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What Is an Equipment Lease?
An equipment lease is a type of contractual agreement. In this agreement, the lessor is the owner of a piece of equipment. That lessor allows a lessee to use their equipment for a specified period of time in exchange for making periodic payment.
After both parties agree to the terms of a lease, the lessee has the right to use the equipment and make payments in return. The lessor still retains ownership of the equipment. The lessor can cancel the equipment lease should the lessee break the agreement's terms or participate in illegal activity using the lessor's equipment.
You may secure various types of equipment with an equipment lease, spanning from high-technology devices to transportation equipment, including:
- Computers and printers
- Diagnostic tools
- Factory machines
- Heavy equipment
- Restaurant equipment
- Specialized equipment
- Telecommunication gadgets
Why Use an Equipment Lease?
Countless leasing companies exist just to lease equipment to other companies in return for set payments. Many companies do not have the budget to acquire large and expensive machines. Costs for some equipment can run into the millions, so companies decide to lease needed but expensive equipment for a specific period of time instead.
Benefits to obtaining equipment via an equipment lease include:
- Easier upgrades: If you determine you need to move to more advanced equipment so you can handle a higher work volume, you can do that without needing to sell existing equipment and shop for replacement equipment.
- Need to update equipment: Likewise, if you plan to use equipment that requires continuous updating, an equipment lease offers a good option that won't get you stuck with equipment that becomes obsolete.
- No down payment: You might need a down payment to purchase expensive equipment, but many lessors won't ask for a significant down payment with an equipment lease.
- Tax credits: Equipment leases often offer the potential for tax credits. You may be able to deduct payments as a business expense, depending on your lease.
Key Components of an Equipment Lease
Equipment lease agreements include certain terms that create the basis of a contract. Important terms in an equipment lease usually include:
- Duration of the lease: Lease duration usually depends both on the business's needs as well as the equipment's cost. A small company that often has changing needs may opt for a short duration, while leasing expensive capital equipment usually makes a longer duration cheaper and more convenient long term.
- Equipment market value: Equipment leased can be very expensive. Before signing a contract, the lessee should understand the equipment's market value so they can assess insurance costs needed to protect against damaged or lost equipment.
- Financial terms: The equipment lease should include terms that detail payment timelines, such as when periodic payments are due and last due dates for late payments.
- Renewal options: Renewal options for the lessee provide guidelines about how to renew a contract once the lease period expires. A lessee might ask for the option to acquire the equipment or make reduced periodic payments.
- Payments due to lessor: A business must consider its project cash flow to determine if it can meet the requirements of the agreement, including principal payments and periodic interests. Here is some further reading about principal payments.
- Provisions for cancellation: Any equipment lease should have guidelines for cancellation. Businesses sometimes decide to cancel an agreement during the period before it expires, either because the equipment is outdated or defective or because they found an alternative. For example, technology-based equipment may become obsolete, and a company might want to find an alternative. Leasing companies may charge a punitive penalty if penalty rates are not disclosed ahead of time.
- Tax responsibility: A lessee may need to pay taxes on the equipment, depending on the type of lease signed.
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Types of Equipment Leases
Equipment leases usually fall into one of two main categories: capital leases and operating leases.
Capital leases are typically long-term leases that cannot be canceled. The leases are used for equipment that a business wants to use for a longer period of time, sometimes even purchasing the equipment at the conclusion of the period of the lease.
A lessee is responsible for maintaining the equipment under a capital lease. The lessee must also pay for any taxes and insurance associated with the asset they lease. During the lease period, the assets and liabilities of the equipment are recorded in the lessee's balance sheet.
Companies tend to use this type of lease when they want to rent expensive capital equipment because they don't have the funds to purchase that equipment immediately.
Operating leases are typically short-term leases that can be canceled before the lease period ends. A lessor retains ownership of the asset with this type of lease. The lessor also bears the risk of obsolescence. Here is some further reading about obsolescence risk.
With prior notice, the lessee may cancel an operating equipment lease agreement at any time before the lease expires; however, canceling the lease usually comes with some type of penalty. Businesses may choose to use this kind of equipment lease if they only need the equipment for a short time period, or if they plan to replace the equipment when the lease expires.
Alternate Types of Equipment Leases
Some other types of equipment leases combine features of the two main types listed above in order to meet the specific needs of the parties signing the lease. For instance, a lessor can opt to use a hybrid lease to make use of financial and tax advantages. Another example is a leveraged lease, which allows the lessee to issue equity and debt against their equipment lease payments to finance the cost of the lease.
How Can a Small Business Secure an Equipment Lease?
A small business may not have adequate cash reserves to finance a necessary equipment lease. When that happens, small businesses may pursue a few different options to get financing assistance or lower rental costs.
Common options to secure an equipment lease include:
- Banks and firms affiliated with banks: Banks may advance credit to a business to help with a lease for expensive equipment. Banks often charge lower fees than companies not predominantly involved in financing.
This forms just a small percentage of the market for leasing. As with real estate or mortgage brokers, these types of brokers charge a fee to act as an intermediary between the lessee and lessor.
- Equipment dealers/distributors: Dealers and distributors frequently own subsidiary companies that also provide services for leasing equipment. Dealers and distributors can also help arrange financing with an independent leasing company.
An increasing number of leasing companies have come into existence to meet the growing demand for leased equipment. Different leasing firms have different services, terms, and product quality, so a small business owner should generally approach a few companies to evaluate the terms and equipment lease agreement each one offers. Small business owners may do a background check or speak with past and current customers. There are two main types of leasing companies:
- Independent leasing companies: The size and scope of independent leasing companies vary a lot, so business owners can find various financing options.
- Captive leasing companies: These are subsidiaries of equipment manufacturers or possibly other firms.
Working with an experienced lawyer when creating an equipment lease can help ensure all necessary terms are in place to get your business what it needs.
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