There are situations in which a bank loan is not a possibility when purchasing a business, property or other asset. This may occur because the buyer is unable or unwilling to secure a bank loan for the requested purchase price.
However, the seller may be eager to sell their asset and be willing to come to an arrangement that ensures this occurs. One such arrangement available to the parties is a vendor finance agreement.
Terms of Agreement
Vendor finance is a loan facility no different in nature to any other commercial loan agreement. Accordingly, the following terms should be carefully agreed in advance:
- the amount that is being loaned at settlement;
- the interest rate that will apply to the loan;
- the schedule for repayment of principal and interest;
- special arrangements for early repayment of the loan;
- details of security for the loan; and
- which party will pay the costs of the vendor finance documentation.
A formal agreement should be entered into and the parties should obtain legal advice about the terms of the documents.
To minimise the risk of vendor financing, the best option would be for the vendor to have security for the loan. It is common for the purchaser in these situations to provide a personal or director’s guarantee. Although this is useful, it is not optimal as it relies on the financial standing of the individual from time to time. We generally recommend to vendors that they request a personal guarantee from the purchaser’s director, alongside a better form of security.
Mortgage of land
The optimal security for the vendor finance is a registered mortgage of real property owned by the purchaser. The value of real property is typically stable, and often increasing, which makes real property ideal collateral.
For the mortgage to be practical, the mortgaged property should be unencumbered (there should not be an early mortgage against the property). If there is an earlier mortgage, the earlier mortgagee will have priority over the asset. If the purchaser already owes the existing mortgagee more than the market value of the property, the vendor finance mortgage will be fruitless.
At the time of the vendor finance loan, the real property may have an existing mortgage (commonly to the bank) but there could be some equity in the property which might be adequate security. In this case, it is critical that a ‘Deed of Priority’ is executed between the bank, the vendor and the purchaser apportioning the extent to which the mortgagees can recover from the land in the event of default.
Often the purchaser does not have unencumbered real property available (if they did, they could likely obtain finance from a bank in the first place).
Alternatively, the vendor can take security over the assets being sold as part of the transaction. This could be a vehicle, business assets, intellectual property or some other type of asset or right (in legal terms this non-land property is called ‘personal property’). Consideration needs to be given to the resale value of the assets when assessing the exposure.
As is the case for security over real property, it is important to ensure that there is sufficient equity in the security, in the event of a default. One common problem is that a bank or financier is already lending part of the purchase price, and will be taking their own security over the transaction assets at settlement. A ‘Deed of Priority’ may again be an option.
To protect the vendors security interest in transaction assets, the security should be registered in the Personal Property Securities Register (PPSR). With some limited exceptions, if the security interest is not registered the vendor may ultimately forfeit its rights.
Because the vendor finance is being provided to the purchaser to acquire the transaction assets, the security interest may be a special type of security called a ‘purchase money security interest’ (PMSI). By registering a PMSI, the security interest is perfected and takes priority over other secured parties, even if other secured parties registered their interest beforehand. However, to receive PMSI status, the security interest must be registered within stipulated timeframes.
Although vendor financing arrangements can be advantageous for both vendor and purchaser, there are commercial risks. When providing vendor finance, the vendor should consider the amount of purchase price to be financed. If it is a significant amount of the purchase price, it may be an indicator that the purchaser is not creditable (if the bank won’t advance them the money, why should the vendor?).
The purchaser will be taking control of the business and its operations. If the purchaser is unable to manage the business and its finances properly, it may result in the business becoming insolvent. In a case of insolvency, there is no guarantee that all creditors will be paid out in the full amount of their debt. A registered security interest would minimise this, however, it would still not guarantee recovery.
On the otherhand, in the case of business sales, the vendor is in a unique position to know the ‘real’ value of business and its profitability. The vendor may be very comfortable granting vendor finance if they have high confidence the business will continue to return a profit to the purchaser, enabling the purchaser to pay off the vendor finance on time.
It is important that any vendor considering a vendor financing option is cautious of the risks that can arise. The vendor should assess their business assets and ensure they seek professional accounting and legal advice about this arrangement.
If you are involved in a vendor finance arrangement or are looking to enter one, feel free to contact NB Lawyers to book a consultation.
Daniel Dash and Zahra Rashedi are part of the commercial law team at NB Lawyers working with individuals and business owners on a range of matters including business sales, property disputes, estate disputes, shareholder agreements, intellectual property, litigation and taxation matters.