Acquisition financing (purchasing another business) is not an easy task for any business, but it is especially difficult for small businesses. If you have no valuable assets to provide the lender with as security, it will prove almost impossible to get a loan, unless you have family or friends willing to guarantee your repayment obligations. One popular alternative for funding an acquisition is Vendor financing. Vendor financing involves a loan agreement between vendor (seller) and purchaser under which the vendor of a business agrees to lend some or all of the purchase price of the business to the purchaser buying the business.
We have an ageing population in Australia and more and more businesses are going up for sale. This has led to more and more people choosing to sell and purchase businesses using vendor financing arrangements.
How does vendor financing work in practice?
Imagine you are selling your business and it currently makes $500,000 profit annually. You would like to sell your business for $1M. You find someone willing to pay the $1M, however, they do not have all the funds available and would like to borrow from you to fund the purchase. This is a typical vendor financing arrangement.
Once you and the vendor have spoken to your lawyers, you should have a loan agreement drafted to ensure that the arrangement is legally binding on both parties. The terms of the vendor finance agreement might require the buyer to repay the $1M over a set period of time. This means that the buyer would most probably use any profits that the recently purchased business generates to service the repayments over that period.
Due to the fact the purchaser is using the profits of the newly acquired business to pay off the debt, the vendor might achieve a higher price for the business than if the buyer had had to purchase the business using its own money.
As a way of encouraging the purchaser to meet its repayment obligations, it is not uncommon for there to be an interest rate integrated into the terms of the vendor finance agreement. This rate is normally between 5-10% annually. Because of the structure of this financing arrangement, both parties have a vested interest in the continued profitability of the business.
What else to consider as the vendor
In the previous scenario, the vendor is funding the purchase of its business by the purchaser to ensure it is sold. Both the vendor and purchaser need to be clear about what will happen if there is a default on the repayments. Depending on how the lawyer has drafted the terms of the agreement, the vendor will sometimes have a right to repossess the business or its assets in a default scenario. This is unpopular with both parties and will be avoided at (almost) all costs.
To avoid losing all of its money in a default situation, the vendor will often require a percentage of the total purchase price to be paid by the purchaser (for example 15%) and the vendor will finance the remainder (for example 85%) under a vendor finance agreement.
If the purchaser does not have 15% down payment, it may choose to raise the funds from another investor in exchange for 15% of the business. The more established the business, the easier it will be to raise private funds for an acquisition. Unfortunately it is not always easy to raise funds for start-ups, however this depends on who is investing, the business model, its revenue figures up to this point, and the amount of equity being offered to potential investors.
This is a popular method of funding a new business venture for two reasons: It attracts foreign investment, which can make the business more valuable, and it requires no upfront money (while retaining 85% ownership).
Nutshell benefits to vendor
As a vendor, you benefit in a number of ways:
- You control whether or not the deal goes through, despite a lack of funding options available to the purchaser;
- The purchase price might be inflated because the purchaser does not want to miss the boat on what they see as a valuable investment;
- You will be earning interest on the balance of the loan over the repayment period; and
- You no longer need to run the company, but continue to have an annuity stream.
Nutshell benefits to purchaser
As a purchaser, you benefit in a number of ways:
- You do not need any substantial funds of your own;
- You can pay off the debt using the business’ profits; and
- You can take control of the business and make it more profitable.
Vendor financing is quickly becoming a popular financing option with both buyers and sellers of businesses in Australia. While it is not without its risks, it can be the arrangement needed for a business sale to go ahead. To ensure you have structured your vendor finance agreement correctly, have a lawyer at LegalVision review or draft the agreement for you.