Purchase order financing is the most frequently requested business loan inquiry we receive. Depending on the size of the orders and opportunities that lie ahead for the company, bringing in an equity investor is also a consideration. There are distinct advantages to both and we will outline the main advantages of each here.
The day has come! The customer you have been chasing for weeks, months or even years gives you the purchase order that you have been hoping for! Now, how do we afford to pay suppliers and other costs associated with the order? Ideally, you would be able to do this with internal cash flow and not have a need for outside financing. However, the truth is, if you are doing a good job on the sales and marketing side, you will quickly outgrow your internal capacity. AND, this is a good thing! Of all the stresses business owners encounter, having a large pipeline of sales if the best!
The conversation quickly turns to, “how do we afford these orders now that we have them?” Is purchase order financing or equity the better option? The answer, it depends.
Purchase Order Financing
By financing the cost of goods for your orders, you are leveraging the growth of your business through outside capital. Let’s go through an example:
- You receive a PO for $100,000
- Your gross profit is 50%
- This makes your cost of good also 50%
- You borrow $50,000 to cover the costs to your suppliers, shipping costs, etc.
- Your working capital cycle is 90 days from the time you receive the order, to the time you ship, to the time the customer pays
- Cost of the financing is 3% every 30 days the money is outstanding
Let’s say a major retailer awarded your company a $100,000 PO as outlined above. You need to borrow $50,000 for 90 days. The cost of the financing will be $4,500 for the 90-day period ($50,000 X 9%). Your adjusted gross margin would be $45,500 ($50,000 – $4,500).
The purchase order finance company is repaid by the customer’s payment. By using this form of financing you are leveraging 100% of the cost of goods and have the capital to grow your business. Additionally, the PO financing allows you the added strength of being a cash buyer. Our clients negotiate discount terms with suppliers to offset a portion of the cost of the financing.
For example, a 2% product discount for early payment in the sample transaction above would equate to $1,000 ($50,000 x 2% = $1,000). This savings in product cost would reduce the adjusted finance cost to $3,500 ($4,500 – $1,000 = $3,500).
The advantage of purchase order financing is that it can grow as your business grows assuming your customers are credit worthy. The PO finance company’s primary source of repayment is the customer. This makes the customer’s financial strength a key factor in underwriting these transactions.
The disadvantage of PO financing is that it only covers variable expenses associated to sales. This is where equity may be a better fit.
Equity comes in to play when you need more than your cost of goods covered. Examples of when equity may be a better call would include the following:
- The equity group brings value outside of the capital being invested such as supplier and customer contacts.
- In-roads and introductions of value that the equity group brings to the table
- When funding for marketing, salaries, plant expansion, and other fixed expenses are needed to grow and scale the company
The equity group will take a percent of ownership in exchange for their investment. The strategy may or may not include the sale of the company in the future at some multiple.
Equity can be a viable option if there are a lot of fixed expenses to be covered. Prepare to give away a large chunk of your company when exploring equity options. The equity group is seeking a return on their investment and realize that they are in the power position by bringing in the majority of the capital needed to grow the company.
Both forms of financing can be useful when growing your business. Purchase order funding can be used as a bridge to finance your growth. Once you scale your business to a certain level and can fund operations internally, you don’t need outside financing and can save the finance cost. On the other hand, equity can cover the costs of a much broader list of expenses. The downside is that it’s a “now and forever” proposition. The equity group and your company are joined “until sale do you part.”
We always advise on debt versus equity when you can. It’s the bridge needed to grow your business, but not permanent by definition. If you would like to discuss which form of financing is best for your business, call us at 844-239-2632. We would be happy to lend a hand!
To your success!
Huntington Coast Capital.