Special Situation: Purchase Order Loan

By Frank Demmler

Raising money without giving up equity remains a popular topic.

This week we’ll look at a special situation and a possible response: the Purchase Order Loan.

When I was with The Enterprise Corporation of Pittsburgh, one of the more frustrating situations occurred when an entrepreneur with whom we were working finally got an order, but didn’t have the working capital to deliver on it.

It always takes longer to get a customer to issue an order than an optimistic first-time entrepreneur ever believes. With some regularity, we would see someone burn through all of the resources at his disposal, always believing that the order would be coming “tomorrow,” and then when it did actually come, they didn’t have the resources to build the product.

There is receivables’ financing once the product is delivered and invoiced. Some organizations will buy invoices at a discount. How does one do “pre-receivables” financing? How can someone finance a bona fide order?

We “invented” the Purchase Order Loan to address this issue. [“We” includes Tom Canfield, John Freyhof and me.] [I use the term “invented” advisedly because I’m sure there must be others who have put such deals together, although I wasn’t, and still am not, aware of them.]

Deal Mechanics

The purpose of this deal structure is to enable the company to build the product, but nothing else. It doesn’t pay for overhead or salaries. It pays for the directly attributable cost of sales.

The entrepreneur still has to act entrepreneurially. He must continue to survive on macaroni and cheese, BUT, if there’s an order, and if it’s priced correctly, then upon completion of the order, the gross margin that the sale generates is available to fund subsequent orders and partially address the ongoing operating needs of the company. [You do remember my admonition from weeks ago that gross margin is good, and more gross margin is better, don’t you?]

The basic requirements of a Purchase Order Loan are:

• A signed purchase order that can be verified.
• An acceptable and reasonable forecast of the costs associated with building the product and delivering it to the customer.
• A negotiated interest rate or other return mechanism for the investor.
• An agreement that says the loan is payable upon receipt of the customer’s check, and that the loan is the first thing paid from that check.
• Personal and company guarantees.
• A loan agreement that encompasses the preceding.

Depending upon the size of the transaction, the number of parties involved, and the trust among them, this deal can be pretty simple to put into place. Also, it can be repeated for the same participants in the future with little or no cost. Just take the prior note, change the date and fill in the blanks for the new deal’s specifics.

An Example

We were pretty proud of this structure and we used it with a reasonable degree of frequency under the proper circumstances. Let me tell you about a classic case.

We were working with some people who had been laid off from the Volkswagen plant that used to be in Westmoreland County. They had developed a business plan for building “kit” cars. These are body shells of classic cars from the past that replace the existing body of current (or at least recent) cars. Instead of finding a used car that the shell would fit, the guys were going to use all new parts and build a “new” car. I think the first model was a 1953 MG convertible.

[What follows may not be exactly accurate due to failing memory and poetic license, but it’s pretty close.]

The idea was intriguing and we challenged them and their business plan until we were all satisfied that it was doable. The only trouble was, we couldn’t raise the financing. Each car cost about $35,000 to make and it was sold for $60,000. Even though these were “new” cars, no bank would finance them since no secondary market existed for kit cars that could be used to comfortably calculate the collateral value of a car. We couldn’t figure out a way to finance an inventory on terms that were acceptable to the founders.

Eureka! Enter the Purchase Order Loan!

Each car was a separate loan agreement. Once a customer signed a purchase order for his car, a group of private investors would lend the company $35,000 to build it. In this case, instead of an interest rate, the company and the investors split the gross margin of the transaction ($60K - $35K = $25K). In this example the investor would get $12,500 for lending $35,000. Since the turnaround from order to delivery ranged from 90 – 150 days, the annualized rate of return wasn’t too shabby. In addition, each transaction was secured by the car itself, so if the customer didn’t pay for some reason, and the owners couldn’t find a way to satisfy the outstanding note, the investors got the car!

This sequence was repeated successfully eleven times!

The company ultimately failed, but not for any reasons associated with this form of financing. The note holders of the twelfth deal did not get all of their money back (nor did they get a car). That’s why the rate of return that private investors seek is significant.

Considerations

For the right set of circumstances this deal structure can be attractive to both the investors and the founders of the company.

The Entrepreneur’s Perspective

First and foremost, you can get access to cash at a time when you most need it.

Second, once the initial transaction is structured, doing subsequent deals is relatively easy.

Third, you can avoid selling equity in your company.

It’s pretty straightforward in terms of administrative overhead.

It is pretty expensive money, cash-on-cash, so you’ll want to try to qualify for conventional debt as soon as you can.

The Investor’s Perspective

First, it’s a deal with an attractive annualized rate of return.

If structured properly, it is less risky than alternative deal structures since it is tied to a specific transaction, and has explicit guarantees.

It might enable you to make significant cumulative investments in a company without having to expose a significant amount of capital to risk at any one time.

There is still significant risk involved. If your specific deal fails, do you really want to take delivery on a car, or a roll of steel, or 200 2X4’s, or…

A Side Note

Tom, John and I became so enamored of this deal structure that we pitched it to local economic development agencies. We weren’t suggesting that they get into the kit car business, but we did try to convince them that establishing this program would be extremely helpful to some of their citizens at critical times. Also, we suggested to each that this might prove to be a competitive strength, since most economic development organizations (other than theirs) wouldn’t be so progressive and able to bend their rules for something so unconventional.

Well, we were right on the last point. While several agencies were intrigued by our proposal, each time we got some enthusiasm for the program, it seemed to stall in the bureaucratic processes, never to be seen again.

Except for one organization: the Corporation for Owner-Operator Projects in Beaver County. Mike Devich, co-founder and Executive Director, was sufficiently intrigued by the program that he took it to his board for consideration. The board, likewise was intrigued, and set up a meeting with me. I did the pitch. Mike and I pushed on how the potential benefits far outweighed the down side. Amazingly enough, the board approved it!

Mike was able to secure $350,000 from foundations to launch the program. He recently wrote me that they have done almost $3 million of Purchase Order Loans, have had only a few write offs, and still have the bulk of the original grant available to recycle through future loans!

While I take some pride in being part of the team that “invented” the program concept, like all entrepreneurial efforts, it’s really the execution that matters. I take my hat off to Mike, his team, and his board, for having the guts and vision to do something different, and to do it superbly!

Advice to entrepreneurs

• Deal structures are only limited by the imaginations of the involved parties.
• It is possible to structure deals without giving up equity.
• Use good professionals to make sure your deal is structured properly.

Frank Demmler is Associate Teaching Professor of Entrepreneurship at the Donald H. Jones Center for Entrepreneurship at the Tepper School of Business at Carnegie Mellon University. Previously he was president & CEO of the Future Fund, general partner of the Pittsburgh Seed Fund, co-founder & investment advisor to the Western Pennsylvania Adventure Capital Fund, as well as vice president, venture development, for The Enterprise Corporation of Pittsburgh. An archive of this series of articles can be found at my website.