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Guide to Vendor Financing

Guide to Vendor Financing
Lauren Ward
Lauren WardUpdated September 9, 2022
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Vendor financing is 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.Is it a good idea for your business? It 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. Recommended: Complete Guide to Promissory Notes

Vendor Financing Example

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.

Pros and Cons of Vendor Financing

Pros of Vendor FinancingCons of Vendor Financing
Can receive goods/services you need even if you are short on cashA missed or late payment can ruin the working relationship between the two companies
Loan can be repaid with profits from the purchased goods/suppliesInterest can be much higher than a standard business loan
Vendor finance agreement can be whatever the two companies agree uponCan have a shorter loan term than would be offered by a traditional lender
No lengthy loan applicationEquity financing means sharing some of your future profits and losing some control over your business
Age of business and credit score may not matterDown 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.  

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.

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.Recommended: Invoice Financing Need-to-Knows

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.

Apply for a Small Business Loan Today

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.   Before you commit to vendor (or any type of) financing, it can be a good idea to shop around and compare the current small business loans to make sure you’re getting the best possible deal. With Lantern by SoFi’s online lending tool, you can quickly access financing offers from multiple small business lenders. There’s no obligation and you only need to fill out one short application.

Frequently Asked Questions

How does vendor financing work in retail and in financial services?
What are some risks of vendor financing?
Are vendor financing and seller financing the same thing?
Photo credit: iStock/Ridofranz

About the Author

Lauren Ward

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
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