What Is Vendor Financing?
Vendor financing is a special type of financing wherein the seller lends money to the buyer to buy the seller’s inventory. The money lent to the buyer will be paid back with interest in a deferred loan. Such financing options exist to enable transactions under circumstances where the buyer isn’t able to purchase outright what the seller is offering.
Exact terms depend entirely on the agreement the buyer and seller set up. In general, vendor financing presents a higher risk to the seller than simply asking the buyer to take out a normal loan with a financial institution but is an effective alternative in cases where the buyer cannot seek out alternative financing options, either due to the state of their business, or the size and nature of the loan.
Because vendors typically bear higher risk in vendor financing agreements, these agreements also come with a steeper interest rate than regular bank loans. Another reason to potentially pursue a vendor financing agreement is to build a financial relationship with an essential service or goods provider for future trade credit agreements. A successful vendor financing agreement may allow a buyer to negotiate for a better deal in the future.
Vendor financing options may also present themselves as a valuable alternative to bank borrowing when businesses foresee requiring a more significant credit from the bank in the near future. This way, they don’t have to juggle multiple loans with a single financial institution. They can save the opportunity to go to the bank for financing options and more favorable interest rates when facing a much more capital-intensive investment.
What Is Involved?
At its core, vendor financing involves entering into an exchange agreement with a vendor, wherein they provide part of the funds needed to purchase their stock or services.
The buyer will still bring a portion of the payment to the table, but at least some of it will be fronted by the vendor. In this case, the vendor’s amount of the payment is being lent to the buyer in the form of a deferred loan, with an interest rate usually higher than what most financial institutions offer (due to the generally greater risk of a default).
However, as with any loan, the buyer can offer different kinds of security to try and reduce the vendor’s risk and negotiate for a more favorable agreement.
The contents of a vendor financing agreement will usually include:
- The size of the loan.
- The lifetime (term) of the loan.
- The repayment schedule for the loan.
- The interest rate for the loan.
- Collaterals are attached to the loan.
- How and when reports will be provided during the loan.
The financing agreement determines the terms of the exchange, including the interest rate and timeframe for the loan and its deferral, as well as the size of the loan.
Types of Vendor Financing
There are different types of vendor financing, though the most common are debt financing and equity financing. We’ve covered debt financing so far, wherein the vendor lends money to the buyer to be paid back with interest.
Equity financing is a different form of vendor financing wherein the buyer will provide the value discounted from the exchange in the condition of company equity, i.e., stocks or shares.
This type of arrangement is more common in smaller startups negotiating a relationship with a major supplier. The supplier becomes a stockholder within the company as part of an agreement to supply the company with essential goods and materials.
The added benefit to the vendor in an equity financing agreement is that the vendor may even receive certain shareholder rights and may have some sway over company decision-making.
This allows them to further exert control and management over their investment in the company’s head start. Vendor financing with equity at play can help young companies with no real credit history or lending history build a relationship with a major lender.
This means no cash repayments are needed for buyers, and they cannot default on the loan. For vendors, this means an investment that may present a much higher return than a traditional loan.
The Benefits of Vendor Financing
Vendor financing allows buyers to:
- Begin a profitable relationship with a major vendor.
- Build up a positive credit history for future financing.
- Save their application for a bank loan for a heavier future investment.
- Benefit from goods and services they would not be able to purchase outright.
Meanwhile, vendors can profit from:
- Equity in a growing business.
- A return on their investment via a loan.
- The opportunity to negotiate for several security options, including:
- Taking charge of the buyer’s business in the case of loan default.
- Mortgage over a major business property of the buyer (such as a warehouse).
- Mortgage over certain business assets.
- Obtain a director’s guarantee.
- Obtaining a deed of priority, putting the vendor ahead of a list of potential creditors.
- Multiple financial reports throughout the lifetime of the debt to help keep track of the investment.
The most apparent risk lies in bad debt. If the buyer defaults or the company goes belly up, depending on the company’s assets and liquidity, the vendor might not be able to salvage much of their investment.
Even if they have a retainer to steer the company back around or go after the directors personally, depending on the buyer’s financial health, the vendor may still be unable to recoup their losses.
However, a carefully crafted agreement made after much due diligence on both the buyer’s and vendor’s behalf should mitigate these issues. As with any other kind of business-to-business financing agreement, it’s critical to go into every minute detail while drafting the agreement.