When financing industrial or manufacturing equipment, there are many pitfalls to avoid. Some of the “gotchas” in equipment financing and leasing contracts are outright scams, while others are more subtle. Knowing the potential financing risks can help avoid a costly and unpleasant experience when acquiring equipment.
One pitfall to be aware of is “interim” or “pro-rata” rent on prefunding. Pro-rata rent refers to payments that are made in advance of a lease or finance commencement date. Pro-rate is similar to rent on an apartment which is due on the first of the month. If a renter moved in on the 15th of the month they would be charged for half a month of rent.
Imagine an order for $2 million worth of production line equipment. Sellers usually won’t start work until receiving the first progress payment (often 25-50 percent of total cost). Also imagine it will take 15 months between the first progress payment and delivery, installation and inspection of a completed production line. Lastly, assume having been approved for an 84-month term with payments of $28,000 monthly.
When a lender makes a payment in advance of delivery, the industry jargon word used is “pre-funding.” Many equipment leases stipulate that pro-rata payments must be made for the time period between pre-funding and delivery, installation and inspection of the completed order. In the above example, interim may consist of 15 months. During that time, 15 payments of $28,000 may be charged, and those payments do not reduce the principal balance of the equipment lease or finance contract. In the preceding example, pro-rata could represent $420,000 in unplanned finance charges. For this reason, equipment lease companies will happily offer to pre-fund progress payments to an equipment vendor, as those pro-rata payments represent almost pure profit.
Large interim payments are a common occurrence in “non-bank” equipment financing. Knowing the dangers of interim payments beforehand gives a company options to mitigate or negotiate unnecessary finance charges. For example, one can negotiate upfront that interim is to be paid only on the advance amount (i.e. on a 25 percent progress payment towards a $2 million equipment purchase, pro-rata could be negotiated to be paid on the $500,000 advance, versus the entire $2 million). Alternatively, short-term credit lines may be an option to fund progress payments. In some cases, qualified buyers can negotiate with equipment lenders to have pro-rata payments removed or significantly reduced.
Another trap to be wary of involves equipment financing or equipment leases with a quarterly payment. These transactions can also carry “pro-rata” language within contracts which is often abused by unscrupulous lenders. Some lenders create lease commencement dates every business day of the year; this allows them to collect 89 days of interim rental payments regardless of the delivery date of the equipment. For example, going back to the example above with $2 million worth of equipment, slipping an extra 89 days of “rent” into a contract allows the leasing company to collect an additional $83,066 in payments without creating any actual value whatsoever.
Evergreen lease clauses can also become a problem for many businesses. Many equipment lease contracts are “lease to own,” meaning ownership occurs immediately upon the last payment. Other lease contracts are written as a “lease with an option to own.” This means that after making the last payment, the company may purchase the equipment or return it. However, buried deep within some contracts is language stipulating that intent to purchase must be made between 90 and 180 days prior to the end of the lease; failure to provide such notice can trigger an automatic 12-month extension of that lease. Back to our $2 million production line, that extension could represent an additional $336,000 in payments. Equipment lease companies often do not notify customers of upcoming lease expirations. There have been reports of companies that have made several years of additional payments because they were unaware that leases had “rolled over.”
All the above financing and leasing traps can often be avoided by carefully reading any equipment financing or leasing contract. It is wise to have an attorney review contracts prior to signing; this is particularly true for purchases of equipment that exceed $150,000 in costs. A further recommendation is to have an attorney that specializes in equipment leasing review contracts as they should be familiar with most of the common problems that companies run into when financing equipment. These simple steps can potentially save a company thousands when financing equipment.
Rob Misheloff is president of Smarter Finance USA.