Can I Take Your Orders?

You have no assets. You have no receivables. How do you get financing? Make purchase orders your entry-level collateral.
Magazine Contributor
6 min read

This story appears in the August 2002 issue of Entrepreneur. Subscribe »

For modular office furniture manufacturer Design Resource Group International Inc., timing was everything. Though its niche was small office installations, the Pine Brook, New Jersey, producer wanted to bid on larger projects when the right opportunity presented itself.

Larger competitors, however, had an advantage. Deep pockets allowed them to offer customers flexible financing terms, while Design Resource Group used deposits to fund orders for the three- to four-month period it took to get paid. Meanwhile, some potential clients, particularly government agencies, rarely made down payments.

Even with bank credit, constricted cash flow hampered growth. "Banks tend to say, 'Make money slowly and build your own cash flow so that, at some point, you can do these jobs off of your own profits and your own cash,'" says David LaTorre, CFO of the $50 million company. "The window of opportunity is generally short, and if we're not there to at least bid on these projects, they may not be there next year or the following year."

"Once the company is through this growth period requiring purchase order financing, they can get into receivables financing."

LaTorre's previous employer, a gourmet food manufacturer, had a similar funding shortfall during an expansion opportunity in the late 1990s. Its accountant recommended purchase order financing, a form of asset-based lending through which businesses can obtain credit to pay suppliers, laborers and other intermediaries for goods or services they need to generate additional sales. For rapidly growing companies, the need for capital is often acute. Huge orders, seasonal sales spikes and market expansions can place strain on a business's cash flow, thus jeopardizing future sales opportunities.

After joining Design Resource Group last year, LaTorre learned that the company would need extra credit to capitalize on significant business opportunities, such as refurbishing the corporate offices of a multinational firm. He called Westgate Financial Corp., the Hoboken, New Jersey-based lender that financed the earlier growth spurt at his former company.

1 in 6
Americans do not have a credit card.
SOURCE: The Gallup Organization.

"It's out-of-the-box financing that banks typically don't like to do on the front side of large projects," LaTorre, 37, explains. "We have grown explosively over the past several years, and much of that is because we're able to obtain financing like this. That can add 20 to 30 percent in growth opportunities right away."

Closing the Credit Gap

Whereas a factor advances funds on a company's receivables, purchase order financing is used to buy inventory. In exchange for advancing funds for inventory-typically finished or nearly finished goods-the lender receives a percentage of the cost of the goods, usually in the range of 1 to 3 percent for a 30- to 45-day transaction. However, the cost varies depending on how the deal is underwritten and the client's historical performance.

While lenders have industry preferences, actual transactions are similarly structured. The funds are applied to the manufacture of goods to fulfill a purchase order, including raw materials and labor, or used to purchase finished goods, either from a domestic or overseas manufacturer. "It fits the gap between traditional bank financing or debt financing and equity," says Paul Schuldiner, national business development director for Northbrook, Illinois-based Transcap Trade Finance, a joint venture with Transamerica Commercial Finance Corp.

Purchase order financing is geared to wholesalers, distributors or importers that outsource production of consumer goods, including apparel, sporting goods, furniture, computer hardware and housewares. "There's a time frame needed to build up the inventory and production requirements," says Schuldiner, "and if they're importing from overseas, frequently the lead times could be 30, 60 or 90 days. They would typically tie up their collateral with their other lenders for that period of time."

Schuldiner maintains that purchase order financing can coexist with bank or venture capital funding. "It creates better cash flow for the client, which flows through to the existing lender," he adds. "Clients may have an equity sponsor or venture capital group that has sponsored the first round or two, but they don't necessarily want to put in additional equity. They're able to leverage off our funding because we provide transaction capital and don't typically take an equity position in a company. As such, we don't dilute the ownership interests of the existing shareholders."

of Americans have five or more credit cards.
SOURCE: The Gallup Organization.

In fact, banks are a leading referral source, along with factors and other asset-based lenders, followed by accountants and consultants, then brokers and attorneys. In terms of lending criteria, industry experience and whether the company has sufficient cash flow to cover expenses are key considerations. Additionally, lenders prefer relationships with borrowing companies-the typical credit line is set up for a 12- to 18-month period-to one-off deals.

Bring on the Bank

Niche players who lend against purchase orders are typically providing credit to companies with established bank ties. Even with a bank's support, it's a complicated arrangement in which concerns arise over ownership of collateral. Additionally, banks are reluctant to have multiple institutions filing liens and rights to a company's assets. "Typically, inventory receivables are the most tangible assets a bank wants to have as collateral, and when you're financing purchase orders, the first thing it does is create inventory," LaTorre says. "When that inventory, in our case, is in the water from Korea, it's technically Westgate's inventory. Then it gets sent to the end-user and becomes a receivable. It becomes an issue of who owns and has rights to the two pieces-when it's inventory and then when it becomes receivables."

Businesses can allay concerns by proactively managing the relationship between bank and purchase order lender, says banker Lyle Frederickson. "It's important that the business owner act as mediator to establish and enhance the relationship," he says. "Take them both to lunch and make sure everyone understands the terms. You want everyone to be invested and committed."

Frederickson, senior vice president of Arizona Business Bank in Phoenix, says the financing tool is mutually beneficial for the bank and borrower. The bank can further gauge the company's creditworthiness, while the entrepreneur eventually gains access to less expensive credit. "Once the company is through this growth period requiring purchase order financing, they can get into receivables financing," he says. "Once that happens, it will be easier for them to get that financing because we've watched the behavior, we've seen that there haven't been overdrafts, we've seen the lockbox funds coming in, and we know who their customers are. We'll probably be able to move into asset-based lending more quickly than if we hadn't been affiliated with the credit."

Crystal detamore-rodman is a Charlottesville, Virginia, writer who covers the small-business finance market.

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