It’s a Win-Win

This story appears in the
August 2005
issue of
Entrepreneur. Subscribe »

In 1994, one of Doug Brendle’s customers, an R&D firm
for the screen-printing industry, approached him about engineering
new technology to streamline the screen-printing process. Brendle
was the ideal candidate to get the job done: An engineer and
physicist by trade, he had also worked as a consultant for the
screen-printing and manufacturing industries. Though he had the
necessary technical expertise, he didn’t have the $300,000
needed to fund a project of that magnitude.

“Not only was it a funding issue, it was a time issue,
too,” recalls Brendle, founder and CEO of HardKore Inc. in
Cheyenne, Wyoming. “It had to be done by a certain time, and
it would have been impossible for a company of our size to acquire
that kind of funding that fast, especially when we were already
leveraged with other jobs.”

But because his $1 million-plus firm was uniquely qualified for
the opportunity, his customer provided the necessary funding to
carry the project to completion. Brendle repaid the loan within six
months by selling the newly manufactured equipment to the customer
at a discounted rate. The customer-financed deal was not only
financially lucrative, but it also took Brendle’s company,
which manufactures a line of fitness equipment, down a new product
path. Says Brendle, “Without it, we wouldn’t be building
our own [screen-printing] product line.”

Filling the Financing Void

While Brendle’s client was willing to meet him halfway
because of his unique manufacturing capabilities, there are a host
of other reasons a customer would support this type of financing
arrangement. Perhaps the business needing the loan is the exclusive
supplier of a product or service in demand by a customer’s
competitors. Or maybe the customer wants its supplier to step up
production to better serve its own needs. In either case, the
customer may have a strong incentive to lend financial support.

“I’ve seen this when you have a large customer dealing
with smaller suppliers that usually are either producing a very
unique product or a proprietary product,” says business
consultant Deborah House, founder and CEO of The Adare Group
in Oakbrook Terrace, Illinois. “The customer needs to buy a
widget. They don’t want to make it and can’t find anybody
else to make it, so they’ll provide financing to outsource
it.”

Even fast-food giant McDonald’s has been known to provide
local bakeries with financial support to manufacture its sandwich
buns. “They will work with the bakery and [provide funding] if
a new plant has to be built or if equipment needs to be
bought,” House explains. “And they do that in a number of
different ways. It can be through a loan, it can be through equity
or a thousand combinations thereof.”

Borrower beware, however: Anytime you invite a customer into
your inner circle, you run the risk of revealing too much about
your business, including how you make a product and how much it
costs to produce. Additionally, the customer may want to dictate
pricing terms in return for investing its own capital.

“There’s always a catch to it,” says House.
“The catch can be that they want you to devote the plant
solely to making the buns needed for McDonald’s restaurants in
a certain region of the country. The thing that comes along with
this is that McDonald’s will usually tell you how much
they’ll pay for the buns.”

Another Cook in the Kitchen

This type of capital often comes with other strings attached.
For instance, it’s not uncommon for the customer to require the
borrower to turn over certain operational functions in return for
putting up the funds. “Often, the business is out looking for
money to begin with because there are some missing elements,”
explains David Young, business development specialist for the
Washington State
University Small Business Development Center in Seattle.
“Those may be management or accounting issues. When the
customer sees some merit in putting funding in, those are the
[deals where] you most often see the operating criteria go in with
[the funding]. They may even take some functions away from the
company seeking the funding. They may decide to do the accounting,
or they may decide to do the backroom management of suppliers if
they see some real weaknesses.”

House concurs: “The business owner is getting capital, but
they’re probably getting an operational partner and an
executive partner as well.”

Brendle discovered this when his customer/lender asked for so
many project updates that it interfered with productivity. “We
had no idea that we needed to lay down some rules, but you
can’t have someone micromanaging you,” he says. “If
you’re going to get funding, it’s got to be funding with
the understanding that you can get your job done. That’s the
biggest thing.” In later deals, Brendle worked out an
arrangement with the customer to provide biweekly updates. “We
had a system so nobody was calling and asking for anything, but
they were kept up-to-date as to where [the project] was going and
whether it was on schedule or behind,” he says.

He was also careful not to part with anything he wasn’t
willing to give up. Case in point: his client wanted exclusive
rights to the screen-printing equipment he manufactured on its
behalf, even though it was Brendle’s own patented design. Says
Brendle, “When they found out how much it would cost to buy
exclusivity, they backed off.”

Risky Business

As Brendle can attest, customer financing isn’t a
relationship to take lightly. In addition to arguments over
ownership rights, there are sometimes long-term funding
ramifications for being so closely connected to a single client.
“Once you get tied to a particular customer and they’re
providing over 50 percent or even 20 percent of your total revenue,
then you may not be as attractive to a bank because you’re a
higher risk if that customer goes away,” House stresses.
“And you may not be able to get venture funding because now
you have a partner in your business.”

As a result of these potential drawbacks, it’s imperative
that you evaluate prospective funding partners carefully. “Do
you like them? Do you trust them? It’s definitely worth
spending some money on professional business and legal
advice,” House advises. “Using other people’s money
is always a really good thing to [help you] grow as long as you
look at what the risks and rewards are. Realize what you’re
giving away and what you’re getting in return. And always know
how you can get divorced before you get married–the exit strategy
is almost more important than the contract signing.”


Crystal Detamore-Rodman is a Charlottesville, Virginia,
writer who covers the small-business finance market.

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