Vendor financing: lending to sell for more

Vendor financing is the part of the price you lend to the buyer instead of receiving it at closing. It's repaid over a few years, with interest. Used well, it eases bank financing, widens the pool of buyers who can afford your price and can raise the total you get. Poorly protected, it leaves you holding a risk.

How a loan can raise the price

A buyer rarely funds a small business purchase with their own money alone. They combine their equity, a bank loan and often other sources. The bank lends based on what the business can repay and on the security available. There is almost always a gap between what it will lend and the asking price.

Vendor financing fills that gap. It has three effects:

• More buyers can pay your price. A manager on your team, a regional competitor or a young acquirer can't all pay cash.
• The bank is often more comfortable. When the seller agrees to wait for part of their money, it shows they believe in the business after they leave. Some lenders treat that loan, if it ranks behind theirs, almost like additional equity.
• You have something to trade. Accepting a vendor note lets you ask for a higher total price, an interest rate, or better terms elsewhere in the letter of intent.

In exchange, you become a lender, with credit risk. The rest of this article is about shrinking it.

How to protect your vendor financing

Security

These are the assets you can fall back on if the buyer doesn't pay. Depending on the deal, you'll often see:

• a hypothec (security interest) on the company's assets, usually ranking behind the bank's;
• a hypothec on the shares sold (Quebec's version of a share pledge), which gives you remedies against those shares after a serious default;
• a guarantee from the buyer personally, if they buy through a company, or from their holding company.

Your lawyer will tell you which ones fit your deal. A hypothec has to be published in Quebec's Register of Personal and Movable Real Rights to protect you against other creditors: making sure that happens is their job.

Ranking

The buyer's bank will almost always want to be paid before you. It will have you sign a subordination agreement setting the order of repayment and what you can do if something goes wrong. Read it carefully: it can suspend your payments if the business breaks its bank ratios. At a minimum, negotiate the right to receive your interest as long as the business is in good standing with the bank.

The buyer's covenants

The loan agreement can spell out what the buyer commits to do, or not do, until you're repaid:

• send you financial statements and a dashboard at regular intervals;
• not pay dividends or exceptional bonuses above a threshold;
• not sell major assets or take on new debt without your consent;
• repay you early if the business is resold.

A serious buyer won't take offence: these covenants simply replace the information you had when you were the owner.

The risks to face squarely

The first risk is that the business does worse after you leave. If it still depends on you, that risk is real, and you carry part of it. That's why the work done in the earlier steps counts twice: a business that runs without you repays its seller more reliably.

The second risk is the choice of buyer. A high price from an inexperienced buyer can be worth less than a lower price from a solid acquirer. Your own due diligence on the buyer matters as much as theirs on your business.

The third risk is time. The longer the note, the more things can change. A shorter note, or one partly repaid faster, reduces that risk.

A note on wording: vendor financing is not an earn-out. A vendor note is a debt the buyer owes you whatever the results; an earn-out is paid only if targets are met. Don't let one quietly become the other in the drafting.

Finally, the tax effect. The interest you receive is taxable income. As for the gain, a mechanism called the capital gains reserve can, in some cases, spread the tax over several years when the price is paid in instalments. Its conditions and maximum period are precise, and it interacts with the capital gains exemption if you qualify for it. Confirm with your tax advisor before setting the schedule.

An example in Mauricie

Picture an electric motor repair and rewinding shop in Shawinigan: $4 million in sales, 22 technicians and winders, a 64-year-old owner. The best buyer is his production manager, backed by an investor partner. They agree on a $3.2 million price. The bank and their own equity cover $2.4 million. That leaves $800,000.

Rather than drop the price, the owner agrees to an $800,000 vendor note over five years, with interest. In exchange, he gets:

• a hypothec on the shares sold;
• a guarantee from the partner's holding company;
• quarterly financial statements;
• no dividends above a threshold until the note is repaid;
• immediate repayment if the shop is resold.

In the subordination agreement, he also secures the right to keep receiving interest as long as the business meets its bank ratios.

Because the shop already had a Transition Document and the production manager had been handling clients for two years, the bank didn't require the owner to stay on for another two years. The numbers are fictional. The principle is real: the loan makes the sale possible, and the business's independence makes the loan safer.

This week

Before you talk to any buyer, sit down with your financial planner and answer one question: how much do you need at closing to live without counting on a single payment from the buyer? The gap between that number and the price you hope for is the most you can lend without betting your retirement. Keep it in mind when you read a letter of intent.

The vendor financing checklist

1. What share of the price can I wait for without putting my retirement at risk?
2. Over how many years, at what rate, on what repayment schedule?
3. What security: hypothec on the assets, hypothec on the shares, guarantee?
4. What ranking relative to the bank, and what does the subordination agreement say?
5. What covenants does the buyer give, and what information do I receive?
6. What happens if the business is resold before I'm repaid?
7. Has my tax advisor confirmed how the schedule affects my taxes?

To combine this loan with other tools, see how to structure a win-win deal and step 8: sell at the right price.

Do it with a pro

Drafting vendor financing alone means lending part of your retirement under a contract prepared by the buyer's lawyer. With us and our regional partner, the loan is designed from the letter of intent onward, negotiated with the bank and protected by your lawyers and tax advisors. Our fees are almost entirely tied to results and mostly paid after the sale.

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