Truth be told, this is not very common in the startups I work with. The more capital intensive your startup is, the more you can and should think about this approach.
Two reasonably common examples of vendor financing in the world of tech startups are equipment financing and development for equity.
Equipment financing is when a vendor of capital equipment, like servers, agrees to sell you their product and takes a loan or a lease instead of cash. We are going to do an entire post on capital equipment loans and leases later in this series and we will cover that in more detail then.
Development for equity is when a third party development firm builds something for you and takes equity in your business (or less commonly, a loan) in return for the development services. It is fairly common for a development partner to take some of their compensation in equity but it is rare for them to take all of it that way. But in this case, a vendor of services to your company is financing your business by reducing the amount of cash you need to lay out to get into business.
In the biotech and cleantech sectors, vendor financing is more common. These sectors have large capital equipment requirements and large third party services requirements. There is a lot of money laid out to third party vendors on the way to cash breakeven and therefore a much greater opportunity to have those vendors finance the business.
When you are starting a company, cash is always tight and so anytime you need a third party vendor to supply your company with services, you should be thinking of vendor financing possibilities. It can be a great way to keep your cash outlays down when the cost of capital is highest.
From the comments
I had a role in large company that supported this type of activity sometime back. Our group’s role was to review all the deal requests like this (and there were many) – we give them equipment/service in exchange for a piece of the company. It can work. If you are an entrepreneur, expect that the really good ‘investors’ that engage in this type of financing are still like cash for equity investors. Meaning, the really good ‘investors’ that finance companies in this manner are still likely to perform extensive due diligence; are still investing in the team as much as the market/product, etc.; and will run the numbers internally – sometimes multiple times as the biz case moves up the chain. The latter part is especially important because these companies have hurdle rates they need to meet, albeit they can be different from traditional capital providers.
Entrepreneurs pursuing this need to still heed all the great advice out there about who to jump into bed with, etc. and do your homework on your potential investors so you have an idea what they might be looking for and what might excite them and entice them to do a deal.
In the early 90’s vendor financing was the way that we grew our company in the apparel industry; we were the manufacturer who actually went out looking for new companies with a great concept that we could then supply with product, it was a win win situation. It grew our business by 10 times in 5 years and gave us diversification, which in turn dramatically increased our margins. We normally started as a loan/license with the right to convert to equity. In some cases we even financed the start up for a period of time.
I really think that more and more vendors need to look at this as a serious option, but I suspect as equipment manufacturers mature and markets consolidate this option will disappear; it has in apparel.
This article was originally written by Fred Wilson on June 27, 2011 here.