Financing Options: Capital Equipment Loans and Leases
Today on MBA Mondays we are going to cover yet another topic in the Financing Options series, financing capital equipment like servers, routers, switches, computers, etc.
Equity capital is expensive. Every time you do a raise, you dilute. It makes sense to look for places where you can use other less expensive forms of capital to fund growth. As we talked about in the last post in this series, I'm not a fan of debt for an early stage startup because there is no obvious way that the debt is going to get paid back. But capital equipment provides an opportunity for debt financing because you can borrow against the equipment. There are two primary ways to do this, capital equipment loans and leases.
Capital equipment loans are loans made by banks and finance companies to provide a company the funds to aquire the capital equipment. The company owns the servers, computers, etc and puts them on its books. The company also has a loan obligation on its books to the bank or finance company. The loan is collateralized meaning that if the company defaults on the loan, the bank or finance company can come take the equipment. The equipment is the security for the loan. These loans are usually self amortizing term loans of around 3 years and carry interest rates of between 6% and 12% depending on the financial profile of the borrower.
Leases are a financing tool used by the manufacturers of equipment (and sometimes by banks and finance companies too). Let's use Dell in this scenario. You want to purchase a bunch of Dell servers to run your web application on. Dell can lease the servers to your company instead of selling them to you. Under a typical lease deal, you will pay the lessor (in this case Dell) a fixed monthly amount for a fixed term, typically three or four years. At the end of the term, your company will have the option to buy the servers for a nominal amount or give them back to the lessor. Some leases will be capitalized and end up on your books and look a lot like capital equipment loans. Other leases will not end up on your books and will look more like renting an office.
In both cases, you are getting capital you need to finance growth (in this case servers and related capital equipment to serve your growing user base) without diluting. And the primary reason for that is the equipment itself provides the security for the loan, not your company, which is likely not credit worthy.
I am a huge fan of this form of financing for startup companies. The risks and rewards are well aligned for both the lender and the borrower and it makes sense for both parties to do these transactions. Don't use your precious funds raised in dilutive equity rounds to buy servers and other capital equipment. Go see a bank, finance company, or manufacturer about a financing arrangement. It's the right way to finance these kinds of growth needs.
Comments (Archived):
I’ve used leasing for both biotech start ups and internet. I don’t think you want to own anything if you can help it. Furniture, laptops, servers – get yourself a leasing company and finance as much as you possibly can.It smooths the cash flow forecasts nicely as well.
Know any good places to lease adjustable tables / chairs, etc?
not in your neck of the woods Matthew!
If it flies, floats or fornicates………………………………………………………………rent it.
My first real job was selling hardware for Hewlett Packard. We did a lot of leases back then (1999-2001). We don’t have a real startup ecosystem in Spain, but that was a boom market and there were many companies trying different things. We, the sales force, loved those deals because they let us sell to companies that were out of our reach without the leases. And we were paid full commission!The ugly part came when everything went to hell. We had many unpaid leases on equipment we didn’t really want. We did a few fire sales and got rid of those machines, but the loss was higher than anyone had expected because prices didn’t consider catastrophic scenarios.Moral of the story: let the vendor cope with as much risk as possible. He has other incentives to approve the deal, so probably he won’t put all that risk into the price.
Yes, but it can get tricky when the technology evolution cycles are so short, and you could be stuck with older models. Unless your lease allows you to upgrade continuously. Why lease servers when you can pay for cloud-services for most needs.
i agree with your points on the cloud. but many of our portfolio companies eventually outgrow cloud services and need to build their own cloud
Of course…I wasn’t thinking beyond the early phase. From Zynga’s S-1 “… we will continue to make big investments in servers, data centers and other infrastructure…”
very big in their case
In what respects do they “out grow”?
it depends on many things but certainly when they start serving hundreds of millions of people every month
Let’s see, assume 200 million Web pages served in a month. Then that would be 200 * 10**6 / ( 3600 * 24 * 30 ) = 77Web pages a second.As a rough guess, for the work of many Web sites, a 32 core server might be able to serve 77 pages a second. We have an offer of a loan of such a server.So far our most complicated Web page can be sent for 14 KB or about 140 Kb. So, at say, 140 Kb per page, that would be 140,000 * 77 = 10,780,000or 10.78 Mbps upload bandwidth. Here 70 miles north of Wall Street, any house can get 15 Mbps upload bandwidth for $55 a month.Let’s see: At 200 million pages a month, one ad per page, and $1 CPM, that would be revenue of $200 K per month. That would let us execute quite a lot of ‘organic growth’.So, summary:200 million pages sent per month77 pages sent per secondone large server, say, 32 cores, on the floor or several mid tower case, six core, servers and a router on a $100 wire rack in a spare room14 KB per page10.78 Mbps upload bandwidth$55 a month for 15 Mbps upload bandwidth1 ad per page$1 CPM$200 K revenue per monthOkay. That would be a good start: Do it from spare room and get plenty of revenue for ‘organic growth’.For more, a colocation site near us has offered us 100 Mbps upload bandwidth for $2250 a month. They can also rent us a 100 square foot cage for $3200 a month.So, assume half fill 100 Mbps upload bandwidth and send 50 * 10**6 / 140,000 = 357pages a second and get, with assumptions above, 357 * 3600 * 24 * 30 / 1000 = 925,344dollars a month in revenue and enough to cover the 100 Mbps upload bandwidth for $2250 a month and the 100 square foot cage for $3200 a month.Also, that site can offer us dual 10 GbE connections. Let’s half fill 10 GbE upload bandwidth with 14 KB pages with one ad per page and $1 CPM and get 500 * 10**6 / 140,000 = 3,571pages a second or 3,571 * 3600 * 24 * 30 / 1000 = 9,256,032dollars of revenue per month. That’d start to be a serious business. We’d be talking something over $8 million a month in pre-tax earnings or close to $100 million a year in pre-tax earnings or a market capitalization north of $1 billion. Maybe that would be “cool”?So, net, first-cut, one server box in a spare room begins to be enough of a ‘server farm’ to outgrow the cloud. Then a few servers in a 100 square foot cage can provide much more in capacity and bandwidth.Good to know. Then I will add weight to my guess of f’get about the cloud!For a little more, we are now just drooling over solid state disks (SSD)! We’d like about 150 TB of such. Soon that will be 75 such in the 2.5″ size. The expectation is that such disks will be able to transmit at full main memory speeds. We’d use the disks heavily for our production work, for just read only data, updated, say, daily. So, we would partition the 75 disks across some number of servers, possibly even 75 (two racks?). Our rough, back of the envelope, ball-park estimate has been that 150 TB with enough data rate would give us capacity enough to saturate our target market around the world and yield $200 billion market capitalization. We’re drooling over SSDs!Of course, now main memory is now down to $5/GB retail so that 2 TB of main memory would be $10 K with such a server for less than $20 K, and 75 such servers in two racks would be $1500 K or $1.5 million, not so much for a company with a market capitalization of $200 billion. So, don’t even bother with SSD and just use unpaged main memory instead!That’s two racks: A 100 square foot cage can have four racks.Also, apparently Intel is now down to 14 nm line width. And they have said that 1000 cores on a processor, working together effectively, are feasible. Amazing.Amazing times!
Love this ballpark comment, you remind me of my early Physics days! I will give it a proper read at home (just quickly reviewed it).
RAM maybe chip, but you will need to buy some expensive super-computer to put 2TB RAM on single node. Then off course you will need to buy OS and special software from the same vendor (SGI?).Keep it simple and stay with commodity servers. Linux boxes can support 256GB RAM max (I think).
There are certain things, especially where they integrate the internet with the real world, that can’t be run strictly in the cloud.In our case we do a lot of stuff on cloud based services, but there’s a key point where the TV world needs to touch the internet and we need dedicated hardware to tie them together.
This would make a great post Erik. Not to give away your secret sauce but to put some perspective on the whole cloud discussion.
There are so many blog posts I need to do (their titles live in a corner of my white board). But between coding, and biz dev, and working with the alpha API users, and trying to put together a round of funding I am just having trouble finding time to write.
Protect the list and promise to write them up when time allows 🙂
If your product is one which requires high availability and high security, cloud-services are still not a great choice (though they are improving). In such cases traditional farms and building your own cloud (typically hybrid) array makes sense. For some, cloud-services are ideal, but for others they can be a nightmare… And if one is planning to outgrow cloud services quickly, it would be prudent to avoid the transition from cloud to farm (data center) and plan funding accordingly.
This mode of financing is quite common in manufacturing sector where the initial cost of the equipment itself is in few millions. We are a medical R&D and manufacturing company and our manufacturing setup cost us more than the R&D and people cost even though we outsource 50% of our manufacturing requirement (mechanical, PCBs, etc) . It may sound like onetime buy but practically it is an investment you have to constantly do every 5-7 years … technology keeps pushing you hard into buy newer ONEs . Second hurdle is you cannot spread it over years, the money is required yesterday… even before you think of production. This scenario may not even appear for many internet startups but very much applicable for equipment manufacturing company … servers, computers, switches and routers can be rented until you want to scale up from 10,000 to few million users…
For a lease that ends up on the books, please discuss the depreciation and tax issues?
i’m not qualified unfortunatelywe need accountant tuesdays!
otherwise known as tedious tuesdays 😉
Ha! that’s accurate and funny at the same time
Good to know! Now I’m less concerned about not knowing! Maybe the practical answer is that the first $150 K or so can be ‘expensed’, and once we get past that we will be able to hire good tax accountants!
Here is a good overview of the basics:http://pages.stern.nyu.edu/…
Thanks. Read the paper; kept a copy.Largely, suspicions confirmed.The line”In general, capital leases recognize expenses sooner than equivalent operating leases.”seems questionable: Suppose I lease a $3000 computer for three years and pay something over $1000 a year. So, the computer does not show as an asset or liability on my balance sheet, and the $1000 a year is an operating expense and, thus, comes from pre-tax earnings.So it would seem that the lease has me “recognize expenses” at something over $1000 a year.But with an operating lease, I would get to count as expenses to be paid by pre-tax earnings only the interest and some depreciation. If the depreciation was ‘straight line’ over more than three years, then it would seem that an operating lease would “recognize expenses” faster than the capital lease.But my rough understanding is that a small business can ‘expense’ expenditures for equipment up to about $120,000 a year. So, early on, $120,000 a year would buy a lot of computer equipment for my business so that I wouldn’t have to worry about ‘depreciation’ and buying equipment from after-tax earnings.I suspect that the little secret is that after paying an operating lease on a computer for the full term of the contact, say, three years, then the lessor would be willing to sell the computer to me for not much more than than a Happy Meal at McDonald’s.And if the IRS believes that a three year old computer has a lot of ‘residual value’, then maybe I should list the thing on eBay and see what it goes for!To me a three year old computer still doing its job is quite valuable because to replace the computer I’d have to do a lot of system management, administration, and documentation, and that takes TIME and EFFORT, not counting the medication for my sore throat from screaming curses while imagining taking a fire ax to the people who wrote the documentation, etc.
Bingo!You recognize, as an example, that all the DC “inside baseball” about jet owners is the result of a policy — accelerated depreciation for the ENTIRE cost in the first year — which was actually good for the country because it ensured that aircraft manufacture, a decidedly strong US industry, would be spurred.Multiple that impact by the company being able to BORROW the money and you have a bonanza policy decision actually driving employment and as even Martha Stewart knows — that’s a good thang!Funny thing, whose policy initiative was this?Why, it was the Obama administration’s and one that while I find them generally incompetent was rightly targeted and worked. Like a champ. Bravo!In one of the great ironies of the world, perhaps one of the most insightful policy tweaks of this administration they also got a fabulous talking point.The administration created — through this policy quirk of the Stimulus — more jet owners than anyone else.Go figure! You can’t make this shit up.
Someone is ultimately going to receive the “benefit” of those deductions, the element of art when crafting “operating” v “financing” leases is to get the benefits to the party who actually has some income to shelter.This seems like a small thing in the greater scheme of things but it makes a huge difference as to the “real” cost of things.The start up with very specious income probabilities is NOT the right party to get these deductions but if they can be left on the income statement of the other party, they serve to reduce the cost of the lease if properly valued.This is why some tax strategies and policies (e.g. Tax Act of 1986) are so dopey, they might have collected a bit of sugar high tax in the short term but they walled off a lot of value which could have had a leveraged impact and multiplier of many times greater than their original value.While all of this is a bit wonky and arcane, it is nonetheless from whence jobs are created. We could use a splash of this today.
Dude – you are making it hard on all the other VCs that blog. You got the VC Post of Day again at Ask the VC.http://www.askthevc.com/wp/…Keep it up. Maybe the rest of the gang will raise their game!
i can’t stop. i’m addicted.
Healthy addiction.
Thank you for a bit of an addiction, I guess
I paid $23.88 for an i Pad 2 32-GB and my girlfriend loves her PanasonicLumiix GF 1 Camera that we got for $ 38.41 there arriving tomorrow by UPS. Iwill never pay such expensive retail prices in stores again. Especially whenI also sold a 40 inch LED TV to my boss for $ 635 which only cost me $ 61.74to buy. Here is the website we use to get it al from, http://EgoWin.com
This form of financing is definitely useful for entrepreneurs and other business people who want to free up capital, but it certainly isn’t applicable or practical to every industry.
We’ve see a huge range of terms on leasing. Fortunately mostly improving as we’ve grown as a company. The vendor lease rates have typically been the best but that doesn’t end up working for all types of equipment. We’ve worked with an independent leasing company as well – one advantage there is that they can get better prices sometimes on the equipment although they have asked for warrants so there is a bit of dilution.
I am a fan of equipment financing and agree with you that it makes all the sense in the world. As a recovering lender, I’m not sure there’s a real difference for an early-stage company between repaying a lease versus a loan as the repayment source is always the company’s cash.The lease provider or lender is really underwriting the creditworthiness of the company at an early stage. If the company shuts down, the last thing the leasing company or bank wants to do is repossess the computer hardware after three years of use. They’ll recoup maybe 10% of the loan as hardware and software depreciates pretty fast.I do think receivables financing is probably the most credit-worthy financing a start-up can do. . .as you’re borrowing against actual sales. . . .
About the leases – Some leases will be capitalized and end up on your books and look a lot like capital equipment loans. Other leases will not end up on your books and will look more like renting an office.Which one do you like better and why?
GOOD introduction, overview, summary, advice. Net, NICE Monday! Copied, saved, indexed it! Got some more following links and via Google. Good stuff.
Yeah it all sounds nice but I would advise start-ups to carefully look into the terms of the lease they are getting into. In most cases, if you do the math, renting from AWS or leasing servers, you end up paying for a whole server in about 18 months. That is far from 3 years. In those cases, owning the equipment outright might be much more economical.
Great post. We’ve been doing this for a couple years now. Interest rates have been pretty low so new equipment is simply a modest bump to monthly operating costs. After 36 months we own the equipment anyway. This allows us to keep cash on hand for other things, like R&D.
Have you ever had experience with startups factoring receivables? I can’t imagine that it happens much in the tech world, but it’s certainly a different financing option for other industries.
Thank you, makes alot of sense.
fred i like your articles
I agree that these capital equipment loans are made by these institutions to acquire the equipment, and puts it on their books, then spreads the upstream inventory capital among those higher institutions and they keep the spread. some call it creative accounting, I call it suspect. http://www.cynergysoftware.com