What You Need to Know About Vendor Financing for Acquisitions

Vendor Financing in Business Acquisitions

For buyers looking to access capital, vendor financing (also known as seller financing), is a helpful tool in business acquisitions, designed to bridge the gap between a buyer's available funds and a seller's asking price.

In this article, we’ll take a look at:

What Vendor Financing Is
How It Works
A Vendor Financing Example
The Benefits and Drawbacks for Buyers and Sellers
Types of Vendor Financing Available
How Banks Percieve Vendor Financing
Some Tips for Negotiating Vendor Financing

By reviewing all the topics in this article, you’ll get a basic understanding of what vendor financing is and how to use it to your benefit.

Let’s get into it.

What is Vendor Financing?

Vendor financing is a type of loan provided by the seller to help the buyer purchase a business. It's often used when there’s a gap between the seller’s asking price and the amount of debt or equity the buyer can get from other sources.

This loan usually has delayed principal repayments and is considered secondary to other loans, allowing the buyer to maximize borrowing from primary lenders.

Interest rates are generally between 5-10% and remain fixed for the loan's duration. There may or may not be collateral, like a General Security Agreement or personal guarantees, and there are rarely any financial or reporting requirements.

Vendor financing is most commonly used when:

The buyer has less than 25% equity for a down payment.
The business valuation, based on cash flow, is higher than usual.
The business is in a sector that isn’t appealing to senior lenders.

How Does Vendor Financing Work?

At the time of closing the deal, the seller and buyer sign a loan agreement, with the seller acting as the creditor for part of the total purchase price.

During the interest-only period, interest payments are made either quarterly or annually. After this period, the loan is paid back (amortized) according to a pre-agreed schedule, usually within 1 to 5 years.

In Canada, it's common to delay paying back the principal until the senior loan is fully repaid. However, senior lenders often allow earlier repayment if certain conditions are met. In some cases, they may even encourage paying off the seller's loan completely after 2-3 years by refinancing with a new loan, depending on how well the business is performing.

This topic is often discussed before signing a Letter of Intent, as it can become a major issue that might delay or prevent closing if not addressed early on.

An Example of Vendor Financing in an Acquisition

Jonas is negotiating with Margaret to buy her business, GreenScene, a commercial landscaping and hardscaping company in Winnipeg. Founded 20 years ago the company, has grown significantly in the past two years, with revenue almost doubling thanks to large projects from two major clients.

For the year ending April 30, 2024, the company had an adjusted EBITDA of $1 million. The average adjusted EBITDA over the last three years is $800k. Margaret wants the sale price to reflect the recent growth, so she's asking for $5 million.

Jonas is interested in meeting the asking price but has limited capital. He has $1 million (20% of the asking price) in equity and has found that lenders are willing to provide up to 4x the 3-year average adjusted EBITDA, which is $3.2 million.

This leaves a $800k gap, so Jonas considers deferred payment options like vendor financing or earn-outs. He proposes that Margaret lend him the remaining $800k, with a 5% interest rate that would pay her $40,000 per year in interest for the next seven years. After the senior loan is paid off, Jonas would repay Margaret in 20 monthly installments of $40,000 plus interest.

Although the bank will need to be informed of this new debt, Margaret has agreed to delay and subordinate her loan to the bank’s loan, so it won’t significantly affect the bank’s lending terms.

With this arrangement, Margaret will get $4.2 million upfront and steady income from the vendor financing for the next nine years. Jonas will become the new owner of GreenScene!

Vendor Financing Benefits and Drawbacks for Buyers

Benefits

Delaying principal payments helps keep cash available during the riskier early years after the transition.
Vendor financing is less rigid and cheaper than mezzanine loans or preferred equity investments.
It incentivizes the seller to stay involved and help the buyer after the deal is closed.
If structured well, senior lenders may view this loan as similar to equity when assessing credit.

Drawbacks

Buyers may prefer not to keep a close relationship with the seller, especially if the deal was difficult or their growth plans differ.
The buyer has another creditor relationship to manage.
There's a risk with refinancing if the company’s cash flow hasn’t grown by the time the seller’s loan is due.

Overall, the benefits largely outweigh the drawbacks for buyers, making them an attractive source of capital but it depends on the situation between the buyer and seller.

Vendor Financing Benefits and Drawbacks for Sellers

Benefits

It allows the seller to achieve a higher sale price than they might get from a buyer with limited funds.
It increases the number of potential buyers, especially if the business is less likely to attract senior debt financing (e.g., a hotel or restaurant).
The seller receives regular income over a set period.
There may be tax benefits.

Drawbacks

The seller's payment is delayed, with the principal sometimes deferred for up to 7 years.
The interest rate is usually lower than market rates, considering the risk of the loan.
In case of default, the seller is unlikely to recover much, as the senior lender gets paid first.
Some sellers may not want to keep a close relationship with the buyer.

Overall, the value of vendor financing to a seller depends on the offers they receive and the availability of debt in their industry.

Types of Vendor Financing

Most vendor financing follows a straightforward structure. However, there are some variations designed to address the seller's concerns.

Suppose the seller doesn’t want to wait years to receive principal repayments. In that case, some agreements include terms that allow early repayment, as long as the company stays within its senior lending agreements.

In rarer cases, the loan may depend on the company's future performance. However, this approach is less common than using "earn-outs" (which are outside the scope of this article).

Both of these variations require greater collaboration and transparency between the buyer and seller since payouts depend on the company’s financial performance. This also increases the chances of future disagreements or legal disputes.

Are Banks Comfortable with Vendor Financing?

Banks are generally supportive of seller involvement in the form of vendor financing, as it shows the seller’s commitment to the business’s success and lowers the risk of default. However, they require the seller’s loan to be subordinated, meaning the bank has the first claim on assets in case of default, and postponed, meaning no principal payments can be made while the bank’s loan is active. This typically adds two collateral documents to the deal:

Priority Agreement: Signed by the seller, acknowledging that the bank has the first claim on collateral.
Postponement Agreement: States that no principal payments will be made to the seller during the bank loan.

Banks usually allow interest payments to the seller, but they may include provisions to stop those payments if the borrower violates any financial covenants. This restriction would be included in the Postponement Agreement.

In some cases, banks may treat vendor financing as equity in their credit calculations if it's structured properly. This could lower the buyer's required equity down payment. However, most banks still want the buyer to have some financial investment in the deal, usually requiring a minimum of 10-15% of the purchase price from the buyer.

Tips for Negotiating Vendor Financing with the Other Party

Vendor financing should be discussed before signing the Letter of Intent.

Buyers should mention that many small business deals include vendor financing for 10-20% of the purchase price (Source: NAI Commercial). It shows commitment to senior lenders and helps reduce the risk of the deal falling through.

Buyers also need to clearly explain what the financing terms mean for the seller’s future cash flow. Some sellers may assume, or be advised, that repayments will start right after the sale, and may be disappointed to learn that payments could be delayed by at least 5 years.

This is an important distinction: Vendor loans that start repayments immediately are only helpful when senior debt is not being used or is unavailable. It doesn’t make sense to have two lenders if both require repayment on the same schedule—it’s more efficient to have just one lender in that case.

Vendor Financing as a Supplement and/or an Alternative

Vendor financing is used to supplement senior bank loans when financing a business acquisition, but it can also be used as an alternative.

When used as a supplement, its main advantage is that principal repayment is delayed, allowing the buyer to secure more senior debt. As a substitute, vendor financing can replace senior debt in industries where banks are reluctant to lend. As a buyer, there’s no reason not to ask for vendor financing unless you prefer not to keep the seller involved as a stakeholder.

For sellers, vendor financing only makes sense if it helps attract more buyers or leads to a higher sale price. If all other factors are equal, sellers will usually prefer offers without vendor financing.