Everything you need to know about vendor financing
If you’re working on a business acquisition, the vendor may be more than just the person who sells you the company. He or she could also be one of the key sources of financing for the transaction.
Vendor financing is often part of an acquisition financing package that also includes the buyer’s own investment, a bank loan and mezzanine financing. Vendor financing typically amounts to 10% to 15% of the transaction amount.
Vendor financing offers unique benefits that make it worth considering as part of an acquisition, says BDC Director of Growth and Transition Capital Rima Bassi.
What is vendor financing?
Vendor financing (also known as vendor take-back or VTB) is a form of business acquisition debt that allows you to hold back a portion of the purchase price as a debt to the vendor.
“Essentially, the current owner of the business is loaning you some of the money you need to buy the business,” says Bassi.
The first 18 months following an ownership transition are the riskiest. Having more cash available during that period can make all the difference in your success.
How does vendor financing benefit a business acquisition?
The most obvious benefit of vendor financing is that it can help you close a deal if you’re unable to raise the entire amount of the purchase price through other financing methods. Having that financing can, in turn, help you secure the bank loans you were unable to get.
“Vendor financing usually indicates that the vendor believes in the business and its ongoing success,” says Bassi. “For a lender, vendor financing gives them confidence in your ability to repay the loan.”
Vendor financing offers several other benefits.
Vendor financing reduces how much cash you need on hand to close the deal, leaving you with more liquidity to cover operations and unanticipated expenses.
“The first 18 months following an ownership transition are the riskiest,” says Bassi. “Having more cash available during that period can make all the difference in your success.”
The payment terms for vendor financing are usually less rigid than traditional bank financing, too—more akin to patient capital. That can mean no payments for several months, or interest-only payments for a set period.
Recourse after close
Even with the most careful preparation, something can always slip through the cracks. A bill, liability or undisclosed issue can crop up and cost you money after the deal closes. Vendor financing can cover those unexpected costs.
Ongoing vendor involvement
Under a vendor financing agreement, the former business owner has a vested interest in the success of the company after the sale. They may be more motivated to do what they can to support a smooth transition. This can include personal introductions to clients and other contacts, training and knowledge transfer in key areas of the business, and other advisory support for a defined period.
Buying a business is one of the biggest investments you’ll ever make as an entrepreneur. You want to take the time to make sure it’s the right fit and that there are no surprises.
How does vendor financing benefit the seller?
The main benefit of vendor financing is the same for the seller as it is for the buyer: It can close any financing gaps—and, more importantly, help close the deal. This can be especially critical when the business being sold carries a lot of intangible value.
“Banks usually prefer secured loans backed by assets like physical inventory, real estate and equipment,” says Bassi. “If a business is based heavily on intellectual property or its value is related to its reputation, it can be harder for a buyer to secure the full value from the bank.”
A vendor financing arrangement also allows for continued cash flow to the seller, even after the business is sold. By extending the seller’s ties to the business, vendor financing can also provide peace of mind that their business is in good hands.
“Small business owners usually put a lot of themselves into their companies, so there’s a significant emotional component to a sale,” says Bassi. “Vendor financing gives the owner the time to feel comfortable that the new owner is a good fit, and that their business—and its staff—will be well taken care of.”
How does vendor financing work?
If you want to include vendor financing as part of your purchase, bring it up as early in the negotiations as possible—ideally, in your initial offer. Then you can decide on mutually agreeable terms, including the amount, interest rate and payback period.
At the close of the deal, the vendor receives the purchase price minus the borrowed amount. You pay that amount back with interest over a set period, which Bassi notes is usually three to five years. Payments are often deferred for the first year.
In almost all cases, vendor financing is considered a junior debt and subordinate to bank loans and other financing—a point you’ll want to ensure the seller understands from the outset.
Your vendor financing agreement should also set out the terms of the vendor’s post-sale involvement with questions that include:
- What role will they play?
- How long will they stay involved?
- What will the financial reporting frequency will be throughout the payment period?
Is vendor financing bank-sanctioned?
In general, banks are fully on board with vendor financing. In fact, many banks view a vendor’s willingness to offer it as a positive sign. Acquisition deals that include vendor financing tend to have an easier time securing bank financing.
In those cases, the bank (or banks) will usually require your primary bank loan to be serviced first, followed by any mezzanine financing your deal might include. On occasion, if financial reporting shows your new business is doing well and your cash flow is strong, the bank may allow some money to go back to the vendor while your bank loans are outstanding. Most of the time, they’ll require that you cover your debts to them before repaying the vendor.
4 tips to get started with vendor financing
1. Seek professional advice
As soon as you start considering an acquisition, it’s a good idea to assemble a strong deal team, says Bassi. That team should include lawyers, accountants, financial advisors and your banking partners.
Involve your deal team early and often to get their advice on every aspect of the deal you’re considering—including any vendor financing. Take the time to understand the business you’re planning to buy and then have your team take a dispassionate second look.
2. Understand the seller
It’s also important to consider the seller’s motivations. Understanding why they’re selling will give you a better sense of what you’re getting yourself into. You’ll also want to consider what they’re offering—or not offering—in terms of vendor financing.
A seller who’s not prepared to offer any financing can be a concern, says Bassi. It could be explained by the seller simply being ready to retire and wanting to make a clean break. But it could also indicate that they’re not fully confident in the business’s prospects.
3. Get clear on all terms
As you put your deal together, you’ll want to ensure all terms are as clear as possible. That includes the financial arrangements as well as the framework for the vendor’s post-sale involvement.
“Without clear terms, you might find yourself fighting for control with a vendor who doesn’t want to let go or, on the other hand, struggling to solve challenges you expected to have assistance with,” says Bassi.
Make sure you establish up front what the vendor’s role will look like, how long their involvement will last, and how they’ll transfer over their contacts and other intangible assets.
4. Check up on the vendor’s due diligence
You’re not the only one who should be seeking professional guidance on the acquisition deal. The vendor should be doing their own due diligence, and ensuring their legal and financial teams approve the terms of the vendor financing.
If the vendor’s teams don’t see the terms until you’re ready to close, the whole deal could fall through. Avoid disappointment by making sure the vendor’s deal team is on board.
Find out what it takes to successfully purchase a business in Canada by downloading the free BDC guide, Buying a Business in Canada.