Nick put down the phone and sat silently in his chair, basking in the feeling of accomplishment. This is why he formed his business two years ago. This is why he invested in countless hours of meetings with suppliers to get the product right. On the other side, sales, he spent double the time and energy pitching the virtues of his product and why it would be a big hit with the consumer.
Although the road to this point was long, the order came suddenly. After testing the product in 10 stores, Costco became a believer and placed a $2,000,000 order that would be placed in stores throughout the U.S. This is why Nick had started his business. This is why he had gone all in with his money, time and energy. His dream had come true.
The future looked incredible. With Costco alone, he could get to $5,000,000 in annual sales. Wouldn’t the other national retailers want to jump on the bandwagon? What kind of sales would he do this year and the next? How big would the company grow? How much money would he make?
As he contacted his vendors with the great news and began to plan for production and delivery, reality hit. This was not only big for Nick, but it was big enough for his vendors that they would not take the financial risk of producing and shipping product without payment in advance. Nick didn’t have that kind of money
What were his options? After a few calls to banks, it became apparent that none of them would advance funds to fulfill the order. A friend introduced him to a couple venture capital firms, but they could not move fast enough to finance this order and they also wanted to own most of the company. He hadn’t worked so hard to give up most of the company when he was on the cusp of taking off.
Then, he remembered that one of the banks that turned him down had suggested that he look into purchase order financing. It seemed terribly expensive at the time, but he needed to find financing fast or this and all of the other opportunities would be gone.
Nick contacted a purchase order lender that explained that they could provide the funding to cover all of his costs of filling this order. Nick would not need to invest any more capital. The purchase order lender would issue a letter of credit payable to the vendors. This commitment satisfied the vendors and they extended credit to Nick. Once they shipped the product, they would be paid immediately by the purchase order lender.
The purchase order lender would need to be paid when the product was delivered to Costco. This seemed to be another impossible problem because Costco would not pay for 60 days. Where would the money come from?
The purchase order lender explained that they have partnerships with other specialty lenders called factors. Once the goods are received by Costco, the factor will provide the financing to cover the time from delivery until payment.
But what about the high cost of financing the banker had cautioned him about. As he reviewed it, Nick discovered that he’d been looking at it the wrong way. Rather than looking at the cost of financing this transaction and comparing it to the profit he would generate on it, he had been thinking in terms of an annual percentage rate. When he broke down the cost of financing this transaction and compared it to his profit, the cost seemed very reasonable. In total, the cost of the financing would be about 5% of the sale price. His gross profit margin is 40%, so he would net 35%. In dollar terms, his gross profit would be $800,000, his financing cost would be $100,000, so he would net $700,000! Not only was that an unbelievable amount of cash he would pocket, but he would now be a player. He would prove to Costco, and then to all of its competitors, that he could handle this type of business.
Within three weeks he had this all in place. This enabled him to issue the letter of credit to the vendors who in turn produced his products in time to meet Costco’s delivery schedule. Costco continued to place orders, and he also got orders from Best Buy and Office Depot. His company had taken off.
Nick continued to use the purchase order financing and factoring for 18 months, although he found that he only needed to use it on larger orders because he now had built up enough cash and vendor credit to self-fund many of the smaller orders. After 18 months, the bank that had referred him to the purchase order lender offered him a line of credit and he no longer needed the purchase order financing and factoring.
Nick’s story is a very common one. It illustrates how borrowers should view their financing alternatives. Bringing in an equity partner is a long, often slow, and expensive process. Although purchase order financing is expensive if viewed from an annual percentage rate viewpoint, the cost is very reasonable in light its ability to fund sales which allow you to generate profit that’s otherwise not attainable and also prove to your customers that you’re a real player.