Joe Johnson, Ph.D.
Entrepreneur. Investor. Startup Expert.
Funding and financing are popular business topics for a reason – businesses require capital in order to grow and succeed. If you’ve investigated small business loans and found them unappealing or have encountered difficulty securing approval, other options do exist. Recently, I discussed factoring as a funding option for invoicing-based businesses. Some of the same financing companies offering factoring also offer purchase order financing.
What is Purchase Order Financing?
If you’re involved in the sale of goods, purchase order (P.O.) financing may be a good fit. Also known as purchase order funding, P.O. financing helps resellers, importers, and distributors to pay their suppliers when a large order is pending.
For example, if you have an order for $1,000,000 worth of widgets pending, you need to purchase the widgets from the manufacturers and then dropship them to your client. The wholesale cost of the widgets is $700,000, which exceeds the limits of your upfront cash. Following some research, you select a purchase order financing company to facilitate your pending transaction. The financing company evaluates both your supplier and client, then informs you of the amount they’re willing to lend and under what terms. If you find the terms agreeable and sign the contract, the financing company will pay your supplier as agreed. When your client receives their ordered widgets, they pay your invoice directly to the financing company which, in turn, deducts the amount they paid to your supplier ($700,000 in our scenario) and their fees. The balance is sent to you as your profit.
Financing company fees vary widely and are generally based on the length of time it takes for your client to remit payment. For P.O. financing to be a good fit, you should be confident that both your supplier and client are prompt and reliable invoice payers. The less time required to get the widgets into your client’s hands and for them to pay your invoice, the better. Therefore, this is likely not a good option when dealing with a client that frequently delays payment.
When a financing company is making the determination on whether they should offer their services and on what terms, they often focus on the creditworthiness of the end client. Since the end client is the one paying the invoice, they want to ascertain that they have acceptable business credit. Financing companies often require that the client be a commercial enterprise or a government entity. It’s in everyone’s best interests that the invoice be paid in full; ensuring that the client is likely to do so is an essential first step in the process.
Who Can Apply For Purchase Order Financing?
Financing company guidelines on businesses they’ll fund naturally cover a range. Throughout, however, there are similarities. These points are not necessarily requirements for companies wanting to utilize purchase order financing, but they are representative of the issues under consideration. If you find that your company is not a good match for many of the requirements, it may be necessary to seek other funding options.
- You’re a reseller, importer, or distributor of finished goods. You make no changes to the product beyond labeling or packaging modifications.
- Your purchase order will result in a gross profit margin of approximately 20-30%.
- Your goods already have a purchaser, which is either a commercial entity or a government agency.
- Your purchase order cannot be cancelable.
- Your company has good credit, as do you personally and any partners or other principals involved with your company.
- Your company has no outstanding liens against it.
- If your company is new, you already have either verifiable experience or a reputation in the industry.
- Your client and your supplier are both reputable and creditworthy.
If you have any doubts as to whether you’re eligible for purchase order financing, speak with a reputable financing company before investing too much time and effort in the process.
While it might seem that startups won’t be eligible for P.O. financing, that’s not necessarily the case. If your company is able to demonstrate knowledge and experience in your industry, that the company and its principals are creditworthy, and that your suppliers and clients are also reputable, your business could be a prime candidate for this type of funding.
Benefits of Purchase Order Financing
Purchase order financing can help you meet the exigencies of promptly filling large client orders. Rather than seeking a bank loan, a process which can absorb weeks or months and require detailed applications, applying for P.O. financing is relatively quick.
For companies which don’t yet have the cash flow to make the large purchases necessary for growth, purchase order financing offers a way to meet larger customer orders.
Many P.O. financing companies combine purchase order financing with factoring. Doing so can effectively reduce the total costs. In this scenario, once the client receives the goods and their invoice, the financing company factors the invoice. Rather than paying your company an advance as with standalone factoring, the advance “pays” the financing company for the money fronted during the P.O. financing process and stops the fee clock started by the purchase order financing. Once your client pays the financing company, it deducts the “advance”, the purchase order financing fees (which stopped when the invoice was factored), and the invoice factoring fees, then sends you the balance. While this may sound a bit convoluted, it can generally save companies some money. Rather than paying 2-4 months of P.O. financing fees, a company may pay only 1-2 months of purchase order financing fees and 1-2 months of factoring fees. Whether or not this makes sense in your particular situation will depend on your company, your client, and your chosen financing company. If the financing company you select mentions that they only do purchase order financing when combined with factoring or accounts receivable financing, be sure that this will work in your favor.
The Disadvantages of Purchase Order Financing
As with invoice factoring, where you pay a fee to receive an advance on your invoice, you pay a fee for the funds sent to your suppliers. The fees and fee structures naturally vary by company. However, as is generally the case with both factoring and purchase order financing, the longer it takes to receive payment from your clients, the higher your fees.
Purchase order financing can help grow your business in that it enables you to fill orders that would otherwise be beyond your company’s means. It does not, however, provide you with cash flow in the same way that a bank loan might. P.O. financing cannot, for example, be used to directly meet your payroll, though it may help to free capital that would otherwise be used to pay suppliers.
Although some companies may not want their suppliers or clients to know that they’re involved with purchase order financing, the nature of this type of funding makes it impossible to disguise. After all, the financing company will be interacting directly with your supplier and possibly with your client, as well. While researching financing companies, ensure that you’re comfortable with the manner in which they’ll be contacting your suppliers and clients.
However you decide to fund your business activities, take the time to ensure that it’s the best move for your company and its goals. The method of funding you eventually pursue may differ from the method you had in mind at the beginning. Although this isn’t a problem and is frequently a part of doing business, you should consider amending your business plan or business model canvas as your funding sources change over time in order to ensure that your goals and projections remain on track.
About the Author
Dr. Joe Johnson is an entrepreneur, investor, and startup expert. He is the founder and principal of GoodField Investments and the GoodField Foundation (www.GoodField.com).
Joe has a Ph.D. in Entrepreneurial Leadership and an MBA. He is the author of the upcoming book on The Science of Why Most Entrepreneurs Fail and Some Succeed.
Most importantly, he is the incredibly blessed husband of one amazing wife and father of six wonderful children. He resides in Bradenton, Florida. For more information on Dr. Johnson and his work, go to www.JoeJohnson.com.