Let me set up a situation for you.
A small company that sells specialty soaps has been in business for two years and sells soaps through an e-commerce platform. The company is profitable and sells around 100 bars of soap each week. An email comes in from a large retailer that wants to carry the company’s product in 10 retail locations in a test market. If all goes well with the test market, the retailer would pick up the product for locations nationwide.
The small company is overjoyed by the email, until it realizes that the retailer needs 100,000 bars of soap from the company within the next few weeks. Now the company has to think about how to persuade its supplier, which produces the soaps, to make the goods.
Why use purchase-order financing?
When small-business owners need cash up front to fulfill orders for hard goods, purchase-order financing is often the best solution to pay the manufacturer and keep the customer happy. Purchase-order financing provides short-term capital to cover the cost of manufacturing and shipping hard goods.
In our example, the manufacturing company that produces the wholesale soaps for the soap company will be paid by a purchase-financing company that the soap company has brought on board to help make the large deal happen. Once the soap is shipped and the large retailer is invoiced, the purchase-order lender will be paid off by a factor who will take over from there.
Purchase-order financing can be great for cash-poor small businesses or businesses that are just getting started and may have trouble getting a traditional business loan. These lenders are primarily interested in the quality of the purchase order and the receivable--not in the core profitability of the company.
So, how does it work?
Let’s break down how the actual purchase flow would work for our soap company.
The large retailer wants 100,000 bars of soap that retail for $10 per unit, and it's willing to pay the supplier $5 per unit, or $500,000, 30 days after the product is shipped. The supplier needs $250,000 to pay its manufacturer, and it needs to do that 60 days in advance. What happens is the purchase-order lender will pay the manufacturer the $250,000 so the supplier does not have to come up with any cash.
When the product is shipped and invoiced, the factor will pay the purchase-order financer the $250,000, plus interest and fees. The supplier will also get some money (85 percent of the invoice value minus the amount paid to the purchase-order lender). When the invoice is finally paid by the end customer, the supplier will earn the balance of its 15 percent, minus the factor's fees.
Factoring and purchase-order financing can be a tricky business, because there are so many moving parts, but the basic flow is the same for all businesses.
Many business owners need inventory to fulfill a large customer order and don’t have the cash up front to produce that inventory, so they choose this route to handle the cash-flow issues. If you’re in this situation, it’s worth a look before selling equity in your business.
Remember, the equity investor will never go away, while the lender probably will.