Vendor Finance When Buying a Business: How Seller Loans Work With a Lender

Key takeaways

• Vendor finance closes the gap between what a lender will fund and the price, without the buyer finding all of it in cash.
• Senior lenders expect the vendor to sign a priority or subordination deed: the vendor ranks second, cannot enforce without consent and is paid only when covenants are met.
• How the vendor loan is repaid matters as much as its size - an interest-only loan with a later balloon can leave cover strong, while repaying the vendor over a short term can break it.
• Build in a right to set off warranty claims against the vendor loan; it is the buyer's most practical protection.
• Each side needs its own lawyer, and the vendor's security should be registered on the PPSR behind the senior lender's.

What is vendor finance in a business sale?

Vendor finance is any arrangement where the seller accepts part of the price after settlement. It comes in two main forms:

• A vendor loan: the vendor lends the buyer part of the price under a loan agreement, with interest, a repayment schedule and security.
• Deferred consideration: part of the price is simply payable on set future dates, sometimes interest-free, under the sale contract itself.

A third cousin, the earn-out, makes the deferred amount depend on future performance; it is treated differently by lenders and is not covered here. The government's guide to buying an existing business says the sale should be documented in a written contract stating the final cost and payment method, and with vendor finance that contract carries most of the risk allocation.

Why vendors agree: it widens the pool of buyers, supports a higher price and signals confidence that the earnings will continue. Why buyers want it: less equity on day one, and a vendor who still has money riding on a smooth handover.

How does vendor finance sit alongside a senior lender?

For illustration, a business priced at $1,200,000 has about $300,000 of equipment and stock; the remaining $900,000 is goodwill. Normalised EBITDA is $360,000.

Without the vendor loan, the senior lender would need to lend $900,000 - three times the tangible assets. Many lenders will not do that without property security, however good the cash flow. With the vendor taking $300,000 behind it, the senior lender's exposure is $600,000 and the vendor shares the goodwill risk. The ranking works like other layered debt; our guide to mezzanine and second mortgage finance explains why the second-ranking layer is the one that waits.

What does subordination mean for the vendor?

A senior lender will usually require the vendor, the buyer and itself to sign a deed of priority or subordination before settlement. Expect it to include:

• Ranking. The senior lender's security ranks first over the business assets; the vendor's ranks second.
• Payment blocker. Payments to the vendor are allowed only while the senior loan is not in default and covenants such as debt service cover are met.
• Standstill. The vendor cannot enforce its security or sue for the debt without the senior lender's consent, or until a set period has passed.
• Turnover. Anything the vendor receives in breach of the deed is held for the senior lender.

The vendor's security is normally a second-ranking security interest over the company's assets, registered on the Personal Property Securities Register under the Personal Property Securities Act 2009. Registration matters: ASIC's guide for creditors in a liquidation says a creditor holding security over personal property should register it on the PPSR to protect it.

What terms does a typical vendor loan carry?

Everything is negotiable, and the ranges below are indicative only.

The personal guarantee point deserves attention. A buyer who signs one owes the vendor even if the business fails; our guide to directors' guarantees explains what that signature commits you to.

How do you negotiate vendor finance terms?

Vendor finance is a negotiation between three parties, not two, because the senior lender's conditions set the boundaries. A practical order of work:

1. Senior lender first. Get indicative terms, including its subordination requirements, so you know what the vendor can and cannot be offered.
2. Pay the vendor for waiting. Offer a fair interest rate, a shorter term, or security over the shares in the buying company as well as a second-ranking security interest.
3. Give information, not control. Quarterly management accounts and notice of any senior default are reasonable requests; veto rights over how you run the business are not.
4. Tie the handover to the deferred amount. A vendor who is still owed $300,000 has every reason to introduce you to each key customer and supplier.
5. Agree the early exit. On a resale or refinance the vendor loan usually becomes payable, and the senior lender will want to see that clause too.

How does vendor finance change the debt service maths?

Continuing the example with illustrative rates (not offers): the senior loan is $600,000 at 9.0% over five years, and the vendor loan is $300,000 at 6.0%.

The same $300,000 can be comfortable or dangerous depending on how it is repaid. Interest-only with a balloon keeps cover above two times, but the balloon has to be met from accumulated cash or a refinance, so plan that exit on day one. Repaying the vendor over two years drops cover to 1.16 times, below what senior lenders commonly accept, which is why they insist on payment blockers. Test your own structure in the ICR and DSCR calculator before you agree the vendor's terms.

What happens if the business underperforms?

This is where vendor finance earns its keep for the buyer and the senior lender, and where vendors need to understand what they are agreeing to.

1. Cover falls below the covenant. The payment blocker stops payments to the vendor. Interest may keep accruing, but cash stays in the business for the senior lender.
2. The buyer finds the earnings were overstated. If the contract allows set-off, the buyer deducts proven warranty claims from the vendor loan instead of chasing the vendor in court.
3. The business fails. The senior lender enforces first. ASIC's liquidation guide explains that distributions are made subject to the rights of secured creditors, in a set order where each class is paid in full before the next, so a second-ranking vendor often recovers little of the goodwill it financed.

Some vendors ask for a right to retake the business if the buyer defaults. That clause conflicts directly with the senior lender's security, and the priority deed will usually override or remove it. A vendor who wants that protection is really asking to rank first, and should price the deal accordingly.

What documents does a vendor finance deal need?

• A sale contract with clear deferred payment terms, warranties and a set-off clause.
• A vendor loan agreement covering interest, repayment, default and prepayment.
• A security agreement for the vendor, registered on the PPSR after the senior lender's.
• A priority or subordination deed signed by the senior lender, the vendor and the buyer.
• Any personal guarantees, with independent legal advice for the people signing them.
• Handover, restraint of trade and consultancy arrangements, so the vendor's knowledge stays available.
• Company searches on both sides through ASIC's registers, so everyone knows who they are dealing with.

Each party needs its own lawyer. A single lawyer acting for buyer and vendor on a vendor loan is a conflict in the one document where their interests are most opposed.

How do different lenders view vendor finance?

Put the proposed vendor terms in your loan request from the start; a senior lender that sees them late may redo its numbers. When the structure is ready, post one business acquisition loan request on ADS and 200+ verified lenders and brokers can ask about it. Our guide to business acquisition finance covers the senior loan side in more detail.

Frequently asked questions

Is vendor finance common when buying a small business?

It is a familiar tool in small and mid-sized sales, especially where goodwill is a large part of the price or lenders will not fund the whole gap. Whether a particular vendor will agree depends on their need for cash at settlement, their confidence in the business and how many other buyers are interested.

Does a bank count vendor finance as part of my contribution?

It depends on the lender and the terms. Some treat a fully subordinated vendor loan with no repayments for an initial period as close to equity. Others count every dollar of it as debt in their serviceability test. Ask how your lender treats it before you agree terms with the vendor.

What security does a vendor take for a vendor loan?

Usually a second-ranking security interest over the business assets, registered on the Personal Property Securities Register behind the senior lender, and often a personal guarantee from the buyer's directors. A priority deed with the senior lender sets out when the vendor can be paid and when it can enforce.

Can I stop paying the vendor if the business is worse than promised?

Only as the contract allows. A set-off clause lets you deduct proven warranty claims from the vendor loan, and a payment blocker in the priority deed may suspend payments if covenants are breached. Simply stopping payments without a contractual basis is a default. Get legal advice first.

Should a vendor loan charge interest?

That is a commercial choice. Deferred consideration is often interest-free, while a formal vendor loan usually carries interest, sometimes below market. The choice affects the price, both parties' tax positions and the buyer's debt service, so have each side's accountant review it before the contract is signed.

Related reading

• Business Acquisition Finance
• Mezzanine and Second Mortgage Finance
• Directors' Guarantees: What You Sign

Sources

• Buy an existing business: contracts, liabilities and the PPSR — business.gov.au
• Personal Property Securities Act 2009 — Federal Register of Legislation
• Liquidation: a guide for creditors (INFO 45) — Australian Securities and Investments Commission
• Search ASIC registers — Australian Securities and Investments Commission