Three options for vendor finance
The gradual sell-down of a business to new owners is becoming a common succession planning strategy.
This is especially the case for staff who have worked in the business for many years as it can ultimately be a seamless process for everyone involved.
Typically, younger staff wanting to step up to ownership aren’t able to pay 100 per cent of their investment up front. Yes, they may own their own home and have some equity in it, but there are limitations on how much they can borrow from the bank. Having skin in the game is important, but vendor finance is often used to plug the gap.
There are generally three options when it comes to vendor finance. I’ll assume the most common scenario of a company structure with a gradual equity purchase/sale.
The three options are:
The company borrows
The company itself borrows from the bank.
The funds are lent/paid to the purchasing shareholder, who settles with the vendor for their equity investment.
The purchasing shareholder is now a debtor (asset) of the company.
Future dividends are applied against the balance to repay the company. The company usually charges interest.
One of the downsides is the vendor shareholder or director associated with these shares is providing security for the loan, as well as a personal guarantee.
The company pays, funds lent back
Like above, except no loan is drawn down from the bank.
Funds are lent/paid to the purchasing shareholder, who settles with the vendor for their equity investment.
The vendor shareholder readvances the funds back to the company, i.e., the original cash position of the company is maintained.
The purchasing shareholder is a debtor of the company, with the vendor shareholder being a creditor.
Future dividends are applied against the balance to repay the company.
Interest should be charged/paid to the respective parties.
The vendor shareholder should consider security for the balance owed by the company.
Debt between vendor and purchaser
The debt is between the vendor shareholder and the purchaser, outside the company balance sheet.
The vendor is effectively acting as the bank.
Terms and conditions should be agreed including security, interest rate, repayment terms etc.
It is normal for there to be a link between dividends and repayment.
The percentage of dividends to be applied against the loan can vary.
The three scenarios above do not need to be mutually exclusive, there could be a blend of two or more, depending on the circumstances. What next?
Although vendor finance is a funding option that can help kickstart a succession plan, there are downsides and pitfalls to be mindful of before going ahead. It’s essential to speak to your advisor and ensure your business succession plan is the right one for you. To speak to an advisor contact us at findex.co.nz