What Is Vendor Financing and How Does it Work?

Vendor financing or trade credit is a mode of financing in which the vendor acts as the lender for its customers who use the money to buy goods or services from the same vendor. Continue reading to understand how it works. 

What is Trade Credit Based Vendor Financing 

This mode of financing is the act of a vendor lending its customer money, who then uses it to buy the vendor’s products. The customers can then pay them back over time. This form of lending can be structured either as equity or debt financing. 

This type of financing enhances the relationship between the customer and vendor and helps preserve the traditional modes of financing for other purposes. However, a customer could also ask for a loan from a vendor when traditional financing institutions are skeptical about lending to a business. 

Purpose and Benefits of Trade Credit Based Vendor Financing 

Vendor financing can benefit the vendor because they can make more sales and earn interest. On the contrary, it can save companies time and get better products and services. 

Here are some more benefits of vendor financing for companies: 

• Vendor financing options are quite flexible. The companies can choose from loan terms, including balloon payments (pay outstanding principal at once) or interest-only loans (no principal payment required). 
• Vendor financing can simplify the buying process and reduce transaction costs. Instead of comparing lenders and their interest rates and filling out multiple applications, the company could just negotiate the terms with the seller. 
• It can help companies purchase essential goods without securing loans from traditional financial institutions or pledging personal assets for collateral. A financing agreement with the vendor could even allow companies to exchange the old equipment for new ones. 

Financing Process

Let’s assume that ABC Ltd wants to buy equipment from the vendor Equip Ltd. But since ABC does not have enough cash or credit to make the purchase, it asks Equip Ltd. to finance it. Equip approves lending of Rs 10,000 at 10% interest per year for three years. ABC agrees and pays Rs 1,000 as a deposit and signs the contract. Equip gives the equipment and keeps a copy of the title. The payment is complete at the end of this period, and ABC now owns the equipment. 

Types of Vendor Financing 

• Equity financing: In this type of financing, the vendor lends products to the company in exchange for stocks. This makes the lender an owner of the borrower’s company, giving them a chance to earn dividends and have a say in major decisions. 
• Debt financing: In this type, the vendor lends products at the sales price, and the borrower has to pay interest. The borrower returns the money to the vendor along with the interest. 

Besides the mode of structuring, you can choose from no-deposit vendor finance and rent-to-own vendor finance. 

• No-deposit (also called no down payment or deferred payment financing): Companies can buy the product they need without paying a deposit. But this increases their monthly repayments and interest rates.
• Rent-to-own: Companies can take the equipment on loan and take their time to pay off the purchase price. It is beneficial for companies having no credit history or bad credit. 

Document Checklist for Vendor Financing 

Companies can apply, get approval, and receive loans from vendors in as less as 24 hours. Here’s a document checklist to keep handy: 

Financial: 

• The balance sheet of the last two financial years
• The profit and loss statement of the previous financial year
• Last 12 months’ bank account statement
• Audited financials with income proof

Business: 

• Business profile and projections
• Copy of the following:
  • Agreement
  • Contract
  • Purchase order 
• Business address proof
• KYC documents

Limitations of Vendor Financing 

Vendor financing can turn out to be bad for both the parties involved due to the following reasons: 

• The vendor may charge higher interest rates.
• The company might default, making it risky for the vendor.
• The shares the vendor receives will have no value if the company defaults.

Frequently Asked Questions

What is the interest rate for vendor financing? 

The interest rate depends on the vendor you are lending from and the type of asset being purchased. 

Does my creditworthiness affect vendor financing? 

No, even if you don’t have a credit score, you’re eligible for vendor financing. 

Are corporate invoices accepted as collateral for vendor financing? 

It is possible to use invoices as collateral. If you fail to repay the loan, the vendor may claim the money from those invoices. This reduces the risk for the vendor.