There is much to be said for limiting the entanglements — financial and operational—that come with lender or investor money. But, realistically, most auto dealerships, like most other businesses, reach a point where outside cash is helpful if not essential. In many cases, outside cash is used to smooth the rollercoaster of seasonal fluctuations. In other cases, it may be required to accomplish long-term objectives such as strategic growth or expansion. To that end, this article surveys the legal framework for four common types of dealership financing.

1. FLOORPLANNING

A floorplan line of credit covers the inventory acquired by the dealer. It is usually paid off on the sale of the underlying units. Typically, it involves a security agreement, a promissory note, an individual guaranty and other loan documents in favor of the lender. The lender is also granted a security interest and rights to repossess inventory and other collateral in case of default. The lender will generally file a financing statement with the state and give public notice of its interest in the collateral.

Obviously, this type of credit has the advantage of being available as it is needed. It’s tied to specific inventory purchases, thus enabling some flexibility in avoiding unnecessary carrying costs. And because it is secured by hard and liquid assets, it will often involve lower interest rates than other types of credit. In many cases, it may provide an alternative for dealers who could not meet the more rigid lending requirements associated with traditional bank loans.

2. RECEIVABLES LENDER OR PURCHASER

There are a number of lenders that will buy or otherwise finance retail installment contracts written by a dealership at a discount to the face value of the underlying contracts and the expected cash flow. This option will often require a master loan agreement with formal assignment of particular contracts or pools of contracts; it can also be done on a retail sale-by-sale basis. Typically, the lender will have to take possession of the underlying installment contracts and have its lien placed on the vehicles’ certificates of title.

The lender may pay the dealer in one of two ways: a set amount up front or payments based on the lender’s actual collections made on the dealer’s installment contracts.The dealer should pay special attention to broad collateral and other rights requested by the lender and to contractual allocation of responsibilities (between dealer and lender) with respect to the retail buyers and collections.

3. UNSECURED BUSINESS LOAN

This option works just the way it sounds. An unsecured loan is a straight loan of or up to a specified amount, with payment terms. The lender has no recourse to specific collateral, so the interest and fees charged by the lender may be higher than with other types of credit. Such loans are usually documented by a loan agreement and/or a promissory note and can be enforced by a breach of contract action. Lenders in certain states may also seek the right to confess judgment against the dealer unilaterally upon nonpayment.

4. EQUITY INVESTMENT

Although less common than the “debt” financing options previously described, dealers sometimes seek “equity” from third-party investors. Equity financing comes in many forms.

A dealer may accept investments from friends and family or from outside parties such as investment funds, strategic investors and wealthy individuals. In each case, the dealer gives up some of its ownership in the business in exchange for the invested funds.

Equity financing is more common in cases where dealers are looking to fund an expansion of the business; however, depending on the agreement between the dealer and the investors, the investment funds might be used for operational or other business purposes as well. Unlike traditional debt, neither the dealer nor its principals are typically responsible for “paying back” the investor if the business fails.

Because equity investors are taking much more risk than a bank or a traditional lender, these investors typically demand a high upside, preferential distribution rights, and special governance rights in the business. In short, this type of financing almost always requires the dealer to give up some control over the business.

There are nearly as many financing options available as there are cars on the road. Whatever the type, it is important to ask questions of the lender or investor and to understand the legal documents requested by them. Even the smallest details in a loan document or other contract can have a major impact on a dealer’s operations and, in some cases, can limit the availability of other funding sources. In that regard, there is no substitute for good legal counsel.