Vendor deferred loans are a form of vendor finance where a vendor offers a loan to a customer so that they may buy from the vendor. Vendor financing is common where traditional financial institutions are unwilling to lend a business significant amounts of money.
In this article we will be covering:
- What is vendor financing?
- What are vendor loan notes?
- What is the difference between deferred consideration and an earnout?
- What are the advantages of an earn-out?
- What are the disadvantages of an earn-out?
- What are the key terms of an earn-out?
- What are vendor notes?
- What are the tax implications of deferred consideration?
- What is entrepreneurs’ relief?
- Losing the ability to qualify for entrepreneurs’ relief
What is vendor financing?
There are two main forms of vendor financing: debt financing and equity financing. In vendor debt financing, the vendor lends money to a borrower to buy the vendor’s products or property. In vendor equity financing, the vendor will subscribe for shares in the borrowing company. This money then provides funds to purchase the vendor’s products or property.
A common form of vendor debt finance is vendor loan notes. Vendor loan notes are a common feature in management buy-in/buy-out (MBI/MBO) deals where some component of the sale price is deferred. On a MBI/MBO, as much as 50% of the purchase price may be deferred and paid out gradually over 3-4 years.
What are vendor loan notes?
Vendor loan notes are a debt representing part of the purchase price owed from a buyer to a seller.
In a buyout, the vendor loan notes represent part of the purchase price for the business that is deferred until a later date. Vendor loan notes may be subordinated to the finance provided by the buyer. The loan notes will typically have similar terms to equity investor loans but with a lower rate of return.
What is the difference between deferred consideration and an earnout?
Deferred consideration is where a seller agrees to defer part of the purchase price. The price is normally fixed but the buyer does not have the funding available to pay the full price. An earnout is a type of deferred consideration where the purchase price is calculated with reference to some future performance.
Earnouts are commonly seen in mergers and acquisitions where the sellers are individuals and where there is some uncertainty over the future performance of the company. An earnout is normally structured so that if the target business meets certain goals then the sellers will receive more money. As part of the sale price, the sellers may receive the right to further cash, shares or loan notes at a later date, with the value determined by the future profits of the company. Frequently, the sellers will continue to work for the company during the earn-out to ensure a smooth transition.
In a typical earn-out, a buyer will make an initial payment on completion followed by one or more deferred payments. These deferred payments will be contingent on the company meeting certain goals. Historically, earn-outs were calculated by reference to the target company’s profits over a period of two to three years following completion.
What are the advantages of an earn-out?
Earn-outs can be an attractive option if the buyer and seller cannot agree on the value of the target company. For example, the buyer and seller may have different views on the future profitability of the company or on the impact of the acquisition.
Earn-outs may also be attractive, if the buyer has limited access to funds. For example, if the buyer does not have access to debt financing then deferred payments can help reduce the buyer’s reliance on third-party funding.
From a seller’s perspective, an earn-out provides a mechanism by which the seller can reap the full benefit of selling the business. The seller may also hope to benefit from synergies realised as a result of the acquisition.
From a buyer’s perspective, an earn-out provides a more realistic valuation of the company and protects the buyer from overpaying. Only if the business proves more profitable will the buyer be required to pay more. Delaying part of the purchase price may also deliver cash flow benefits for the buyer. The earn-out may also help align the seller’s interests with the buyer’s to ensure that the company is as profitable as possible.
What are the disadvantages of an earn-out?
The disadvantages of an earn-out include that they mean that the seller will retain a significant interest and involvement in the business after completion. The buyer may feel constrained in its ability to do what they want with the business.
Disagreements can also arrive over how the earn-out targets are calculated and how the buyer runs the business following completion. Economic factors and other business acquisitions may also depress profitability and may jeopardise earn-out targets.
Earn-outs are often criticised for encouraging short termism amongst sellers and require time and resources to monitor the company’s performance against pre-set goals. Earn-outs are also often hotly debated and can significantly extend the timetable needed to get a deal done.
What are the key terms of an earn-out?
The key terms of an earn-out tend to be:
- Targets – the performance indicators against which a company will be judged
- Length – the period of time that the earn-out period will last
- Disputes – the process for resolving disputes over the earn-out
- Restrictions – on how the buyer may run the company after completion
What are vendor notes?
Vendor notes are short-term loans to a customer that are secured by the goods the customer buys from the vendor. Typically, vendor notes will become repayable after three to five years. Vendor notes vary but may place limitations on the types of business practices the buyer can engage in or restrict the borrower’s ability to acquire other inventory unless certain financial ratios are maintained.
What are the tax implications of deferred consideration?
One of the biggest risks with deferred consideration is unplanned tax liabilities. For example, entrepreneurs’ relief does not apply to deferred consideration and HMRC assesses deferred consideration as income rather than a capital gain.
What is entrepreneurs’ relief?
Entrepreneurs’ relief reduces the amount of capital gains tax (CGT) an individual must pay when they sell shares in all or part of their business. The person selling the shares must own at least 5% of the ordinary share capital of the company, they must be an officer or employee of the company and the company must have traded for at least 24 months prior to the sale.
Entrepreneurs’ relief results in a tax rate of 10% on the value of the sale. There is no limit on the number of times an entrepreneur may claim the relief and they may claim up to £10 million of relief during their lifetime.
Losing the ability to qualify for entrepreneurs’ relief
An entrepreneur may not qualify for relief on deferred consideration, even if the payment would have qualified if it had been made on completion. This is because the seller may no longer be employed in the company or may no longer own at least 5% of the share capital of the company.