Vendor Financing & The Fashion Industry
This guide explains what vendor financing is and explains how vendor financing works. Fashion designers need to understand vendor financing as these arrangements can help them scale. Here, we'll look at how these arrangements are typically structured and why they are beneficial. If you own a fashion brand then this guide is designed to help you understand how this option may or may not be a good fit for your business. Understanding Vendor FinancingVendor financing is a type of financing in which a vendor lends a business money in order to purchase their products. So, if your business makes clothing, then this arrangement would entail you approaching your vendor (the one that manufactures your clothing or materials) and obtaining a loan from them to buy your inventory from them.
To understand this arrangement, we need to first understand why a fashion business would want to borrow money, and why a vendor would want to loan it.
Typically, when fashion businesses operate, they purchase inventory in advance, wait for delivery from the vendor, stock the merchandise, and then offer it for sale to their customers. This process will be different for each business, respectively. The point here is to understand that this process creates what is known as a working capital funding gap. Basically, this fashion business needs to spend money upfront to buy the inventory, then wait for the vendor to produce the end product, have it delivered, and then get it ready for sale. Then, they try to sell it to customers.
We look at the time it takes them from when they have the cash outflow (when they pay the vendor) to when they receive the cash from their customers as the working capital funding gap. So, if a fashion business needs to buy inventory, but it takes them 60 days from the time they place their order until they receive it, and it takes them another 45 days to sell the inventory to the customer then the working capital funding gap is 105 days.
Fashion businesses need to have enough cash on hand to be able to wait those 105 days in order to sell their clothes at a profit. As a quick side note here. Working capital funding gaps don't look at profitability. If that fashion business buys its inventory at $45 a piece, and it's able to sell the end product for $300, then the business has excellent gross profit margins.
Here, we're just looking at the problem that the business has to outlay large amounts of cash (to buy inventory) and it needs to be able to wait 105 days to receive that profit. For most fashion businesses, this is an issue when they are trying to scale. To go from making $1 million in annual revenue to $10 million, the business will need lots of inventory.
Vendor financing can help with this. Often businesses build good relationships with their vendors over time. These vendors also understand that early-stage businesses typically have difficulty obtaining traditional loans for financing. In this arrangement, the vendor creates a loan that the fashion business agrees to, and the terms are set as to how the loan will be paid back. Vendor financing is different than traditional loans in that no money is actually given by the lender to the borrower. Here, the value of the inventory the fashion business wants to buy makes up the principal amount for the loan, and the interest rate agreed to will be the vendor's compensation. The vendor then gives the fashion business their inventory and the fashion business repays the loan and the interest out of the profit they make on selling their end products to their end customers.
This arrangement is beneficial for the vendor as well because they give their customer the ability to grow faster, and thus buy more from them. So they both grow at the same time. These arrangements can be structured differently. Normally, the vendor receives interest on the amount they borrow as their compensation. However, in some cases, vendors can ask for a percentage of equity in exchange for the loan. This is more common when the amount requested is high. Additionally, this type of arrangement can also be a type of M&A (mergers and acquisitions) strategy. Specifically, vertical integration (where a business buys another on its supply chain). To learn more about vertical integration, you can check out this guide here.
If you're considering vendor financing, it's important to understand how these arrangements work and their resulting impact on the business' financials. To learn more about this, why early-stage businesses typically have difficulty obtaining traditional loans, and the different ways that vendors typically structure these financing arrangements, we recommend you read over this full guide here.
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