Last year, we demolished our old Vancouver teardown house.
In one of the walls, I noticed the builders had used newspaper as insulation, which explains why we were so cold all the time. The newspaper was an issue of the Vancouver Sun from 1911. As I examined the news of the day, I turned to the real estate section and saw that land parcels and homes were selling for about $400 to $600. Inflation – I wish I had bought then. But perhaps even more interesting was that just about all the sellers offered vendor finance, not just for some of the down payment but for the whole deal. My first question was: where were the banks? Surely one could get a mortgage rather than pay the vendor over five years? Why would vendors agree to this unless they had no choice? Some quick research showed that there were banks in operation, but it was still a very early market and perhaps it was difficult for “immigrant buyers” to qualify.
As I reflected further, I realized that vendor finance is still the norm today when it comes to selling your business. We often see vendors carrying between 20% and 50% of the financing on the sale of their company.
Why? The most common explanation I hear is that it helps successfully transition the business to the new owner. However, there are other ways to ensure that process occurs such as holdbacks or representations and warranties in the share purchase agreement. Even better is when the owner plans for succession by delegating responsibility to the management team (although the recent Canadian Federation of Independent Business research study on succession suggests this is done only about half the time). In any case, the transition is usually settled within 12 months, so why is the norm to insist the vendor provide finance for four or five years?
The real answer is that it favours the buyer. Vendor finance is normally unsecured and comes at an attractive rate of interest, compared with borrowing. It also boosts the amount of equity in the deal, which helps raise external credit without it coming from the buyer’s pocket.
As such, it’s worth examining the characteristics of vendor finance from the seller’s perspective.
•Vendor notes are effectively unsecured. Even if you obtain a pledge of shares or a general security agreement supporting the promissory note, that security will be completely subordinated to the security of the lenders, including in most instances a senior bank and a subordinated lender. The secured lenders will fully encumber the assets of the business and require the vendor to sign an inter-lender agreement. In the event of business failure, the vendor note will be worthless.
•All payments to the vendor note are postponed to the senior lenders, so if there is a breach or default of their loans, the senior lenders can prohibit the business from making payments to service the vendor note. This means the vendor can be waiting a lot longer than anticipated for payment, with little recourse. Further, the vendor might be asked to “stand still” in demanding the loan by the senior lenders.
•The usual interest rates on vendor notes are between 5% and 10%, about the same return one would expect for an investment in a blue chip stock. However, an investment in a small company you no longer control lacks any liquidity and is highly risky. Therefore, the return does not match the risks.
Much like vendor finance for real estate 100 years ago, vendor notes on business sales should be confined to the history books. In today’s market for businesses, demand exceeds supply, creating a seller’s market. Therefore, sellers can insist on more favourable terms. Perhaps in another hundred years, someone else will look back and laugh at how funny vendor finance was when it came to selling your business.