WHAT IS THIS THING CALLED SOFTWARE LEASING

This article was written by Mark S. Bazrod for the Computer Dealers and Lessors Association magazine called Dataline.

All of us, from the smallest broker with one customer to the largest leasing company, are involved in niche markets - although some of us are in numerous niches. What do we do when our niche starts to shrink - and at the same time begins to change radically? This is exactly the question being faced by members of the computer leasing community.

Mainframes, both in unit volume and price, have been decreasing at more than a 20% rate for several years. Mainframes are being replaced by networks of powerful workstations. Large disk drives are being replaced by networked drives with capacities far exceeding the older ones. Tape drives are being replaced by tiny little machines. The average price per box has fallen beyond anyone’s expectations. An efficient remarketing structure for these thousands of low cost boxes has yet to evolve. A very bad headache, yes, but not a killer. The real problem is that computer equipment prices, if not in a free fall, are declining at such a rate that residual risk taking is becoming a very hazardous occupation. And if that is not enough of a problem, the pace of technological change has accelerated to such a point that in many cases older boxes are simply not desired.

So what is an operating lessor to do in this environment? An intrepid few continue to arrange operating leases, although taking lower residual risk. Many have gone out of the operating lease business altogether. Some have left the leasing industry entirely. Some have gone into related businesses. One of those businesses is the leasing of computer software. Today, there are only a few leasing companies which focus on this niche. Lease Programs Inc. and its subsidiary, LPI Software Funding Group, Inc., are among those few. Thus, we can provide you with some up-to-date information about this market segment so that you may have a better idea of what is involved in software leasing, what its benefits are, what headaches it entails and what opportunities exist.

First and foremost, you have to get rid of any antiquated ideas that software is a "soft" cost, has little value, and you are doing the lessee a favor in leasing the software. Unfortunately, the longer one has been in the equipment leasing business, the more ingrained those ideas are and the harder it is to get rid of them. As a person with more gray hair than most, I can recognize the difficulties one can run into when paradigms change and it is necessary to discard long held assumptions. However, in most cases hardware has become very much of a commodity and it is the software which now tends to provide the bulk of the value to the user.

Secondly, you 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. Depending upon the market researcher, the number of software developers ranges between 15,000 and 20,000, with the overwhelming bulk of them being 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. In addition, there is a fair amount of movement of people between companies in the industry so that the personnel also keep changing.

Thirdly, you ought to examine your lease documents. Although most provisions are satisfactory for software leasing, there are numerous provisions that should be reconsidered and then rewritten when you deal with an intangible such as software rather than hardware.

Fourthly, you will probably want to develop some sort of marketing plan to decide what segments of the market you want to address, such as vendor or user, PC or mainframe, application areas, etc. You should be prepared to spend more time explaining leasing and determining how to meet the needs of your customers, almost all of whom will be new to the world of leasing software.

Lastly, and certainly not least importantly, you have to convince your internal or external funding sources and credit people that your strategies make sense and that the risks associated with the software leasing business are acceptable ones. This will be a time consuming and difficult task and I think you will find that many of the funding sources which had been supportive of your transactions in the past will decide to wait some time for experience to develop in this market segment before they support it.

But before you do all the work and change your business, you will have to decide whether software leasing is a viable leasing market or just a fad which will never grow to maturity. Is it a solution looking for a problem? My personal opinion is that the market will grow extensively throughout the 90’s because it serves the needs for vendors, having the potential to become a powerful sales tool. Users benefit from faster internal approval, convenience, non-use of bank lines, and all the other good reasons for leasing.

If this is the case, why hasn’t software leasing grown to a major market segment. After all, leasing industry statistics indicate that less than 2% of all leasing involves software. The basic reasons for this lack of growth have been that the leasing industry has been slow to appreciate the value of software; funding sources have likewise been slow to appreciate the value of software; equipment prices were much higher and it was a developed market not requiring additional expertise; software leasing has additional legal complexities; and there are only a few pioneers in this area. But the world is changing and more leasing companies and funders are beginning to appreciate the value of software. More software is being leased (we are even currently working on several large cross-border software leases). And there is a gradual increase in the number of companies which lease software. Legal issues are beginning to be understood.

This being the case, what are the main obstacles to leasing software? The answer is, as is often the case, legal and funding. (I assume you will address the psychological problems, the acquisition of industry knowledge, and the development of marketing programs.)

In order to lease software, one has to understand the software license as all rights flow from that document. Software is intellectual property, in many respects similar to movie or book rights, clearly foreign territory for most of us in the equipment leasing business. The owner of those 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 normally places limitations upon the user, including the right to transfer the copy to someone else, to use it on another machine or to allow more than a specified number of users, often concurrent but not always, to have access to a copy - - or all or some of the above. There are significant differences in licenses granted by software developers. Therefore, the leasing company must carefully examine the license to ascertain what rights it will have in the software. We have even seen licenses which state that in the event of a default by the lessee, the leasing company must destroy the software or return the software to the software company. In this situation, the software has absolutely no collateral value and the software lease clearly constitutes an unsecured loan. Financing in this case will not, in all probability, be available except for investment grade credits. Thus, you probably should consult counsel before progressing too far in negotiations.

The other major obstacle to software leasing is the time consuming effort to arrange funding. Most financing sources view software financing as unsecured financing. I disagree, but the reasons for such a statement go far beyond the space limits of this article. Be that as it may, you will have to be prepared to spend extensive time explaining to your funding sources the value of software and why you think that lending is a prudent risk. You will not be successful all the time - at least for the next five years. Nonetheless, there are funding sources who understand the value of software leasing and will participate in this market. Your job will be to educate your funding sources and perhaps locate new ones.

In summary, software leasing is not a large market at the current time, it will be a viable market segment for a number of leasing companies, 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, there can be substantial benefits to software vendors and users, but you will have to commit significant amounts of resources, both time and dollars, to develop a material business which meets the needs of your customers.

© 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