Vendor Finance: How a Vendor Loan Ranks Behind the Bank

Business sales often stall on a gap. The buyer has some cash, the bank will lend against the business's earnings and security, and the price the seller wants is more than both together. A vendor loan closes the gap: the seller is paid most of the price at completion and lends the rest to the buyer, to be repaid over an agreed period with interest. The seller gets its price, if not all at once, and the buyer gets the business.

To the bank, the vendor loan carries a signal and a claim. The signal is that the person who knows the business best is willing to be paid out of its future cash. The claim is on that same cash, and often on the same assets. A bank that lets both creditors draw freely has lent less safely than its own loan-to-value or cover ratio suggests, because the business is servicing more debt than the bank's figures show.

The ranking is set in a subordination deed, or an intercreditor agreement where the arrangements are larger, signed by the bank, the seller and the buyer at completion. Its working parts recur. Payments to the seller are permitted only while no default is continuing and, often, only if a test is met after the payment. A breach or default blocks them. Money the seller receives in breach of the deed is held for the bank and handed over. The seller agrees not to sue, demand repayment or enforce any security until the bank is repaid or a standstill period has passed.

Security is ranked as well as payments. In New Zealand and Australia a seller who takes a general security agreement registers it on the personal property securities register, and the deed puts it behind the bank's. Registering second is not enough on its own. Where the business is sold as assets and the seller's security secures their unpaid price, it can be a purchase-money security interest, which under both statutes can rank ahead of an earlier general security over the same assets if registered soon enough after the buyer takes possession (10 working days in New Zealand; 15 business days in Australia for goods other than inventory, marked as purchase money). Both statutes also let a secured party subordinate its interest by agreement, enforceable by the party it is meant to benefit, and the deed uses that to take the priority away. In the UK, which has no equivalent statute, the same result is reached by contract. Where both take mortgages over land, a deed of priority sets the order.

The founder of a precision engineering workshop, constructed for this page like every figure in it, sells to the workshop's manager for US$8.0m. The bank offers a five-year term loan of US$4.0m at 7%, the manager puts in US$1.6m, and the founder agrees to lend the remaining US$2.4m at 6%, repaid in four equal annual instalments of principal. The business is forecast to leave US$1.6m a year for debt service after tax and capital spending.

On the bank's own figures the deal looks comfortable. On the business's, it fails in the first year: the workshop cannot pay both creditors as drafted. Under the subordination deed the bank proposes, vendor payments are permitted only if cover on both loans stays at or above 1.25 times after the payment, a level that belongs to this example. That test would block the founder's instalment in every year of the original schedule, leaving the founder unpaid and the manager in breach of the sale agreement.

The fix is made before completion, not after the first missed payment. The founder agrees to take interest only while the bank's loan runs, and principal afterwards:

The founder waits longer and is paid from cash the bank no longer needs, though year 6 is tight on flat cash, and the founder carries that risk. The bank's reading of the buyer's stake changes too: the manager's US$1.6m is 20% of the price, and the bank counts the vendor loan beside it, making 50%, only because the deed now holds it behind the bank in both payment and enforcement.

A vendor loan is fixed at completion: the amount, the dates and the interest are known, and they fall due in a good year or a bad one. An earn-out is contingent: it is paid only if the business reaches agreed targets, and its size moves with performance. Deferred consideration, a fixed part of the price simply paid later, sits between the two and is often documented without interest; a lender reads it much as it reads a vendor loan, because it is a fixed claim on future cash.

The difference changes how the bank protects itself. With a vendor loan, the risk is that fixed payments fall due in a bad year, so the bank subordinates and blocks. With an earn-out, the payment is largest when the business does best, so the bank's concern is less whether it can be paid than whether the targets reward the seller for lifting short-term earnings at the business's expense.

DEFINED IN ONE PARAGRAPH → · THE EQUITY CONTRIBUTION → · SUBORDINATION, DEFINED →

It decides the structure the bank will approve. A credit paper that tests cover on the bank's loan alone has missed half the debt service, and a sanctioner will ask for the combined figure. It decides the documents: the sale agreement, the vendor loan and the subordination deed must say the same thing about when the seller is paid, and a vendor loan agreement that gives the seller a right to accelerate that the bank's deed forbids is a conflict to resolve before signing. And it decides what happens if the business struggles. Some sale agreements let the buyer set off warranty claims against the vendor loan, which can shrink the seller's claim, and the seller who is still on the premises as a consultant is a creditor the bank will meet at every difficult conversation.

WHAT YOUR BANK HOLDS AS SECURITY → · DEBT SERVICE COVER → · INTERCREDITOR AGREEMENT →