Vendor finance when buying a business

In a vendor financed sale the buyer pays most of the price at settlement and the vendor lends the rest back. The buyer takes over the business on day one and repays the vendor in instalments, usually with interest, over an agreed term. It is a loan from the seller, written into or alongside the contract of sale. It is different from a deposit paid before settlement, and different from an earn-out, where part of the price depends on future performance.

Vendors agree to it for practical reasons. It widens the pool of buyers, it can support a higher price, and it helps a sale complete where lenders will not fund all of the goodwill. For the buyer it lowers the cash needed at settlement and keeps the vendor interested in a clean handover. Lenders often read a vendor's willingness to leave money in the business as a sign of confidence in the figures. How lenders treat goodwill usually decides how large the gap is in the first place.

There is no standard figure. Where a senior lender is involved, the vendor's share is commonly a minority of the price, often somewhere between 10% and 30%. A structure brokers often describe is roughly 60% senior debt, 20% vendor finance and 20% buyer equity. Larger vendor shares do occur in sales with no bank involved, particularly small businesses that are nearly all goodwill, but a vendor carrying half the price is taking most of the risk of their own sale. Terms are commonly one to three years, sometimes up to five, with monthly or quarterly repayments.

The interest rate, repayment pattern and security are all negotiable. Some vendor loans are interest only with a lump sum at the end. Others step up after a settling in period. A lump sum at the end needs a realistic plan, because it is usually cleared by refinancing, and a lender will only refinance it if the business has performed. Buyers should model the vendor repayments and the senior loan repayments together against maintainable earnings before agreeing to a term that looks comfortable in isolation.

The senior lender must be told about it. Vendor finance left out of a loan application is a misstatement of the buyer's liabilities and of the contribution they are making. Once disclosed, most lenders treat a vendor loan as a hard liability. The repayments go into the debt service calculation alongside the senior loan, and the combined debt has to be covered by maintainable earnings, commonly by 1.25 to 1.5 times. A vendor loan with repayments deferred for the first year or two is easier on servicing than one that amortises from the first month.

Ranking is the second issue. The senior lender will take first-ranking security over the business and any property offered. If the vendor also wants security, such as a general security agreement registered on the Personal Property Securities Register, the lender will usually require a deed of priority or a subordination deed. These put the vendor second and commonly stop the vendor from enforcing, or from being repaid early, while the senior loan is in default. Many lenders also will not count vendor finance as the buyer's equity. They still expect real cash or property equity from the buyer in any business acquisition loan.

A vendor loan is a fixed debt. The buyer owes it whether the business does well or badly. An earn-out is a contingent part of the price, paid only if agreed targets are met after settlement, such as revenue, EBITDA or client retention over 12 to 24 months. Earn-outs and retention adjustments are common in sales of accounting practices, financial planning books and other client based businesses, where the real question is how many clients stay once the vendor has gone.

Lenders treat the two differently. A vendor loan is a known liability with a repayment schedule. An earn-out is uncertain, so assessors usually test the deal as if the full earn-out will be payable and check that the cash flow can carry it. Earn-outs shift risk from the buyer to the vendor, but they produce disputes if the formula is loose. The contract needs to define exactly how the target is measured, which accounting policies apply, who controls the business decisions that affect the result, and what happens if the buyer sells or restructures during the period.

A vendor loan needs the same discipline as any other loan. The usual documents are the contract of sale with the deferred amount recorded, a separate loan agreement setting out the rate, repayments, default events and early repayment rights, a general security agreement or specific security over business assets registered on the Personal Property Securities Register, personal or director guarantees, and the deed of priority with the senior lender. The tax timing of deferred payments and earn-outs differs for each party, so both sides should get accountant and legal advice before signing.

The vendor's main risk is non-payment. They rank second, the assets securing them may be worth little if the business fails, and the priority deed can limit what they can do about it. The buyer's main risk is over-commitment. Two sets of repayments in the first years of ownership leave little room if revenue dips during the handover. Buyers should also resist clauses that let the vendor step back in or demand full repayment over minor breaches. Where property is available as security, a larger senior loan with a smaller vendor loan is usually the simpler and cheaper structure.