In 2003, venture capitalists and investors dispensed over $18 billion to promising young U.S. companies, according to VentureOne and Ernst & Young Quarterly Venture Capital Report. Less documented and reported is venture leasing's activity and volume. This form of equipment financing contributes greatly to the growth of U.S. start-ups. Yearly, specialty leasing companies pour hundreds of millions of dollars into start-ups, permitting savvy entrepreneurs to achieve the biggest 'bang for their buck' in financing growth. What is venture leasing and how do sophisticated entrepreneurs maximize enterprise value with this type of financing? Why is venture leasing a cheaper and smarter way to finance needed equipment when compared to venture capital? For answers, one must look closely at this relatively new and expanding form of equipment financing specifically designed for rapidly growing venture capital-backed start-ups. The term venture leasing describes the leasing of equipment to pre-profit, start-ups funded by venture capital investors. These companies usually have negative cash flow and rely on additional equity rounds to fulfill their business plans. Venture leasing allows growing start-ups to acquire needed operating equipment while conserving expensive venture development capital. Equipment financed by venture leases usually includes essentials such as computers, laboratory equipment, test equipment, furniture, manufacturing and production equipment, and other equipment to automate the office.
Commercial leases can be described in four categories: gross, modified gross, triple net, and absolute net. A gross lease does not require the tenant to reimburse the landlord for any of the expenses that the landlord might incur in operation of the premises. Under a gross lease, the tenant pays base rent and the landlord absorbs all costs for common area maintenance ("CAM"), real property taxes, landlord's insurance, and other charges associated with the operation and maintenance of the property. A modified gross lease typically requires the tenant to reimburse landlord for "pass through" costs over a stated expense stop or base year. For example, the tenant may be required to reimburse landlord for all CAM over $4.00 per square foot, or alternatively, the tenant may be required to reimburse landlord for all CAM in excess of base year 2005. In most situations, the commercial tenant will be asked to sign a "triple net" lease, which requires the tenant to reimburse landlord for CAM, real estate taxes, and landlord's insurance. The "pass through" costs included in a "triple net" lease can vary, and can include additional items other than just CAM, taxes, and insurance. Thus, a prospective tenant will be well served to review a proposed lease with counsel to ensure that tenant understands the nature and type of pass through costs it will be expected to absorb under the lease. Also, in certain circumstances, a landlord may utilize a "net" or "absolute net" lease, which requires the tenant to absorb ALL costs of maintenance and operation of the property, including capital expenditures and major repairs. Typically, an absolute net lease is utilized where the tenant is the sole and 100% occupant of the building - for example, a restaurant or an office building occupied by one tenant.
Generally, a major round of equity capital raised from credible investors or venture capitalists makes venture leasing viable for the early stage company. Lessors structure most transactions as master lease lines, permitting the lessee to draw down on the lines as needed throughout the year. Lease lines usually range in size from as little as $ 200,000 to well over $ 5,000,000, depending on the lessee's need and credit strength. Terms are typically between twenty four to forty eight months, payable monthly in advance. The lessee's credit strength, the quality and useful life of the underlying equipment, and the lessor's anticipated ability to re-market the equipment during the lease often dictate the initial lease term. Although no lessor enters a leasing arrangement expecting to re-market the equipment prior to lease expiry, should the lessee's business fail, the lessor must pursue this avenue of recovery to salvage the transaction. Most venture leases give lessees flexible end-of-lease options. These options generally include the ability to buy the equipment, to renew the lease at fair market value or to return the equipment to the lessor. Many lessors limit the fair market value, which also benefits the lessee. Most leases require the lessee to shoulder the important equipment obligations such as maintenance, insurance and paying required equipment taxes.
Leasing companies do frequently (usually quarterly) send equipment vendors a list of their lease portfolios with that leasing company in hopes the vendor will upgrade the customer's equipment and extend the customer's leasing relationship with the leasing company. If the equipment vendor is paying attention to their customer base, they will notify you of the approaching lease expiration (and try to upgrade your equipment). If an equipment lease renews, this makes it very difficult (read expensive) for a competing equipment vendor to economically upgrade the equipment before the expiration of the renewal term. This strategy was constructed intentionally to give the incumbent equipment vendor (and leasing company) a financial advantage in upgrading the equipment before the expiration of the renewal lease term. A lease renewal limits your options, which is never good for you. Only the incumbent equipment vendor who agrees to use the same leasing company can upgrade equipment on a renewed lease without penalty. Any other combination of equipment vendor and/or leasing company will have to pay the remaining payments of the renewed lease term (usually 12 months).
In addition to base rent, the tenant customarily will be asked to pay "additional rent", which constitutes pass-throughs (CAM, taxes, and insurance) and any other charges that landlord might deem to include in your lease. CAM, pass-throughs, and other charges reimbursable under the lease are the primary source of tension in the modern commercial landlord/tenant relationship. The tenant wants the certainty of knowing what his rent and charges are going to be on a monthly and yearly basis. The landlord wants protection from unexpected rises in taxes or the costs of providing services to the property. The key: read your lease and KNOW every charge you will be faced with once your tenancy begins. In the retail context, in addition to base and additional rent, the prospective tenant is often asked to pay landlord a percentage of tenant's gross sales on a monthly or quarterly basis. The landlord usually justifies these charges as a necessary component of compensating landlord for providing a vibrant mall or strip center for tenant to conduct business. In most commercially viable retail property, payment of percentage rent is unavoidable. However, the "breakpoint" and amount of percentage rent should be negotiated. Another area of significance to the commercial tenant is the services that will be provided by landlord and reimbursement of landlord for those services. Similarly, tenant should understand those services that landlord will not provide, because tenant will be responsible for those services as an out of pocket expense. Further, unless the lease is gross, the landlord should identify the components that constitute the costs of operating the "common area" for which it seeks reimbursement through tenant's monthly CAM charges. The definition of CAM varies from lease to lease based on landlord preference, the type of property, and the negotiations of the parties. If a gross lease is not available, the tenant should negotiate the items to be included in CAM, the items that will not be included in CAM, and an annual cap or limit on expenses that landlord may attempt to pass through to tenant.
Once the start-up finds a capable venture lessor, negotiating a fair and competitive lease is the next order of business. A number of factors determine venture lease pricing and terms. Important factors include: 1) the perceived credit strength of the lessee, 2) equipment quality, 3) market rates, and 4) competitive factors within the venture leasing market. Since the lease can be structured with several options, many of which influence the ultimate lease cost, start-ups should compare competing lease proposals. Lessors typically structured leases to yield 14% - 20%. By developing end-of-lease options to better accommodate lessees' needs, lessors can shift some of this pricing to the lease's back end in the form of a fair market value or fixed purchase or renewal option. It is not uncommon to see a three year lease structured to yield 9% - 11% annually during the initial lease term. Thereafter, the lessee can choose to return the equipment, purchase the equipment for 10% - 15% of equipment cost or to renew the lease for an additional year. If the lease is renewed, the lessor recovers an additional 10% - 15% of equipment cost. If the equipment is returned to the lessor, the start-up reduces its cost and limits the amount paid under the lease. The lessor will then remarket the equipment to achieve its 14% - 20% yield target. Another way that leasing companies can justify slashing lease payments is to incorporate warrants to purchase stock into the transaction. Warrants give the lessor the right to buy an agreed upon quantity of ownership shares at a share price predetermined by the parties. Under a venture lease with warrant pricing, the lessor typically prices that lease several percentage points below a similar lease without warrants. The number of warrants the start-up proffers is arrived at by dividing a portion of the lease line - usually 3% to 15% of the line - by the warrant strike price. The strike price is typically the share price of the most recently completed equity round. Including a warrant option often encourages venture lessors to enter transactions with companies that are very early in development or where the equipment to be leased is of questionable quality or re-marketability.
Commercial leases can be described in four categories: gross, modified gross, triple net, and absolute net. A gross lease does not require the tenant to reimburse the landlord for any of the expenses that the landlord might incur in operation of the premises. Under a gross lease, the tenant pays base rent and the landlord absorbs all costs for common area maintenance ("CAM"), real property taxes, landlord's insurance, and other charges associated with the operation and maintenance of the property. A modified gross lease typically requires the tenant to reimburse landlord for "pass through" costs over a stated expense stop or base year. For example, the tenant may be required to reimburse landlord for all CAM over $4.00 per square foot, or alternatively, the tenant may be required to reimburse landlord for all CAM in excess of base year 2005. In most situations, the commercial tenant will be asked to sign a "triple net" lease, which requires the tenant to reimburse landlord for CAM, real estate taxes, and landlord's insurance. The "pass through" costs included in a "triple net" lease can vary, and can include additional items other than just CAM, taxes, and insurance. Thus, a prospective tenant will be well served to review a proposed lease with counsel to ensure that tenant understands the nature and type of pass through costs it will be expected to absorb under the lease. Also, in certain circumstances, a landlord may utilize a "net" or "absolute net" lease, which requires the tenant to absorb ALL costs of maintenance and operation of the property, including capital expenditures and major repairs. Typically, an absolute net lease is utilized where the tenant is the sole and 100% occupant of the building - for example, a restaurant or an office building occupied by one tenant.
Generally, a major round of equity capital raised from credible investors or venture capitalists makes venture leasing viable for the early stage company. Lessors structure most transactions as master lease lines, permitting the lessee to draw down on the lines as needed throughout the year. Lease lines usually range in size from as little as $ 200,000 to well over $ 5,000,000, depending on the lessee's need and credit strength. Terms are typically between twenty four to forty eight months, payable monthly in advance. The lessee's credit strength, the quality and useful life of the underlying equipment, and the lessor's anticipated ability to re-market the equipment during the lease often dictate the initial lease term. Although no lessor enters a leasing arrangement expecting to re-market the equipment prior to lease expiry, should the lessee's business fail, the lessor must pursue this avenue of recovery to salvage the transaction. Most venture leases give lessees flexible end-of-lease options. These options generally include the ability to buy the equipment, to renew the lease at fair market value or to return the equipment to the lessor. Many lessors limit the fair market value, which also benefits the lessee. Most leases require the lessee to shoulder the important equipment obligations such as maintenance, insurance and paying required equipment taxes.
Leasing companies do frequently (usually quarterly) send equipment vendors a list of their lease portfolios with that leasing company in hopes the vendor will upgrade the customer's equipment and extend the customer's leasing relationship with the leasing company. If the equipment vendor is paying attention to their customer base, they will notify you of the approaching lease expiration (and try to upgrade your equipment). If an equipment lease renews, this makes it very difficult (read expensive) for a competing equipment vendor to economically upgrade the equipment before the expiration of the renewal term. This strategy was constructed intentionally to give the incumbent equipment vendor (and leasing company) a financial advantage in upgrading the equipment before the expiration of the renewal lease term. A lease renewal limits your options, which is never good for you. Only the incumbent equipment vendor who agrees to use the same leasing company can upgrade equipment on a renewed lease without penalty. Any other combination of equipment vendor and/or leasing company will have to pay the remaining payments of the renewed lease term (usually 12 months).
In addition to base rent, the tenant customarily will be asked to pay "additional rent", which constitutes pass-throughs (CAM, taxes, and insurance) and any other charges that landlord might deem to include in your lease. CAM, pass-throughs, and other charges reimbursable under the lease are the primary source of tension in the modern commercial landlord/tenant relationship. The tenant wants the certainty of knowing what his rent and charges are going to be on a monthly and yearly basis. The landlord wants protection from unexpected rises in taxes or the costs of providing services to the property. The key: read your lease and KNOW every charge you will be faced with once your tenancy begins. In the retail context, in addition to base and additional rent, the prospective tenant is often asked to pay landlord a percentage of tenant's gross sales on a monthly or quarterly basis. The landlord usually justifies these charges as a necessary component of compensating landlord for providing a vibrant mall or strip center for tenant to conduct business. In most commercially viable retail property, payment of percentage rent is unavoidable. However, the "breakpoint" and amount of percentage rent should be negotiated. Another area of significance to the commercial tenant is the services that will be provided by landlord and reimbursement of landlord for those services. Similarly, tenant should understand those services that landlord will not provide, because tenant will be responsible for those services as an out of pocket expense. Further, unless the lease is gross, the landlord should identify the components that constitute the costs of operating the "common area" for which it seeks reimbursement through tenant's monthly CAM charges. The definition of CAM varies from lease to lease based on landlord preference, the type of property, and the negotiations of the parties. If a gross lease is not available, the tenant should negotiate the items to be included in CAM, the items that will not be included in CAM, and an annual cap or limit on expenses that landlord may attempt to pass through to tenant.
Once the start-up finds a capable venture lessor, negotiating a fair and competitive lease is the next order of business. A number of factors determine venture lease pricing and terms. Important factors include: 1) the perceived credit strength of the lessee, 2) equipment quality, 3) market rates, and 4) competitive factors within the venture leasing market. Since the lease can be structured with several options, many of which influence the ultimate lease cost, start-ups should compare competing lease proposals. Lessors typically structured leases to yield 14% - 20%. By developing end-of-lease options to better accommodate lessees' needs, lessors can shift some of this pricing to the lease's back end in the form of a fair market value or fixed purchase or renewal option. It is not uncommon to see a three year lease structured to yield 9% - 11% annually during the initial lease term. Thereafter, the lessee can choose to return the equipment, purchase the equipment for 10% - 15% of equipment cost or to renew the lease for an additional year. If the lease is renewed, the lessor recovers an additional 10% - 15% of equipment cost. If the equipment is returned to the lessor, the start-up reduces its cost and limits the amount paid under the lease. The lessor will then remarket the equipment to achieve its 14% - 20% yield target. Another way that leasing companies can justify slashing lease payments is to incorporate warrants to purchase stock into the transaction. Warrants give the lessor the right to buy an agreed upon quantity of ownership shares at a share price predetermined by the parties. Under a venture lease with warrant pricing, the lessor typically prices that lease several percentage points below a similar lease without warrants. The number of warrants the start-up proffers is arrived at by dividing a portion of the lease line - usually 3% to 15% of the line - by the warrant strike price. The strike price is typically the share price of the most recently completed equity round. Including a warrant option often encourages venture lessors to enter transactions with companies that are very early in development or where the equipment to be leased is of questionable quality or re-marketability.
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