SOFTWARE LEASING—AN UPCOMING OPPORTUNITY FOR THE TURKISH LEASING INDUSTRY
This article on software leasing was written by Mark S. Bazrod, President, LPI Software Funding Group, Inc. for the Fall 2005 issue of The Turkish Leasing Association Journal.
The threshold question addressed in this article is: “Should a lessor finance an asset which is an intangible, which normally cannot be repossessed upon lessee default, where the right to remarket generally does not exist, where one does not fully understand the legalities, and which requires a substantial amount of education of both your funding sources and your vendor’s salespeople?” The asset referred to is software.
Although most financiers/lessors are not comfortable leasing software, it is an area that could provide substantial opportunities to those willing to expend some time examining this area in the forthcoming revision to the Turkish Law on Financial Leasing. The search for niche markets is becoming more important since there often are too many generalists in equipment finance and margins are being continually squeezed.
Software leasing provides tremendous opportunities for a variety of reasons. To begin with, software is almost always an essential asset. Entities cannot operate their businesses without software. Also, given that software companies continually upgrade the software (typically for an annual support fee of 15% to 20% of the license fee), software does not depreciate in value. To top it off, there is less competition in this niche area than in general equipment leasing, the risk is truly less than perceived, and there is room for knowledgeable lessors to move into this area.
The market potential is immense. In the U.S alone, there are somewhere between 40,000 to 50,000 software companies. One study indicated that only 45% of companies with annual revenues over $10 million offer some form of software financing (often merely payment terms) to their customers; while less than 10% of companies with annual revenues less than $10 million offer any such financing. Look at the potential for a lessor coming into this market! To boot, most users are unaware that software can be leased.
Although there are over 1,000 lessors in the U.S., only 25 or so offer 100% software leases, mostly for transactions exceeding $1 million for investment grade lessees. This is slowly changing - more small ticket lessors are offering partial software leases and some are offering 100% software leases.
Software still only accounts for less than 2% of the total dollar value of leasing in the U.S. while computer hardware represents more than 20%. Thus, there are many opportunities in the mature U.S. market, but there should be even more opportunities for Turkish lessors.
What is Software Leasing?
A software lease is normally structured as a full payout finance lease with a $1 purchase option. It is similar to an equipment lease, except that it finances an intangible asset—the software license. It is the functional equivalent of a loan; it can be secured by the license or it can be unsecured. The lease term ranges from 1 to 5 years and normally there is no recourse to the vendor upon lessee default.
Some lessors use a promissory note; some others use an extended payment rider to the software license. LPI prefers using a lease as it is best from a marketing standpoint and it is simple. We do not take title to the license; we obtain a lien on it. Our rights expire when all payments have been made.
Leases are simpler as the vendor grants the license directly to the customer—the leasing company need not get in the middle of the vendor’s marketing or its obligations. At the end of the lease term, the customer/lessee owns the license free and clear. In the event of payment default, the lessor should have the right to require the customer to stop using the software and return it. This provision is a must for lessors since it gives them real leverage over a nonpaying lessee. This is no different than any other form of lease financing – if the lessee defaults, the lessor has the right to repossess the leased asset.
Benefits to Vendors and Users
A software vendor obtains the usual benefits of a vendor program—shortening the sales cycle, expanding the customer base, better satisfying customer needs, improving competitive and financial position, gaining a competitive advantage, obtaining marketing support from a leasing company, obtaining 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, eliminating or reducing capital budget approval delays, 100% financing, new source of funds, preserving existing bank lines, often simpler and faster than a bank loan, etc.
What are the main obstacles to leasing software? The obstacles are education of funding sources and software vendor salespeople; understanding the software industry, the value of software, software licenses and other software legal issues; and overcoming 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 as well as its credit department that its strategies make sense and that the risks associated with software leasing are acceptable ones. This could be a time consuming and difficult task.
Most financing sources, both external and internal, view software financing as unsecured financing. This is not basically incorrect in the U.S. 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. In any event, a lessor should be prepared to spend time explaining to its funding sources the value of software and why it thinks that financing software is a prudent risk.
The other educational task is education of software vendor salespeople. Unlike the hardware industry, the overwhelming majority of them do not have any leasing experience. However, it does not take a lot of time. It does 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 asset that the user needs to operate its business. Thus, when financial difficulties arise the software lease tends to get paid. Software does not go down in value like hardware. You cannot get a cheaper up-to-date version. Since support includes upgrades and new versions, the customer always has the current version of the software. 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 will be enforceable in Turkey will depend on the new leasing law. 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 cannot recognize a sale if it must assist in remarketing, a major difference from equipment leasing. Thus, one should not generally expect to have the software company agree to remarket software.
A lessor should review its lease documents. Although most provisions are satisfactory for software leasing, there are numerous provisions that should be rewritten when one deals 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.
Software leasing unquestionably has its share of challenges; however, the opportunities are immense— particularly in a country such as Turkey where the leasing industry should have a chance to make sure that new leasing legislation protects the lessor’s interest and thus encourages this leasing product.
Mark S. Bazrod, President of LPI Software Funding Group, Inc. (www.lpilease.com), founded LPI in 1983 to focus on vendor operating lease programs (“VOLP”) for computer manufactures. LPI now focuses on computer software leasing and is a leader in this area. LPI has acquired more than $500 million of equipment and software.
Prior to founding LPI, he held senior executive positions at Management Data Corporation and Lease Financing Corporation, lastly in charge of VOLP, responsible for the acquisition of more than $1 billion of computer equipment in North America and Europe. LFC was considered by many to have been the leading VOLP company.
Mr. Bazrod is a past Board member of the Equipment Leasing Association and a past Trustee of the Equipment Leasing and Finance Foundation. He is a member of the Board of ELA Business Services, Inc. He has served as Chairman of the ELA’s Operating Lease Committee, Federal Government Relations Committee, and Information Technology Committee. He has been a frequent speaker for ELA, EAEL, Amembal & Associates, and other organizations.
Mr. Bazrod is both a Certified Public Accountant and an attorney. He may be reached at email@example.com.
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February 27, 2006