A vendor guarantee is a tool that can help some companies cover their supplier expenses. Companies that manufacture products but cannot obtain conventional financing commonly use vendor guarantees. This article explains how vendor guarantees work, who can use them, and the product’s limitations. We cover:
- How to finance supplier costs
- What is invoice factoring?
- What is a vendor guarantee?
- How do vendor guarantees work?
- An example of a vendor guarantee
- Will your supplier agree to this program?
1. How to finance supplier costs
Paying for supplier expenses can be challenging for small and midsize companies that are growing quickly. They have not achieved the needed size or track record needed to get net-30 terms (or longer) from suppliers. Instead, they must prepay their supplier expenses or get small trade lines. Ultimately, supplier payments end up straining their limited cash reserves.
Some companies try to solve this problem using purchase order (PO) financing or supplier financing. These tools can work very well, but they work only in specific situations. Purchase order financing works only in transactions where the client is a strict re-seller (e.g., no manufacturing). Supplier financing is more flexible and can work with manufacturing companies. However, the company must meet some size and longevity requirements.
Vendor guarantees are a tool that can bridge the gap left by supplier financing and PO financing. The guarantees are implemented by using an invoice factoring line and a special vendor agreement.
2. What is invoice factoring?
Invoice factoring is a solution that allows companies to finance invoices that are payable in 30 to 60 days. It works by selling your invoices to a factoring company. The factoring company that buys your invoices pays for them in two installments.
The first installment is called the advance. It covers about 80% of the invoice’s total value. It is deposited into your bank account when you submit the invoice to the factor. The remaining 20%, less the factoring company’s fee, is deposited into your bank account once your customer pays the invoice in full. Learn more by reading “What is Factoring?” and “How Does Factoring Work?”
3. What is a vendor guarantee?
A vendor guarantee, also called a vendor assurance, allows you to leverage a factoring program to help with supplier payments. It involves an agreement between your company, your supplier, and a factoring company. As part of this agreement, the factoring company agrees to pay your supplier directly out of the proceeds of financed invoices. Consequently, the factoring company agrees to pay your supplier before they send the payment to your company.
The factor can pay your vendor only “out of the proceeds of factored invoices.” The factor agrees to forward your advances and rebates to your supplier until your obligations are fulfilled. Once your obligations are fulfilled, any additional funds are remitted to your company. It’s important to note that the factor is not able to cover your vendor expense if the proceeds for factored invoices are not sufficient.
4. How do vendor guarantees work?
Transactions are simple and can be incorporated into conventional factoring programs. Each finance company offers the plan slightly differently. However, the plans usually follow these steps:
- Your supplier agrees to this arrangement
- Transactions proceed like factoring transactions
- Once an invoice is factored, the finance company remits the funds to your suppliers
- After your suppliers are paid, the remaining funds go to your company
5. A vendor guarantee in action
The following example illustrates how vendor guarantees work. Assume a small manufacturing company has been in business for a few years and has a good relationship with its suppliers. The supplier is willing to give them up to $100,000 of vendor credit on net-30 terms.
a) A large contract can create problems
The manufacturing company wins a major contract with a large company. The contract has good profit margins, but the customer demanded net-60-day terms. After signing the contract, the manufacturing company realizes they need to increase vendor credit to $170,000.
The supplier reviews the situation and informs the company that it cannot raise the limit to $170,000. This situation creates a dilemma for the manufacturer, who has a valuable contract but is unable to fulfill it.
b) Vendor guarantee is put in place
The manufacturer contacts a factoring company and implements a vendor guarantee program. The supplier agrees to increase their client’s line to $170,000 (net-30 terms) as long as the factor pays the supplier before they remit any proceeds to the client.
The manufacturing company gets the supplies from the vendor, manufactures the product, and delivers it to the end customer. They invoice the customer and then remit the invoice to the factor for financing.
c) Vendor gets paid
The factoring company processes the invoice. They determine that 60% of the factoring advance (first installment) is needed to pay the supplier. The factor remits those funds to the supplier, and the remaining funds go to the manufacturing company.
The factor settles the transaction once the end customer pays. They remit the second installment to the manufacturing company, which closes the transaction. The manufacturing company can repeat this process as needed as long as the vendor guarantee agreement is in place.
6. Will your suppliers agree to this program?
Vendor guarantees work only if your supplier agrees to them. In our experience, you have a greater chance of success if you have a solid track record with the supplier. These suppliers know your company and may be willing to be flexible. It helps if you can articulate how this program may translate into bigger sales for them.
Lastly, these business financing agreements can often be complicated. It’s best to review them with a competent financial and/or legal professional to ensure you understand how they work.
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