Imagine this: Aaron owns a garment shipping business and wants to upgrade his facilities. He has been looking for investors for the last six months and has finally found an appropriate investor who understands the business and its demands.
However, the investor wants Aaron to invest 30% of the total amount from his side before he agrees to invest the remaining 70%.
After much deliberation and negotiations, Aaron’s accountant suggested a sales leaseback solution for his office space. Aaron was a little hesitant at first but decided it could be his best step moving forward.
This method would allow him to access quick cash by selling the asset while continuing to own it.
Now you must be wondering how this is possible. How can one sell an asset and continue to own it? Worry not; we are here to explain all about the process referred to as a leaseback or sales leaseback.
Under the sales leaseback arrangement, a seller sells an asset to a buyer, who then agrees to lease back the asset to the original seller immediately.
This way, the seller obtains quick cash without losing the asset, whereas the new owner is saved from the hassle of finding a new lessor.
In Aaron’s case, with the sales leaseback process, he can sell his office space and immediately sign a long-term lease contract with the new owner.
He'll have access to quick cash for his part of the investment, and he won’t even need to empty his office space.
On the other hand, the new owner will get a new asset, a long-term lease contract, and a steady cash flow.
In such financial situations and business planning, a sales leaseback solution benefits both the parties, the lessee and the lessor.
There are two major types of sales leasebacks - operational leases and capital leases.
Most leaseback deals are operational leases where the lease amount is simply treated as an operational cost for the seller-lessee, and it stays off the balance sheet.
In a capital lease, the asset is still treated as capital owned by the seller-lessee and it continues to stay on the balance sheet.
Capital leases are less common than operational leases. In this arrangement, the lessee continues to pay maintenance, insurance, and other tax liabilities.
Corporate offices and companies often use sales leasebacks for a variety of reasons. Real estate property owners and builders who utilize heavy equipment and machinery also use them.
Some of the reasons for using sales leaseback are as follows:
Owning fixed assets and pricey equipment can be risky for growing businesses. A sales leaseback allows them to continue using the asset/equipment without having to face any losses during an unforeseeable financial crisis.
Apart from freeing capital tied to fixed assets, companies also rely on sales leaseback when money is tight.
A leaseback promises quick cash without disturbing the business's transactions and payment cycles majorly.
Additionally, the current market cost is often much higher than the initial purchase cost, allowing the company to make a profitable sales leaseback deal.
In Ajay’s example mentioned above, the sales leaseback method allowed him to have access to a quick cash influx without having to leave his office space or disrupt his daily business operations. Moving an office can be both physically and financially draining.
Leaseback transactions allow companies to improve their balance sheet by decreasing debt amounts. The moment the debts are cleared off, the liabilities will reduce, and the asset turnover will increase.
The moment an asset is sold off, the company saves itself from tax liabilities. When they continue holding the asset on a lease contract, the landlord is responsible for the tax liabilities. This also helps in improving the balance sheet in the long run.
Companies also opt for sales leasebacks when the loan interest for a particular asset is much higher than the monthly rental. A lease contract helps them reduce rental costs and eliminate interest costs.
When a company or business is selling an asset, its primary goal is to raise money and create a steady cash flow.
As mentioned above, raising funds through a sales leaseback is a lucrative idea because the current market value of the asset is much more than it was purchased.
However, all the profits made by the seller-lessee must be deferred for the duration of the lease contract.
Consequently, for accounting purposes, the seller-lessee must mention the asset in the ledger as a direct financing lease to dissolve tax liabilities, whereas the buyer or the lessor should mention it as an investment capital.
To understand the sales leaseback transaction in its entirety, let's break it down into two transactions.
The first transaction is the sale and purchase of the asset by the seller and the buyer respectively. Both the sides involved here sign a sales-purchase agreement to ensure both parties are on the same page.
The second transaction is the signing of the lease contract prepared by the new buyer for the new lessee. The usual lease period in a sales leaseback agreement can be somewhere between 5 to 10 years.
As mentioned earlier, a sales leaseback transaction consists of two smaller transactions. The first one is the seller-purchase agreement, whereas the second one is the signing of the lease.
Let's get into more detail.
The seller and purchase agreement (SPA) is a binding contract between the buyer and the seller. In the agreement, each detail of the transaction is mentioned to ensure both parties agree with the decided terms.
While making the seller purchase agreement, the following things must be kept in mind:
As part of the second transaction of the sales leaseback process, the lease agreement is signed.
The lease agreement can be understood as a contract between the tenant and the landlord where the landlord permits the tenant to live on their property for a stipulated period.
Lease agreements in the sales leaseback process range from 5 to 10 years.
Lease agreements should not be confused with rental agreements. The lease agreement is a contract for a long duration of the tenancy, whereas rental agreements are short-term contracts.
The following information must be mentioned in a lease agreement for a sales leaseback:
A sales leaseback can prove to be highly effective and beneficial for companies trying to reallocate capital, create cash flow, or improve their balance sheet or ledgers.
However, do not be alarmed if the process seems very complex. Many platforms and software can assist you with the process.