Financing Options: Vendor Financing

Last week's financing options post was about getting your customers to finance your business. This week's post is about getting your suppliers to finance your business.

Truth be told, this is not very common in the startups I work with. The more capital intensive your startup is, the more you can and should think about this approach.

Two reasonably common examples of vendor financing in the world of tech startups are equipment financing and development for equity.

Equipment financing is when a vendor of capital equipment, like servers, agrees to sell you their product and takes a loan or a lease instead of cash. We are going to do an entire post on capital equipment loans and leases later in this series and we will cover that in more detail then.

Development for equity is when a third party development firm builds something for you and takes equity in your business (or less commonly, a loan) in return for the development services. It is fairly common for a development partner to take some of their compensation in equity but it is rare for them to take all of it that way. But in this case, a vendor of services to your company is financing your business by reducing the amount of cash you need to lay out to get into business.

In the biotech and cleantech sectors, vendor financing is more common. These sectors have large capital equipment requirements and large third party services requirements. There is a lot of money laid out to third party vendors on the way to cash breakeven and therefore a much greater opportunity to have those vendors finance the business.

When you are starting a company, cash is always tight and so anytime you need a third party vendor to supply your company with services, you should be thinking of vendor financing possibilities. It can be a great way to keep your cash outlays down when the cost of capital is highest.

#MBA Mondays

Comments (Archived):

  1. awaldstein

    Presuming that you are including services like recruiting, web development, even legal and accounting under this as well? They would be reduced cost/some equity type of deals. We’ve all done them at times.

    1. fredwilson

      yes, all of those would qualify

  2. CliffElam

    You are so right on about vendor financing.My wife’s NCSU IP spinout (GalaxyDX) got discounted equipment at 0.01% financing – if they’d take the models ‘on hand’ in the warehouse.  They got double and triple upgrades of expensive equipment by paying cash.Normally paying cash is not what you’d call financing, but by getting automated equipment using grant money that couldn’t be used for labor they reduced the labor cost of their testing.My wife is very very smart.  No idea why she married me.-XC

    1. JLM

      The fact that SHE is very, very smart and the fact that SHE married YOU and you are clueless as to why — just shows how very smart she really is.Enjoy it.  You are her boy toy.  And apparently thus far you are living up to her expectations.Just kidding, right?

      1. CliffElam

        LOL. I’ll tell her that.

  3. Jan Schultink

    As a “vendor of services” people often ask me to work for free.But startups do not take into account the risk premium this investment requires. It is the same as putting hard personal cash into a risky company.From a startup perspective, this is great. A vendor who agrees to get paid later, without a significant risk premium provides super cheap capital.A 1-man supplier can just not afford this…

  4. Mike Kijewski

    It’s important to note how powerful a strategic combination of these financing options can be. We got our startup off the ground by a) convincing a third party development firm to build an alpha in return for equity, b) raising a small amount of angel funding (using the alpha) that helped us finish the beta, and c) got a customer to pay us for v1.0 while still in beta.None of these financing options would have worked for us alone. Using a few different types along the way was perfect for us.

  5. JLM

    As to personal service — advice, contacts, legal, accounting — this is sometimes an exercise in karma.I am often approached by start up guys who want some advice and feel compelled to pay for it. I never, ever accept payment and always receive it as a compliment which soothes my vanity immeasurably.I have a simple rule — I usually eat lunch and I love to drink coffee.I will give you a 3-meat BBQ plate (2 sides mind you) and an Arnold Palmer of advice for free, if you will pay for the Q and the AP.I will give you a coffee cup (maybe even a refill) — hell, even a one Equal latte, if you can afford it — of free advice, if you will pay for the coffee.If you are broke, I will even spot you the first round of Q or coffee.I have on occasion helped someone find something they might have found by themselves or made a damn good intro which panned out for them and the folks feel compelled to “reward” me somehow but I just put it into the karma bank.The karma bank has done me well and I don’t want to screw with the karma bank.We are all coming this way but once, so don’t screw with the karma bank.

    1. Guest

      History has proven to me again & again that people who enjoy barbeque tend to be generous. Nice!

      1. JLM

        BBQ — as one of the earliest methods of preserving meat — has always been there when the frontiers of our Nation and our intelligence have expanded.It only seems fair that it have a seat at the table of innovation, no?On the other hand, if a person did not love Q — love mind you, not just like — then one’s radar should begin twitching and a cloud of suspicion and skepticism should fall onto the proceedings.Don’t get me started on “jerky” and bacon. Particularly very thick sliced apple and mesquite cured bacon.Westward ho!

        1. ShanaC

          I got to ask, even though it is off topic.what is your favorite barbecue joint east of the Mississippi?

          1. JLM

            I am an extremely serious student of BBQ and asking me that question is the gastronomic equivalent of asking which of my children do I love the best.  I love them all.The Q starts w/ the meat and there are several schools —1.  The best Q starts w/ the best meat; or,2.  Alternatively, the best Q is the greatest improvement in the most modest cut of meat.Then, of course, you have to wrestle with the beef v pork question.Then, you have to resolve the sauce v no sauce challenge.Then, you have the Q “school” to deal with — as an example Eastern NC Q v Lexington Q (Western NC).So, darling, Q is very very very difficult to choose one winner.Having said that you cannot go wrong w/ Flip’s BBQ in Wilmington, NC.Or, any BBQ in Lockhart, TX (I recognize this confuses the path of the Mississippi just a bit) especially without sauce — Black’s being my favorite.I tip my hat to Kreuz Market, Chisolm Trail and Smitty’s.  You cannot find bad Q in Lockhart.Lockhart being the beginning of the El Camino/Chisolm Trail and the home of TX barbecue.Right now, I am headed to Green Mesquite in Austin because you have aroused my BBQ passion.  Shame on you.

          2. PhilipSugar

            Kreuz and Smitty’s sausage!!!  Mostly beef but with some pork.  No other!!!I’ll be in Dallas in two weeks.  It almost makes me want to take the dirty bird and fly to Austin.

          3. Guest

            I still need to hit Kreuz.

          4. ShanaC

            Thank you – and when it comes to finding out what makes for delicious food, I will admit to shamelessness 🙂

          5. Guest

            ** cough – a Kansas City joint – cough **:-)

          6. Guest

            I am biased (my father in law and his partner own an old and established joint). I have to be politically correct because of that fact – well, I do not have to be but I am going to be.  @JLM:disqus is right – it is about the meat.  Sauce is important and distinctive sauce can can add flair and originality to a BBQ joint.  NYC has a BBQ joint that passes the test of this long time (and somewhat experienced BBQ lover). Dinosaur Barbeque was a fantastic BBQ experience. I have already told many KC folks to give it a go when they are in NYC. It is on 125th (I believe) just off the West Side Highway – next to the Cotton Club. My personal, general rule of thumb is the more the place looks like a dive the more often very good BBQ exists somewhere closeby. 

          7. ShanaC

            Thank you too!

          8. hangtime79

            East of the Mississippi:Jack’s BBQ in NashvilleBig Bob Gibson’s in Decateur, ALDreamland BBQ in Tuscaloosa, ALIn Texas – Agree with JLM – All Lockhart, TX jointsSnow’s in LexingtonLocal:Dinosaur, Hill Country, and my Terrace where I do Brisket, Pull Pork and Spare Ribs. Big Apple Meat Market at 42nd and 9th for cheapest/decent quality meat in the city.My philosophy is the cheaper the meat the better the value-add on cooking for 8 – 24 hours at 200 – 250 degrees.

    2. PhilipSugar

      I agree that advice or connections are not worth equity.  They are worth the karma and the cost of food or drink.  Its a good point to bring up.If its services then you can either pay or do without.As far as development to actually move the company forward, lots of minuses but you do what you have to do.

  6. CarlMistlebauer

    In the early 90’s vendor financing was the way that we grew our company in the apparel industry; we were the manufacturer who actually went out looking for new companies with a great concept that we could then supply with product, it was a win win situation.  It grew our business by 10 times in 5 years and gave us diversification, which in turn dramatically increased our margins.  We normally started as a loan/license with the right to convert to equity.  In some cases we even financed the start up for a period of time.I really think that more and more vendors need to look at this as a serious option, but I suspect as equipment manufacturers mature and markets consolidate this option will disappear; it has in apparel.

    1. JLM

      Well played and the fact that you initiated it makes it a true investment operation.You were investing excess capacity at a wholesale price to develop a retail relationship.There is more than a bit of wisdom in that concept.Well done.

      1. Carl J. Mistlebauer

        JLM,Sometimes in our mad rush to come out ahead in the great game of business we tend to forget the simple logic, like “…there is more than one way to skin a cat….” (apologies to ASPCA)!

        1. Peter Beddows

          Never mind apologies to ASPCA, I thought the expression “…there is more than one way to skin a cat….” was mine but I also usually add “than just ripping its fur off” – the point being that so often we miss the easy, obvious, choices before us as we struggle to find options that will meet our needs with minimal expenditure of effort and/or cash.So your description of the choices you made in building your business are clearly very smart; they worked, albeit perhaps that it did take courage and ingenuity to implement and close on such deals: Brilliant solution.

          1. Carl J. Mistlebauer

            Peter, the hardest thing to get anyone to understand in the apparel industry is that the world is not necessarily only a “win lose” proposition…most old timers in this industry believe that if you are not “screwing” someone then you are not successful.The concept of “win-win” is foreign in apparel and retail for that matter…words such as “joint venture” or “collaboration” are considered socialist terms! If you just sit down and do the math, reality is obvious.  A company with an idea comes to me with artwork and a marketing plan….I know that it is going to cost X in production and development I also realize that they are going to need financing for overhead, and personally they are probably in debt up to their eyeballs.  So, you commit to producing your goods, and of course you get full price plus, then you finance their overhead and bail them out personally.  You cannot be successful without them, you need the retail outlets or you are nothing but a commodity good, and logically no one gives 100% if you own them and there is nothing in it for them…Within 2 years you have been paid back with interest, you made additional profit in getting full price for the produced goods plus, you made 10% interest on the operations that you funded, and they paid you back for the personal loan….and you have either a license agreement or a 20% share in equity.  Then when they expand, or what is known as the Second funding series, you go through it all again, except for the personal loan, and then you end up with 40%.You have diversified your customer mix, and you never have to do a trade show, or sell product to Walmart where you end up with a proft of 165,000 on a 5 mil purchase order….but you would be shocked at the number of folks that are chasing the Walmart business….its because most folks in apparel come with a production background and they focus on units, the more units of the same thing going across the plant floor is the ideal for them…they manage for cash flow and constant production rather than margins.  Thats because everyone wants to duplicate what the big players do….they have never adapted to the realization that one package with 5 shirts in it on a B2C order has more profit than a box of 60 shirts going to JC Penneys. Always question your assumptions….and those of your industry….and don’t fear looking at what other companies in other industries do when seeking solutions….That is why I read this blog….

          2. JLM

            Please tell me where to send the tuition check.Well played and instructive.Thanks.

          3. Peter Beddows

            Terrific response Carl: Really appreciate the depth of information you have shared here.I can even relate, having been on both sides of this equation at various points in my life ~ ie: not just in my career.For example, my Grandmother was a very successful “Milliner” and retailer in the UK in her day and, as I was growing up, I learned a great deal about the apparel business working with her. My Uncle was also in the Millinery Trade as an Indepependent dealer and a cousin was a fashion designer and had a shop on Carnaby Street back in the day.I also remember that Woolworth ~ the Walmart of yesteryear ~ was also a “bad partner” to be in bed with frequently placing increasingly large orders on suppliers and then suddenly cutting off the business leaving the supplier high and dry, often failing and thus a ready target for buy-out by Woolworth at firesale price.Hence, as always has been the case, one needs to be very aware of relative margins, overhead costs and business partnership risks to your point of “one package with 5 shirts in it on a B2C order has more profit than a box of 60 shirts going to JC Penneys” and thus not get carried away into disaster by being blinded by product volume preventing realization of decreasing  profit and increasing continuity risk.

    2. ShanaC

      Do you have examples on how to structure the loan to equity?

      1. Carl J. Mistlebauer

        Shana,I sat down and recollected, there were 17 deals…and each one was different.  Honestly, if I am financing to develop a customer, why do I want to own them?  If you develop a program that requires hardware, as long as I have some way of assuring that my hardware will be purchased from firms that use the software, then why equity?  Of course you want it initially to give you security….If you bring me something that could benefit me, then I should know the end market well enough to have a basic idea of how your idea will benefit me.  I don’t want to own you because you are software and we are hardware….but I want the benefit without the headache. If I review your product and believe it could generate 5 million a year in sales, of which half would go to product.  Then it is real easy to calculate what it is going to take to get you going operationally, and then how much product to start with,  so I know what I have to put in and what I get out of it….Its kind of like the intel and microsoft relationship…one always benefits from the actions of the other.You really want to get paid back on your loan with interest so that you can reinvest those proceeds in other potential opportunities….and you want just enough equity and or a long term license to ensure that you always benefit from future growth.I am really surprised that the software/hardware industry doesn’t do alot more of this.  The relationship between hardware and software is so intertwined and so mutually benefitial.  

  7. Aaron Klein

    And let’s not forget that one of the most powerful combinations of customer + vendor financing is getting paid upfront by customers and getting terms with your vendors.I believe it was Dell who optimized this back in their heyday. Customer paid on Day 1, order shipped on Day 9, Dell financed operations the whole time with the cash and paid the vendor on Day 90.Terms can be hard to get but can be an extremely powerful cash flow tool if you can get them!

    1. JLM

      Still doing it.  They are practically a bank and certainly an arbitrageur.

      1. Aaron Klein

        True. My only reference to past tense is that the front end is not quite thecash generation machine it used to be…

  8. Guest

    I had a role in large company that supported this type of activity sometime back. Our group’s role was to review all the deal requests like this (and there were many) – we give them equipment/service in exchange for a piece of the company. It can work. If you are an entrepreneur, expect that the really good ‘investors’ that engage in this type of financing are still like cash for equity investors. Meaning, the really good ‘investors’ that finance companies in this manner are still likely to perform extensive due diligence; are still investing in the team as much as the market/product, etc.; and will run the numbers internally – sometimes multiple times as the biz case moves up the chain. The latter part is especially important because these companies have hurdle rates they need to meet, albeit they can be different from traditional capital providers.Entrepreneurs pursuing this need to still heed all the great advice out there about who to jump into bed with, etc. and do your homework on your potential investors so you have an idea what they might be looking for and what might excite them and entice them to do a deal.

  9. Laura Yecies

    Some of the third party development firms are providing extremely important services – besides saving cash I like them to have skin in the game with equity.

  10. John Ball

    Most of Fred’s posts reflect Union Square’s focus on software and web startups.  Recently, we see an increase in startups developing hardware products/platforms, which take advantage of previously developed chip sets, ASICs, and similar componentry.  Each effort still requires an upfront development and integration effort known as non-recurring engineering (NRE).  Frequently, Taiwanese, Chinese, and similar companies working in partnership with larger hardware/software vendors “own” the IP for these efforts and are increasingly receptive to taking a portion of the NRE expense as equity, often characterized as convertible debt.

  11. Eunice Apia

    Will keep this one on file. That makes 3 steps on my ladder to funding.

  12. paramendra

    Very few examples of this in web tech, or maybe I just don’t know. 

  13. kenberger

    Re development for equity: *sounds* good Fred, but in my experience, for most early stage startups this is easy to say, tough to do.From the vendors’ perspective, adverse selection rules apply, and usually the startups most willing to offer the equity are the ones least worthy of taking it from. And then if the stock actually does become worth something, the chances of getting f*cked down the road are large, especially if you’re an ex-vendor at that point (which happens almost all the time these days as companies shed most all vendors in later rounds). And so, many boutique development contractors– who are self-funded startups themselves– can’t afford to do too much of this (mine included).That said, I’d love to personally help make a change happen here.

  14. Tien Wong

    Good post, Fred.  I have found in some of the companies I have been involved in that the smaller and more entrepreneurial the vendor (be it a small law firm, PR firm, graphic design company, for example), the better your chances are of getting them to “finance” a startup, either for equity, terms, or a combo of both.

  15. Timothy Chen

    Vendor financing is becoming very common in hardware startups. 

  16. thirtythirtynyc

    These efforts and are increasingly receptive to taking a portion of the NRE expense as equity, often characterized as convertible debt. Midtown Manhattan Hotel

  17. Marco T.

    Asking your vendors to give you net 30 to net 60 terms payment terms is also a way to get vendor financing. This specifically helps with cash flow, since you get to use their service/product before having to pay.The catch is that the company needs to establish commercial credit, which can be tough for a start up.Cheers,Marco

    1. Carl J. Mistlebauer

      Marco, it depends…if your vendor factors receivables then they can carry you on recourse.  If they carry receivables in house then it shouldn’t be an issue at all.  The reality is then that you get terms and you build a credit history.

      1. Marco T.

        Hi Carl -Funny you mention factoring – that is what I do 🙂 I guess my point is that offering 30 day net terms is the same as giving your client an interest free loan by providing use of your product or service. You can alleviate the cash flow problem by factoring – but the you (the vendor) pays for it.That is why large credit worthy companies demand 30 to 60 day terms. It’s paramount to short term vendor funding.Best,Marco

  18. Lee

    exactly what if suppliers are ready to finance our business that interested me a lot,,very nice post thanks for sharing…

  19. Cheap android tablet

    Vendor financing is a new idea I’ve never heard before. That a good way of financing and very useful for my small business.