When it comes to acquiring an existing business, many purchasers find that the seller can actually be one of the most flexible sources of funding. Here’s a complete guide to vendor financing — what it is, how it works, and how to make it work for you.
If you want to buy a business, you need to understand that vendor financing is not the same as financing provided by a bank or other financial institution. The lender in this case is actually the seller of the business. Why would this type of funding be desirable? Here are some of the main reasons:
- Vendor financing can close the gap if you have trouble raising enough funds from equity investors and other types of lenders.
- Vendor financing leaves room for flexibility and creativity because it is not subject to the formalities of traditional lenders.
- Vendor financing terms can include methods of recourse and accountability in the event some aspect about the business or the transition process does not live up to the agreement.
- Vendor financing gives the seller a financial incentive to help you succeed as the new owner.
For all of these reasons and more, vendor financing can be a strategic move. Keep reading to learn more.
What is Vendor Financing?
Vendor financing (also known as vendor take-back or VTB for short) is a form of business acquisition debt. Typically, the seller or vendor of the business agrees to receive part of the purchase price from the buyer over a set period of time with interest.
For example, let’s say you agreed to buy a business for $500,000, and you had $100,000 of your own money to invest. If the bank was only willing to loan you $300,000, you might be able to arrange for the final $100,000 in the form of a vendor take-back.
The seller could agree to receive a payment from you every month until they receive their entire $100,000 plus an agreed-upon amount of interest. In this scenario, vendor financing helps both parties because it enables you both to close the deal.
Benefits of Vendor Financing for Business Acquisition
The most obvious benefit of vendor financing is that it can help you close a deal if you’re unable to raise the entire amount of the purchase price through other financing methods. Having that financing can, in turn, help you secure the bank loans you were unable to get.
Vendor financing carries the added benefit of signaling to other lenders that the vendor believes in the viability of the business. If they’re willing to defer receiving some of the purchase price, it indicates that they trust that the business will succeed and that the revenue will be sufficient to service the loan.
Vendor financing offers several other benefits:
Vendor financing reduces the amount of capital you need in order to buy a business. This can help in multiple ways. In some cases, it could mean the difference between being able to buy the business or simply not having enough cash. But in other cases, it can afford the buyer more flexibility.
Even if you have access to sufficient equity and credit to purchase the business, you might prefer not to spend it all at once. Retaining some cash on hand can allow you to more confidently manage transitional costs, invest in growing and improving the business, and covering any unanticipated expenses.
In addition, the payment terms for vendor financing are usually more flexible than those from a traditional bank. Depending on the deal you strike, you could have no payments or interest-only payments for a period of time, or even payments that are tied to the performance of the business.
Recourse After Closing
When buying a business, due diligence is key. That means conducting a careful assessment of every important aspect of the business, from inventory levels and customer lists, to property leases, employee contracts, and vendor agreements.
However, it’s always possible that an unexpected issue could pop up, whether it’s an unpaid bill or a piece of equipment in disrepair. With vendor financing in place, you have the ability to withhold payment to cover your costs if the issue was not properly disclosed to you.
Ongoing Vendor Involvement
A great advantage of vendor financing is that the seller retains a financial interest in the success of the business under its new ownership. This provides an incentive for the seller to work towards a smooth transition. Depending on your needs, the seller might be willing to provide ongoing training, introductions to clients and suppliers, help solving problems and advisory support — at least until they have received full payment.
Benefits of Vendor Financing for the Seller
The fundamental benefit of vendor financing is the same for buyer and seller — it paves the way to close a deal that might not have been possible otherwise. This is especially true for businesses that are valued mainly on their intangible value (like the client relationships of an IT consulting firm) rather than on hard assets that a bank can hold as collateral (like the equipment in a factory).
Some sellers will also appreciate the softer transition process that a vendor financing arrangement can provide. There will be a period of time when they continue to receive cash flow from the business and potentially have a role to play in the transition. For those who have poured their blood, sweat, and tears into creating a business, this may be preferable to just handing over the keys and walking away.
How Does Vendor Financing Work?
If you want to use vendor financing to purchase a business, it’s a good idea to bring it up with the seller as early as possible. You might include with your letter of intent initial offer. This way, you can start a dialogue with the seller about whether they are open to idea, and what the amount, interest rate, and payback period might look like.
When the deal closes, you will give the seller the purchase price minus the amount that has been financed by the seller. You will pay that amount back based on the terms you have agreed to with the seller. It is common to agree to no payments in the first year and full repayment over three to five years.
Your vendor financing agreement should also set out the terms of the vendor’s post-sale involvement with questions that include:
- What role will they play?
- How long will they stay involved?
- What financial reporting will they expect from you?
Is Vendor Financing Approved by Banks?
Banks are generally favorable towards vendor financing. For one thing, it reduces the percentage of the acquisition price that they are funding, which reduces their risk. And for another, it indicates that the seller believes in the business so much, they are still willing to risk their own money.
Having said that, banks will usually insist on being the senior lender on your new balance sheet. In other words, repayment of their loan gets priority over the vendor financing.
4 Tips to Get Started with Vendor Financing
Sometimes vendor financing is a last-minute solution to an unexpected funding gap. But it’s a lot more effective when you anticipate needing it and lay the groundwork for success. Here are some tips that might help you:
1. Seek Professional Advice
As soon as you intend to buy a business — even if you haven’t identified the exact business yet — it’s time to put together a deal team. Why? Because if you start down this path and do not already have a lawyer, an accountant, a financial advisor, and a banker on speed dial, you will risk scrambling to find a team under time pressure or worse, making moves without the right professional advice.
It’s best to have a team from the very beginning who can help you assess potential business acquisition candidates and to consider when, if, and how vendor financing might be part of the deal.
2. Understand the Seller
Why is the business for sale? Is the seller open to vendor financing? These are things you want to understand very early in the process. It will help you in your negotiations and in your financing strategy.
A seller who is not willing to consider vendor financing might simply wish to retire with a clean slate, or they might have unspoken concerns about the viability of the business.
3. Clarify All Terms
One of the reasons a lawyer is so important on your deal team is that they can draft up the terms of your vendor financing. This is not something you want to do on a handshake, because the details can be quite nuanced.
Beyond the interest rate and repayment schedule, there could be other questions to answer, such as what financial recourse will be taken if issues arise after the sale, what the seller will be expected to do in terms of transferring knowledge and relationships and assisting with the transition, and when their involvement with the business will end.
4. Verify the Vendor’s Due Diligence
It’s important for due diligence to be a two-way street. Just as you will want your lawyer and accountant to help you carefully review the business you are proposing to acquire, it’s wise to make sure that the vendor has their own experts reviewing your vendor financing proposal. Failure to get on the same page regarding details of the vendor financing could result in the deal breaking down at the last minute.
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