David Newport: Vendor finance - swear word or saviour?

David Newport. Photo / supplied

David Newport, principal of Switch Business on vendor finance:

For business owners wishing to exit their business, the term 'vendor finance' is almost an obscenity. But what is it, exactly?

Put simply, it is money left in a transaction by the owner so they can achieve the asking price for their business when there is a shortfall in a purchaser's equity and bank finance.

Vendor finance can take many guises, from a straight 'no strings' loan to a complex 'earn out' arrangement that is based on the business achieving a series of milestones.

Vendor finance is far more prevalent when the market is down. Purchasers, their advisors and especially financiers see it as a way to mitigate risk.

In its purest form, vendor finance offers a purchaser an opportunity to bridge a gap between what they have in personal equity and bank finance to equal something close to the purchase price. The purchaser will be able to offer some security and, in most cases, pay the owner an interest rate that is close to bank rates.

At the more complex end, vendor finance takes the guise of 'if you want to achieve your purchase price then we have to both take a part of that risk together'. This is an 'earn out'.

For example:

• Purchase price of a business is $2,000,000

• Purchaser pays $1,500,000 on settlement, a further $100,000 after the owner has completed the vendor assistance period, and the balance upon the business achieving the milestones listed below:

* Should the business in the next financial year achieve an agreed growth factor then a further $200,000 will be paid by the purchaser to the owner

* Should the business in the next +1 financial year achieve an agreed growth factor then the final $200,000 will be paid by the purchaser to the owner.

There are a number of other methodologies, but to keep it simple these would be the most normal in small to medium transactions. Vendor finance is a lot more prevalent in more difficult markets because there will often be a significant gap between what a buyer can raise and what a purchaser hopes to achieve.

As an example, three years ago banks would often lend over three times EBIT (earnings before interest and tax), and in a lot of cases up to 100 per cent of the value of the business, plus in some cases the working capital required. In today's market that would in most cases be significantly under two times EBIT and generally well less than 50 per cent of the value of the business.

Therefore, any purchaser that would look to 100 per cent finance the business is out of the market. That is probably not a bad thing. Purchasers have to have at least 50 per cent equity or hope that the vendor will contribute through vendor finance.

The reasons that business owners cringe when they hear the words vendor finance are many; here are the major ones:

1. Business owners would like a clean break from the business. Having money still tied up in the business means they have to have a certain involvement in the business to protect their investment;

2. The exiting owner effectively gives away control of the business when a new owner takes over, and as such can't guarantee the business will be run as well as it was under their stewardship;

3. The exiting owner may require the money for a new interest or business venture;

4. If the new owner has borrowed money to complete the transaction then their financiers, in most cases, will take all their available security;

5. The exiting owner is effectively lending money to a party that they have only just met;

6. The more complex earn out agreements can become very difficult to manage and to measure because the performance of the company is out of the exiting owner's hands;

7. There is always a possibility that litigation might be required to realise that money should things not go as well as predicted.

We would expect that, in this economy, as many as 75 per cent of business sales transactions with an enterprise value exceeding $1,000,000 will need to involve vendor finance. This will likely remain the case even when the market turns, because it will be a long while before financial institutions will have the confidence to bridge that gap.

Business owners will need to get the services of a good transactional accountant, lawyer and business broker to best look after their interests in this regard, because it will be a reality for the foreseeable future.

David Newport is a principal of business sales & acquisitions firm Switch Business Ltd.