OWNER'S MANUAL

Should You Lease Back to Customers?

Sometimes the benefits of ownership make sense for you and not your customer.
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Dear Jeff,

A customer wants to sell us back a piece of equipment he purchased from us and then lease it. What concerns should I have?

-- Name withheld by request

A bunch.

Generally speaking, a lease back is an arrangement where a company sells an asset to a buyer and immediately leases that asset back from the buyer. A lease back lets the initial buyer make full use of the asset while avoiding tying up capital tied in the asset.

In your case the only difference is the timing.

A lease back can also be used to generate needed cash. For example, say my company owns a building: I could sell the building to you, pay off any loans I have, pocket the difference, and lease the building back from you.  The net result is I stay in the building and get some cash. Of course that also means I'm on the hook for monthly lease payments because now you're my landlord.

So first let's look at it from your customer's side, since I'm guessing some of your interest in the deal is to build a stronger relationship with that customer.

Say his equipment is worth $40,000.  He has a short-term cash flow problem and needs cash. He wants to sell it to you for $40,000 and immediately lease back for, say, $700 a month for five years.

He retains the use of the equipment, gets immediate cash to cover his shortfall, and spreads the payback period over a reasonable period of time.  He may also want to include in the agreement that he can buy the equipment back at the end of the lease, ensuring he retains use of that equipment for as long as he likes.

Sounds pretty good for him. The only thing he "loses" is the ability to depreciate the equipment for tax purposes. (Since you're the owner, that tax break is yours.)

Doesn't sound so great for you, though. One, you'll only receive $42,000 in total payments. That's not a particularly good return for a 5-year loan. Worse, unless your agreement states otherwise you are now responsible for all the maintenance, repairs, etc on the equipment. The lease payments need to cover those estimated expenses. And if you aren't responsible for upkeep, you need a way to ensure that repairs and maintenance he performs keep the equipment in good working order. (Sure, he has a vested interest in keeping the machine running, but only until the day the lease ends.)

Of course your customer will argue that the equipment will have a fairly high value at the end of the lease, and since you will benefit from that value, the lease payments should be lower as a result. (Why should I pay full value in lease payments for an asset that only loses, say, half its value over the term of the lease?)

That puts you in a tricky spot. It's in your best interests to argue the equipment will have relatively low value at end of term, but then again, since you sold him the equipment the last thing you want to argue is that it will be nearly worthless before your sales brochure claims it will be worthless.

Also keep in mind that while the lease obligates your customer to make payments for the entire term, if he's struggling now, he could be struggling later, and could go out of business. Then you'll have a used piece of equipment on your hands that might be tough to sell.

That doesn't mean a lease back isn't a good idea. Companies with decent cash on hand or sizable lines of credit lease back assets all the time. Just make sure you look closely at the financials and make sure you're comfortable with what happens if one of your "what if?" scenarios actually comes true.

Check out these financial and performance measurement articles:

IMAGE: Sayantan Chaudhuri / Flickr.com
Last updated: Jan 8, 2014

JEFF HADEN | Columnist

Jeff Haden learned much of what he knows about business and technology as he worked his way up in the manufacturing industry. Everything else he picks up from ghostwriting books for some of the smartest leaders he knows in business.

The opinions expressed here by Inc.com columnists are their own, not those of Inc.com.



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