There are two main ways that cloud-based technology businesses can acquire technology assets such as servers, switches, routers, storage devices, and data center racks. Cloud companies can purchase them or lease them. Purchasing assets outright (or CAPEX) is fairly simple. Companies buy the assets out of the retained earnings of the business.
On the leasing side, cloud-based technology companies can choose from two different kinds of leases: a capital lease or an operating lease. A capital lease is similar to a term loan, with interest and principal payments. After the completion of the lease term, ownership rights of the asset are transferred from the lessor to the lessee.
With an operating lease, also sometimes referred to as a true lease or a fair market value lease, the lessee has the option of purchasing the asset at the end of the lease term or simply returning it to the lessor. The lease payments are considered to be operating expenses so they are kept off of the balance sheet.
Which option is usually better for cloud-based technology companies?
Three Reasons Cloud Vendors Should Lease (Rather than Buy) Technology
An operating lease is usually the best option for equipment and asset acquisition by cloud-based technology corporations.
Here are three reasons why:
#1) Leasing Aligns Equipment and Asset Expenses with Revenue
Instead of shelling out millions of dollars in cash to pay for equipment and assets upfront, cloud-based technology corporations are able to spread out these expenditures over time via lease payments. This way, the cost of equipment and assets is more closely aligned with the income they are generating.
For example, instead of spending $2 million on a technology asset upfront, a company can spread the capital outlay out over several years by leasing – paying perhaps $60,000 per month. This will generate more free cash flow on a quarterly basis, which is what investors are looking for (see below).
#2) Leasing Generates Free Cash Flow
The best way for these businesses to generate free cash flow is by growing their revenue faster than their fixed costs. The stronger the cash flow, the higher the stock price. Put another way, every dollar that is spent on equipment and assets tomorrow instead of today adds value to the business from an investment standpoint.
As the example above illustrates, avoiding a $2 million upfront payment on a technology asset will significantly improve a corporation’s quarterly cash position. The further into the future corporations can push payment for technology assets, the higher the corporation’s current valuation will be. In other words, time becomes an ally.
#3) Leasing makes it easy for corporations to refresh their equipment and assets
It’s critical that cloud-based technology corporations have a “refresh mentality.” In other words, they need to be disciplined when it comes to updating high-tech equipment and assets that have reached the end of their useful life. The operating costs of using and maintaining obsolete equipment can be higher than the cost of the equipment itself.
Leasing makes refreshing old and obsolete equipment and assets easy. At the end of the lease term, lessees can simply return the equipment to the lessor and upgrade to newer equipment. This way they don’t get stuck with data centers full of obsolete equipment they have to try to sell for a fraction of what it cost them originally. Nor are they sinking money into assets that will only depreciate over time.
More Leasing Benefits
In addition, leasing is an environmentally friendly way to acquire assets and equipment. This is something that shareholders today are increasingly concerned about. When their equipment has become obsolete, cloud-based technology companies often can’t even give it away. Old technology equipment then must be discarded, often in ways that are harmful to the environment. Returning equipment to the lessor is a “green” solution to dealing with old, obsolete high-tech equipment.
Moore’s Law also applies here: It’s critical that cloud-based technology corporations maximize their processing power and data storage per square foot of real estate in their data centers. Leasing makes it easy for them to upgrade their high-tech assets to the most powerful and energy-efficient equipment at the end of the lease term. Operating infrastructure and data centers with the most modern and efficient high-tech equipment and assets increases profitability and minimizes the total cost of equipment ownership.
Finally, there are the data security benefits of refreshing old equipment that has reached the end of its useful life. Continuing to use outdated, obsolete equipment in data centers can pose a huge data security risk to cloud-based technology corporations as this equipment can be especially vulnerable to hackers. In fact, the devastating data breach that occurred a few years ago at Sony Pictures Entertainment was traced back to an old server that hackers compromised to steal employees’ personal information, corporate e-mails, executives’ salaries, copies of unreleased Sony films, and more.