Vendor Financing

Vendor financing can be defined as lending of money by a vendor to a customer, customer then use this
money to buy vendor’s inventory or service. The settlement takes the form of a deferred loan from the
vendor, and this may involve the transfer of shares from the customer to the vendor.

It is common when traditional financial institutions are notwilling to lend a business significant amount
of money. This may be simply due to the fact that the business is relatively new or doesn’t have
sufficient 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 prefer vendor financing when purchasing essential goods that are available at the vendor’s
warehouse. This allows them to obtain credit without the need to borrow from the bank or use their
retained earnings.

A vendor financing arrangement helps in improving 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.

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.

Annuity stream

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.
Retains control

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