This week I have devoted some time to defending the sale-leaseback of a 747 as a reasonable and prudent financing decision. In the airline industry, a sale-leaseback creates liquidity and also introduces operational flexibility, particularly if a short term leaseback is arranged. This leasing product becomes very attractive for these cash-strapped and credit-challenged companies. What, then, is a sale-leaseback, and what are some of the other reasons why a company would want to enter into one? Much is said in the press about why lessors provide these transactions, but every business interaction is a two-way street. Without some benefit, the seller-lessee would not agree to the transaction. So, how does it work?
In its most basic form, a sale-leaseback occurs when an owner of equipment sells it to a lessor, and then immediately leases it back from that lessor. Let’s look at an example to help illustrate the transaction. Assume that Andrea owns a machine shop that makes parts for custom choppers. Her business is growing fast, her bank lines are full, and she is having a hard time finding working capital.
After looking at several different options, Andrea decides to sell two of her machine tools to a lessor and lease them back. Effectively, the equipment never leaves Andrea’s shop and, in fact, isn’t even unbolted from the floor. What has changed for Andrea, then, that would justify her jumping through the hoops of a sale-leaseback?
The primary motivation in this example is the immediate inflow of cash that Andrea receives. In this respect, a sale-leaseback is just another financing vehicle, although one of the very few available to Andrea at this time. She retains use of the equipment, which still generates revenue, plus she has cash in hand that can be used to fund working capital needs. The same thing can be accomplished with a loan if Andrea can find a lender willing to loan money collateralized by used equipment, but this really is not an option for her.
The sale-leaseback might also help improve Andrea’s balance sheet, if it is structured properly, or the proceeds are used to pay down debt. Businesses that use this product typically believe that the equity tied up in their equipment can be better utilized elsewhere. Other companies use sale-leasebacks to manage their midquarter, NOL, and alternative minimum tax problems. Andrea may negotiate some form of purchase option at the end of the lease if she is concerned about retaining the equipment or, alternatively, the lessor could arrange for upgrade financing for new machine tools when the time comes. All in all, the sale-leaseback has some very attractive features.
Shawn, accounting question:
Part Supplier A sells parts to Vendor B (related to Part Supplier A). Vendor B engineers the parts to create a final piece of equipment that they will install and maintain at restaurants throughout the country. The restaurants sign a multi-year service agreement with Vendor B. Vendor B enters into a lease with Lessor A for the equipment to be installed in the restaurants. Lessor A reimburses Vendor B the cost of the final product. Lessor A is fully aware of the circumstances and gives its permission for the long term rental, etc. The lease between Vendor B and Lessor A is a 72 month FMV deal with an EBO at month 60 and a cap of 20% at end of term. Vendor B's auditors say that the transaction is a sale leaseback not a lease. The auditors also say that the lease is a capital lease/financing and not an operating lease because the lessee has an option to buy the equipment. The auditor calls the option to buy "continuing involvement". The auditor says that the issue is not whether the option is a bargain, just the mere fact that the option exists and that the lessee can repurchase the asset disqualifies the transaction as an operating lease for accounting purposes. The auditor references L10.130G. Vendor B/lessee needs off b/s treatment. Your thoughts on the matter would be appreciated.
Posted by: Jay Zeinfeld | April 5, 2006 5:21 PM | Permalink to Comment