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Evolution of Software Financing: The Past Informs Our Future

Date: Apr 08, 2014 @ 07:00 AM
Filed Under: Technology Finance

When it comes to financing technology, software applications that play an integral role in just about every aspect of business today are now fueling the growth of the technology sector. This is an ironic flip-flop from 20 years ago, when software was just the grease that kept the machines running smoothly.

Today, a growing array of software applications means there really is “an app for that” for every major business need, whether automating back-office functions, producing analytics to drive decision making or streamlining the way an enterprise’s machines work together.

Software is increasingly a business necessity, as evidenced by total investment in software, which was $309 billion in 2011, up 23% from $251 billion five years prior, according to the 2012-13 U.S. Equipment Finance Market Study commissioned by the Equipment Leasing & Finance Foundation. With software now one of the largest equipment investment categories, software financing is omnipresent. It is hard to believe that not long ago it was a negligible asset class.

Much in the same way that the option to finance software posed many questions in the 1990s, services financing today is generating a host of questions, such as:

  • What are the specific objectives vendors and end users are trying to achieve?
  • What is the essentiality of the specific services being performed?
  • How do finance companies get their arms around the market demand for the financing of “pay-as-you-go” services?
  • What value does a financing company bring into the cloud/managed services equation?

One way to seek answers is to look at how we tackled similar challenges in the past, because today looks a lot like the 1990s looked when software manufacturers and finance companies created solutions to help clients with significant software investments.

Trip Down Technology Lane

In the 1980s, more businesses began acquiring digital tools to realize gains in efficiency and financing became an acceptable means to acquire technology equipment. The terms of such deals weren’t any more difficult to sort out than those involving other tangible assets such as manufacturing and industrial equipment. If the borrower defaulted, there was a piece of collateral that could be recovered. The environment began to change, however, in the late 1980s and early 1990s when innovation led to advancements in software as well as hardware.

For larger businesses, the desktop computer revolution caused a migration away from mainframes toward a server environment, which brought the need for more and different software applications to make everything run.  With companies embracing database software and enterprise resource planning systems, software – even though you couldn’t put your hands on it - was rapidly becoming the more valuable aspect of the system.

In the early days of growing software prominence, pioneering technology vendors and financing partners quickly realized software was integral in hardware transactions and had to be bundled into any deal. Software manufacturers paved the way for software financing by developing extended payment options to help their clients acquire the software. The payment plans helped the clients pay for the high dollar transactions over time while also allowing the software manufacturer to achieve their revenue recognition requirements. These changes took place around the same time SOP 97-2 rules were adopted around software revenue recognition.
Also in response to the demand for financing solutions, Key Equipment Finance and other pioneering lessors adopted the Installment Payment Agreement (IPA). The IPA allowed the finance company to pay for a software transaction and provide the end user with a loan to pay for the software. At this point, the software vendor would be paid and out of the deal, allowing the vendor to recognize the revenue. In addition, documentation was developed between the finance company and the vendor that offered additional protections. From that point, the software financing agreement was transacted between the finance company and the business or end user of the technology.

The challenge, then, was figuring out the considerations involved in financing the software, knowing that traditional financing is for tangible assets and software is an intangible asset. With tangible assets, when a company defaults on its payments, the finance company has something tangible it can recover. Software, as an intangible asset, generated a host of difficult questions because it couldn’t be recovered in the event of a default.

More companies, however, were figuring out terms and getting on board with a payment plan design, including lessors, who by taking into account some core considerations were able to determine if a software financing deal was a good financial risk they wanted to take.

At Key Equipment Finance, in addition to understanding the creditworthiness of the customer, software financing boiled down to four primary considerations:

  • Essentiality of the software
  • Difficulty of displacing the software
  • Vendor history and performance
  • Enforceability of the documentation

Back to the Future

In our minds, not much – perhaps nothing – has changed in the key considerations in financing these intangible assets. Still, we are challenged in new ways by the concept of services financing, which in reality can include anything and everything related to technology, has many more variables, and can rely on many different parties.

Even though we are in our infancy when it comes to understanding services financing, this new frontier will take us back to the same core principles we used in those early software financing days. The reason? They are fundamental assessments that still appropriately judge the business uses and risks associated with technology solutions. Going forward, the key is to apply the core considerations at each step as the market evolves into managed services arrangements and pay-as-you-go technology solutions.

Our financing experts continue to put our best thinking toward all aspects of true services financing. Even so, we will continue to revisit the guideposts of the past as we determine the services financing of the future, knowing that fundamentals always lead us down the right path.

Scott Sullivan
Senior Vice President | Key Equipment Finance
Scott Sullivan is senior vice president at Key Equipment Finance and leader of the technology and software financing division.
Comments From Our Members

Susan Carol • View APN Profile
It is interesting to consider how the industry can be returning to its roots of looking for creative ways to structure financing around the customer's needs.
4.14.2014 @ 11:05 AM
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