A Purchase Order Finance Perspective On Evaluating Prospects

Sunday, May 1, 2011

The purpose of this article is to relate an understanding of the situations where purchase order financing may be appropriate and the risk analysis on a company from a purchase order finance perspective. 

Purchase order financing is essentially a facility to satisfy an interim need for a company to take advantage of a short term opportunity.  The following are a couple of primary situations for dealmakers to consider purchase order financing to provide the flexibility of a solution in facilitating that interim capital need.

-  A prospective company has potential for growth but currently does not meet the criteria for a minimum investment and return required of private equity.  Purchase order financing can bridge this gap, facilitate the company’s growth and create a future opportunity for the dealmaker.          

-  A portfolio company where current traditional financing has become fatigued or maxed out on extending more credit.  Private equity may either invest more capital, possibly having to restructure ownership or has determined that the return on any additional capital investment in the company is not of strategic interest.  Purchase order financing is an alternative to a long term debt instrument when the need is a short term infusion.  It can also potentially help to avoid further deterioration in the financial condition and value of the company by the necessity to downsize and reduce the capacity of the company to generate profits.         

Purchase order financing is “transactional equity” since it steps out beyond the scope of traditional financing.  However, it does not dilute ownership.  The collateral associated with purchase order financing is the goods, materials, parts, etc. that the company needs in order to fulfill the order.  In the world of purchase order financing, the order is fulfilled when it is invoiced, and as a result, creating traditional collateral for whoever is financing the company’s accounts receivable, be it a bank, asset based lender or factor.    

Since purchase order financing is based on pre-sold goods, the company must have a firm order from a credit worthy customer.  The amount of purchase order financing is contingent upon the advance rate on accounts receivable established by the company’s bank, asset based lender or factor, in order to take out the amount of purchase order financing, plus fees.  That relationship is established between the parties through an intercreditor agreement.       

The following examples attempt to illustrate some general scenarios from finished goods to production and evaluation of each from the purchase order financing perspective.   As with all purchase order financings, a key element in evaluating risk is the company’s gross margin.  Value of the collateral to the market is in theory worth more the larger the gross margin.  Therefore, the easier it will be to find another buyer if the purchase order is cancelled by the company’s customer and the higher probability of the funds employed by purchase order financing getting repaid.  In addition, the more specialized the product is to the company’s customer, the more risk associated with finding another buyer.

Finished Goods:  Manufactured overseas drop shipped directly to company’s customer

The goods are produced, packaged and ready for delivery to the company’s customer by the factory/supplier overseas.  The order is completely fulfilled by the overseas supplier.  The goods are paid for by purchase order financing through letters of credit or documents for payment and all that remains is the delivery of the product to the company’s customer.  The finished goods being drop shipped directly to the company’s customer mitigates the risk of the client touching the goods and any reliance on the company’s ability to perform in physically handling the goods.  The risk is essentially transferred from the client to the factory producing the goods and third party logistics for handling the goods and/or staged at a third party warehouse for delivery to the company’s customer.

Finished Goods:  Delivered to a domestic third party fulfillment warehouse.

In this case, the process entails different items; each item on its own is essentially a finished good but assembled by a domestic third party fulfillment warehouse into a final product for delivery to the company’s customer. 

As with goods drop shipped directly to the company’s customer, the risk is transferred to a third party entity in the handling of the goods in fulfilling the order to the client’s customer.  However, risk parameters increase due to funds being employed by the purchase order financing to suppliers, either foreign or domestic, for goods to then be delivered to the fulfillment warehouse for final assembly of the finished good.  Although not a requirement, some history of the company utilizing the suppliers and fulfillment warehouse will obviously offset a considerable amount of the risk.  Regardless, the suppliers and fulfillment warehouse will be vetted out in the due diligence process confirming their ability to perform.        

 

Finished Goods:  Manufactured overseas delivered to company’s own warehouse/facility.

In the prior scenarios, the goods were handled by third parties.  In this case, the goods come in to the company’s own warehouse where they have to be picked, packed and shipped or some additional value add by the company to fulfill the order.  We now have to evaluate the history and ability of the company to physically perform.  Although the process may be simple, the company must not only have the capacity to fulfill the order but also have verifiable cash flow from other sources than purchase order financing to cover overhead to fulfill the order.  If these facts are not evident, an alternative may be a requirement that the company use a third party fulfillment warehouse to fulfill the order.       

 

Production Deal:  The company utilizes a domestic contract manufacturer in fulfilling an order:

The production risk is transferred away from the company to the contract manufacturer.  The emphasis is then put upon the contract manufacturer’s ability to perform.  Acceptable risk is a contract manufacturer that has experience in the business of producing this product and sustain due diligence with references.  In most cases, the contract manufacturer will require a deposit or assurance to get paid to begin production or payment to release goods.  Since it is a domestic contract manufacturer and verified through due diligence the ability to perform, this is a viable transaction even if it is an early stage company.  History with the use of the contract manufacturer is not a requirement but certainly helpful in evaluating the risk.   

Production Deal:  The domestic company is producing the goods

Known as production finance or work in process financing, a product is being produced by the company and shipped to the company’s customer.  Since purchase order financing provides only direct costs in fulfilling the order, the company must have a proven history of not only producing the product but also the capacity and the cash flow to cover other non-direct costs.  Purchase order financing can include the cost of materials, parts and direct labor to fulfill the order.

The company must be profitable or at least cash flow neutral.  The basic concept in mitigating the significant risk associated with production finance is that the order being financed is incremental sales to the company, i.e., if the company lost the sale, it would still be a going concern.  In most cases, the company has maxed out not only the credit lines with their suppliers but also their borrowing capacity with traditional financing sources.    

In addition, two main items must also be addressed in the initial assessment of the potential for purchase order financing on a production deal:  (1) the number of suppliers required to fulfill the order; and (2) the time involved with the production cycle. 

The greater the number of suppliers means more work required in due diligence in vetting out the suppliers and ability to control the collateral of raw materials and parts delivered to the company. The fewer the suppliers, the more likely that production is of a low tech nature.  The more suppliers, the more involved the production process and more risk associated with the transaction.

Ideally the production cycle is in days or weeks and the company can invoice as product is produced and shipped, especially on larger orders.  If the production cycle is much more than 60 days, the cost of purchase order financing to the company and the risk with the longer exposure of employed funds by the purchase order finance company, the transaction may not make economic sense for either party.    

Full understanding of the production process is essential in assessing the risk.  In general, there is less risk associated with light assembly where the work done by the company is relatively simple.  This includes fabricators, cutting, sewing, mixing, packaging, etc.  On the other hand, full production deals are considered a higher risk when the company is taking more of a raw material and production involves tooling, molding, milling, etc. in producing a finished product.

Purchase order financing must make economic and strategic sense for the company.  It can facilitate growth, enable a company to take advantage of a short term opportunity and contribute to the company reaching its full potential.  Since it is transactional, purchase order financing can provide a flexible and effective solution in facilitating the interim capital needs of a company.

Chip Scoggins, Business Development Manager with King Trade Capital, has almost 30 years experience in the commercial finance and banking industries.  You can reach him at cscoggins@kingtradecapital.com or 214-368-5100