Vendor Note Meaning Terms Pros and Cons

Vendor Note: Meaning, Terms, Pros and Cons

What Is a Vendor Note?

A vendor note is a short-term loan a vendor makes to a customer secured by goods the customer buys. It is a form of "vendor finance" or "vendor financing," usually a deferred loan made by a vendor. Vendor notes are employed when a vendor has more confidence in a customer’s business prospects than a traditional lender (a bank).

Key Takeaways

– A vendor note is a short-term loan a seller makes to a customer backed up by products the customer buys.

– This type of deal is called a deferred loan and is used when a company is unable to borrow the desired capital from traditional lenders.

– These loans often have a higher rate of default than those offered by banks and therefore offer a higher interest rate to compensate for the risk of defaulting.

– Vendor note loans are often secured by the inventory being sold but may also be backed by the buyer’s business assets or cash flow.

– Vendor notes vary in terms of maturity, but it typically takes three to five years to reach total maturity.

Understanding Vendor Notes

Vendor notes can be a useful and convenient form of financing, especially when established vendors with diverse customer bases take on new, smaller buyers with limited working capital.

In some cases, customers may rely entirely on vendor note financing to secure vital inventory or equipment. Using vendor financing can make it easier for a company to increase sales volume and revenue but also incurs the risk of buyers not paying back their loans.

Terms of Vendor Notes

Vendor notes vary in time to maturity, but notes with time horizons of three to five years are common. Different terms and conditions can be built into a vendor note, such as limitations on the buyer’s business practices, restrictions on acquiring other inventory or assets, and requirements to maintain specific financial ratios.

While vendor notes are often deferred loans, there may be an interest charge on the borrowed sum. Maintaining a relationship by helping with financing and being paid back over time (sometimes with interest) is better than no sale at all.

Advantages and Disadvantages of Vendor Notes

Depending on the inventory or equipment you plan to buy, vendor notes or vendor financing, in general, have advantages and disadvantages. It’s important to consider whether vendor financing or a traditional bank loan is a better option for your business.

One primary advantage of a vendor note is purchasing equipment at a good value. Many vendors offer customers discounts on the items they need for their business. As the product and financing come directly from the manufacturer, the deal you receive may be better than elsewhere, making it an attractive option.

Another selling point of a vendor note is the ease of obtaining the purchase and financing simultaneously. A manufacturer wants to make the sale and understands the product, making financing straightforward. Comparatively, a bank’s evaluation process is much longer.

There are generally two types of vendor financing: debt financing (vendor note) and equity financing, where the vendor receives stock or equity in the business.

Obtaining financing directly from the vendor also typically has lower upfront costs and makes it easier to update your equipment over time as you deal directly with the manufacturer.

One main disadvantage of vendor notes is dealing with a third-party non-bank financing entity if the vendor does not have an in-house financing department. This entity, unfamiliar with the vendor or equipment, may charge higher interest rates or finance a small portion of the cost.

Additionally, purchasing used equipment may be more costly as manufacturer incentives no longer apply, and the vendor considers that when pricing the financing.

Lastly, some vendors only provide financing for the equipment without any additional terms that may benefit your business, such as transportation and training costs.

Example of a Vendor Note

A new medical office buyer wants to acquire a laser device used for special outpatient surgeries costing $1,000,000. The buyer only has $100,000 to spend. Instead of seeking a business loan from a lender, a medical device vendor offers the equipment to the customer under the agreement that the buyer pays back the $900,000 balance over a five-year period at a 2% interest rate.

What Is Vendor Financing?

Vendor financing is financing that a business obtains directly from the vendor when purchasing inventory or equipment. It stands in contrast to traditional methods of financing, such as obtaining a bank loan. Vendor financing is often a deferred loan and can lead to building a strong vendor-customer relationship.

Are Vendor Notes Subordinated Debt?

Vendor notes are subordinated debt, meaning they sit below senior debt in the repayment waterfall in the event of bankruptcy. Holders of subordinated debt are always paid after holders of senior debt are paid off.

What Is a Vendor Loan Agreement?

A vendor loan agreement is a financing agreement between a vendor and a buyer in which the vendor provides capital for the purchase of the vendor’s product. The buyer pays an upfront cost, and the remainder, plus interest, is paid over time. The vendor loan agreement specifies the parties involved, the amount financed, the time to maturity, and the interest rate.

What Happens If You Default on a Vendor Note?

The repercussions of defaulting on a vendor note can vary depending on the arrangement and the terms of the vendor loan agreement. The vendor can repossess the inventory or equipment sold and other business assets to recoup losses. The vendor may also be entitled to future cash flows of the business.

The Bottom Line

A vendor note can be a good option for a business seeking inventory or equipment, particularly for new businesses with limited cash or credit history. Vendor notes also establish a relationship between the vendor and the business that could be profitable in the future.

Choosing between a vendor note and a traditional bank loan depends on what’s best for your business. It is important to weigh the pros and cons of each before making a commitment.