If you're like most people, you probably use the terms equipment lease agreement and equipment finance agreement (EFA) interchangeably. They are certainly similar in many ways.
An equipment lease is a financing option where a business owner rents a piece of equipment for a fixed term at fixed monthly payments. At the end of the term, the business operator has the option to turn in the equipment or purchase it for an extra fee.
An EFA is described by industry experts to be a bridge between a lease and a loan. It has some of the characteristics of a lease, but it has the language of a loan.
Let's take a closer look at the features of both financial products.
Today's law schools are turning out thousands of ambitious lawyers, and their numbers seem to be keeping pace with the increasing number of lawsuits that are being filed with the courts. Many of those lawsuits center around leased equipment accidents.
A warehouse worker drives a leased forklift to move inventory from the receiving area into a temporary storage spot. The forklift that the driver has been using to do her job for a month suddenly slipped a gear and caught on fire. The forklift driver suffers third-degree burns.
After leaving the emergency room, her husband suggested getting legal counsel. While it's apparent who the plaintiff is in this case, you may be surprised at the defendants.
Most people will look to the woman's employer as the responsible party when it comes to compensating her for injuries, missed work time, and medical care reimbursement. However, the law generally points the finger at the equipment owner as the responsible party when pieces of equipment malfunction due to negligence and cause injuries. The forklift was a piece of leased equipment, and the woman's employer did not own the forklift.
Depending on the circumstances surrounding the malfunction, the employer could shift the blame for the entire accident to the company that leased it the forklift. When signing over leased equipment, the lessor must make sure that the leased equipment is in good working order and has no faulty components. If a lawyer can prove that the injury was caused by negligence to make a critical repair that should have been done several months ago, then the lessor will be liable for the forklift driver's injuries.
Failing to provide lessees with user manuals for leased equipment and not having adequate liability insurance coverage are other scenarios that land lessors in hot water.
These lawsuits have become so common and costly over the years that federal legislation was enacted to shield lessors from liability in many of these instances. The law is called the Graves Amendment 49 U.S.C. 30106, but it doesn't totally protect lessors from liability.
As a result, industry experts had to get creative. They came up with the EFA as a response. An EFA has the look and feel of a lease agreement. It has fixed monthly payments. It also has a streamlined application process that's similar to an equipment lease. However, the language of an EFA is a dead giveaway that the ownership of the leased equipment is being shifted away from the leasing company.
EFAs use loan terms such as "lender" and "borrower." After the agreement is signed, it's clear that the owner of the equipment is the borrower. If you use an EFA to finance your heavy equipment and machinery, you're considered the owner. You're responsible for equipment maintenance and for getting adequate insurance coverage for your new piece of equipment. You also will likely be the only defendant in a lawsuit such as the one in the forklift example.
Equipment ownership is one of the main differences between equipment leases and EFAs. While nearly every equipment lease agreement gives the lessee the option to buy the equipment at the end of a fixed period, the terms of the sale can vary.
EFAs automatically assign ownership to the "borrower" or at the end of the fixed term; no extra payments are required. Is this desirable? Consider the advantages and disadvantages of equipment ownership through lease agreements and EFAs.
When you lease equipment, the end of the term almost always ends in more payments. You can turn the equipment in and buy or lease new equipment, or you can pay an extra fee to purchase the leased set of equipment. With an EFA, you're done making payments on equipment, and you're free to use the cash for other things.
Businesses rely on credit to quickly expand their territories and to stave off disaster during emergencies. When you finance equipment using an EFA, you'll receive the title to the equipment after making the last payment. With title in hand, you can borrow from lending institutions using the equipment as collateral.
Liability insurance is a key expense, whether you do equipment financing using a lease or an EFA. With a lease, the leasing company requires that you have liability insurance on the equipment during the entire term of your lease. Leasing companies require lessees to make the finance company the "loss payee'' for any insurance claim payments.
Since the leasing company holds the title and is liable if the equipment causes harm, it has a vested interest in maintaining insurance coverage. If you drop the coverage, the equipment leasing company will get its own liability insurance and charge you to use it.
There are some benefits of using the leasing company's insurance. The leasing company will nearly always have broader coverage for its equipment than the standard coverage that small businesses tend to get. When things go awry and a claim needs to be made, you'll always pay a deductible if you're using your own policy. If you use the leasing company's policy, you will only pay a deductible if the claim is under $100. Also, insurance companies are known for canceling basic policies if a company has too many claims. This isn't the case with the leasing company's policy. If you're leasing your equipment and have the option to use the leasing company's liability insurance, it may be a good idea to do so.
If you finance your equipment using an EFA, you're solely responsible for keeping up with liability insurance. There is no safety-net insurance policy from a leasing company in place to help you.
Many businesses rely on updated equipment for successful operations. For instance, a software company develops sensitive systems for financial services companies. Instead of relying on a public cloud to develop, test, and deploy its software builds, the company decides that it wants to host its own private cloud using equipment that it maintains in-house. This type of company may want upgraded equipment at the end of its term and not be the owner of outmoded hardware and middleware at the end of an EFA term.
In this case, leasing gives the company more flexibility to evaluate the market and decide what to do at the end of the lease agreement. Lease payments show up on the balance sheet as operating expenses that are fully tax deductible. If tech equipment manufacturers introduce new items to the market at the end of the leasing period, the software company may decide to sign new leasing terms to get the updated equipment. This is often a better idea than attempting to get board approval for a new capital equipment expenditure.
The differences between equipment leases and EFAs are subtle but important. Consider your industry's economic climate, your company's strategic goals, and the advice of your CPA when choosing between these two financial products.