Is Vendor Financing Necessary in a Business Sale?
Learn about the risks associated with vendor financing for a seller.
Last year, we demolished our old Vancouver tear down house. In one of the walls, I noticed the builders had used newspaper as insulation, which explains why we were so cold all the time. The newspaper was an old issue of the Vancouver Sun from 1911. As I examined the news of the day, I turned to the real estate section and saw that land parcels and homes were selling for about $400 to $600. Inflation— I wish I had bought then. But perhaps even more interesting was that just about all the sellers offered vendor finance, not just for some of the down payment, but for the whole deal.
My first question was: where were the banks? Surely one could get a mortgage rather than pay the vendor over five years? Why on earth would the vendor agree to this unless they had no choice? Some quick research showed that there were banks in operation, but it was still a very early market and perhaps it was difficult for "immigrant buyers" to qualify.
As I reflected further, I realized that vendor finance is still the norm today when it comes to selling your business. We often see vendors carrying between 20 and 50 percent of the financing on the sale of their company.
Why is Vendor Financing the Norm?
Why? Do we not have banks and credit unions that will finance the purchase of a business? Of course we do. So why do vendors agree to this? The most common explanation I hear is that it helps successfully transition the business to the new owner. The vendor may have business goodwill attached to her/himself personally, such as customer and partner relationships, and it is important this transitions to the new owner. Tying the vendor in makes certain that happens.
However, there are other ways to make sure that process occurs such as hold backs, or representations and warranties in the share purchase agreement. Even better is when the owner plans for succession by delegating responsibility to the management team (although most research studies on succession suggests this is done only about half the time). In any case, the transition is usually settled within 12 months, so why is the norm to insist the vendor provide finance for four or five years?
The real answer is that it favors the buyer. Vendor finance is normally unsecured and comes at an attractive rate of interest, compared to borrowing. It also boosts the amount of equity in the deal, helping to raise external credit without it coming from the buyer’s pocket.
The Risk of Vendor Financing for the Seller
As such, it is worth examining the characteristics of vendor finance, from the seller’s perspective:
- Vendor notes are effectively unsecured. Even if you obtain a pledge of shares, or a general security agreement supporting the promissory note, that security will be completely subordinated to the security of the lenders, including, in most instances, a senior bank and a subordinated lender. The secured lenders will fully encumber the assets of the business and require the vendor sign an inter-lender agreement. In the event of business failure, the vendor note will be completely worthless.
- All payments to the vendor note are postponed to the senior lenders, so if there is a breach or default of their loans, the senior lenders can prohibit the business from making payments to service the vendor note. This means the vendor can be waiting a lot longer than anticipated for payment, with little recourse. Further, the vendor may be asked to "stand still" in demanding the loan by the senior lenders.
- The usual interest rates on vendor notes are between 5 and 10 percent, about the same return one would expect for an investment in a blue chip stock. However, an investment in a small company you no longer control lacks any liquidity and is highly risky. Therefore, the return does not match the risks.
Much like vendor finance for real estate 100 years ago, vendor notes on business sales should be confined to the history books. In today’s market for businesses, demand exceeds supply, creating a seller’s market. Therefore, sellers can insist on more favorable terms. Perhaps in another hundred years, someone else will look back and laugh at how funny vendor finance was when it came to selling your business.
Robert Napoli’s column was originally published in issue 1214 of "Business In Vancouver" and on First West Capital's website.