Let vendors hold the bag

Vendor finance is a form of lending in which a company lends money to be used by the borrower to buy the vendor’s products or property. Vendor finance is usually in the form of deferred loans from, or shares subscribed by, the vendor. The vendor often takes shares in the borrowing company. This category of finance is generally used where the vendor’s expectation of the value of the business is higher than that of the borrower’s bankers and is usually offered at a higher interest rate than would be charged elsewhere.

Vendor finance bridges the valuation gap due to the time value of money. If the buyer of a business does not have to repay the vendor loan for a few years, then the value of that portion of the purchase price is worth less. In some cases there is an interest charge on a vendor loan, but in other cases it is simply a deferred payment. Vendor finance is different to an  earn-out, because it is not contingent on performance. Since there is no contingency, vendor finance is more risky for the buyer. Vendor finance can also be used when the buyer does not have the funds to purchase the entire business. In this case the vendor creates a loan with an interest charge to help the buyer complete the purchase and help the seller complete the sale, usually on better terms for the seller.

Some management teams wisely attempt to reduce the level of assets tied up in working capital – things like cash on hand and  inventory on store shelves. The reason is straightforward: each dollar freed is a dollar that can be used to pay down long-term debt, repurchase shares or open new stores. At the same time, it is necessary to have sufficient products on the shelf to satisfy demand. A solution to this dilemma is a form of vendor financing known as pay-on-scan. Here’s how it works. One of the executives at a rental operation (let’s call it Borkowski Rentals) will approach its vendors: the manufacturers and wholesalers of the products stocked on its store shelves. Traditionally, Borkowski selects the products it wants to carry, orders them from the vendors, pays the bill and sticks them on the shelf for rental. Instead, the executive will propose that Borkowski not actually purchase the product until the customer has picked it up, walked to a cash register and paid to rent it. The vendors, in other words, still own the products sitting on the shelves in Borkowski’s stores. In exchange, Borkowski might give the vendors volume rebates, special placement in its stores or other incentives.

The result is a drastic reduction of working capital risk and the ability to expand much, much more rapidly. Why? When a rental company opens new stores, one of the biggest startup costs is the purchase of the initial inventory. Now that the inventory is being provided on a pay-on-scan system, all Borkowski has to do is sign a lease, improve the property to match its other store designs and hire new employees. The lower upfront costs will allow it to open two or three stores for every one store it could afford prior to the POS system implementation.

The only apparent drawback of this arrangement is a dramatic increase in accounts payable, which shows up on the balance sheet as a short-term liability. Despite the fact that the business doesn’t really have any additional risk – the product, remember, can be returned to the vendor if it is not rented – some investors and analysts treat this debt as an obligation that could threaten liquidity. This is clearly a case of accounting not representing economic reality. The shareholders are infinitely better off despite the apparent rise in the debt-to-equity ratio.