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 financial institutions are unwilling to lend a business significant amounts of money. This may be simply due to the fact that the business is relatively new and/or doesn’t have substantial established credit. A vendor of the business 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. This compensates vendors for the higher risk of default.
Companies often prefer vendor financing when purchasing essential goods that are available at the vendor’s warehouse. The practice allows them to obtain trade credit without the need to borrow from the bank or use their retained earnings.
A vendor financing arrangement helps enhance the relationship between vendor and customer, as it results in mutual benefits. Also, by borrowing from sources other than a bank, the borrower preserves bank financing that may be used later for 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. The interest charge accrues as time progresses, and the borrower can either repay the loan 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 provides 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.
The vendor becomes an equity shareholder and participates in receiving dividends, as well as in making major decisions in the borrower’s company. Equity vendor financing is common with startup companies that have yet to build a credit history with traditional lenders.
How Vendor Financing Works
Once a vendor and a customer have entered into a vendor financing arrangement, the borrower is required to make an initial deposit. The balance of the loan, plus any accrued interest, is paid over an agreed period with regular repayments. The rate of interest may vary from 5% to 10%, or be more, 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 borrow from a financial institution. One is when the borrower fails to meet the lending requirements of banks. This forces the borrower to look for an alternative option to help complete the purchase. Even though vendors are not in the business of providing credit, they often do so to facilitate sales. Such an arrangement also gives sellers of high ticket items an advantage over their competitors.
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 the transaction. It can only pay $300,000 in cash and must borrow the rest. ABC is willing to enter into a vendor financing arrangement with XYZ for the remaining $700,000.
ABC is charging 10% interest and 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 protect against default.
Benefits of Vendor Financing to the Vendor
The following applies to vendor (or seller) financing for the purchase of a business.
One of the benefits that vendors enjoy is the ability to receive an annuity stream even after ceasing to control 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 sell 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 depend on the vendor’s goodwill to finance the transaction. The high level of control also enables the vendor to obtain a higher sales price.
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. This can be a major advantage for the buyer.
Less substantial personal funds needed
In vendor financing, the borrower is not required to use personal funds to finance the asset or business purchase. Beyond whatever downpayment is required, the buyer can fund the rest of the loan repayments with business earnings.
Thank you for reading CFI’s explanation of vendor financing. 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: