Vendor Financing in the Purchase of a Business
In carrying out a purchase and sale of a business, it is not uncommon for a potential purchaser to have difficulties in obtaining financing through traditional financial institutions such as banks or credit unions. As an alternative, the vendor may be agreeable to providing some or all of the financing to the purchaser.
Vendor financing can be beneficial for both the purchaser and the vendor. Not only does the purchaser have the benefit of obtaining financing that he/she may not otherwise have obtained through conventional means, but the purchaser may also be able to set off, against the outstanding balance, any losses incurred as a result of the vendor failing to disclose liabilities or misrepresenting information.
By providing financing to the purchaser, the vendor has the ability to obtain the full value of the shares or assets sold, with interest (often at rates above those of financial institutions). Further, depending on the type of security in place, the vendor may be in a position to recover and act against the purchaser’s known assets in the event of default.
Options for Securing the Loan
There are a variety of options for a vendor to secure a loan to a purchaser. Some of those options include:
- a security agreement against personal property of the purchaser;
- in the context of a share sale, a share pledge agreement under which the purchaser pledges the subject shares to the vendor until the purchase price is paid;
- a personal guarantee by the principal of the purchaser or another party (such as a relative); and/or
- a mortgage against any real property (land) owned by the purchaser.
A security agreement can be either general, charging all of the personal property of the purchaser, or specific, charging particular assets of the purchaser such as vehicles or equipment. A security agreement can also be structured to secure either a specific obligation (i.e. a loan agreement for the balance of the purchase price) or all of the purchaser’s obligations to the vendor (present, future, direct or indirect).
Share Pledge Agreements
In the context of a purchase and sale of shares, a share pledge agreement allows the vendor to take back the shares sold in the event of a default by the purchaser. Unless and until there is a default, the purchaser has all rights of ownership, including the right to receive dividends and to vote. The shares of the company are registered in the name of the purchaser, and the share certificate is endorsed in blank for transfer and placed with a third party (the escrow holder) who holds the share certificate in trust. Vendors should be aware, when considering this type of security, that the purchaser may deplete the business while it is under the purchaser’s control, leaving little for the vendor to repossess upon default.
Where the purchaser of the business is a newly-incorporated company, it is usually in the best interests of the vendor to obtain a personal guarantee from the principal of the purchaser company, as the purchaser’s assets are likely limited. If the principal is also of limited means, then additional personal guarantees from other parties, such as relatives of the principal, may also be obtained.
In a share sale transaction, the vendor corporation may also provide a guarantee for the purchase price, which can then be secured by security interests or mortgages in the assets of the vendor corporation. This provides the vendor with some assurance that the company will not be stripped of assets before the full purchase price has been paid.
It is important to note that the enforceability of personal guarantees can be limited by a number of factors, including bankruptcy of the guaranteeing party.
A purchaser can also provide security by way of a mortgage over real estate it currently owns or, in an asset purchase transaction, over a piece of property that is among the assets being sold.
It is also important for the vendor to consider the priority that the security will have in relation to that of other securities the purchaser has or may promise to other lenders.
Where both conventional financing and vendor financing are involved, the bank will generally insist that its security rank first and may require the vendor to enter into a priority agreement postponing the vendor’s interest in favour of the bank. In this situation, a vendor should ensure that there are limits on the amount of credit that the bank can secure ahead of the vendor and that the vendor retains the ability to enforce its security should the purchaser default.
Although vendor financing can be advantageous for both the vendor and the purchaser, there are a number of issues to consider. If you are considering vendor financing (as a vendor or a purchaser), speak with a lawyer to ensure that you have a complete understanding of your rights and obligations.