Vendor finance explained — how sellers help fund the deal

Many business purchases come down to a funding gap. The buyer has some equity, a lender will provide some debt, and there is still a shortfall between the two and the price. Vendor finance is one of the most common ways to close that gap, and it can also make a deal safer for the buyer. It is worth understanding before you start negotiating.

What vendor finance is

Vendor finance is an arrangement where the seller (the vendor) agrees to receive part of the purchase price after settlement rather than all of it on the day. In effect, the seller lends that part of the price to the buyer, who repays it over an agreed period, usually from the business's cash flow.

It is sometimes called a vendor loan, deferred consideration or a vendor note. The details vary, but the principle is the same: the seller keeps a financial stake in the business doing well after the sale.

A simple example

Here is an illustration. The numbers are examples only.

• Agreed price: $1,000,000
• Buyer's own equity: $300,000
• Bank loan: $500,000
• Vendor finance: $200,000, repaid over three years with interest

At settlement, the seller receives $800,000. Over the following three years, the buyer pays the remaining $200,000 plus interest from the business's profits.

Without the vendor finance, the buyer would have needed another $200,000 of their own money or a larger bank loan, which the lender might not have been willing to provide.

Why sellers agree to it

Sellers would usually prefer all their money on day one. They agree to vendor finance for several reasons:

• It widens the pool of buyers. More buyers can afford the business if part of the price is deferred.
• It can support a better price. A buyer may pay more when the terms are easier.
• It signals confidence. A seller who believes the business will keep performing is more willing to wait for part of the price.
• It may suit the seller's tax or retirement planning, though the seller should get their own advice on this.

Why buyers value it

For buyers, vendor finance does more than fill a gap.

• Less equity needed. You can buy a larger or better business than your cash alone would allow.
• Alignment. A seller who is still owed money has a reason to help with a smooth handover, introduce you to customers and answer questions.
• A signal. If a seller refuses any vendor finance at all, it is worth asking why. It does not always mean a problem, but it is a fair question.
• Flexibility. Repayment terms can sometimes be shaped around the business's seasonal cash flow.

The key terms to negotiate

Vendor finance is a loan, and it needs to be documented properly. Your lawyer should prepare or review the agreement. The main points are:

1. Amount. How much of the price is deferred.
2. Term. How long you have to repay it. Shorter terms mean bigger repayments.
3. Interest. Whether interest is charged, and at what rate. Some arrangements carry interest; others are priced into the overall deal.
4. Repayment schedule. Monthly, quarterly or in lump sums. Whether there is an initial period with no repayments while you settle in.
5. Security. Sellers usually want security, often a general security agreement over the business's assets registered on the Personal Property Securities Register, and sometimes a personal guarantee from the buyer.
6. Ranking. If a bank is also lending, it will almost always want to rank ahead of the seller. The bank and the seller may need to sign a priority or subordination arrangement. The bank's requirements can dictate what vendor finance terms are possible, so involve the lender early.
7. Default. What happens if you miss a payment, and how much time you have to fix it.
8. Set-off. Whether you can reduce what you owe if a warranty in the sale agreement turns out to be wrong. Buyers value this right; sellers resist it.
9. Early repayment. Whether you can repay early without penalty, for example if you refinance.

Vendor finance and bank lending

Australian lenders assess business acquisitions on the buyer's equity, experience and the business's ability to service debt. A lender may view vendor finance favourably because it shows seller confidence and reduces the amount it has to lend. It may also treat the vendor loan as debt that must be serviced, which affects how much it will lend. Requirements differ between lenders and change over time, so discuss the full structure with your lender before you commit to terms with the seller.

Can the business afford it?

The most important test is cash flow. Add up:

• the bank loan repayments
• the vendor finance repayments
• a reasonable salary for you
• tax
• money for maintenance, equipment and growth

If those exceed what the business reliably earns, the structure is too tight, however attractive the price. Use normalised earnings for this, not the most optimistic figure; see SDE vs EBITDA. Build in a margin for a slow year.

Vendor finance or earn-out?

Vendor finance and earn-outs are both forms of deferred payment, but they are different.

• With vendor finance, the amount owed is fixed. You owe it whether the business does well or not.
• With an earn-out, the amount depends on the business hitting agreed targets after the sale.

Vendor finance helps with funding. Earn-outs help when buyer and seller disagree about value. Some deals use both. See earn-outs explained for more.

Tax points

Interest on money borrowed to acquire a business is often deductible to the buyer, and interest received is generally assessable to the seller, but the details depend on the structure and the parties' circumstances. How the deferred price is treated for capital gains tax purposes is a question for the seller's adviser. Both sides should get advice before signing.

Vendor finance is not just a funding tool. It keeps the seller invested in your success at exactly the time you most need their help.

How we can help

Kainos Consultants helps buyers model whether a funding structure works, test cash flow under vendor finance and bank debt, and negotiate terms that suit the business. Learn more about our investment and financial advisory service, or contact us to talk through a deal.

This article is general information only and does not take into account your circumstances. Speak to a qualified adviser before acting on it.