Attention Lessors! There are Multiple Opportunities in Software Leasing
by Mark S. Bazrod June 2008
Looking to find a new niche market to explore? Well look no further — software leasing could be just the market for many lessors looking to reach beyond their current core businesses. What are the benefits of branching out into this unexplored territory? LPI Software Funding Group’s Mark Bazrod explains.
The threshold question this article presents is: “Should you finance an intangible asset, which you normally can’t repossess, don’t have the right to remarket, have to educate your funding sources, credit resources and vendor’s salespeople, and you don’t understand the legal underpinnings of software and intellectual property?”
The answer for some of us is an unequivocal “yes!” Software leasing has great potential. For instance, software is an essential asset (the lessee can’t operate its business without software), it doesn’t depreciate in value, there is less competition than in equipment leasing, the risk is less than perceived, and the software industry needs knowledgeable lessors.
More small-ticket leasing companies are offering 100% software leases. Apart from a small number of software vendors, only about 25 other lessors offer 100% software leases, mostly for investment-grade transactions over $750,000. There is a shortage of lessors for transactions between the small-ticket area and $750,000 and also for noninvestment grade prospects.
Computer hardware has become a commodity and it is software that now provides the bulk of value to the user. Software expenditures generally exceed computer hardware costs. Yet while computer hardware represents more than 20% of the dollar value of all leasing transactions, software represents less than 2%.
The purpose of this article is to offer some guidance to lessors who may be considering software leasing as part of their business strategy.
What is Software Leasing and What are its Forms?
What is software leasing and what do software leasing transactions look like? In general, software leasing is the financing of a perpetual, nonexclusive, nontransferable software license (not the developer’s rights in the software) under a capital lease, where the lessee makes no payment at lease termination and the lessor’s rights expire. It can include related costs such as hardware, implementation, training, consulting services, custom programming and first-year maintenance or support. It can be secured by the license or be unsecured. The normal term is one to five years. There is generally no recourse to the vendor for credit defaults.
The transaction can be documented as a lease, an installment payment agreement, a promissory note or an extended payment rider to a license. We, at LPI Software Funding Group, Inc., use a lease, but do not take title to the license. We obtain a lien on the license. We prefer a lease because we think it’s better from a marketing standpoint and simpler as well. The vendor grants the license to the customer so the lessor doesn’t get in the middle of marketing or the vendor’s obligations. We believe the lessor should have a security interest in the software license and have the right, if the customer doesn’t pay, to require the customer to stop using the software and return the software. That’s similar to an equipment lease where the lessor has the right to take the equipment if the lessee doesn’t pay.
Obstacles to Software Leasing
What are the obstacles to leasing software? The main ones are: the failure to recognize that software is more valuable than hardware, the need to educate funding sources and credit resources, unfamiliarity with intellectual property concepts, the perplexing terminology of software licenses, the novelty of leasing intangible property, the lack of substantial guidance in the Uniform Commercial Code (UCC) prior to its 2001 revision, and the software industry’s lack of knowledge about leasing.
Lack of belief by the lessor in the value of software, particularly if a default occurs, is probably the major hurdle. Software is, in almost all instances, an indispensable asset that the user needs to operate its business. When financial difficulties arise, the software lease generally gets paid. Software doesn’t decrease in value like hardware. Since support includes upgrades and new versions, the customer always has the current version of the software — it doesn’t become obsolete like hardware.
Education of funding sources (internal or external) and credit resources is another major hurdle. A lessor must convince them that the risks associated with software leasing are acceptable ones — a process that can be time consuming.
The other educational task involves software salespeople. The overwhelming majority of them don’t have any leasing experience, unlike the hardware industry. It does you no good to arrange a program with the vice president of sales, but neglect to educate the salesforce.
A lessor should attempt to understand the software industry. Estimates of the number of software developers range between 40,000 and 50,000, with the overwhelming bulk of them private and with revenues of less than $25 million. Also, there is a fair amount of personnel turnover.
A lessor should examine its lease documents. Although most provisions are satisfactory for software leasing, there are numerous provisions that should be rewritten when you deal with an intangible such as software. For example, the term “equipment” should be changed to “equipment and software” in most provisions. Similarly, a lessor will need additional remedies, such as the lessee agrees to not use the software or support in the event of default.
It’s a sad commentary that so many software companies and users are not aware that software can be leased. One study indicated that 45% of software companies with revenues more than $10 million offer some form of software financing (often merely payment terms), while less than 10% of software companies with revenues less than $10 million offer some software financing.
Software Doesn’t Depreciate Quickly
New business models continue to evolve, but that does not mean users quickly adopt new software and models. Many users use older versions for years. Conversion costs, cost of integration with other applications, cost of retraining personnel, and the need for additional IT resources are often high. Business spent billions on revising older software applications to solve the Y2K problem rather than acquire newer software applications.
Arguments for rapid depreciation ignore one of the most salient aspects of the software business model: most users obtain a maintenance contract with the vendor so that they are entitled to new releases of the software without further payment. Thus, three years after software acquisition, the user has the latest version of the software, making the argument of rapid change in the software industry often academic and irrelevant. So, software generally does not become obsolete like hardware. A lessee generally cannot obtain a cheaper up-to-date version, and making lease payments is cheaper than obtaining a replacement.
Software Financing is Secured Financing
Under the old UCC, a lessor could get a security interest in general intangibles and thus presumably in software. Revised Article 9 of the UCC, which became effective in 2001, specifically provided — for the first time — that the term general intangibles includes software. Without going into detail, a lessor can be very confident that a UCC filing is effective for nonexclusive licenses — and most software licenses are nonexclusive licenses. For an exclusive software license, a lessor will need to have the software intellectual property registered and have the exclusive license and its security interest recorded with the U.S. Copyright Office.
Nonetheless, many financing and credit people argue that software leasing is effectively unsecured financing since software licenses are almost always nontransferable and cannot be sold in the event of a default.
What they overlook is that software is an indispensable asset that the user needs to operate its business. Thus, when financial difficulties arise, software lease payments tend to be made because of the indispensable nature of the software. A software lease should preclude the user from using the software in the event of default.
The essence of a security interest is the right of the lessor to enforce the obligations of the lessee through a preferred claim on a specific asset. Thus, the probability that the lessee will continue making payments for software means that a security interest in such collateral has very high value.
A Lessor Doesn’t Need to Obtain Title to the License
There is an unstated assumption in the leasing industry that the lessor should have title to whatever is leased, which is certainly necessary in operating leases. It is not necessary in capital leases, however, where what you need is a security interest and title is irrelevant — either you are secured or you are unsecured. In fact, the heading of Revised UCC §9-202 is “Title to Collateral Immaterial.”
Most licenses are nontransferable, so the lessee cannot legally assign the license to the lessor. It’s possible that the license could be granted to the lessor with a right to sublicense to the user or lessee, but it is rarely done. There are numerous issues, which would have to be resolved between the developer and the lessor, and the lessor would be exposed to claims by the user unless complex agreements are negotiated. Thus, the normal lease documents providing for title in the lessor should be redrafted if the lease is to reflect the fact that the lessee has title to the license.
Software Has Value in Bankruptcy
Most software vendors do not permit a license to be transferred, (i.e., remarketed.) Therefore, the critical question is not whether the lessor can remarket the software; it is whether remarketing is critical or even necessary. A lessor will not need to consider the remarketing question because the lessee will often either pay or go into bankruptcy.
The problem has been that until recently it was not possible to prove that remarketing is not critical. Software has been leased for a relatively short time, and most leases have been with better credits so that the potential for default has not been great.
Two of our larger software lessees filed for bankruptcy several years ago. Our claims as a secured creditor were recognized in both cases. Consequently, there is some validation that a secured interest in software will be recognized and that the economic value of the software will result in payment of the lessee’s obligations.
These cases should provide a lessor with a high degree of comfort that software has substantial in-place value and that a well-structured software transaction should protect the lessor against loss in a Chapter 11 proceeding.
There is no court decision that squarely rules that not only is a perfected security interest in a nonexclusive software license valid, but also that the value of the software (the maximum value of the secured party’s claim) is the in-place value of the software.
Applying the concepts of Associates Capital Corp. v. Rash to software financing, one should conclude that in a Chapter 7 liquidation proceeding, the value would be zero if the license is nontransferable and has no resale value, whereas in a Chapter 11 reorganization proceeding, the value would be the in-place value. This value will almost always be more than the lessors’ claim.
No Purchase Money Security Interest
The Revised UCC dubiously provides that a purchase money security interest (PMSI) can be obtained only in goods. Software is not a “good,” and therefore one cannot obtain a PMSI in software. This followed the prior UCC. Prior law took precedence over common sense. It didn’t have to be that way. Canadian law allows a PMSI in software. If there is a blanket lien, obtain the agreement of the blanket lien holder that your security interest takes priority over the blanket lien. That is rarely a problem.
Services & Custom Software Are Essential
Almost all software is essential to the operation of the business and therefore leaseable. If one agrees, the same logic applies to the services. It also applies to custom software. All should be leaseable.
Vendor Approval Is Not Needed to Finance the License
Some vendors require their approval for a lessor to finance a license. Unless the license specifically requires such an agreement, it is not necessary, and revised UCC §9-408(a) and (c) provide that a licensor’s restriction on a licensee granting a security interest in the license is not enforceable. However, revised UCC §9-408(d) does provide that a lessor or other financier cannot transfer the license.
No Vendor Remarketing Assistance
Equipment leasing programs often include remarketing assistance. They are a rarity in software leasing programs, primarily because AICPA SOP 97-2 denies sales treatment to a vendor that has even the hint of an obligation to assist in remarketing assistance, even if compensated.
Software leasing should be a viable product for many lessors, the competition is not as intense as it is in equipment leasing, and the business is a credit business rather than a residual business. You will have to commit significant resources to develop a meaningful business that meets the needs of your customers, but the effort should be worth it.
Mark S. Bazrod, CPA is president of LPI Software Funding Group, Inc., and an attorney. He has been involved in the leasing industry for 40 years. Bazrod founded LPI in 1983 to expand upon his experience in structuring operating lease programs, and LPI has specialized in computer software leasing for the past 16 years.
He is a past board member of the ELFA and a past trustee of the Equipment Leasing & Finance Foundation. He previously chaired ELFA’s Operating Lease, Federal Government Relations and Information Technology committees. He has been a frequent speaker for ELFA, EAEL, Amembal & Associates, the World Leasing Conference and other organizations. His articles have appeared in numerous magazines.
For a more extended discussion of some of the material in this article, see Mark S. Bazrod, “Puncturing the 15 Myths of Software Leasing,” Journal of Equipment Lease Financing, Vol. 24, No. 3 (Fall 2006), as well as other articles on www.lpilease.com.
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