SOFTWARE LEASING OPPORTUNITIES IN 2005


This article on software leasing was written by Mark S. Bazrod, President, LPI Software Funding Group, Inc., for the first edition of the Asian Leasing Yearbook, published by Amembal & Associates in 2005. 


 

 

The threshold question which the article addresses is “Should you finance an asset which is an intangible when you normally can’t repossess it, don't have the right to remarket it, probably have to do a fair amount of education of both your funding/credit resources and the vendor’s salespeople, and you don’t understand the legal underpinnings of software and intellectual property?

To many people the answer is an unequivocal “YES!” Software leasing has great potential, software is an essential asset (the lessee can’t operate its business without software), software doesn’t depreciate in value, there is less competition than in equipment leasing, the risk is less than perceived, and the software industry needs knowledgeable lessors.

It’s a sad commentary that most users are not aware that software can be leased. And most software companies are also not aware, although more are becoming aware. One study indicated that 45% of software companies with revenues over $10 million offer some form of software financing (often merely payment terms), while less than 10% of software companies with revenues less than $10 million offer some software financing.

Only about 25 lessors offer 100% software leases, mostly for transactions over $1 million for investment grade users. The major hurdle has been psychological resistance of banks and leasing companies - they do not appreciate the value of software. But the world is changing and there is a gradual increase in the number of companies which offer software leasing.

The price of computer equipment has fallen far beyond anyone’s expectations. Computer equipment prices keep declining at such a rate that residual risk taking is a very hazardous occupation. And if that is not enough of a problem, in many cases older boxes are simply not desired. Computer hardware has become a commodity and it is software that now provides the bulk of value to the user. Software expenditures generally exceed computer hardware costs. Yet while computer hardware represents more than 20% of the dollar value of all leasing transactions, software represents less than 2%.

Growth in middle market and large ticket software leasing has been gradual, but is growing slowly. We see more small ticket leasing companies offering partial software leases and several offering 100% software leases.

Of course, software leasing will grow only if it benefits the users. In general, for large companies leasing is often a solution to capital budget delays; for medium-sized companies, it is a convenient method of financing; and for smaller companies, it is an excellent source of funds.

WHAT IS SOFTWARE LEASING

A software lease is a financing, not an operating lease. It’s similar to an equipment lease, except it’s for an intangible -  the software (actually, the license). It is the functional equivalent of a loan from the leasing company or a conditional sale lease. It is almost always a capital lease. It can include related costs such as hardware, implementation, training, consulting services, custom programming, and first year maintenance or support. It can be secured by the license or unsecured. The normal term is 1 to 5 years. Normally, there is no recourse to the vendor for credit defaults.

In contrast to the computer hardware industry, few software companies lease and hold the leases. Some large companies write leases and then sell them off to banks or leasing companies. Most software companies (there are over 40,000) either do no software leasing or let the user try to find a lessor.

WHAT ARE THE FORMS OF SOFTWARE LEASING

Software leasing is almost always done through a capital lease, normally with a $1 purchase option. However, some lessors or software companies use a promissory note, and others use an extended payment rider to the software license. We use a lease, but do not take title to the license, get a lien on the license, and our rights expire when all payments have been made. In extremely rare cases (other than from the vendor), a true operating lease may be used.

I prefer a lease because I think it’s best from a marketing standpoint and it is simplest. The vendor gives the license directly to the customers so the leasing company doesn’t get in the middle of marketing or the vendor’s obligations. At the end, the customer owns the license free and clear. During the time that the lease is in effect, we believe the lessor should have a lien on that software and have the right, if the customer doesn’t pay, to require the customer to stop using the software and return the software. Maybe the lessor can do something with it or not, but basically the customer has to understand that. That’s no different from any other financing. If you lease equipment and you don’t pay, the lessor has the right to take it away.

WHAT ARE THE BENEFITS TO SOFTWARE VENDORS AND USERS?

A software vendor obtains the usual benefits of a vendor program – Shorten the sales cycle, expand the customer base, better satisfy customer needs, improve competitive and financial position, gain  a competitive advantage, obtain marketing support from a leasing company, obtain an extensive financing program with no financial obligations, etc. Also,  the vendor avoids obtaining bank lines to carry financing and establishing lease billing and financial lease accounting systems.

The user obtains the normal benefits of leasing – Lease payments tailored to user needs, eliminate or reduce capital budget approval delays, 100% financing, new source of funds, preserve bank lines, often simpler and faster than a bank loan, etc.

SOME OF THE ISSUES FOR A LEASING COMPANY CONSIDERING SOFTWARE LEASING

What are the main obstacles to leasing software? The answer is, as is often the case, in the realm of legal, funding and industry knowledge. The obstacles are education of funding sources and software vendor salespeople, understanding the software industry and the value of software, understanding software licenses and other software legal issues, and getting past the psychological barrier of leasing non-tangible property.

Education of funding sources probably is the major hurdle. A lessor will have to convince its internal or external funding sources and credit people that its strategies make sense and that the risks associated with software leasing are acceptable ones. This probably will be a time consuming and difficult task and I think you will find that many of the funding and credit resources which had been supportive of your transactions in the past may decide to wait some time for experience to develop in this market segment before they support it. Most financing sources, both external and internal, view software financing as unsecured financing. I disagree, but the reasons for such a statement go far beyond the space limits of this article. Outside the U.S. a key question will be whether a lessor can obtain a lien on the license under the laws of the particular country where the user or software is located. Be that as it may, an interested lessor will have to be prepared to spend extensive time explaining to its funding sources the value of software and why it thinks that financing is a prudent risk.

The other educational task is education of software vendor salespeople. Unlike the hardware industry, the overwhelming majority of them have not has any leasing experience. However, it doesn’t take a lot of time. It does you no good to arrange a program with the vice president of sales, but neglect to educate the sales force.

Next, the lessor must believe that software has value. Not only does software constitute a greater share of the cost of a typical computer installation, but software is in almost all instances, an indispensable  assets that the user needs to operate its business. Thus, when financial difficulties arise the software lease gets paid. Software does not go down in value like hardware. You can’t get a cheaper up-to-date version. Since support includes upgrades and new versions, the customer ends up with the current version of the software. The software does not become obsolete like hardware.

Although a lessor generally can not repossess software and legally transfer the license to another, a software lease should preclude the user from using the software in the event of default. That provision is enforceable in the U.S.; whether it is enforceable in a particular country must be researched by the lessor. Our experience is that, unless the user is liquidated, we tend to recover the monies due. A lessor should be aware, however, that under many accounting rules a software company can not recognize a sale if it must assist in remarketing, a major difference from equipment leasing. Thus, do not generally expect to have the software company agree to remarket software.

A lessor will have to attempt to understand the software industry. I say “attempt to” because the industry is not an easy one to get your arms around. Estimates of the number of software developers range between 40,000 and 50,000, with the overwhelming bulk of them private and with revenues of less than $25 million. In addition, there are numerous segments of the software industry and since it is extremely dynamic, the players keep changing, new ones coming in all the time and some of the older ones disappearing through acquisition. Also, there is a fair amount of movement of people between companies in the industry so that the personnel also keep changing.

In order to lease software, one has to understand the software license since all rights flow from that document. Is the license exclusive? (Generally, no.) Is it transferable? (Generally, no.) Is it perpetual? (Generally, yes.) The owner of the intellectual property rights, normally the software developer, grants the user the right to use a copy of the software, but retains title to the software. The license places limitations upon the user, normally making the license nontransferable. There are others and there are significant differences in licenses granted by software developers. Therefore, the lessor must carefully examine the license to ascertain what rights it will have in the software.

 

A lessor will also have to examine its lease documents. Although most provisions are satisfactory for software leasing, there are numerous provisions that should be rewritten when you deal with an intangible such as software rather than hardware. For example, the term “equipment”  should be changed to “equipment and software” in many, but not all places. Similarly, a lessor will need additional remedies such as the lessee agrees to not use the software or support in the event of default.

CONCLUSION

In summary, software leasing should be a viable product for many lessors, the competition is not as intense as it is in equipment leasing (but you still have to have competitive rates), the business is a credit business rather than a residual business, but you will have to commit significant amounts of resources, both time and dollars, to develop a significant business which meets the needs of your customers.

If you want more information on software leasing, look at our Web site, www.lpilease.com.  One of the software companies said to us that it was the best Web site they’ve seen from a leasing company. I can be reached at LPI Software Funding Group, Inc., 593 Cricket Lane, Suite 200, Wayne, PA 19087, 1.610.341.6100, or msb@lpilease.com.

© LPI Software Funding Group, Inc.  

593 Cricket Lane, Suite 200     Wayne, PA 19087  

610.687.4434      610.341.6100   sales@lpilease.com
                         February 27, 2006