What is Vendor Financing?
Vendor financing refers to the lending of money by a vendor to a customer who then uses the money to buy the vendor’s inventory or service. The arrangement takes the form of a deferred loan from the vendor, and it may involve the transfer of shares from the customer to the vendor.
Vendor financing is common when traditional institutions fail to recognize the value of the customer’s business, and the vendor comes in to bridge the gap and create a business relationship with the customer. Often, these types of loans come with a higher rate of interest than those offered by banks as vendors seek to compensate for the high risk of default.
Companies prefer vendor financing when purchasing essential goods that are available at the vendor’s warehouse. The practice allows them to obtain the necessary trade credit without the need to borrow from the bank or use their retained earnings.
The vendor financing arrangement helps enhance the relationship between the vendor and the customer since it results in mutual benefits. Also, by borrowing from other sources other than the bank, the borrower preserves the bank financing to a future date when undertaking a capital-intensive activity.
Types of Vendor Financing
Vendor financing takes two main forms: debt financing and equity financing. In debt vendor financing, the borrower receives the products or services at a sales price but with an agreed interest charge on the sales price. The interest charge accrues as time progresses, and the borrower can either repay the sales price or the debt is written off as a bad debt. When the latter happens, the borrower will be unable to enter into another debt vendor financing arrangement with the vendor.
Alternatively, in equity vendor financing, the vendor can provide the goods or services needed by the borrower in exchange for an agreed amount of the borrower’s stock. Since the vendor is paid in shares, the borrower does not need to make cash repayments to finance the purchase of goods or services.
The vendor becomes an equity shareholder and participates in the sharing of dividends, as well as in making major decisions in the borrower’s company. Equity vendor financing is common with startup companies that are yet to build a credit history with the traditional lenders.
How Vendor Financing Works
In vendor financing, the person selling the business also provides credit for funding part of the purchase price of a product or service. Once a vendor and a customer have entered into an arrangement, the borrower is required to make the initial deposit, and the balance plus any accrued interests are paid over an agreed period with regular repayments. The rate of interest may vary from 5% to 10%, and can sometimes go higher, depending on the agreement between the two parties.
There are several situations when a borrower may opt to obtain trade credit from a vendor rather than a financial institution. One of these situations is when the vendor fails to meet the lending requirements of banks. It forces the borrower to look for an alternative and more convenient option to help complete the purchase. Even though vendors are not in the business of providing credit to businesses, they can get into the arrangement if they will get the price they are looking for. Such an arrangement also gives sellers of high ticket items an advantage over their competitors.
The other situation when borrowers may opt to use vendor financing is when the buyer lacks funds to purchase the seller’s business. In such a case, the vendor creates a loan for the buyer plus an interest charge to help the buyer complete the purchase.
Example of Vendor Financing
Assume that XYZ wants to purchase inventory from ABC at the cost of $1 million. However, XYZ lacks enough capital to finance its transaction. The company can only pay $300,000 in cash and borrow the rest. ABC is willing to enter into a vendor financing arrangement with XYZ for the remaining $700,000.
However, ABC is charging a 10% interest on the loan, and it requires the debt to be paid within the next 24 months. The vendor also wants the inventory to be used as collateral for the loan to ensure that the buyer does not default on the loan.
Benefits of Vendor Financing to the Vendor
One of the benefits that vendors enjoy is the ability to receive an annuity stream even after ceasing control of the business. The buyer relies on the vendor for financing; the vendor will continue to enjoy interest payments from the business profits even after they stopped running the company. If the borrower defaults on the loan repayment, the vendor reserves the right to repossess the business or sell assets of the company to recoup the unpaid amount.
The vendor also enjoys the power to determine whether the transaction will go through or not. Since the buyer may be unable to access loans from financial institutions, they will depend on the vendor’s goodwill to finance the transaction. The high level of control also allows the vendors to inflate the price since the buyer lacks enough options for accessing trade credit.
Benefits of Vendor Financing to the Purchaser
Pay debts using business profits
When a purchaser obtains vendor financing to purchase a business, they are not required to make all the payments at once. Instead, they can use the profits earned by the business to make regular payments to service the loan. It is more advantageous to the buyer, compared to other types of loans where borrowers are required to repay the debt from personal accounts.
Less substantial personal funds needed
In vendor financing, the borrower is not required to raise substantial personal funds to finance the asset or business purchase. The buyer only requires a small percentage of the total cost of the transaction, i.e., 10%-20%, while the rest of the money can be raised later after taking possession of the asset or business.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: