How Should You Use Sale-Leaseback Proceeds?

The purchase price is not the amount available to spend. Several items come out before the company has usable cash, and they should be estimated before any plan is made.

• The balance of any mortgage on the property, which is paid off so the lender releases its lien, plus any prepayment charge.
• Transfer taxes, title charges, legal fees, brokerage fees and other closing costs.
• Any holdback or escrow the buyer requires for repairs or environmental matters.
• Any security deposit or letter of credit required under the new lease, which ties up cash you just raised.
• Income tax on the gain from the sale.

The tax item deserves early attention. The IRS explains in Publication 544 that if you dispose of depreciable property at a gain, you may have to treat all or part of the gain as ordinary income. A building that has been owned and depreciated for many years can produce a larger taxable gain than its owners expect. Ask your CPA for an after-tax estimate before you commit to a use of funds, and confirm how the result flows through to the owners if the company is a pass-through entity.

Build your plan on after-tax net proceeds. A plan built on the gross price is usually short by a meaningful amount on closing day.

A sale-leaseback exchanges a one-time payment for a recurring obligation. The cash can be spent only once. The rent, with its annual increases, is due every month for the life of the lease. So the question for each proposed use is whether it produces a lasting benefit that is worth more than the lease costs.

One way to frame it: compare the annual rent you are adding with the annual benefit the money creates, whether that is interest saved, profit from new capacity, or earnings from an acquired business. Then ask how certain that benefit is. Interest saved on retired debt is nearly certain. Returns from a new product line are not.

Uses that fail the test are those that consume the cash without changing the company's earning power, such as covering ongoing operating losses with no plan to end them. In that case the business ends up with the same problem, less cash, no building and a new fixed cost.

• Paying down debt. Retiring the mortgage is automatic. Using remaining proceeds to reduce other borrowings lowers interest expense and may ease covenant pressure. Compare the interest rate on the debt retired with the effective cost of the lease, and remember that the lease itself is a long-term fixed commitment.
• Investing in the business. Equipment, automation, inventory, hiring or a new location can earn more than real estate does for an operating company. Tie the investment to a written plan with expected returns and a timetable, and keep a reserve in case results arrive late.
• Funding an acquisition. Proceeds can supply equity for buying a competitor or a complementary business. Timing is the difficulty, since a sale-leaseback and an acquisition each have their own closing schedule. Agree with your advisors on which closes first and what happens if one slips.
• Liquidity for owners. Distributions can fund a retiring partner's buyout, diversify a family's wealth away from a single building, or return capital to investors. This use adds nothing to earnings, so the remaining business must be able to carry the rent comfortably without the cash.

Most companies use a mix. A sensible order is to settle required payoffs first, set aside a reserve, fund the highest-confidence uses next, and treat distributions as what remains.

Your lenders have a say in both the transaction and the use of the money. The mortgage lender must be paid and must release its lien. Beyond that, a line of credit or term loan agreement may restrict the sale of significant assets, limit new lease obligations, require that sale proceeds be applied to the loan, or restrict distributions to owners.

Lease accounting also matters to these agreements. Under US GAAP a seller-lessee applies lessee accounting to the leaseback, recording a right-of-use asset and a lease liability. Whether that liability counts as debt in your covenant calculations depends on the definitions in each agreement. Have your CPA and attorney read them before you approach the lender, then have the conversation early.

• ✓What is the payoff amount on the mortgage, and is there a prepayment charge?
• ✓Do any loan agreements require consent for the sale or for entering the lease?
• ✓Must any portion of the proceeds be used to repay a lender?
• ✓How will the new lease liability and rent expense affect our financial covenants?
• ✓Are distributions to owners restricted after the transaction?
• ✓Do shareholder, partnership or operating agreements require owner approval for the sale or for a distribution?

A written use-of-proceeds plan does more than organize your own thinking. Investors underwrite the tenant, and a company that can explain how the cash will strengthen the business presents a better credit story than one that cannot. The plan also sets the minimum net proceeds you need, which in turn tells you how much rent is worth accepting.

1. List each intended use with an amount, a timetable and the benefit expected.
2. Rank the uses by how certain the benefit is.
3. Set a cash reserve, sized to cover rent and operating needs through a weak period.
4. Have your CPA estimate after-tax net proceeds at several possible prices.
5. Work backward to the minimum price you need, and check the rent that price implies against what the business can carry.
6. Review the plan with your lender and owners, and adjust before offers arrive.

If the minimum price can only be reached with rent above what the building would lease for on the open market, treat that as a warning about the plan, not as a negotiating target. We start every sale-leaseback engagement with this conversation, because the intended use of the proceeds determines how much cash is enough and therefore which trade between price and lease terms is right for you.