Vendor Financing (Seller Note) in a Business Sale

Vendor financing is the part of the purchase price that the seller agrees to lend back to the buyer. At closing, the buyer pays cash from its own equity and any bank loan, and signs a promissory note for the balance. The seller becomes a creditor of the business it has just sold.

A seller note fills the gap between what a bank will lend and what the business costs. It also sends a signal: a seller willing to be paid over time is telling the buyer and the lender that the cash flow supports the price. In owner-managed sales the note is usually a minority slice of the price that sits behind senior bank debt; its size depends on the buyer's cash, the lender's limits and the seller's appetite for risk.

Not the same as a VTB mortgage. A vendor take-back mortgage is seller financing secured by a registered charge on land and enforced under mortgage law. Vendor financing in a business sale is normally secured on the business's personal property and shares instead. If the sale includes the building, both can appear in one deal.

Not an earn-out. A seller note is a fixed debt, owed whatever the business earns. An earn-out is contingent price, paid only if the business hits agreed targets after closing.

The note's commercial terms are negotiated, not set by statute. The usual checklist:

Because the note is part of the price, its terms belong in the share purchase agreement or asset purchase agreement as well as in the note itself. Settle them at the letter of intent stage: our guide to negotiating a letter of intent as the seller explains why a take-back should be treated as a loan with interest, security and a guarantee from the start.

Set-off deserves early attention. A buyer that finds a breach of the seller's representations after closing will want to stop paying until the claim is resolved. A seller will want set-off limited to claims that are agreed or finally decided, so a disputed claim cannot freeze the payments. A purchase price holdback is the cleaner tool for indemnity security.

An unsecured note leaves the seller as an ordinary creditor of a leveraged buyer. The usual security package is:

• A general security agreement from the buyer and, in a share deal, often from the purchased company, covering present and after-acquired personal property.
• Registration of a financing statement under Ontario's Personal Property Security Act, which perfects the security interest. Between registered interests, priority generally follows the order of registration; PPSA registration and search explains the mechanics.
• A pledge of the purchased shares, so the seller can take back control of the company on default.
• Personal guarantees from the buyer's principals, because the buyer is often a new holding company whose only asset is the business.

Security is only as good as its rank, and in a bank-financed deal the seller's security usually ranks behind the bank's, whatever the registration order.

A bank lending to the buyer will usually make it a condition of its loan that the seller sign a postponement and subordination agreement, sometimes called an intercreditor or priority agreement. Section 38 of the PPSA allows a secured party to subordinate its security interest to another, and the subordination is effective according to its terms. The seller typically gives up two things:

• Postponement of payment. The note may be paid only as the agreement permits, usually scheduled interest and principal while the bank loan is in good standing, and nothing once the bank declares a default.
• Subordination of security. The seller's security ranks behind the bank's, whatever the order of registration.

Most agreements add a standstill, which bars the seller from demanding payment, suing or enforcing for a set period after a default or until the bank is repaid, and a turnover clause requiring the seller to hand over any payment received in breach. These terms decide whether the seller is paid in a downturn, so they deserve as much negotiation as the interest rate. Points worth pressing are a cap on the bank debt that ranks ahead, a time limit on the standstill, the right to keep receiving scheduled payments unless the bank has declared a default, and notice of any bank default.

The Canada Small Business Financing Program will not finance the part of the price the seller finances, so a buyer pairing a CSBFP loan with a seller note needs both lenders' terms to fit.

Seller. A capital gain is generally realized in the year of sale even if part of the price is paid later. Subparagraph 40(1)(a)(iii) of the Income Tax Act lets the seller claim a reasonable reserve for proceeds not yet due, which spreads the gain over at most five years, or ten for certain transfers; the capital gains reserve entry shows the calculation. The reserve does not defer recaptured depreciation in an asset sale. The commercial risk is that the buyer fails: the seller is lending to a leveraged business it no longer controls, behind a bank.

Buyer. A note reduces the cash needed at closing and keeps the seller invested in a smooth handover. Interest on the note is generally deductible under paragraph 20(1)(c) of the Income Tax Act where the business assets or shares were acquired to earn income. The cost is a second creditor with default rights and, usually, a personal guarantee.

Lamba Law's free seller financing calculator models note payments alongside bank debt and debt service coverage, and our vendor take-back and earn-out service drafts the note, security and postponement terms.

Teresa Almeida owns all the shares of a commercial printing company in Oakville. She agrees to sell them for $1.8 million to a holding company owned by Daniel Okafor. Daniel's bank will lend $1,080,000 and he has $360,000 of equity. Teresa takes a seller note for the remaining $360,000: five years at 7%, with equal monthly payments of about $7,130.

The security package is a GSA from both Daniel's holding company and the printing company, each perfected by a PPSA registration, a pledge of the purchased shares and Daniel's personal guarantee. The bank requires Teresa to sign a postponement and subordination agreement. Her lawyer negotiates that she keeps receiving scheduled payments unless the bank has declared a default, and that any standstill ends after 180 days.

In year three the company loses its largest customer and breaches a bank covenant. The bank declares a default and Teresa's payments stop. Because the standstill is capped, Teresa can demand payment and call on Daniel's guarantee once 180 days pass. Daniel refinances the bank debt with another lender before that point, and the new lender's postponement terms allow Teresa's arrears to be paid. Without the cap and the guarantee, she would have waited behind the bank with no leverage.