Something a lot of people don’t know is that the entire venture debt industry (which now holds somewhere between $20-$30 billion in startup debt) actually grew out of the equipment leasing, or equipment financing, industry.
How Does Equipment Leasing for Startups Work?
There were a lot of companies in the ’80s and ’90s who were buying really expensive hardware (since computer servers and lab equipment have always been expensive), but they needed to finance some of these purchases. As a result, a company called Comdisco, Inc. pioneered the business of equipment financing/leasing.
Ultimately, a lease is just another form of debt. A company like Comdisco would finance equipment so that the startup company that needs it doesn’t have to pay for it right away. This enables the startup to stretch out their cash flows and then pay back the lender over time with some interest. As long as they make their payments, the lender is in good shape. If you, as a lender, layer on a cost of capital that works for you, then all of a sudden you’re making money.
Naturally there have been ups and downs in this industry. For example after the dot-com bust, Comdisco actually went bankrupt. From that Gwill York and Rick Stubblefield at Lighthouse emerged from the Comdisco roots and were pioneers of the industry as well. Essentially, however, like with anything, there can be unprecedented defaults that can happen, such as when, all of a sudden, Comdisco went down.
Equipment Leasing Risks
Lending to startups in any capacity can be risky. It’s very cyclical but, actually, equipment leasing tends to be a little bit safer sometimes. That’s because the amount of money you give the startup is predicated on them using it to fund the actual equipment they’re going to use in their business. They need that equipment to function.
So even if the company is trying to restructure their senior debt, they’re still going to keep paying their equipment leases or equipment loans because they just need it to continue operating. Otherwise the business is basically worthless.
Equipment Leasing as Capital into Startups
The way we look at it is that equipment leasing is just another way of getting capital into a startup. The three main sources of capital for startups are:
- Traditional venture equity
- Traditional venture debt
- Equipment leases
Equipment leases are just another way to provide the company with capital.
Leasing Warrants and Runway Extensions
Equipment leases to startups do typically have warrants attached to them, although these warrants are often a lot smaller. There are some providers who do not have warrants at all, but those deals tend to be higher interest rates instead.
Getting a runway extension on an equipment lease is a little bit harder than a traditional venture loan. This is because, for a traditional venture loan, you structure a forward commitment where you can draw the money down into the future. This is usually six to nine months later, so you’re not making interest and amortization payments for a while.
For equipment leases or loans, often you are mandated to actually draw the money down or finance that purchase on the day you buy the equipment. Therefore, your clock starts a lot earlier than it would on a traditional venture loan with that forward commitment. With an equipment lease it can be a little bit harder to get true runway extension, but it can also be a really nice source of capital.
Not Paying Your Startup’s Equipment Lease
One common misconception people have is that it won’t matter if they don’t pay their equipment loan or lease. They believe that the equipment will just be retrieved or removed as a result of not paying. However, equipment lenders do have some form of recourse and they can sue you like any other creditor, or even sue together with a group of creditors.
We advise you not to assume that if in 12 months, for example, you decide you don’t like the terms or the deal, you just won’t pay for it. That’s not a possibility. Your debt is only secured by the equipment you have leased. It is still a financial liability.
You also have to remember that documenting a loan that’s an equipment loan or lease is more difficult since you have to submit your purchase orders (POs) on the things you purchased. The creditor ends up financing it, but you still have to have that documentation. It’s more work than a traditional venture loan where you can just pull down $1 or $2 million whenever you feel like it.
Sales Terms in Equipment Leasing
Another thing to think about is that sometimes equipment lending can have a very strong sales culture. Lenders may gloss over some of the important details in the term sheet. We’ve seen equipment lenders try to sneak in a personal guarantee for the founder (making the founder liable for the debt) in the documents, which is just a little bit sketchy. You should work with someone who has high integrity and won’t try to sneak questionable clauses into the loan documents.
Equipment Lease Buyouts
Finally, you also need to remember that frequently at the end of the lease period or the loan period, there will be a buyout. That might be around 10% or 15% of the original equipment value which you have to pay to hold onto the equipment. Otherwise you can just give it back.
Most of the time, people actually want to keep the equipment as it becomes critical to the business. They’re probably either using it in the lab or to run their data center and so they’ll often make that payment. That payment helps improve the return and get to the right cost of capital for the lender. So expect that cost and be prepared for it; you’re most likely going to make that final payment to keep the equipment.
Pros and Cons of Equipment Leasing for Startups
Pros
- Lower Upfront Costs. Leasing allows startups to acquire equipment without a large initial investment.
- Flexibility. Leasing provides flexibility to upgrade or change equipment as technology evolves or business needs change.
- Tax benefits. Lease payments can be tax-deductible as a business expense.
- Maintenance and support. Many leasing agreements include maintenance and support services.
- Another source of capital. Leasing lets the company use funds that would buy equipment for other purposes, helping to manage working capital.
- Cash flow management. Predictable monthly payments help with budgeting and cash flow management.
- Easier approval process. Leasing companies may have lower credit requirements compared to traditional lenders.
Cons
- Higher long-term cost. Leasing can be more expensive over the long term compared to purchasing equipment outright.
- Lack of ownership. Startups don’t own the equipment at the end of the lease term unless they choose a lease-to-own option.
- Contractual obligations. Leasing contracts can be complex and may include penalties for early termination, limited usage terms, or restrictions on modifications.
- Lack of depreciation. Startups miss out on any depreciation benefits that come with owning equipment, which can be significant for tax purposes.
- Long-term commitment. Entering a long-term lease can be a risk if the company’s needs change.
- Interest and fees. Lease agreements often include interest and fees that can add up, increasing the overall cost.
- Large buy-out. If the startup chooses lease-to-own, the buyout price at the end of the lease term can make the overall cost much higher than purchasing the equipment initially.
Equipment Leasing Is Another Source of Capital
So equipment leasing is another way of getting capital into your startup. You still have to act carefully, just like you would if you were getting a venture loan, but it can be a good source of capital. Especially if you’re buying a lot of equipment, such as medical lab equipment.
If you have any other questions on equipment leasing, valuations, startup investing, startup accounting, or taxes, please contact us. You can also follow our YouTube channel and our blog for information about accounting, finance, HR, and taxes for startups!
