Vendor Financing: Definition, How It Works, Pros, and Cons

What Is Vendor Financing?

Vendor financing is a financial term that describes the lending of money by a vendor to a customer who uses that capital to purchase that specific vendor's product or service offerings.

Sometimes called "trade credit," vendor financing usually takes the form of deferred loans from the vendor. It may also include a transfer of stock shares from the borrowing company to the vendor. Such loans typically carry higher interest rates than those associated with traditional bank loans.

Key Takeaways

  • Vendor financing is a term describing the lending of money by a vendor to a business owner, who, in turn, employs that capital to buy that same vendor's products or services. 
  • Vendor financing deals often carry higher interest rates than those imposed by traditional lending institutions. 
  • Vendor financing helps cement the relationships between vendors and business owners.
  • Vendors engaged in this practice may include payroll management facilitators, security firms, and other service providers.

Understanding Vendor Financing

Vendor financing helps business owners purchase essential goods or services without requiring those owners to secure traditional bank loans or pledge their personal assets as collateral. Vendor financing offers numerous other advantages. Not only does it help loan recipients cultivate strong credit histories, but it also allows them to table the use of bank financing until it becomes abundantly necessary to make revenue-boosting capital improvements.

Vendor financing most commonly occurs when a vendor sees a higher value in a customer's business than a traditional lending institution does. Consequently, a healthy, trusting relationship between the borrower and the vendor sits at the heart of the vendor financing dynamic.

From the perspective of the vendor, while it's certainly not an ideal situation to provide products or services without immediately receiving payment, making a sale with delayed payment is better than making no sale at all. On the upside, the vendor collects interest on the deferred payments. Furthermore, by offering vendor financing programs, a vendor can win a competitive advantage over rival firms.

Vendor Financing Types

Vendor financing can be structured with either debt or equity instruments. In debt vendor financing, the borrower agrees to pay a particular price for inventory with an agreed-upon interest charge. The sum is either repaid over time or written off as a bad debt. With equity vendor financing, the vendor can provide goods in exchange for an agreed-upon amount of company stock.

Equity vendor financing is more common with startup businesses, which often use a form of vendor-supplied financing known as "inventory financing," which essentially uses inventory as collateral to back lines of credit or short-term loans.

In business, the use of credit in vendor finance is called an "open account."

Vendor financing can also be used when individuals lack the capital needed to buy a business outright. A vendor may rely on the sales it makes to a particular business, to make its own financial targets. And by providing financing in the form of a loan, it can secure the business, while strengthening the relationship with the business owner, to make sure it thrives over the long haul.

Various Vendor Types

Vendors can take many forms, including payroll management outfits, security firms, maintenance organizations, and other service providers. Business-to-business suppliers, such as office equipment manufacturers are common providers of vendor financing. Materials and parts suppliers likewise frequently engage in vendor financing activities.