How to lease in peace.

Are you squeezing everything you can out of your equipment-leasing transactions? Find out how smart leasing arrangements can cut your costs -- for software, too -- and relieve the pressure on your balance sheet.

Today, almost every company leases some of its equipment -- and with good reason. Leasing can be a convenient financing alternative, partly because it doesn't involve capital-budget financing. Another advantage is the ability to match costs with the revenues the equipment generates. And if you structure your lease financing properly, you can account for it off the balance sheet and shift your tax deductions to the lessor, which lowers your after-tax cost compared with buying.

This benefit can help your company maintain its debt-to-equity ratio. And leases can protect against inflation because leased equipment usually retains its productive capacity, even as the dollars used to pay the rent lose their purchasing power. Interest-rate fluctuations won't affect the fixed leasing rate. Of course, leasing also offers you a hedge against technological change and obsolescence, because by upgrading to new equipment when your lease expires, you can shift to the lessor the risk of getting stuck with outdated equipment.

Given these advantages, how do you get the most financial leverage possible out of your leasing transactions? First, when you're at the negotiating table with your lessor, try to anticipate your needs before you sign the lease, because it's tough to get lessors to make changes later on. This reluctance stems from the fact that the lessor actually finances the purchase price of the equipment through a nonrecourse loan from (or discounted rental-stream assignment to) a bank or other funding source, which will then take a security interest in the lease, the lease rentals and the equipment. This normally doesn't create a risk for you, since the lender's primary interest is maintaining cash flow. But it does create some distance between you and the assignee of the lessor.

QUIET ENJOYMENT AND OTHER PROTECTIONS

Although the lessor will probably want to make these assignments without your consent, you should at least insist on being notified. You'll also want the lease to stipulate that your company has the right to "quietly enjoy" uninterrupted use of the equipment as long as you continue to pay the leasing fees and comply with the lease terms. You can ask that assignees of the lessor's interest confirm this in writing.

The next thing you need to know is that most equipment leased in the United States today is covered by a "triple net" lease. Generally, this means that all essential risks and obligations relating to the equipment during the lease term, including the risk of loss or damage to the equipment and responsibility for taxes, are your sole responsibility. Property, sales and use taxes, as well as any miscellaneous taxes, are also usually your responsibility. Since you're responsible for insurance and maintenance, as well as all wear and tear to the equipment, consider self-insurance as an option. If you can self-insure, you may be able to get the lessor to remove the standard insurance requirements in the lease.

Also, almost all leases address the subject of returning the leased property, including refurbishment, modification, storage, shipping and crating responsibilities. Before signing the lease, you must consider if you want an option to buy the equipment at the end of the lease term for a nominal price, a predetermined price or a price equal to the property's then-current fair-market value.

Nominal-purchase options are particularly useful in instances where the cost of removing and shipping the leased equipment may well exceed its fair-market value, such as with telephone systems and restaurant or store fixtures. If you have a similar situation and your lease doesn't contain this option, you may face potentially burdensome return penalties. You don't want to find yourself in the position of being forced to purchase equipment you no longer need and losing the benefit of your lease transaction simply to avoid paying these penalties.

Don't delay about returning your equipment, either. Leases often contain automatic renewal, or "evergreen," provisions. This means you're still liable for the equipment after the lease expires or, in the case of an initial lease term, for "renewal" of the lease term, usually for up to one year. Establish monitoring systems to ensure that you return or purchase the leased equipment when the lease term expires. Of course, that also goes for your rental payments. Leasing companies may not always invoice you for your monthly rentals, but that won't stop them from charging substantial penalties for late payments.

As your company grows, you may need to relocate the leased equipment to another location, subsidiary or other affiliated company in a distant city. Generally, the lessor won't provide you with absolute freedom to sublease the equipment or to move the equipment from one location to another, so if moving or subleasing your equipment is a possibility, talk it over with your lessor before signing the lease. You should be ready to assure the lessor that you'll respect its interests by giving appropriate notice before you move a piece of equipment and by re-filing Uniform Commercial Code financing statements if necessary. When agreeing to permit the equipment to be used by a subsidiary or affiliate company, the lessor will also require a guarantee from you that your responsibility won't be diluted in any way, and that you'll continue to remain fully and primarily liable for all your obligations.

THE LOWDOWN ON UPGRADES

Similarly, if you think you may need to upgrade or modify the equipment during the lease term, you should ask for provisions that grant your company reasonable permission in advance to alter the equipment. It's customary for the lessor to keep any modifications to its equipment. But if you want to retain the rights to the upgrade, you can structure the lease to reflect this without increasing the lessor's risk.

For example, the lease can specify that the lessor has the right of first refusal for any proposed upgrades. This means it doesn't have to finance the upgrades that you request. And you can guarantee that any upgrades you make will be removable without damage to the equipment. If you can't get your lessor's cooperation to permit an upgrade, you may have to negotiate to avoid paying the entire lease rental balance in order to relieve yourself from contractual liability.

Warranties are another aspect of your leasing arrangements to which you should pay close attention. In most lease financing (other than a warranty of good title), the lessor will disclaim every type of warranty, representation or obligation on its part. Therefore, get the appropriate warranties and protection from the vendor or distributor furnishing the equipment. Most leases contain "hell or high water" provisions, which means your company must pay the rental fees regardless of the circumstances -- even if the equipment is defective. Since the protections you get from the vendor or manufacturer are so important, the lease should assign to you all the lessor's rights against the manufacturer and vendor of the equipment for any express and implied warranties. Also, keep copies of all express warranties.

A NEW WAY TO PAY FOR SOFTWARE

With all this information under your belt, you may want to consider extending your leasing arrangements to include computer software, which is a rapidly growing area in the leasing industry. Until recently, software packages typically involved only the purchase of the right to use, manage and handle the computer programs. In other words, companies that use software don't technically buy it; they receive a license to use the software under specific terms.

The cost of licensing software typically is several thousand dollars for prepackaged software, but larger systems, which are typically customized, can range in price from several hundreds of thousands of dollars up to several million dollars. Some leasing companies may even be willing to foot the bill for in-house development and software modification, but that's not always the case.

Therefore, as software packages eat up more and more of companies' data-processing budgets, financial executives are turning to new financing alternatives. Leasing companies seeking to accommodate both users and vendors have evolved the ability to finance large software packages, particularly systems software for significant data-processing installations. Third-party leasing companies typically include one-time software license fees in the cost of the system, and they'll also finance the total system cost. Under the third-party financing structure, the leasing company pays the software or systems vendor in full upon delivery and installation of the software package. Usually the leasing company requires the software to meet performance tests or acceptance criteria before it will pay the vendor.

This innovative method of financing differs from traditional equipment leasing in some important respects. For example, instead of purchasing the software from the vendor and leasing it to your company, the lessor may obtain a license to use the software and then sublicense it to your company. This structure requires cooperation between the software vendor and the lessor, and it assumes that you'll work out with the vendor all aspects of the software license and the right to use the software, giving you the same result as if you paid the vendor directly in cash.

With software leasing, the vendor retains ownership of the software and remains involved in maintenance and control. In this respect, the vendor continues to be a party to the lease transaction throughout its term. The usual restrictions software licenses contain, including limitations on use, copying, maintenance and disposition, carry over into the software lease.

Another difference between software leasing and traditional equipment leasing lies in the lessor's collateral security for the user's payment obligations. Since software can't truly be repossessed and then sold to recover payment deficiencies, new technology has provided a remedy for lessors and vendors. Lessors now depend on the same control techniques vendors use in enforcing ownership rights in software licenses. These techniques include disabling the program through various mechanisms in the software code, refusing to maintain or upgrade the software package and exercising controls over the program source code.

As you might guess, it's also a good idea to be careful about disposing of or transferring the leased software. Most vendors require you to clearly identify how you intend to use the software, and they may ask you for the specific serial number of the hardware you'll be using with the software. Transferring the software to other hardware, using it on other equipment, granting subleases and sublicenses, or otherwise letting a third party use the software is strictly prohibited, unless you negotiate those arrangements in advance.

A FINAL CAUTION

One final caution for any kind of leasing transaction: It's important to investigate the reputation of the leasing company and the equipment vendor. Many leasing companies are small businesses whose entire operation may consist of a single employee, a desk and a telephone.

To ensure that you're dealing with a reputable company, contact some trade associations for information, get referrals from other companies and contact the company's previous customers. Often, manufacturers will provide a list of the lessors they recommend. But don't limit yourself only to those companies, since they may not be as competitive as independent third-party lessors.

Mr. Leichtling is a partner in the New York law firm Parker Chapin Flattau & Klimpl, where he heads the equipment leasing and financing group.