Formula for Buying a Leasing Company

The tight money market has produced some un­expected repercussions in the leasing business, not the least of which has been the need for many of the smaller leasing companies to sell out because they have been unable to retain their credit lines, bringing home to the leasing industry once again the fact that leasing is a precarious business indeed. Always, it is dependent on three factors over which it has no control-the availability of new ears of the right make and model at the right time; the ability to insure leased vehicles; and the willingness of the financing industry to continue to finance the vehicles that are to be put on lease.

Establishing Net Worth

One of the questions that has come to the fore as a result of this latter problem, now plaguing the leasing business, is how one determines the true net worth of a leasing company, when one is consider­ing the purchase of one of these smaller lessors that is in trouble. From the seller's point of view, there is the question of how much should he ask for his company, recognizing that if he does not sell, he is faced with the expense of liquidating the cars on lease over a period of a year or more, while income drops steadily as ears are taken out of serv­ice and not replaced with new ones. In such cir­cumstances, how does one establish a price that is satisfactory both to the buyer and to the seller?

Businesses of all kinds are generally bought and sold on a formula which rests on past earnings, averag­ing out profits for a certain number of years so as to establish a base. Even when dealing in common stocks, listed on any one of the exchanges, this for­mula is constantly used to determine the true value of any company's stock. Most professional investors will rate the value of any given stock by how many times its earnings it is selling for, generally using from fifteen to twenty times earnings as the maxi­mum it will pay for a given stock.

It is virtually impossible, though, to try to use a formula of this kind in buying and selling a leasing business because, only too often, the leasing com­pany being offered may never have shown a profit, and, therefore, has established no basis of earnings. Because it is possible for a leasing company to re­main "in the red" year after year so long as it continues to expand its operations, many leasing com­panies have taken advantage of this accounting "break" for tax reasons and their financial statements have reflected no profits, even though they may have been in business for a considerable number of years.

Bankers have often remarked about this, pointing out that leasing companies, especially those operat­ing principally under the finance type of lease, do not properly indicate their true profit and loss posi­tion. In preparing financial statements, they ignore the unearned profit that will be accruing to them over the term of the lease.

Fixed Assets

Another problem is that there is little in the way of fixed assets in most passenger car leasing com­panies other than office furniture and equipment. Invariably it will be found that the vehicles on lease have been financed for the full value of each car and that the repayment schedules are generally tied to the amortization rate the customer pays. If the repayment rate to the bank is higher than that paid by the customer the leasing company will, it is true build up some equity, but it is difficult to determine the exact amount of any such equity because its true value can only be realized when the lease is terminated and the used car has been sold. Any at­tempt to establish equity value during the term of a lease is really only a guess, which cannot very well be used in "a buy and sell arrangement" un­less there are fairly safe reserves set up to protect the buyer if the expected equity is not recovered.

There have been many attempts to establish a price for a leasing company by using an average figure that one will pay for each lease contract, usually from $300 to $400 per lease. While a formula of this kind may simplify the contractual arrangements, there is the danger of oversimplification and there may be a tendency to "sweep under the rug" many items that should be examined carefully. There are just too many loose ends in any leasing operation to warrant the, use of a simplified formula. And, too, each type of lease, the finance lease, the ''net" lease, and the full service program has to be looked at from almost completely different viewpoints in order to  properly  appraise  the profit  potential  of each.

The Finance Lease

The finance lease is probably the easiest to evalu­ate and presents no real problem because it really requires only an application of simple arithmetic to determine whatever profit remains in each lease. Finance leases generally are of the add-on type un­der which the leasing company works on a mark­up or fee basis while the customer pays the full cost of ownership-depreciation and interest. If the mark-up or fee is added monthly, one need only determine the number of months the lease has been in operation and deduct from the original mark-up the total of the profit payments that have already been earned. The remainder of the mark-up profit will come to them either in monthly payments or when the lease is terminated and the vehicle is sold. In computing the value of a finance lease, therefore, the total unearned income on each vehicle, plus interest profit for the remaining months, must be calculated and taken into consideration to es­tablish true net worth.

In some instances, agreements have been made on finance leases which allow the seller some con­sideration or participation in possible renewal profits on the grounds that he is entitled to some premium beyond merely what has been written into the leases he is selling. A formula which allows him 25% of the profit mark-up on new leases, payable as they are written, has been used a number of times.

The Net Lease

The flat-rate or so-called "net" lease, under which the customer agrees to maintain the ear at his own expense but accepts no responsibility for deprecia­tion losses on the sale of the used car, is a diffi­cult one to evaluate. One must be sure the leasing rate includes a substantial amount of money as a safety factor to cover resale losses due to high mile­age, wear and tear beyond the normal, or just plain abuse, or that a sufficiently large deposit has been made by the lessee to protect the lessor against cracked windshields, rusted fenders, and accident damage that has not been repaired, or to take care of any abuse or lack of maintenance.

In looking at leases of this kind, the purchaser must disregard all the formulae normally used in buying a business and approach the deal from the stand­point automobile people understand best-buying a quantity of used cars at a price established a year or more ahead of the date on which they will be turned in. So long as there is no possibility of re­course to the lessee for excessive depreciation or maintenance expense, there is no other sale or sound formula that one can use in buying "net" motor vehicle leases.

 The Full Service Lease

Probably one of the most difficult lease arrange­ments on which to establish a value is the main­tenance or full-service arrangement because, not only is there a gamble on the residual value of the used car, there is a much more substantial gamble on how much it will cost to maintain the ear for the duration of the lease. Here one needs to examine carefully the records on each vehicle to determine how much money was spent up to the time, the survey is being made, and how much more will have to be spent to keep the ear in operation, using well-known national average figures as a guide.

Full-service leasing can be dangerous, though, and there are many items to be considered because hill-service leasing is possible and practical only where all the facts of the operation are known and where there is some pattern of usage which will enable the leasing company to reasonably estimate its main­tenance costs.

When guaranteeing the other fellow's maintenance expense, for example, a leasing company needs to protect itself against the high-mileage, hard-riding user, and it is important that the lease provides for a charge of anywhere from two to three cents per mile for all miles over the usual one-year average of 18.000 miles.

It is important, too, to know the type of service to which the vehicle will be put. Cars used by ex­ploration companies looking for oils or minerals, utility companies who generally use the "pool" ar­rangement, or where one is unable to see a pattern of usage which runs almost the same in mileage and maintenance and operating expenses year alter year require that a substantial reserve remain in escrow until the termination of each such lease, to be used if adjustments in the purchase price are found to be necessary.

It has been argued that because an insurance agency, for example, can be sold for the possible renewals, a leasing company also should have a right to consideration for possible lease renewals. This, though, is a hazardous gamble for any purchaser to take because there is no assurance of the renewal, Actually, if consideration is to be given to anything other than actual used ear values, it should go to the purchaser for relieving the seller of the obliga­tion of having to carry out everything he contracted to do under the terms of his leases. The liquidation of a leasing business must necessarily take a long time during which the lessor will be under heavy expense with no additional income coming in so long as he is not taking on new business.

Common Problems

Regardless of which lease the company that is offered for sale has been using, or if it has used all three types, there are a number of problems that are common to all leasing companies that need to be carefully considered, most of which are almost elementary to the sophisticated leasing executive, but:  they probably do  bear  repeating  here.

One needs to carefully analyze the various types of leases to be sure that the rates at which the leases were sold are equitable. Administrative expense, for example, will vary in direct relation to the services the leasing company has contracted to perform and one needs to be sure that full recognition was given to these costs when leasing charges were originally figured. And, if it is determined that these rates were too low, what: chance is there to increase the rate when the lease runs out? How much value should one place on leases that are being purchased where the rental rate is not sufficient to cover administrative expense, let alone to provide a profit and how much should one pay for a lease of this kind when there is not too much assurance that it can be renewed at a more equitable rate?

Particular attention needs to be paid to the ques­tion of licensing and taxes. It should be obvious that if a leasing company has entered into a blanket agreement to pay any and all taxes, it has exposed itself to all sorts of unknown expense, particularly if the vehicles are being operated over a fairly wide area. The purchaser of a leasing company with such a provision in its leases would take over this ex­posure, and should be protected against unforeseen costs. It is almost impossible to determine that there will be no new tax increases or no new areas of taxation in the leases it is purchasing.

The same is true, of course, with regard to license plate expense. While most leases place the responsi­bility of license cost on the lessee, many leases have been written in which the lessor agrees to provide license plates. This expense, too, can vary from year to year, generally upward. Thus, to avoid having to look over each lease separately, a clause should be included in the "buy and sell agreement" which guarantees the purchaser against any unforeseen tax or licensing expense.

Unless each insurance policy supplied by lessees has been looked over by a competent insurance man, no one can be sure of exactly what kind of coverage is provided, or what restrictive clauses there might be in some of the policies. There is a further prob­lem of making sure that the lessee's insurance cover­age has not run out or that it has not been can­celled. A careful inspection should be made of all insurance certificates. It should be stipulated that the purchaser is not to take over any leases on which there is any question whatsoever about the validity of the insurance coverage. Even though the purchaser obtains a contingent liability policy against errors and omissions, and carries substantial umbrella coverage, he should not accept any vehicles on which the insurance coverage is not satisfactory.

Other Considerations

The credit strength of the lessees also becomes a factor when negotiating the purchase of a leasing company. Obviously, one cannot go into the credit application and the credit check that has been made on each lessee to determine how many bad credits one might be acquiring. A quick rule of thumb that can be followed is to accept any leases that are not over 60 days delinquent and to omit from any computation of the total value of the leasing com­pany, those leases that are over 60 days delinquent. Those leases can be placed into a separate group­ing for adjustment on termination. If they pay out and do not become involved in a repossession or a suit of any kind, then they can be added into whatever is open for adjustment on termination.

Another area which must be given considerable thought and consideration is whether or not the finance line can be transferred to the purchaser. Obviously, if one is paying the remaining profit in the leases to the seller, there is no other profit po­tential except to be able to renew the leases. If financing cannot be obtained, then the leases cannot be renewed and there is not much point to making the purchase. Thus, it is important that the financing agency be willing to transfer the full line over to the purchaser so that he can be assured of replac­ing each unit in the fleet with a new one that will earn him the future profit potential he figures on. If the credit line is not available, then the purchase price must be reduced considerably because the pur­chasing company will have to use up money that it has available for writing new leases it might be able to develop for itself without the acquisition of another leasing company.

The sad truth is that, while there appears to be a golden opportunity for leasing companies to grow by acquisition, buying up or absorbing many of the small independents who are being forced out of business, there are many pitfalls along the way. Each company must determine for itself whether it should take what looks like the easy way and acquire a few of these companies, or if it would not be better off expanding its operation through normal growth along the same path it has been following for years.