It's a Win-Win
In 1994, one of Doug Brendle's customers, an R&D firm for the screen-printing industry, approached him about engineering new technology to streamline the screen-printing process. Brendle was the ideal candidate to get the job done: An engineer and physicist by trade, he had also worked as a consultant for the screen-printing and manufacturing industries. Though he had the necessary technical expertise, he didn't have the $300,000 needed to fund a project of that magnitude.
"Not only was it a funding issue, it was a time issue, too," recalls Brendle, founder and CEO of HardKore Inc. in Cheyenne, Wyoming. "It had to be done by a certain time, and it would have been impossible for a company of our size to acquire that kind of funding that fast, especially when we were already leveraged with other jobs."
But because his $1 million-plus firm was uniquely qualified for the opportunity, his customer provided the necessary funding to carry the project to completion. Brendle repaid the loan within six months by selling the newly manufactured equipment to the customer at a discounted rate. The customer-financed deal was not only financially lucrative, but it also took Brendle's company, which manufactures a line of fitness equipment, down a new product path. Says Brendle, "Without it, we wouldn't be building our own [screen-printing] product line."
Filling the Financing Void
While Brendle's client was willing to meet him halfway because of his unique manufacturing capabilities, there are a host of other reasons a customer would support this type of financing arrangement. Perhaps the business needing the loan is the exclusive supplier of a product or service in demand by a customer's competitors. Or maybe the customer wants its supplier to step up production to better serve its own needs. In either case, the customer may have a strong incentive to lend financial support.
"I've seen this when you have a large customer dealing with smaller suppliers that usually are either producing a very unique product or a proprietary product," says business consultant Deborah House, founder and CEO of The Adare Group in Oakbrook Terrace, Illinois. "The customer needs to buy a widget. They don't want to make it and can't find anybody else to make it, so they'll provide financing to outsource it."
Even fast-food giant McDonald's has been known to provide local bakeries with financial support to manufacture its sandwich buns. "They will work with the bakery and [provide funding] if a new plant has to be built or if equipment needs to be bought," House explains. "And they do that in a number of different ways. It can be through a loan, it can be through equity or a thousand combinations thereof."
Borrower beware, however: Anytime you invite a customer into your inner circle, you run the risk of revealing too much about your business, including how you make a product and how much it costs to produce. Additionally, the customer may want to dictate pricing terms in return for investing its own capital.
"There's always a catch to it," says House. "The catch can be that they want you to devote the plant solely to making the buns needed for McDonald's restaurants in a certain region of the country. The thing that comes along with this is that McDonald's will usually tell you how much they'll pay for the buns."
Another Cook in the Kitchen
This type of capital often comes with other strings attached. For instance, it's not uncommon for the customer to require the borrower to turn over certain operational functions in return for putting up the funds. "Often, the business is out looking for money to begin with because there are some missing elements," explains David Young, business development specialist for the Washington State University Small Business Development Center in Seattle. "Those may be management or accounting issues. When the customer sees some merit in putting funding in, those are the [deals where] you most often see the operating criteria go in with [the funding]. They may even take some functions away from the company seeking the funding. They may decide to do the accounting, or they may decide to do the backroom management of suppliers if they see some real weaknesses."
House concurs: "The business owner is getting capital, but they're probably getting an operational partner and an executive partner as well."
Brendle discovered this when his customer/lender asked for so many project updates that it interfered with productivity. "We had no idea that we needed to lay down some rules, but you can't have someone micromanaging you," he says. "If you're going to get funding, it's got to be funding with the understanding that you can get your job done. That's the biggest thing." In later deals, Brendle worked out an arrangement with the customer to provide biweekly updates. "We had a system so nobody was calling and asking for anything, but they were kept up-to-date as to where [the project] was going and whether it was on schedule or behind," he says.
He was also careful not to part with anything he wasn't willing to give up. Case in point: his client wanted exclusive rights to the screen-printing equipment he manufactured on its behalf, even though it was Brendle's own patented design. Says Brendle, "When they found out how much it would cost to buy exclusivity, they backed off."
As Brendle can attest, customer financing isn't a relationship to take lightly. In addition to arguments over ownership rights, there are sometimes long-term funding ramifications for being so closely connected to a single client. "Once you get tied to a particular customer and they're providing over 50 percent or even 20 percent of your total revenue, then you may not be as attractive to a bank because you're a higher risk if that customer goes away," House stresses. "And you may not be able to get venture funding because now you have a partner in your business."
As a result of these potential drawbacks, it's imperative that you evaluate prospective funding partners carefully. "Do you like them? Do you trust them? It's definitely worth spending some money on professional business and legal advice," House advises. "Using other people's money is always a really good thing to [help you] grow as long as you look at what the risks and rewards are. Realize what you're giving away and what you're getting in return. And always know how you can get divorced before you get married--the exit strategy is almost more important than the contract signing."
Crystal Detamore-Rodman is a Charlottesville, Virginia, writer who covers the small-business finance market.