Dec 10, 2023

The Founder's Guide to Getting an Operating Lease in 2024

Arc Team

Go-To-Market

Operating leases enable startups to access assets needed for their day-to-day operations without the long-term commitment of ownership. Unlike capital leases, operating leases provide flexibility in asset use, making them a popular choice among startups looking to manage their cash flow. In this guide, we cover the basic elements of an operating lease, including what they’re commonly used for and we break down the key factors to consider when deciding if this form of financing is a good fit.

Operating leases - the basics

What an operating lease is (and isn’t)

An operating lease is most similar to a rental agreement, allowing startups to use an asset without taking ownership of it. In this arrangement, the lessee (the startup leasing the asset) can utilize the asset for the agreed-upon duration, which is typically shorter than the useful life of the asset. Some startups prefer this structure over a capital lease, as they can avoid the burdens associated with asset ownership.

The key features that distinguish operating leases include:

Limited Ownership Rights: Unlike a finance lease or capital lease, the lessee does not have the option to purchase the asset at the end of the lease term.
Short-Term Commitment: Operating leases usually have a shorter duration, providing flexibility for the lessee to adapt to changing business needs.
No Maintenance Responsibility: In most cases, the lessor (the entity providing the asset on lease) is responsible for maintenance and repairs, so the startup is off the hook.

How startups account for operating leases

Recent changes in accounting standards, such as ASC 842 or IFRS 16, require operating leases to be recognized as a liability on startups' balance sheets. Please note: This is not financial or legal advice, this is strictly for informational purposes.

Commonly accessed assets with an operating lease

Operating leases are commonly used for a variety of assets, including but not limited to technology equipment (computers, servers), commercial real estate (office spaces, retail locations), vehicles, manufacturing equipment, and more. We’ve outlined a few of the more common use cases below.

Healthcare Equipment: This can include imaging machines, diagnostic tools, and other medical equipment used by healthcare facilities.
Agricultural Machinery: Tractors, harvesters, and other machinery used seasonally by farmers and other agricultural businesses.
Construction and Heavy Equipment: Construction companies frequently lease heavy equipment such as bulldozers, cranes, and excavators for individual jobs.
Transportation and Vehicles: Airlines, shipping companies, and logistics firms commonly use this form of financing for aircraft, ships, trucks, and other vehicles.
Retail Store Equipment: Some retailers such as Halloween express and Party City, operate only seasonally as such they need access to cash registers, POS machines, and display cases for only a short duration.

Common terms found in an operating lease agreement

Operating lease agreements typically include a set of terms and conditions that outline the rights and responsibilities of both the lessor (owner of the asset) and the lessee (the startup leasing the asset). While the specific terms may vary from lender to lender, and based on the underlying asset, the basic terms that will be included in most agreements are outlined below.

Lease Period: The duration for which the lessee (e.g. you) has the right to use the asset.
Lease Payments: The agreed-upon monthly or quarterly payment that the lessee is obligated to make to the lessor.
Interest Expense: Included in the monthly payment is the interest expense charged by the lessor to the lessee.
Usage Restrictions: These outline the limitations on how the asset can be used.
Maintenance Responsibilities: Specifies whether the lessor or lessee is responsible for the maintenance, repairs, and servicing of the leased asset.
Insurance Requirements: Outlines the insurance coverage that the lessee is required to maintain on the leased asset during the lease term.
Option to Renew or Purchase: Indicates whether the lessee has the option to renew the lease at the end of the term or purchase the asset at a predetermined price.
Return Conditions: Specifies the condition in which the leased asset should be returned at the end of the lease term. You can think of this like the number of miles that a car can be driven during each year of its consumer lease.
Residual Value: The estimated value of the asset at the end of the lease term. The residual value can impact lease payments and purchase options.
Default and Termination Provisions: Describes the conditions under which the lease can be terminated, including provisions for default and remedies in case of non-compliance.
Subleasing Restrictions: These outline whether the lessee is permitted to sublease the asset to another party.

Finance lease vs operating lease

The main difference between an operating and financing lease is that at the end of an operating lease, there is no transfer of ownership. Whereas at the end of a finance lease, the lessee typically gains ownership rights.

Ownership Transfer: In an operating lease, the ownership of the asset typically remains with the lessor (the entity that owns the asset). In a finance lease, the asset’s ownership is transferred to the lessee.
Duration and Flexibility: Operating leases often have shorter terms and thus provide more flexibility for startups who do not intend to use the asset long-term.
Maintenance Responsibilities: In an operating lease, the lessor (party that owns the asset) usually retains responsibility for maintenance and repairs of the asset. In a finance lease, the lessee (e.g. you) typically assumes maintenance responsibilities
Purchase Option: Operating leases usually do not include a purchase option at the end of the lease term. Finance leases often include a purchase option at the end of the term, allowing the lessee to buy the asset at its fair market value.
Term Length: Operating leases are typically for less than 75% of the asset’s estimated economic life (time), while finance leases are usually for 75%+ of the asset’s estimated economic life.
Present Value: In an operating lease, the PV of the lease payments is usually less than 90% of the asset's fair market value, whereas in a finance lease the present value of the lease payments are greater than 90% of the asset's original cost.

Assessing whether an operating lease is right for your startup

The advantages of operating leases

Operating leases offer startups several advantages, making them an attractive option for startups that require expensive assets to operate. They are flexible, have predictable payments, require minimal upfront capital and can potentially save the startup money.

Flexible: this form of financing provides startups with the ability to use an asset without making a long-term purchase commitment.
Minimal Operating Expenses: most agreements do not require the startup who is leasing the asset to perform maintenance or repairs on the asset.
Predictable Payments: The fixed monthly payment from an this form of lease allows startups to budget more effectively, and avoid a large upfront capital expenditure.
Short-Term Commitment: This form of lease typically has shorter terms compared to finance leases which means they can be entered and exited more frequently.
Potential Cost Savings: In most situations, the cost of this form of lease is lower than cost of purchasing the asset, especially when considering maintenance and resale values.

The disadvantages of operating leases

Limited Ownership Rights: Operating leases do not provide the lessee with ownership rights at the end of the lease term, limiting the ability to build equity in the leased asset.
Potentially Higher Cost: The cumulative lease payments over time may exceed the cost of purchasing the asset outright, especially for long-term leases.
Limited Control: Typically startups leasing an asset cannot sublease it to another entity, and they cannot use it for purposes other than those stated in the operating agreement.
Potential Exit Penalties: Exiting a lease before its completion can result in additional monetary penalties.

Frequently asked questions (FAQs) about operating leases

What types of assets can be leased through an operating lease?

Operating leases are versatile and can be used for various assets, including equipment, vehicles, real estate, manufacturing machinery, and more.

What are the advantages of opting for an operating lease?

The advantages of opting for an operating lease include flexibility in asset use, reduced maintenance responsibility, improved cash flow management, and it being a short-term commitment.

What are the disadvantages of operating leases?

The disadvantages of operating leases include limited ownership rights, potentially higher overall lease costs, restrictions on modifications, and accounting complexity.

What are the qualifications for an operating lease?

The qualification for an operating lease typically involves demonstrating creditworthiness, providing financial statements and tax returns, articulating the purpose of the lease, and meeting specific requirements set by the lessor.

What happens at the end of an operating lease term?

At the end of the lease term, the lessee can typically choose to return the leased asset, renew the lease, purchase the asset at its fair market value, or enter into a new lease agreement.

Are operating leases suitable for short-term or long-term needs?

Operating leases are often suitable for short to medium-term needs, as they are their flexibile and adaptable to changing business requirements.

How do operating leases impact a company's cash flow?

Operating leases can positively impact cash flow by spreading the cost of an asset over time through fixed monthly payments, thus avoiding a large upfront capital expenditure.

What happens if an operating lease ends early?

Ending an operating lease early may result in penalties or fees. That’s why it's essential to review the lease agreement for specific termination clauses and the associated costs.

Can I purchase the leased asset at the end of the operating lease term?

Some, but not all, operating leases offer a purchase option, allowing the lessee to buy the asset at its fair market value at the end of the lease term.

What types of startups are best suited for an operating lease?

Startups that require flexibility, have varying needs for the asset, or prefer to avoid long-term commitments may find operating leases well-suited to their needs.

Wrap up - signing an operating lease in 2024

Operating leases are a great option for startups that need to use high-cost assets in their day-to-day operations, but do not have sufficient capital to purchase them, or do not want to make a large capital outlay upfront. Opting to rent such assets is a practical and cost-effective solution for the short to medium term until purchasing the underlying asset is feasible.

While making an outright purchase is likely the more cost-effective option in the long term, the maintenance and repair responsibilities that come along with ownership are a drawback. Ultimately, early-stage startups should consider an operating lease over a financing lease until their economics have been established and they have reached cash flow positive.

If you’re interested in an operating lease, get in touch with us.