Vendor finance is a program in which a software company (vendor) works with a bank or leasing company (funding source) to extend credit to customers to facilitate the acquisition of software products and services. This article discusses the documentation between the vendor and its customer, with the focus on how to make the receivables under the customer software license attractive to a potential purchaser.
Vendor Finance Programs Goals & Objectives
Once the decision has been made to start a vendor program, it is important to identify the goals and objectives of the program, and then review the vendor’s standard form customer documentation to determine if improvements can be made to help achieve those goals and objectives. The principal goals and objectives of a typical vendor program are the following:
Making Receivables Attractive to Funding Sources: If the vendor does not want to enter into the lending business itself, then it is critical to make sure that the receivables meet the standard criteria required by a funding source for any financing transaction.
Permitting Revenue Recognition: It is important to avoid activity that may inadvertently impair revenue recognition. For example, under SOP 97-2, if the vendor offers payment terms of more than a year, this raises a presumption that the fees are not fixed and determinable, and that revenue should not be recognized upfront. The key is to consult with the auditors early on.
Allowing for True Receivables Sales: In an assignment program, it is critical that the sale of receivables constitute a “true sale” under FASB ASC 860-10-40-5 (formerly FAS 140, as amended by FAS 166). This in turn requires, in many instances, that the vendor obtain a “true sale” legal opinion from its counsel. One of the most important true sale criterion is that the funding source must purchase the receivables without recourse to the vendor, except for recourse in connection with the breach of certain customary representations and warranties.
Some changes to the customer documentation can make the receivables much easier to finance and make it easier for legal counsel to give a true sale opinion, without having a significant negative impact on the customer relationship.
Perhaps the single most important issue to a funding source when purchasing a receivable, is whether or not the receivable is an existing, enforceable and non-cancellable obligation of the customer that is payable come “hell or high water.” If not, it is highly unlikely that a funding source will pay full price for the receivable without recourse to the vendor. (The presence of recourse would be an impediment to true sale treatment and revenue recognition.)
Whether the receivable is non-cancellable depends, in turn, on whether the customer has received the products and/or services that it bargained for; that is, has the vendor performed the obligations that give rise to the receivable? If the vendor has not yet performed, it is unlikely that the customer will agree to sign up for a non-cancellable payment obligation.
The best way to handle the performance risk issue is to 1) identify the different products and services offered by the vendor under the license, 2) specify what portion of the total receivable relates to each product or service, and 3) specify when each component of the total receivable is deemed to have been earned by the vendor; therefore becoming a non-cancellable obligation.
Equipment: If the vendor happens to offer any equipment to the customer through a lease or other financing arrangement, it is customary in the leasing industry for the payment obligation to become non-cancellable upon delivery and acceptance of the equipment by the customer.
Software: Although some vendors use acceptance certificates, in the case of software many do not. The customer payment obligation often arises upon delivery of the software as opposed to acceptance of the software. If so, this should be spelled out clearly in the license documentation.
Services: With respect to services, the point at which the obligation to pay for the services becomes non-cancellable depends upon the type of services offered. The key is to spell this out clearly in the customer documentation. For example, 1) some services, like routine maintenance, are billed annually in advance, whether or not the customer actually uses the services; 2) some services are billed net 30 days on a time and material basis as the services are performed; and 3) in other cases the obligation to pay for services arises as certain milestones are met.
In each case, it is critical to identify the point in time when the payment obligation becomes non-cancellable, which is also the point when most funding sources become willing to purchase the receivable on a nonrecourse basis. As a general rule, this occurs when the vendor has substantially performed the obligations giving rise to the receivable.
Typical Customer Documentation
The customer documentation in a software vendor finance transaction typically includes the following:
License Agreement: The license agreement contains the standard terms and conditions that apply to all license transactions.
Product Quotation or Schedule: The product quotation or schedule sets forth the list of particular products and/or services licensed or contracted for by the customer. Each product quotation or schedule should constitute an independent contract and incorporate by reference the terms and conditions of the master license agreement.
Installment Payment Agreement (IPA): IPAs or promissory notes are recommended, but not always used. When using an IPA, the product quotation or schedule should quote a cash up-front price and all of the extended payment terms should appear in the IPA. The advantages of using an IPA are many, including the fact that there is a stronger argument that the payment obligation is independent from the license, non-cancellable and not subject to claims of set-off arising under the license.
Financing Addendum to License: Usually the funding source will require an addendum to the license that contains a cross-default provision stating that a default under the IPA constitutes a default under the license. The financing addendum also makes the funding source a third-party beneficiary of the cross-default provision, so that the funding source can require the parties to terminate the license if the customer is in default of its payment obligations under the IPA.
Principal Issues In Customer Documentation
The following are the principal issues that the parties need to address in the software financing documentation:
Non-cancellable: Perhaps the most important issue to the funding source is that the customer payment obligation must be non-cancellable. It is important to make sure that upon delivery of the software, the customer payment obligation with respect to the software is non-cancellable. If the vendor later breaches a service obligation, such a breach might allow the customer to avoid paying the related service fees, but it should not allow to customer to avoid paying for the software that was previously delivered.
Assignment of Receivables by Vendor: The vendor should be expressly permitted to sell and assign the receivables under the license, product quotation or schedule, and IPA.
Waiving Defenses Against Assignees: It is standard practice in financing transactions for the customer to waive as against the vendor’s assignees, any defenses to payment that the customer may have against the vendor. Such “waiver of defense” provisions are reasonable, so long as the receivable in question has been substantially earned. Problems tend to arise when the vendor requests the customer to waive defenses as to payment for future services that have not yet been performed.
No Assignment by Customer: From a financing perspective, the customer should not be able to assign nor delegate its obligation to pay under the license or IPA because the funding source approved the credit of the original customer, not the assignee.
Cross-Default Between the IPA and License: This is often covered in the financing addendum to license that amends the license in those instances in which the customer chooses to finance the acquisition of software by signing an IPA.
Default Interest: Funding sources typically look for a provision requiring the customer to pay interest on late payments. In vendor finance arrangements it is not unusual, however, to find long-cure periods of up to 30 days.
Acceleration upon Termination or Default: If a customer defaults, it is essential to have an acceleration clause stating that the present value of the remaining payments becomes immediately due and payable in full.
Notification of Assignment: Although vendor programs can be operated on a non-notification basis where the customer is not notified of the assignment of receivables, there are numerous legal advantages to providing the customer with notice, such as making it easier to give a true sale legal opinion in an assignment program.
Will the Customer Agree to the Financing Terms?
If the only options the customer has are 1) to pay cash upfront, 2) to borrow money from a third-party lender pursuant to a 20-page loan agreement, or 3) to finance over time with a two-page IPA through the vendor program, then the IPA may very well start to look like the most attractive option.
In summary, to ensure the success of a software vendor program, vendors should review their standard form customer documentation and make changes that will allow the vendor to sell the customer receivables on a nonrecourse basis. Although this may seem like a daunting task at first, it is possible to draft customer documentation that is both palatable to the customer and attractive to a funding source interested in purchasing receivables on a nonrecourse basis.
William S. Veatch is a partner in the Financial Transactions Practice Group and a member of the Finance Department at Morrison Foerster LLP.
Software Financing Part 1: How to Structure a Software Vendor Program