Dec 11, 2023

The Founder’s Guide to Raising Inventory Financing in 2024

Arc Team

Go-To-Market

Inventory financing is one of the most straightforward forms of financing available to startups, e-commerce merchants, and other retailers. It’s especially helpful for businesses that receive large purchase orders, operate seasonally, or are growing rapidly. In this guide, we break down this form of financing, examining the key benefits and drawbacks and addressing the commonly asked questions. Let’s dive in!

Inventory financing - the basics

What inventory financing is (and isn’t)

Inventory financing, a subset of asset-based financing, is a type of business loan or credit facility that uses a company's inventory as collateral. This form of financing allows businesses to secure a loan or line of credit, to purchase products that they intend to resell at a later date. It's typically used by e-commerce merchants or 3rd party merchants that sell into retail but do not have sufficient capital to purchase additional inventory. It is also typically used by seasonal businesses that need to purchase inventory for an upcoming “season” but do not have the capital to do so.

How inventory financing works

Inventory financing can either be broadly categorized as a line of credit or a traditional loan.

If it's structured as a line of credit, also known as a “revolver”, the startup draws down the available credit to purchase inventory well ahead of the period it plans to sell it in (to account for the manufacturing and transportation time). As the inventory arrives, it is sold. At the end of the seasonal period (typically either the summer or the holidays) the startup repays its entire line of credit, and begins planning for the next period. While interest is charged on the outstanding balance, typically startups will opt for a bullet structure so they reserve their working capital and make a lump-sum payment once all of the inventory is sold.

If it's structured as a traditional loan (less common), the startup is approved for a lump sum of money and must access it during the draw period. Throughout the life of the loan, the startup must make interest and principal payments, however, unlike a line of credit the funds do not become available again. Some startups prefer a traditional loan because they can typically access a larger sum of funding upfront and the interest rate is much lower.

The types of inventory financing

As mentioned above, there are two broad categories of inventory financing: lines of credit and traditional loans. Under those are the specific types or structures of this form of financing, which we have outlined below.

Secured Loans: In this traditional approach, a business offers its current inventory as collateral to secure a loan. This loan typically is not used for the purchase of additional inventory, but rather for working capital in the business.
Asset-Backed Loan: This is a traditional loan in which the startup uses the value of its current (and future) inventory, as well as its other assets to back the loan. It is often used to purchase additional inventory. For more information, check out the founders guide to asset-backed loans.
Purchase Order Financing: This is tailored to meet the demands of a specific order, and the purchase order itself serves as collateral. This is typically used when the startup receives a large order from a retailer such as Walmart, or Target, but does not have the necessary capital to purchase the inventory ahead of time to satisfy the request.
Supplier Financing: This is an arrangement in which the manufacturer, or supplier, provides the inventory on credit to the distributor or end retailer. As the distributor or end retailer sells through the inventory the supplier is repaid.
Line of Credit: This is also known as a revolving line of credit, where the startup draws down the balance as needed and repays it to “unlock” the credit again in the future. For more information, check out the founder's guide to lines of credit.

The key advantages of inventory financing

Scalable: As startups and other retailers scale their businesses, inventory financing typically scales as well. For high-growth startups, traditional loans are not as scalable as a new facility needs to be spun up each time the startup grows.
Flexible: Lines of credit are infinitely flexible, they can be drawn down, repaid, and replenished nearly instantaneously.
Fast Funding: Compared to other forms of financing, inventory financing is much quicker to qualify and be approved for. Often purchase order financing can be lined up and funded within a week, especially if it is a repeat order from a large reputable retailer.
Cost-Effective: Compared to equity financing, inventory financing is much more cost-effective for satisfying short-term inventory requirements.
Cash Flow Friendly: Most inventory financing comes with an interest-only period, followed by a bullet payment. This is especially helpful for startups that operate seasonally or have seasonal periods of high demand.

The key disadvantages of inventory financing

Expensive: Most forms of inventory financing come with a high-interest rate, which can compound exponentially. For startups that turn their inventory quickly, this is not an issue, for startups that sit on inventory or have slow inventory turns this can become problematic.
Dependent on Accurate Forecasting: Because most forms of inventory financing are used to purchase future inventory, the startup or retailer must accurately forecast how much inventory they intend to sell. If they under-forecast, they will not have enough inventory to satisfy the demand. If they over-forecast, they will purchase more inventory (and a larger loan) than they need, which can quickly add up.
Not Permanent: Unlike equity financing, inventory financing must be repaid in relatively short order. It also cannot typically be used to satisfy OP-EX and working capital needs.

When to consider inventory financing

Inventory financing is a tool that can be employed in a variety of scenarios. Outlined below are some of the common scenarios when startups may consider pursuing this form of financing.

Seasonal Startups - these businesses, characterized by fluctuating demand throughout the year, often encounter periods of heightened activity followed by slower seasons. This form of financing becomes particularly advantageous to manage inventory levels during peak seasons, avoiding stockouts, and providing financial flexibility during slower periods.
Periods of Rapid Growth - Startups experiencing rapid growth may encounter challenges in financing the increased demand for inventory, as such this form of financing can be useful for navigating the complexities associated with scaling operations.
Strategic Channel Partnerships - Landing a partnership with Walmart or Costco can indefinitely change the growth trajectory of a startup, however, satisfying the inventory demands of retailers can be challenging – that’s where this form of financing comes in.
Navigating Economic Downturns - This form of financing can provide financial support during challenging economic periods, helping startups maintain inventory levels, and positioning the startup for a more robust recovery when conditions improve.

Frequently asked questions about inventory financing

How does inventory financing differ from traditional loans?

Unlike traditional loans that may require a broader range of assets as collateral, inventory financing specifically uses a company's inventory as the primary collateral.

What is the eligibility criteria for inventory financing?

Eligibility criteria can vary among lenders but often include factors such as a strong credit history, a reliable inventory management system, and the financial stability of the business.

How is the value of inventory determined in inventory financing?

The value of inventory is typically determined through a thorough assessment, considering factors such as market value, turnover rates, and the condition of the inventory. Lenders may use appraisers or industry benchmarks to evaluate the value of the collateral.

What are the typical interest rates and terms associated with inventory financing?

Interest rates and terms can vary based on the lender, the type of inventory financing, and the perceived risk. Generally, interest rates may be higher than traditional loans.

Can inventory financing be used for any type of inventory?

The suitability of inventory for financing depends on the lender's policies and the nature of the inventory. Perishable or rapidly depreciating inventory may face more restrictions compared to stable or high-demand inventory.

Is inventory financing suitable for my industry/business type?

Inventory financing is commonly used in retail, manufacturing, and wholesale industries, among others. Its suitability depends on the specific needs and circumstances of the business.

What happens if my inventory value changes after securing inventory financing?

Lenders may conduct periodic assessments, and changes in inventory value could impact the amount of financing available.

Can I repay the inventory financing early without penalties?

The terms regarding early repayment vary among lenders. Some may allow early repayment without penalties, while others may have specific pre-payment penalties.

What happens if I can't repay the inventory financing?

If a startup is unable to repay the inventory financing, it may lead to the liquidation of the inventory used as collateral.

Wrap up - raising inventory financing in 2024

Inventory financing is a great tool for retailers, merchants, and startups that are growing quickly, operate seasonally, or have recently signed a strategic partnership. The sizing scales as the business grows, it is flexible, the funding is fairly simple to qualify for, and is cost-effective. However, it is also more expensive than other forms of financing, it's not permanent so it must be repaid and it is highly dependent on accurate forecasting so businesses that order more than they sell can quickly become underwater. If you’re interested in inventory financing, we’d love to help—get in touch!