Vendor financing: Considerations for business sellers

Following a year focused heavily on concerns surrounding inflation, the Bank of Canada made its seventh rate increase of 2022 on December 7. After a period of cheap access to money fuelling robust M&A activity, some prospective buyers may be finding themselves in a more challenging position to finance a business purchase. These conditions may increase the appeal of, or need for, vendor financing.

Vendor financing (often called a “vendor take-back” or “VTB”) involves delaying payment of some or all of the purchase price, as a debt repaid by the buyer to the vendor after closing and over an agreed period of time. It is available in both share and asset transactions. Often providing more flexibility than bank financing, the portion of the purchase price to be financed, applicable interest rate, and period for repayment are all subject to negotiation between the buyer and vendor. Payments could be made monthly, quarterly, annually, or at any other interval agreed by the buyer and vendor. There might also be an initial period without any payments (for example, the first six months or year), providing the buyer a buffer to build up cash from the business. Vendor financing is understandably an attractive option to a buyer looking to bridge the gap between its available resources and the purchase price for a business.

From the vendor’s perspective, vendor financing is a practical option to help solve financing constraints and get a deal completed. It is common with our clients, many of whom are involved in owner-managed small and medium sized businesses. In some cases, the vendor may be happy to offer financing to aid an ideal buyer (such as a longstanding employee) in taking over the business. However, vendor financing also increases risk to the vendor, who transfers ownership of the business to the buyer at the time of closing without having received full payment. There are some important considerations for a vendor in determining whether to agree to provide financing, and how best to address some of the risks.

Security

The buyer’s debt to the vendor should be documented in the form of a promissory note. However, while a promissory note provides evidence of the debt, it does not give any self enforcement options to the vendor. If the buyer defaults and the vendor’s demand for payment is ignored, the vendor must rely upon the courts for a remedy. In the meantime, other creditors of the buyer with secured debts may have already seized the buyer’s assets, leaving nothing for the repayment of the vendor. It is therefore essential for the vendor to take some form of security on the debt (and in many cases, more than one form of security will be preferred).

Some common forms of security are described below:

• General security agreement – A general security agreement (“GSA”) grants the vendor a security interest in all the buyer’s current assets (personal property, not land) as well as those acquired in the future. The GSA will include rights for the vendor to enforce the debt against the buyer’s assets upon default. The vendor’s security interest must be registered under a registry system in order to attract the rights afforded to secured creditors under the applicable statute (in Ontario, the Personal Property Security Act). Registration also gives notice to others of the vendor’s security interest.
• Security on specific assets – Alternatively to a GSA, the vendor might take security only in certain assets of the business. For example, it is common for a vendor take an interest in certain business assets sold by the vendor to the buyer, such as a vehicle fleet in a business where the vehicles are the key assets.
• Mortgage on real property – If there is real property involved in the business, the buyer might grant the vendor a mortgage on the real property for some or all of the value of the debt.
• Personal guarantee – The vendor might also ask one or more principals of the buyer to sign a personal guarantee, giving the vendor access to the individual’s personal assets in order to satisfy the debt. A personal guarantee could be unlimited, meaning it is intended to cover the entire debt, or limited to a certain dollar amount.
• Share pledge – The vendor could also take a pledge of the shares of the corporation operating the business, allowing the vendor to take control of the corporation and step back into operating the business or to sell off its assets following the buyer’s default.
• Insurance policy – As a final example, in businesses where the income of the business is closely tied to the services of its principal (being the buyer, in replacement of the seller after the completion of the transaction), the parties might consider taking out an insurance policy on the life of the buyer and payable to the vendor.

Other debts and priority

The vendor will also want to consider what other debts, if any, the buyer will be paying off while repaying the vendor. The vendor will be in the best position to understand the cash flow generated by the business that the buyer is purchasing. As such, when determining the dollar amount of vendor financing and other applicable terms, the vendor should consider whether the buyer could be taking on too much debt to repay the vendor as promised.

If the buyer does have other debt to service, this could become relevant to how the vendor payments are structured (for example, banks will typically require vendor financing to be subordinate to the bank’s loans). With other creditors in play, the vendor will also need to understand how its security will rank in relation to the other creditors (again, banks generally require their security to rank ahead of the vendor’s financing). Understanding the vendor’s position in relation to other creditors is an important element of assessing the risks associated with vendor financing.

Business profits

The vendor should also consider what the buyer will be permitted to do with business profits while the debt is outstanding. Although an individual buyer is usually free to take a salary and other reasonable compensation from the business, the vendor may not want the buyer withdrawing profits from the business (for example, through dividends) before the vendor is repaid. Similarly, a corporate buyer may be prohibited from taking dividends or other distributions from the purchased business until the debt is repaid (or such distributions might be limited to a certain amount).

Access and role after closing of the transaction

The vendor will also want to consider their role in the business, if any, and their level of access to information concerning the business after the closing of the transaction. For example, a vendor will often be asked to remain through a transitionary period in an employee or consultant role. A vendor who has not yet received the full purchase price is motivated to ensure that the business is operated well. In addition, regardless of whether the vendor is directly involved in the business after closing, the vendor will likely want access to key business records until the debt has been paid (for example, by receiving monthly or quarterly financial reporting regarding the business). Keeping informed about the condition of the business is a good way to monitor the buyer’s ability to continue repaying the debt and to avoid learning about difficulties too late.

These are only some of the considerations for vendor financing.¹  If you have any questions regarding vendor financing or business purchase and sale transactions in general, please reach out to me or any member of Siskinds’ Business Law Group.

¹ A vendor should also check with the accountants for the business to determine any other relevant considerations for vendor financing from an accounting or tax perspective.