It’s not uncommon for us to speak to a prospect who is very excited about a large purchase order they just received from a very reputable company. Furthermore, as we review the details of the order, we believe that the order will be a good candidate for purchase order financing because it meets these three basic financing criteria:
- Reputable supplier who can accept a letter of credit
- Great client who has issued a solid purchase order
- High profit margins (>= 30%)
(Editor’s note: To learn more, read “What is purchase order financing?“)
However, when we review the small print in the contract or the purchase order, we then discover that it’s a guaranteed sale. Although it sounds harmless, a guaranteed sale clause can kill your chances of getting financing for your purchase order. Why? Because a guaranteed sale is not considered a sale until your client sells the goods to their customers.
This condition means that the client can return unsold goods – usually for whatever reason – at any time. From the perspective of a finance company, an order with a guaranteed sale clause is not very solid and cannot be financed.
1. Why can’t guaranteed sales be financed?
If you think about this from the perspective of the purchase order finance company, their collateral is the payment generated when you deliver acceptable goods to your customer. The finance company’s position is weakened if the final payment amount is threatened because the client can return unsold goods.
By the way, returns for damaged goods are usually OK and expected during the normal course of business. It’s the unpredictable return of perfectly acceptable goods that creates a problem. This is also why consignment sales cannot be financed this way.
2. How to solve the problem
The only way to solve this problem is to negotiate with your client and ask them to remove the guaranteed sales clause from their contract. This is easier said than done, especially if you sell goods that can be bought easily from other suppliers.
An alternative that often works is to negotiate a cap on the amount of goods that can be returned. If your profit margins are high enough – and if the cap is reasonable – it may be possible to structure the transaction to account for that. Let me give you an example that assumes the following:
- Your supplier cost is $100,000
- Your sales price is $200,000
- You negotiate a ‘guaranteed sales’ cap of 20% (or 200,000 x 0.20 = $40,000)
Under these conditions, the lowest payment you can get is $160,000 ($200k – $40k), which is still high enough to cover the supplier cost plus the cost of financing. From the finance company’s perspective, this transaction looks like it can be funded.
3. Remove the clause before you sign the contract
An even better alternative is to remove the guaranteed sale clause from your contracts while you are negotiating. It won’t be easy – it never is. However, you have a better chance of removing the guaranteed sale clause when negotiations are ongoing rather than after signing the contract.
One last point, be sure to get the advice of a competent attorney when reviewing client contracts. These clauses can be written in a way that is hard to understand and can often go undetected – until you get a payment check from your client – with a huge charge-back. If that happens, you can find yourself in a world of trouble with unexpected cash flow problems.
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