Vendor finance happens when the person selling a business also funds part of the purchase price. The buyer pays an initial amount upon settlement, and the balance (including interest) is met over an agreed period of time with regular repayments. Using vendor finance in the sale of a business can present various risks. It can also present opportunities for buyers and sellers.

When Should You Use Vendor Finance?

Vendor finance may be appropriate when, for example, the purchaser is having problems getting a bank to finance the purchase of the business. While these arrangements are not always the most desirable option for the selling party, sometimes this type of funding allows the vendor to get the price it is looking for.

Risks Related to the Vendor

If the purchaser defaults on its repayments, there is an obvious financial risk to the seller providing vendor finance. There are a number of effective methods for minimising the risk. This includes making sure that:

• The loan agreement is properly drafted by an experienced commercial lawyer;
• The ‘repayment’ clause and ‘interest rate’ provision are appropriate for the loan;
• The loan is secured by the business’ assets;
• The vendor does not provide too much finance, as this may reduce the buyer commitment to the business based on its investment.

Terms of Vendor Finance Loan Agreement

In a vendor finance arrangement, the parties’ lawyers will usually incorporate the following terms into any loan agreement:

• How much is being borrowed;
• What the interest rate will be (typically between 7%-12% annually);
• The repayment time schedule (e.g. every month, etc.);
• The term of the Loan Agreement (typically 1-2 years);
• Form of the loan (e.g. interest-based only, etc.);
• How financial reports will be provided; and
• Securities and how they will be provided.

These terms are normally incorporated into a Contract of Sale, or otherwise drafted into a separate loan agreement.

Type of Security the Vendor Should Require

The vendor should make sure that it is adequately protected in the event that the buyer is unable to meet the repayment schedule deadlines and defaults. Security may include things like:

• A mortgage covering particular business assets (chattel mortgage);
• A charge over the assets of the buyer’s company (general security agreement); or
• A mortgage over property owned by the buyer.

It is also a good idea to have the buyer (and its directors) provide personal guarantees so that you are not relying solely on the buyer.

Make sure that any potential security has enough equity in case it needs to be used by the vendor.

Other Requirements of a Buyer

A vendor might also require the buyer to do any of the following:

• Enter a deed of priority, which would give the seller priority against third party lenders. This means the vendor is “first in line” in terms of debt repayment;
• Have a statement of assets and liabilities drafted by a certified accountant so that the securities attached the vendor finance loan agreement can be verified;
• Limit the buyer’s ability to share the business’ profits until the seller has received full repayment under the repayment schedule of the Agreement;
• Require the buyer grant power of attorney to the vendor in the event of a default. This will allow the vendor to regain control over any licences for the business, which the buyer will need to lawfully operate the business.

Under any company charge (when one party has an interest in another party’s assets), a fundamental right of secured creditors is the ability to appoint a receiver. A receiver usually runs a company to try and maximise its assets, but will collect/sell the charged assets to service the debt owed to the seller. This might mean selling off particular assets or the entire business. Either way, the receiver’s primary duty is owed to the secured creditors or the company.

Directors’ Guarantees for Vendor Finance

Obtaining directors’ guarantees allows the vendor to pursue the directors personally if there has been a default.

The seller can only rely on a director’s personal guarantee when he or she has assets to service the debt.

Conclusion

Any proposed vendor finance arrangement should be discussed with your lawyer and accountant to determine the viability of any agreement. Is it financially wise? How likely is a default? What kind of security can the buyer offer? If you are considering entering into a vendor finance arrangement, keep in mind the following:

• The assets of the business can depreciate if the business is not run effectively;
• There is always the risk that a guarantor may sell their personal assets.

Any vendor finance arrangement will have its own risks. These risks should be weighed against the potential benefits with legal assistance and financial advice.

To have a sale of business agreement, loan agreement or general security agreement drafted or reviewed by a commercial lawyer, contact LegalVision on 1300 544 755.

LegalVision, a trusted adviser of The Finn Group, is a commercial law firm that provides Australian businesses with cost-effective and high-quality legal services through an innovation model.

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About the author

James is a Practice Leader at LegalVision with a broad range of legal experience in dispute resolution, M&A and commercial law assisting small, medium and large businesses. Prior to his role at LegalVision, James advised mainly NSW Business Chamber SME members with litigation matters and their general business and commercial law issues.