Tuesday, March 08, 2005

Vendor Financing

A great article........could not have said it better myself

Vendor Madness - An article from VanCity

When a business is sold there is often a vendor financing component to the transaction – i.e. a portion of the purchase price that the seller is willing to receive over a period of time. In many cases the level of vendor financing can be considerable…which prompts the question "just what are vendors thinking?!"

Vendor financing typically commands little or no interest and has a fully subordinated claim on both the cash flow and assets of the business. As an asset class it consistently defies the typical relationship between risk and expected return in that the vendor essentially faces an equity risk level and generates at best a return (0% to 8% interest) commensurate with a fully secured debt position.

Additionally, it makes little sense from the vendor’s personal portfolio perspective. Often when a business is sold it is because the vendor seeks to retire. In retirement one typically wants to hold an investment portfolio that is relatively low risk, liquid and diversified. A sizable vendor note meets none of these objectives as it is a high risk, illiquid investment in a single private company that the vendor no longer controls. So why do vendors do it? Likely one of three reasons:

1. They don’t price for risk. After all, they’re not finance geeks…and thus may not fully understand the true price of risk. Generating a 7% return might sound OK when GICs are paying 2%...if you don’t realize the price of equity risk is 30%.
2. They underestimate the level of risk. The vendors know the businesses they are selling intimately and often feel very comfortable that the businesses will be successful going forward – classic entrepreneur’s bias. Since they perceive there to be little or no risk they are comfortable accepting a lower return. However, a subordinated investment in any small to medium sized private company is risky…particularly in one where the vendor no longer has a controlling interest.
3. They have to provide significant vendor financing in order to close the sale. In some circumstances this may be a valid reason. However, in today’s market there are more buyers than sellers so the vendor is typically in a strong negotiating position. Additionally, there are institutional financing tools such as subordinated debt that are ideally suited to financing the goodwill component of a transaction and thus can substantially reduce the need for vendor financing.

So to the vendors out there…don’t carry more than you have to…call Vancity Capital before you complete your deal - it could mean a lot more cash for you at closing!

Used with permission

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