before that, IBM had already invented a number of lease-like financing arrangements for its mainframe operating systems, and now the company has an extensive leasing operation. Oracle, meanwhile, has taken a high profile position at the Equipment Leasing Association and similar organizations.
Leasing programs vary enormously. Some vendors, like IBM, have their own internal “captive” leasing groups, maintain their own funding sources, provide their own customers with lease options, and, customarily but not always, allow their VARs to remarket leasing finance–in effect, turning the VAR into a lease broker. In other settings, the vendor does not have an internal lease operation and instead will act as a matchmaker between the potential customer and an independent leasing company.
Who should look into leasing?
Even for a company with large cash reserves, leasing can still make sense. It allows a business greater control over the timing of software acquisitions. “For large companies, leasing is budget driven,” explains LPI’s Bazrod. “What happens is that [an IT executive] needs a piece of software now, and it’s July.” The company and his department have the cash, but the IT person is (as always) at the mercy of accounting, and a large purchase isn’t in the budget for a year or more. “So what [the IT manager] does is lease, and that extends the payment over a three-year period.”
Some IT professionals and some vendors have, in fact, chosen to go on a completely lease-based model–that is, the software in question never changes hands. It remains the property of the vendor and is, instead, rented for as long as the two companies care to work together.
One vendor using such a model is Wellesley, Mass.-based ITS Associates (http://www.itsww.com), which offers a multicurrency management package for institutional investment and financial services companies. “In effect, our clients expect us to be the engineering component of their trading systems,” says company president John G. Fitzgerald. To this end, the company rents its software, rather than leasing or selling it. ITS’s clients never take title of the package. Instead, it remains the property of the vendor, who also provides everything from service to upgrades. If the lessees should ever become dissatisfied with either the product or its support, they can end the arrangement, similar to a tenant at will real estate rental. “We don’t lease our software, and we don’t lease our services,” says Fitzgerald. “In a way, we lease our company.”
Independence International Associates, an investment management firm in Boston, has chosen to lease Fitzgerald’s company. Says Norman Meltz, senior vice president, “We use PMIS [the ITS product] to keep multicurrency portfolio records. There aren’t many other choices when you are dealing with multicurrencies,” he notes.
Independence International Associates is running the ITS product on a Digital Alpha system, which is outsourced to ITS. Meltz says that leasing in this fashion gives him a number of advantages–not the least of them being the ability to pressure ITS. If he’d merely bought the software, or arranged for its financing through a third party, then the software vendor would be largely out of the picture except for whatever service and support Meltz could purchase or negotiate at the time of purchase. However, with ITS’s revenue dependent on Meltz remaining a happy customer, he can push for more of what he wants.
While leasing is a useful tool for the IT shop, it can also provide some unique advantages when it comes to bookkeeping. “Leasing lets you take the software off your books,” explains Gene Glenn, manager of engineering services for Atlas Copco Wagner, an OEM suppler of mining equipment in Portland, Ore.
Glenn’s organization is a mostly Intel shop with some AS/400s. On these systems, Glenn runs software ranging from PC personal productivity tools to CAD/CAM to accounting and financial packages. He purchases most of the less expensive PC tools outright. “NT’s so cheap already,” he notes, “that it doesn’t make any sense to finance it.” For big ticket items, however, Glenn chooses to lease–notably his financial and CAD/CAM software.
Here’s the advantage: There are two kinds of software leases–finance leases and operating leases. With a finance lease, a company is simply renting to own. At the end of the lease period, the customer has paid in full for the leased item, and the leasing company either hands it to the customer outright, or else arranges a transfer for some token payment, usually one dollar. As such, Wall Street (and the IRS) treat this as a simple time-payment arrangement.
With an operating lease, the leased item still contains some of the purchase value at the end of the lease. For example, say an item costs the leasing company $100,000. The user pays $90,000 over the course of the lease, and returns the property to the lessor. The leasing company then seeks to recover its remaining $10,000 by some other means–perhaps selling the item on the used equipment market.
Of course, with software, there is no used equipment market. But at that point, the leasing company may arrange to sell the software to the user for a more than token fee. That is, it will recover the total remaining value of the software from the user.
This means that you can structure a software purchase as if it were an operating lease. That means, in turn, your lease payments are regarded as operating expenses–and can be deducted as such. “If you structure it as an operating lease, you don’t have to put it on your balance sheet,” explains Gary LoMonaco, senior vice president and manager of the Healthcare, Information, and Technology group at Heller Financial, which is headquartered in Chicago and provides (among many other things) financing for manufacturers and software developers to offer with their products. “You just put it down in expenses. And it helps minimize your tax position.”
Renting the future
Leasing is not without drawbacks. For instance, unscrupulous lenders pose a danger to unsuspecting companies (see sidebar, “Lessee as loser!”). But it does seem to be a viable alternative at present.
What will the situation be for software leasing in the future? Some observers, such as David Levine, president of Web-oriented software developer HuskyLabs of Baltimore, envision an age when large corporations will rent or lease entire software infrastructures and then customize them accordingly. “Vendors won’t really be software companies anymore,” he suggests. “Rather, they’ll have technology that they’ll make available as part of their customers’ underlying distributed commercial infrastructure.”
That vision still remains some years away. Leasing, though, is very much a tool that IT can use today. “It’s not the future,” says Levine. “It’s now.” //
Lessee as loser?
There are real advantages to software leasing, but there are also some dangers. You should have your eyes wide open when entering into a lease agreement
First, there’s the issue of taxation and accounting. Richard M. Contino, in his book Handbook of Equipment Leasing: A Deal Maker’s Guide, (Amacom, 1997) argues that it can be almost impossible for a lessee to gain significant tax benefits from leasing. In which case, you should consider leasing software only for its direct business value rather than as a bookkeeping or tax avoidance strategy.
Second, leasing agreements–while not nearly as complex as loan documents–are still anything but simple. You can get yourself into trouble with them if you don’t read the fine print. “If the end user doesn’t pay close attention to exactly what they are contracting for, it can be a problem,” warns Michael Regentz, president of Winchester Business Systems.
Third, and perhaps most dangerous to IT, is that not everyone in leasing is on the side of the angels. Jennifer Gordan, a Y2K analyst at the market research firm Datapro, is a fan of software leasing in general. “Leasing can be an interesting outgrowth to the Y2K problem,” she notes. “You have the option of not sinking a lot of cash into your Y2K process by leasing.” However, she is very cautious regarding whom you should lease from. “There are a lot of people out there who are just trying to make money,” she warns.