Deep Tier Financing

Supply Chain Finance for the Global 200 Million

Call me weird, but I fell in love with “Supply Chain Finance” in a very nerdy way the first time I heard about it more than 10 years ago. That was the time when we started Taulia, the leader in Supply Chain Finance,which we scaled up to a global network of more than 1.5 Million suppliers.

Supposedly, there was a magic way to transfer the easy access to liquidity large corporations have down to its suppliers, resulting in ridiculously cheap access to liquidity for those companies?? SMBs could bridge the often lengthy payment terms with affordable cash that their customer provided to them, directly or indirectly. And the downside? None. A win-win for both parties.

That sounded too good to be true — and as it turned out, it kind of was. But not for the reasons you would expect, along the lines of “if something is too good to be true, it likely is a fraud”. No, the concept, the flow, the legal pieces where all real, and this financing scheme was used in many supply chains. It was just that the incumbents, which at the time were only banks, neither had the technology, nor the financial incentives to scale this democratizing instrument to what it could be: A financing solution for every single supplier that does business with a large corporation. Instead, those Bank-lead programs limited themselves to only a few of the top suppliers that a Global 2000 does business with, the largest ones. What about the other thousands of suppliers, the so called long-tail, mostly SMBs? Well, those didn’t make the cut. Too expensive to onboard, to vet, not enough spend to make the exercise worthwhile. This screamed opportunity, and platform providers solving those issues are now some of the success stories of the first wave of FinTech.

Let’s take one step back and look at what “Supply Chain Finance” actually is. First of all, depending on where you are in this world, the term is used as an umbrella term or for a specific flavor of trade finance. Other common names are “Reverse Factoring” or “Confirming”, as it is called in Spain. Some would even throw in the term “Dynamic Discounting”, although purists get offended by that. For this conversation, I want to define Supply Chain Finance, or SCF, as a scheme where the (beneficial) credit rating and/or (cheap) access to liquidity of a large corporation is transferred “down” to this organization’s suppliers. Then the suppliers can bridge the time delay between issuing an invoice, and waiting to be paid by accessing much needed capital at cheaper rates than they normally could. Companies wait an average of 60 days to be paid. Depending on industries, regions and a multitude of other factors, the terms can be up to 180 days or even 360 days.

SCF works in essence thanks to one of two “tricks”:

  • Trick one: The buyer uses their own cash directly, and pays the supplier earlier, for a discount based on a sliding scale (meaning the later a supplier requests to be paid, the less the discount she grants). This is the above mentioned “Dynamic Discounting”, and even here, there are different varieties, such as invoice auctions, marketplaces or, dynamic payment terms. All of them have in common that no third party is involved in terms of financing — it’s a transaction between the large, cash rich buyer, and its suppliers. These transactions are usually brokered or facilitated through a technology provider.
  • The second trick is the arguably sexier and cooler one, at least for me (and the one I fell in love with, as I confessed above!). In this case, the large buying organization provides a guarantee to a third party financial institution, promising payment of the full invoice amount at maturity date. It’s as simple as that. Big corp guarantees that after, let’s say, 60 days, the invoice of EUR 25,000 is paid in full to the “funder”. That little fact (and admittedly a lot of legal, compliance, and technology magic) makes it possible to inject liquidity into the system, so that every single supplier can decide to be paid earlier, if they feel like. The cost of such an earlier payment would be more or less in line with the cost of borrowing for the large corporation who provided the guarantee. The liquidity is provided by the funder, and to repeat, at the cost of capital of that large buying organization that provided the promise of payment at maturity date.

Over the last 10 years numerous startups popped up and leveraged those concepts. Compared to traditional bank programs, those FinTech platforms were able to scale to thousands of suppliers for a single buyer, serving millions of businesses with cheaper access to capital. In recent years, those FinTechs buddied up with banks to provide joint solutions, and now we have a happy ecosystem of supplier financing!

So what’s the issue you might ask — supplier financing seems to be solved! And I agree, the industry made a huge step forward, broadening access to much needed liquidity from a few selected suppliers to all suppliers of a buying organization. But what about those suppliers that are not in such a fortunate position to do business directly with a Global 2000 buyer who is offering SCF to their business partners? Well, today they are mostly out of luck, except for lending opportunities that don’t involve their customers, such as factoring.

Isn’t there an opportunity to look deeper into a buying organization’s supply chain? Or, looking at it from the other direction: aren’t many companies within global supply chains supplying a good or a service that eventually ends up being used by the large Global 2000 at the top of the “food chain”? Wouldn’t it therefore be terrific if we could find a way to go that one step further than traditional SCF, and find a way to transfer the access to credit and liquidity from the largest companies down multiple levels within their supply chain?

Let’s use an example to clarify this point: imagine a leading foot and apparel company. We’ll call it “Athena”. Athena needs laces and orders those from “Laces Inc.”. To produce laces, fabric is needed, which Laces Inc. orders from the “Fabric Corp”. Fabric Corp in return needs the raw material, which is delivered by “Cotton Picker Group”. Wouldn’t it be amazing if there would be a way to transfer access to much needed capital and credit from the top of the supply chain, Athena, down several levels all the way to the Cotton Picker Group? This could happen across borders and regions where payment terms and interest rates are more unfavorable than in Europe or the US? So now, Cotton Picker Group, instead of waiting 120 days for Fabric Corp to pay their invoice, and bridging that gap in financing by borrowing money at a double digit annual interest rate, Cotton Picker Group can choose to have their invoices paid almost instantly, for the cost of capital of Athena. This would be a much cheaper rate, for example Libor+100 bps. For the non-finance folks among us: this means currently roughly 1% / year. For a fraction of a percent, the SMB could have her money instantly. With that, we would have graduated Supply Chain Financing 1.0 from a Tier 1 supplier offering to an offering that the whole supply chain has access to, over multiple levels, true Deep Tier Financing.

This concept still works with either the help of a third party injecting liquidity (think of a bank), or by using the large buyers cash directly (as a reminder, this is called Dynamic Discounting in the FinTech 1.0 world). One of the (unjust) criticisms of Dynamic Discounting is that the APR (the annual interest rate) is often too high. I truly believe that this is not the case for most of the best-in-class run Dynamic Discounting programs. However, let’s assume a (rather high) APR of 8% that a buyer charges for offering early payments using his OWN cash. That 8% might be way too high for many suppliers in the first tier of the supply chain. For SMBs in developing countries, where the alternatives are placed somewhere between usury and bankruptcy then 8% are highly attractive.

Why would a buying organization, as Athena above, care about Deep Tier Financing, you might wonder? The answers are in essence the same ones as for traditional SCF programs. They range from increasing margins (if they use their own cash in a sustainable way at a fair price), to optimizing their working capital, to Corporate Social Responsibility reasons, to securing their crucial supply chain and keep their business partners in great financial shape.

If there would just be a tool that could address such a deep chain….and potentially use something like a token to transfer the risk….

We will share soon more details, but our work on the Centrifuge OS is highly motivated by the use case of Deep Tier Financing. Decentralized reputation, which we wrote about before, including the ability to verify a business relationship, traceability of transactions and the right incentive model are key elements to solve this complex puzzle.