A Tenant Perspective - The Elements Of A Commercial Lease
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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.
Venture leasing enjoys many advantages over traditional venture capital and bank financing. Financing new ventures can be a high risk business. Venture capitalists generally demand sizeable equity stakes in the companies they finance to compensate for this risk. They typically seek investment returns of at least 35% - 50% on their unsecured, non-amortizing equity investments. An IPO or other sale of their equity position within three to six years of investing offers them the best avenue to capture this return. Many venture capitalists require board representation, specific exit time frames and/or investor rights to force a 'liquidity' event. In comparison, venture leasing has none of these drawbacks. Venture lessors typically seek an annual return in the 14% - 20% range. These transactions usually amortize monthly in two to four years and are secured by the underlying assets. Although the risk to the venture lessor is also high, this risk is mitigated by requiring collateral and structuring a transaction that amortizes. By using venture leasing and venture capital together, the savvy entrepreneur lowers the venture's overall capital cost, builds enterprise value faster and preserves ownership. Venture leasing is also very flexible. By structuring a fair market value purchase or renewal option at the end of the lease, the start-up can slash monthly payments. Lower payments result in higher earnings and cash flow. Since a fair market value option is not an obligation, the lessee has a high degree of flexibility and control. The resulting reduction in payments and shift of lease expense beyond the expiry of the transaction can deliver a higher enterprise value to the savvy entrepreneur during the initial term of the lease. The higher enterprise value results from the start-up's ability to achieve higher earnings, upon which most valuations are based. Customers benefit more from venture leasing as compared to traditional bank financing in two ways. First, venture leases are usually only secured by the underlying equipment. Additionally, there are usually no restrictive financial covenants. Most banks, if they lend to early stage companies, require blanket liens on all of the companies' assets. In some cases, they also require guarantees of the start-ups' principals. More and more, sophisticated entrepreneurs recognize the stifling effects of these limitations and their impact on growth. When start-ups need additional financing and a sole lender has encumbered all company assets or required guarantees, these young companies become less attractive to other financing sources. Correcting this situation can sap the entrepreneurs' time and energy.
I asked the executive how they could be so sure that equipment would go into renewal. Without hesitating, he answered because historically most of their equipment leases do. After getting up off the floor, I asked his opinion why that many leases went into renewal. He replied that it was either the lack of tracking the lease expiration or turnover in the customer position that was responsible for notifying the lease company in a specific time frame (designated within the lease agreement). The majority of copier leases are written for a 5-year lease term. Turnover (either promotions or by leaving) within a customer's business does usually occur before the end of the lease. In addition, during the course of busy days at the office, no one stops to document lease expiration dates. It seems so far away and therefore unnecessary at the time.
Venture lessors target lessee prospects that have good promise and that are likely to fulfill their leases. Since most start-ups rely on future equity rounds to execute their business plans, lessors devote significant attention to credit review and due diligence - evaluating the caliber of the investor group, the efficacy of the business plan and management's background. A superior management team has usually demonstrated prior successes in the field in which the new venture is active. Additionally, management's expertise in the key business functions -- sales, marketing, R&D, production, engineering, finance --- is essential. Although there are many professional venture capitalists financing new ventures, there can be a significant difference in their abilities, staying power and resources. The better venture capitalists achieve excellent results and have direct experience with the type of companies being financed. The best VCs have developed industry specialization and many have in-house specialists with direct operating experience within the industries covered. Also important to the venture lessor are the amount of capital VCs provide the start-up and the amount allocated to future funding rounds. After determining that the management team and venture capital investors are qualified, venture lessors evaluate the start-up's business model and the market potential. Since most venture lessors are not technology specialists - able to assess products, technology, patents, business processes and the like - they rely greatly on the thorough due diligence of experienced venture capitalists. But the experienced venture lessor does undertake an independent evaluation of the business plan and conducts careful due diligence to understand its content. Here, the lessor generally attempts to understand and concur with the business model. Questions to be answered include: Is the business model sensible? How large is the market for the prospect's services or products? Are the income projections realistic? Is pricing of the product or service sensible? How much cash is on hand and how long will it last according to the projections? When is the next equity round needed? Are the key people needed execute the business plan in place? These and similar questions help determine whether the business model is reasonable. Satisfied that the business model is sound, the venture lessor's greatest concern is whether the start-up has sufficient liquidity or cash on hand to support a significant portion of the lease term. If the venture fails to raise additional capital or runs out of cash, the lessor is not likely to collect further lease payments. To mitigate this risk, most experienced venture lessors pursue start-ups with at least nine months of cash or sufficient liquid assets to service a substantial portion of their leases.
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.
To keep your company from getting snared in the lease renewal trap, set a calendar reminder in several support staff's computers to remind you to send the lease expiration notice on time (usually 90 to 120 days in advance of lease expiration-check your lease for specifics). This should prevent staff turnover from erasing memory of that necessary step. Another option is to set up "delayed send" e-mail messages from several computers to be sent to several staff members reminding them to send the lease expiration. There are also free external calendars that you can set up to send an e-mail reminder to several people in case your organization deletes all information from previous users of a computer. Applications like calendar.yahoo.com and Google calendar can be set up to provide e-mail reminders to multiple people to assure you cover your turnover and promotion events. This way you can notify the leasing company in a timely manner. As you execute a new equipment lease, make a 30-day renewal mandatory before you approve it. If you do miss the notification deadline your lease only renews for 30 days. Remember you do have to provide the written intent to return equipment to prevent or end the renewal cycle.
Venture leasing enjoys many advantages over traditional venture capital and bank financing. Financing new ventures can be a high risk business. Venture capitalists generally demand sizeable equity stakes in the companies they finance to compensate for this risk. They typically seek investment returns of at least 35% - 50% on their unsecured, non-amortizing equity investments. An IPO or other sale of their equity position within three to six years of investing offers them the best avenue to capture this return. Many venture capitalists require board representation, specific exit time frames and/or investor rights to force a 'liquidity' event. In comparison, venture leasing has none of these drawbacks. Venture lessors typically seek an annual return in the 14% - 20% range. These transactions usually amortize monthly in two to four years and are secured by the underlying assets. Although the risk to the venture lessor is also high, this risk is mitigated by requiring collateral and structuring a transaction that amortizes. By using venture leasing and venture capital together, the savvy entrepreneur lowers the venture's overall capital cost, builds enterprise value faster and preserves ownership. Venture leasing is also very flexible. By structuring a fair market value purchase or renewal option at the end of the lease, the start-up can slash monthly payments. Lower payments result in higher earnings and cash flow. Since a fair market value option is not an obligation, the lessee has a high degree of flexibility and control. The resulting reduction in payments and shift of lease expense beyond the expiry of the transaction can deliver a higher enterprise value to the savvy entrepreneur during the initial term of the lease. The higher enterprise value results from the start-up's ability to achieve higher earnings, upon which most valuations are based. Customers benefit more from venture leasing as compared to traditional bank financing in two ways. First, venture leases are usually only secured by the underlying equipment. Additionally, there are usually no restrictive financial covenants. Most banks, if they lend to early stage companies, require blanket liens on all of the companies' assets. In some cases, they also require guarantees of the start-ups' principals. More and more, sophisticated entrepreneurs recognize the stifling effects of these limitations and their impact on growth. When start-ups need additional financing and a sole lender has encumbered all company assets or required guarantees, these young companies become less attractive to other financing sources. Correcting this situation can sap the entrepreneurs' time and energy.
I asked the executive how they could be so sure that equipment would go into renewal. Without hesitating, he answered because historically most of their equipment leases do. After getting up off the floor, I asked his opinion why that many leases went into renewal. He replied that it was either the lack of tracking the lease expiration or turnover in the customer position that was responsible for notifying the lease company in a specific time frame (designated within the lease agreement). The majority of copier leases are written for a 5-year lease term. Turnover (either promotions or by leaving) within a customer's business does usually occur before the end of the lease. In addition, during the course of busy days at the office, no one stops to document lease expiration dates. It seems so far away and therefore unnecessary at the time.
Venture lessors target lessee prospects that have good promise and that are likely to fulfill their leases. Since most start-ups rely on future equity rounds to execute their business plans, lessors devote significant attention to credit review and due diligence - evaluating the caliber of the investor group, the efficacy of the business plan and management's background. A superior management team has usually demonstrated prior successes in the field in which the new venture is active. Additionally, management's expertise in the key business functions -- sales, marketing, R&D, production, engineering, finance --- is essential. Although there are many professional venture capitalists financing new ventures, there can be a significant difference in their abilities, staying power and resources. The better venture capitalists achieve excellent results and have direct experience with the type of companies being financed. The best VCs have developed industry specialization and many have in-house specialists with direct operating experience within the industries covered. Also important to the venture lessor are the amount of capital VCs provide the start-up and the amount allocated to future funding rounds. After determining that the management team and venture capital investors are qualified, venture lessors evaluate the start-up's business model and the market potential. Since most venture lessors are not technology specialists - able to assess products, technology, patents, business processes and the like - they rely greatly on the thorough due diligence of experienced venture capitalists. But the experienced venture lessor does undertake an independent evaluation of the business plan and conducts careful due diligence to understand its content. Here, the lessor generally attempts to understand and concur with the business model. Questions to be answered include: Is the business model sensible? How large is the market for the prospect's services or products? Are the income projections realistic? Is pricing of the product or service sensible? How much cash is on hand and how long will it last according to the projections? When is the next equity round needed? Are the key people needed execute the business plan in place? These and similar questions help determine whether the business model is reasonable. Satisfied that the business model is sound, the venture lessor's greatest concern is whether the start-up has sufficient liquidity or cash on hand to support a significant portion of the lease term. If the venture fails to raise additional capital or runs out of cash, the lessor is not likely to collect further lease payments. To mitigate this risk, most experienced venture lessors pursue start-ups with at least nine months of cash or sufficient liquid assets to service a substantial portion of their leases.
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.
To keep your company from getting snared in the lease renewal trap, set a calendar reminder in several support staff's computers to remind you to send the lease expiration notice on time (usually 90 to 120 days in advance of lease expiration-check your lease for specifics). This should prevent staff turnover from erasing memory of that necessary step. Another option is to set up "delayed send" e-mail messages from several computers to be sent to several staff members reminding them to send the lease expiration. There are also free external calendars that you can set up to send an e-mail reminder to several people in case your organization deletes all information from previous users of a computer. Applications like calendar.yahoo.com and Google calendar can be set up to provide e-mail reminders to multiple people to assure you cover your turnover and promotion events. This way you can notify the leasing company in a timely manner. As you execute a new equipment lease, make a 30-day renewal mandatory before you approve it. If you do miss the notification deadline your lease only renews for 30 days. Remember you do have to provide the written intent to return equipment to prevent or end the renewal cycle.
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Frank Miller has a Debt Consolidation Blog & Finance, these are some of the articles: How To Acquire Private Cash Lenders? You have full permission to reprint this article provided this box is kept unchanged.
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