Vendor financing occurs when a company procures goods or services from a vendor without making immediate payment. Instead, the vendor agrees to extend that company debt or equity financing, or to make a trade swap.
Vendor financing can be a good solution if a small business is having temporary cash flow issues and doesn’t want to apply for third-party financing, or would have trouble qualifying for a traditional business loan.
Whether this is a good idea for your business depends on the terms of the vendor financing agreement. Read on for a closer look at how vendor financing works, its pros and cons, plus alternative funding options to consider when cash flow is tight.
What Is Vendor Financing?
Vendor financing, also sometimes referred to as trade credit, is when one company loans another company the money it needs to purchase its goods or services.
How the borrowing company will repay the loan to the vendor will depend on the agreement, but vendor financing typically takes one of three forms. The vendor gives you the goods/services in exchange for:
• A promise of repayment (typically with interest)
• Equity in your company
• Goods or services you provide to them
Depending on the arrangement, the vendor financing may not cover the full purchase. In that case, you may need to make a down payment.
How Vendor Financing Works
While vendor financing allows borrowing companies to avoid applying for a small business loan with a traditional financing institution, there still needs to be some sort of loan agreement between both parties if debt is being created.
With debt financing, it can be a good idea to establish the following details before you sign off on the deal.
Loan term: When is payment expected in full?
• Down payment: Does the borrowing company need to put down a minimum payment to receive the goods or services?
• Interest: Will there be a financing fee and what will the rate be?
• Collateral: Are the purchased goods to be used as collateral?
• Payment: Is the borrowing company expected to make regular monthly payments or one balloon payment?
• Fees:
• Are there to be any additional fees for the loan? What happens if a payment is missed?
If equity financing or a service swap is used instead of debt financing, then an alternative agreement would need to be drawn up.
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Vendor Financing Example
Here’s an example of vendor financing: A small flooring company needs to purchase $20,000 worth of materials to complete the floors of a new school. Normally, it would be able to make the purchase without any issues, but four of its past ten clients have yet to pay their invoices, which means the company is currently having temporary liquidity issues.
Because the flooring company has been working with its supplier for a number of years, the supplier is willing to provide the $20,000 worth of flooring materials if the borrowing company agrees to pay back the full amount within 6 months with 10% interest. They need to make an initial deposit of $2,000, followed by monthly installment payments. Because the contract the flooring company has with the school district is so large, they readily agree to the terms and conditions from the vendor.
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Pros and Cons of Vendor Financing
The chart below captures the pros and cons of vendor financing:
| Pros of Vendor Financing | Cons of Vendor Financing |
|---|---|
| Can receive goods/services you need even if you are short on cash | A missed or late payment can ruin the working relationship between the two companies |
| Loan can be repaid with profits from the purchased goods/supplies | Interest can be much higher than a standard business loan |
| Vendor finance agreement can be whatever the two companies agree upon | Can have a shorter loan term than would be offered by a traditional lender |
| No lengthy loan application | Equity financing means sharing some of your future profits and losing some control over your business |
| Age of business and credit score may not matter | Down payment and monthly payments may be too demanding |
Types of Vendor Financing
As mentioned above, there are three main types of vendor financing. Here’s a closer look at each type.
Debt Financing
With debt financing, the borrower receives the products or services but must pay back the vendor in regular installments with interest. If the vendor will only finance a percentage of the cost, the borrower will likely need to make a down payment. Should the borrower default on payments, the vendor writes the debt off as a bad debt. Further business between the two companies is unlikely, and the defaulting company’s reputation with other vendors is likely to be damaged as well since they didn’t practice good business money management.
Equity Financing
With equity financing, the vendor provides the borrower with the requested amount of products or services in exchange for equity in the borrower’s company. This means the vendor becomes a shareholder and will receive dividends and also weigh in on business decisions. Equity vendor financing tends to be more common with startup companies that may have difficulty getting financing from banks or other lenders.
Service Swap
A service swap is an agreement between two companies where no debt or equity is exchanged. Instead, both businesses agree that the services or products one offers are of the same value to the services or products offered by the other. In other words, it is an equal trade. This type of vendor financing tends to be more informal and only occurs between companies that already have a strong working relationship.
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Alternatives to Vendor Financing
With so many different types of business loans on the market, there are a number of alternatives to vendor financing. Here are some other ways you may be able to get short- or long-term capital funding.
Merchant Cash Advance
A merchant cash advance (MCA) is a unique type of financial product that doesn’t involve traditional monthly payments. Instead, an MCA company gives you an upfront sum of cash that you repay using a percentage of your debit and credit card sales, plus a fee. MCAs can be handy for small businesses that need cash quickly, but tend to cost significantly more than other types of financing.
Invoice Financing
With invoice financing, you receive a cash advance on your outstanding customer invoices. When your customers pay you, you pay the lender back, plus fees. Since your invoices serve as collateral for the loan, invoice financing can be easier to qualify for than a traditional small business loan. However, costs tend to be higher.
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Small Business Loan
There are a variety of small business loans on the market. Traditional bank and small business administration (SBA) loans typically have the lowest interest rates, but can be difficult (and time consuming) to qualify for. Online lenders often offer faster funding, but may charge higher rates. You may also consider short-term business loans vs. long-term ones.
The Takeaway
Vendor financing is a way to fund the purchase of goods or services from a vendor when cash is tight. However, it’s not your only, or always your best, option, since vendor financing often comes with higher interest rates than those charged by traditional lending institutions.
SoFi's marketplace is owned and operated by SoFi Lending Corp. See SoFi Lending Corp. licensing information below. Advertising Disclosures: SoFi receives compensation in the event you obtain a loan through SoFi’s marketplace. This affects whether a product or service is featured on this site and could affect the order of presentation. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider.
FAQ
How does vendor financing work in retail and in financial services?
Vendor financing works in a similar way no matter what the industry. With this type of financing, the vendor selling you a product or service also finances it. Vendors can take many different forms, including business-to-business suppliers, payroll management firms, and security companies.
What are some risks of vendor financing?
There are risks on both sides of the deal. If a borrower is unable to make their payments on time, they risk ruining the working relationship they have with the vendor, which could jeopardize future business dealings with that company. For vendors, there is a risk that they will never get paid for their goods/services and have to write the loan off as a bad debt.
Are vendor financing and seller financing the same thing?
No. They are similar, but not the same thing. Seller financing refers to a form of real estate lending in which a property owner also serves as a mortgage lender. Vendor financing, on the other hand, is a business-to-business arrangement in which a vendor that is selling a product or service to a business also finances it.
Photo credit: iStock/Ridofranz
SoFi's marketplace is owned and operated by SoFi Lending Corp. See SoFi Lending Corp. licensing information below. Advertising Disclosures: SoFi receives compensation in the event you obtain a loan through SoFi’s marketplace. This affects whether a product or service is featured on this site and could affect the order of presentation. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
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