As businesses continue to expend an increasing percentage of their overall technology budget on software, the question of financing the acquisition of software becomes increasingly important to both providers of software and their customers. This column is the first of two that will explore software financing in some detail, including the issues of greatest concern to software vendors, their customers and the funding sources providing the acquisition financing.
What Is Vendor Finance?
Vendor Finance is defined as a program in which the software company extends credit to its customers to facilitate the acquisition of software products by customers. Usually, there is a bank or leasing company behind the scenes, working with the software vendor to provide the extension of credit. For example, when a customer makes the decision to license software, the price for the software is typically due net 30 days. The customer must pay for the license either with its own cash, with funds borrowed from a bank or leasing company, or through an extension of credit by the software vendor. Customers often prefer to choose the vendor finance option, if available, not because they do not have the cash, but because they would rather pay over time for budgeting reasons. For example, if the license has a three-year term, even Fortune 500 companies would often prefer to make payments over three years in order to match the payments with the use of the product, rather make the entire capital expenditure in year one.
Why Start a Vendor Finance Program?
Once the customer has decided to finance the acquisition of products, financing through the vendor is often more desirable than going directly to a bank or leasing company for a variety of reasons.
Managing Credit Risk
Software vendors need to carefully consider whether they want to enter the business of lending money, or outsource this function to a bank or leasing company that is in the business of extending credit. In fact, many software companies inadvertently enter the lending business. For example, suppose the software vendor normally requires cash upfront, but the customer wants to pay in 12 quarterly installments. If the software vendor agrees to accept quarterly payments, it has arguably entered into the lending business.
Another example is the subscription license model. Suppose the software vendor switches from cash upfront to a subscription model in which the customer makes monthly subscription payments. While this may be a desirable way to account for the revenue, if the software vendor is not careful, it may inadvertently enter into the lending business.
As a lender, the software vendor should consider, among others, the following issues:
Partnership with a Funding Source
Rather than enter into the business of lending money, it may be preferable for the software vendor to enter into a program agreement with a bank or leasing company (funding source), whereby the funding source is the party extending credit and taking all of the risks associated with being a lender. There are two basic structures for software vendor finance programs:
There are many reasons for a software vendor to consider setting up a vendor finance program, perhaps the most important is to use the vendor finance program as a tool to increase sales. Unless the software vendor is committed to learning the business of lending money, it is preferable to separate the financing from the underlying license transaction and outsource the financing part of the business to a bank or leasing company. The next installment will address in more detail the specific issues that must be worked out among the software vendor, its customer and the funding source.
William S. Veatch is a partner in the Financial Transactions Practice Group and a member of the Finance Department at Morrison & Foerster LLP. He is resident in the San Francisco office.
Software Financing Part 2: Making Customer Receivables Attractive to Potential Purchasers