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Purchase Option

Purchase Option Definition

Purchase option, defined as the opportunity to purchase a piece of property which is being leased after the lease is completed, is part of the many options available in a lease agreement. A purchase option is often agreed upon by the two parties involved before the contract is made.

Purchase Option Explanation

Purchase option, explained by many business owners as an option to “try it before you buy it”, is available on almost any leased asset. The value of a lease purchase option agreement is evident. A party wants to lease a piece of equipment because they can not afford to buy it. However, to keep their options open they decide on a purchase option lease. This benefits the lessor by allowing her to choose, at the final moment, whether the item has created value and is worth keeping. Additionally, the lessor can account for changes in needs, expectations, or operations by leaving their options open and opting for a purchase option.

For the lessee, it allows them to make the income from leasing the item while also making the income from selling the item. In this way, a purchase option provides a benefit to both parties. It also allows access to and income from the asset almost instantaneously. A purchase option fee may be accrued while choosing to engage in such a contract.

Purchase Option Example

Asal is renting a piece of equipment for her graphic printing firm. Asal, because of her vast equipment needs, has to watch to make sure she has the cash flow necessary to operate her business based on the current needs it has. She currently can not afford to buy this piece of equipment. Still, she sees the value in having it available in her office. Asal balances these two needs by agreeing on a purchase option with the lessor.

Asal is creating a short-term agreement to lease the piece of equipment, a commercial quality printer. She will keep this printer in her office for one year, at which point she will buy the item. Asal and her lessor agree on a fair market value for the printer. So Asal completes the purchase option agreement and begins use of the item.

One year later, Asal is seeing a lot of growth in her business. So much growth, in fact, that she is going to outsource the printing for her customers to a better equipped company. She trusts this vendor and knows the quality of the products they produce, so she trusts the company.

This change of pace negates her need to purchase the printer she was leasing. Asal is nearing the end of her lease agreement, so she informs the lessor that she will not be accepting the purchase option at end of lease. She has more important expenditures to make at this point.

Asal is happy that she made a purchase agreement. She made the right business decision and will soon see the fruits of her labor. She opens the office the next day with the feeling of success.

purchase option

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Lease Term

See Also:
Capital Lease Agreement
Lease Agreements
Operating Lease
Sale-and-Leaseback
Why Is Intellectual Property Risk Everybody’s Problem?

Lease Term Definition

Defined as the period of time in which a contracted lease is in place, lease term establishes the time period to both the lessee and lessor. Lease terms generally come on 3 forms: fixed, periodic, and indefinite. Additionally, a lease can cover either material or non-material property. An example of this would be a real estate lease as compared to a software lease.

Lease Term Explanation

Lease term, explained to many as the period of time where they have usage rights to a piece of property, is a deeper concept than this. It forms part of the lease term sheet, the document which spells out the entire lease agreement. Lease term, also known as lease tenure, lease period, and more, is merely a part of this agreement. Still, it serves as the basis and arguably most crucial aspect to any lease.

Lease term can last for a specific period of time (fixed), can be extended at the will of both parties (periodic), or can last for an undetermined period of time (indefinite). Additionally, leases can exist as either capital or operating leases. Here, these leases would be casually referred to as “lease-to-own” or “rental”. These two leases often create a lease term which is differed by the needs of both parties. Capital leases, often, are not at will, periodic, or indefinite. Operating leases, on the other hand, can be more lax on time expectations while more specific to the rights of the tenant. Naturally, the soon-to-be property owner will begin negotiations with more clearly defined rights than the soon-to-leave renter. The flexibility of leases negates mathematical calculations on a lease term calculator. Negotiating leases is as much an art as a science.

Lease Term Example

Tex, an entrepreneur from Texas, has been quite successful as a “land man”. With a keen eye, a good team, and a little luck he has gained the mineral rights to several properties which are oil rich. Finding and tapping the natural resources that the land offers has created a mutually lucrative environment for both Tex and the property owners he leases from.

As a part of his business, Tex works with all kinds of leases. Based on his research, the work of his team of geologists, his legal counsel, and his sense of adventure, Tex decides which lease term options to take part in. Tex is now working with two property owners.

First Property Owner

One, Louie, has a property with a small well. This well, close to the surface of the land, can be easily accessed by the equipment Tex uses. Tex has encouraged Louie to get his land appraised so that the two men can make an agreement which benefits both parties. It is now time to negotiate the lease to the mineral rights of the land. At the table, Tex expresses that he is interested in an indefinite operating lease on Louie’s land. Tex thinks the well will be tapped within a couple years but wants to hedge his bet by keeping rights until the job is finished.

The two men agree and begin to decide on the terms of the lease. They decide on fixed payments, rights of use on Louie’s property, and that the lease will be at will. To ensure that he maintains use for as long as he needs, Tex includes a commission plan which gives Louie a percentage of the income made from the oil in this commercial lease term sheet. As Tex puts it, “you can catch a cow better with sweet feed than with sour grapes”.

Second Property Owner

Next, Tex begins talks with another property owner known as Okie. The two men meet at the table after each has performed the proper due diligence on the property. The findings indicate that there is little limit to the oil that can be gained from this property, though it is deep into the earth. Being a man with many projects, Tex opts for a capital lease rather than buying the property outright. This allows him to eventually own the property while gaining profits from it now.

Okie sees this as a fair trade and the two men begin the specifics of the agreement. They discuss duration until ownership is transferred, the amount of regular payments, and more. It is decided that Tex will start a balloon payment schedule, where he makes minimum lease payments until the end of the lease where he pays much of the property off in a large, final payment. He will sweeten the deal by paying slightly more to Okie for his property than he normally would. The two men agree and complete the lease term agreement.

Tex is satisfied with the two deals he made. He knows that each serves a certain place in his company. Tex also knows that he has given a fair deal to Louie and Okie. To Tex, everything has gone according to plan. He begins the cycle anew by reviewing an equipment lease term sheet that has been placed on his desk.

Lease Term

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Lease Agreements

Lease Agreements

A lease agreement is a legal contract between two parties for the usage of an asset or property over a set period of time in exchange for rent payments. The owner of the asset or property allows another party to use the asset or property for payments. Often a lease agreement includes an option to buy the leased asset or simply transfers ownerships to the lessee at the conclusion of the lease.

Parties in a Lease Agreement

The party that owns the asset is the lessor, or the landlord. The party that pays for using the asset is the lessee, or the tenant. The lessee is the party that pays for the usage of the property. The lessor is the party that owns the property and collects rent payments from the lessee.

Advantages of Leasing

A lease agreement can benefit the lessee by giving them access to and usage of an asset they might not be able to afford. For example, if a company is starting up and does not have the capital to purchase expensive equipment or machinery, the company would be better off leasing the equipment or machinery for monthly payments.

A lease agreement can benefit a lessor by turning an unused asset into a source of income. If the lessor owns a valuable asset but is not making use of it, they would be better off leasing it to another party who can make use of it, and in return receive the rental payments.

Types of Lease Agreement

In accounting, there are several types of lease agreements. The conditions of the lease agreement determine how the transaction is recorded in the company’s financial statements. The types of lease include capital lease, operating lease, and sale and leaseback.

In a capital lease, also called a financial lease, the lessee acquires all the benefits and responsibilities of ownership of the property. They must record the lease on their balance sheet as an asset with a corresponding liability.

An operating lease is also called a service lease. The lessor retains all the benefits and responsibilities of ownership. However, the property is not recorded on the lessee’s balance sheet.

Whereas in a sale-and-leaseback agreement, the owner of the property sells it to another party. Then, they immediately lease it back from that party. The owner becomes the lessee and the buyer becomes the lessor. Companies do this to free up cash that may be tied up in an illiquid fixed asset.

Lease Agreements

See Also:
Lessor versus Lessee
Sale and Leaseback
Capital Lease Agreement
Agency Costs
Make-or-Buy Business Decision

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