What Is Vendor Financing & When Should Your Small Business Use It?
Businesses that have exhausted normal methods of acquiring capital may find themselves turning to less known methods, such as vendor financing. Like most forms of alternative financing, it’s less a broad solution and more a specific help for small businesses whose needs fall into a specific niche.
Is it the best choice for your particular small business financing needs? Read on to find out.
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What Is Vendor Financing?
Vendor financing, sometimes called “seller financing” or “trade credit”, is a financial practice in which the vendor selling you a product or service also finances it. Businesses with vendor financing in hand won’t need to approach a third party lender, like a bank, to get financing.
Since the vendor is taking on substantial risk in this type of arrangement, vendor financing is usually only an option for businesses that have a strong working relationship with the vendor, although there are exceptions.
How Vendor Financing Works
In a way, vendor financing harkens back to the barter system, with two businesses making a trade.
Vendor financing typically takes one of three forms, which I’ll go into in the next section. In either case, the vendor will allow you to acquire their goods or services in exchange for:
- A promise of repayment
- Equity in your company
- Credit with which to acquire your goods or services.
Depending on the arrangement you agree to, the financing may not cover the entirety of the purchase. In that case, you’ll be asked to make a down payment.
Types Of Vendor Financing
The term “vendor financing” encompasses a number of different arrangements a vendor can make with a small business. The three most common are:
If your vendor is extending debt financing, they’re essentially offering you a loan. But instead of receiving a lump sum of cash, you’ll receive the goods or services agreed upon. In many cases, the vendor will only finance a percentage of the cost of their item, which means you’ll have to produce a down payment of some kind.
From here, debt financing looks a lot like a loan. You’ll work out a payment schedule with your vendor, as well as an interest rate–if your vendor wants to make the sale badly enough, there may not be one, but don’t count on it–and put up any collateral necessary. If you’re acquiring a tangible item, debt financing might resemble an equipment loan, with the item serving as collateral.
Whether or not this is a good deal for your business will depend on the terms agreed upon, especially in comparison to any loans you may qualify for. Mature businesses looking for vendor financing will probably prefer debt financing to equity financing since it has fewer long-term repercussions on your operations.
Vendor financing doesn’t necessarily involve taking on debt. In some cases, a vendor may offer your goods or services in exchange for a share of equity in your company. The vendor then becomes a shareholder, receiving dividends and participating in your business decisions.
In most cases, a business that agrees to equity financing will be a startup that doesn’t have the credit or history to qualify for other types of financing. Since you’re involving outside entities in your business operations, you’ll need to factor that into your business plans and risk assessments.
In less common cases, a vendor may be willing to trade their product for one of your own of similar value. These types of agreements are much more likely to be informal and between companies that already have a strong working relationship.
Vendor Financing Pros & Cons
So what are the pro and cons of using vendor financing?
- You Can Bypass Financial Institutions Entirely: If you don’t match the profile of a good borrower, it can be difficult to get the money you need to buy inventory, equipment, or vital services. Vendor financing allows you to plead your case directly to the company you’d be spending your money with.
- Startups Can Get Important Items: Startup financing is one of the great stumbling blocks when you’re starting a business. Without a business history, lenders may not want to take a risk on you. Equity financing gets around this Catch-22.
- It Helps Vendors Make Sales: While “giving away” a product with an IOU may carry some risk, a deferred payment still allows a company to move inventory it may not otherwise have been able to.
- You’re Limited To What The Vendor Sells: Vendor financing is only good at the company that you’re petitioning. With a working capital loan, for example, you can split your lump sum between multiple expenses.
- It’s Not That Common: If you’re counting on vendor financing, you’ll likely end up constrained in terms of your choice of vendors.
- It Exposes Both The Vendor & Buyer To Risk: Neither company is a bank. Vendor financing adds complexity to what would otherwise be a pretty simple retail transaction. The vendor needs to have a plan for if the buyer defaults. The buyer needs to read the fine print and make sure they have recourse under state law if they’re unable to fulfill the terms of the agreement.
When To Use Vendor Financing
If you’re considering debt financing, it’s probably because you have a strong working relationship with the vendor in question. Trust is the name of the game here, so being a reliable, valued customer will come in handy. Whether or not it’s a good deal relative to an equivalent loan will depend on the terms you’re offered, though it’s quite possible that you can end up spending less than you would servicing a traditional loan.
When it comes to equity financing, you’re looking at a more specific niche. Startups willing to part with some of their equity to obtain necessary equipment may find it easier to cope with than taking on personal debt.
Finally, any two businesses that are comfortable with the arrangement may be happy to swap services.
Final Thoughts On Vendor Financing
Vendor financing is a quirky but legitimate way to get your business the inventory, equipment, or services it needs, so long as you approach the matter with a clear idea about its perks and drawbacks.
For other ways to get vendors to finance their own products, you may want to read up on captive lessors.
Looking for forms of financing that don’t involve taking out a loan? Read The Merchant’s Guide To Invoice Factoring. Have a startup and need financing, but aren’t sure you want to give up equity right now? Find out how to Get The Equipment You Need For Your Startup Business With A Loan Or Lease.