What is Vendor-Take-Back Financing?
Vendor-take-back (VTB) financing or Vendor Financing has increasingly become a common tool used by automotive dealers to close acquisitions. In light of the recent COVID-19 crisis, VTB loans have also become an important substitute to traditional bank financing allowing dealers to continue closing deals; however, it has been fairly common to see that either the seller or buyer misunderstood the purpose and, most importantly, the value that VTB financing brings.
VTB financing occurs when the seller becomes the “bank” and finances a portion of the transaction by carrying a loan with similar terms you would commonly see from your traditional bank.
This article will help demystify and explain how VTB financing works and when it should be utilized to help close transactions quicker and realize greater value for the seller.
Based on our experience advising on more than 240 dealership transactions in North American markets and over $2B+ in closed transactions, we identified key terms and aspects essential to fully understanding VTB financing.
Size: VTB loans can make up between 10 to 25% of the goodwill purchase price. With COVID-19, while dealership goodwill values may not have decreased as much as initially thought, transactions are now seeing much larger VTB loans to account for the uncertainty in the market.
Security: All VTB loans rank behind the senior bank or financial institution which usually has a first position on the business through floorplan financing, an operating line of credit, or a senior term loan. To protect the value of the VTB, the seller would rank behind the bank and either take a second position in the property or a second charge on the business supported by a pledge of shares.
In some instances, should the seller holding the note require more assurance, a personal guarantee from the buyer may also be requested to support the VTB. An important aspect to understand is that a certain “tug-of-war” may follow: the more a seller requests in security, the less is available for the bank to leverage; therefore, resulting in a lower proposed loan. Advising on VTB security can be very complex and DSMA can help you navigate through these negotiations as your M&A advisor along with a trusted legal counsel.
Interest Rates: In the current marketplace, sellers will expect to receive anywhere from a 3% to 6% annual rate of return, depending largely on the size of the VTB loan as well as the quality of the dealership & prospective buyer. Typically, the interest (and amortization) is paid on a quarterly or annual basis. In very rare instances, a portion of the interest may also be capitalized or “rolled” onto the outstanding principal rather than paid in cash up front. This concept is referred to as a balloon payment at the end of the term.
Amortization: One of the most misunderstood components of VTB financing is the amortization of the loan. Sellers naturally want to get paid faster, whereas buyers prefer to keep as much money in the company after a transaction closes. In general, VTB loans in the automotive dealership world are usually amortizing starting in Year One and are paid back within 2 to 4 years. The industry is unique in this regard as VTB loans have much shorter amortization terms compared to other industries. Our team has also advised on transactions involving manufacturing and transport companies and VTB loans are non-amortizing (i.e. interest-only) for the first 2-3 years and the balance is either paid in full at the end of the term or amortized during the last two years of the term.
Additional Protection: Other overlooked aspects of VTB financing are financial reporting and loan covenants.
Like a traditional bank or financial institution, a seller may express a certain level of concern regarding the viability of the new buyer and can ask for additional protection to ensure the safety of their loan. Financial reporting, generally on an annual basis, can be required of the new buyer to ensure that the business continues to perform well while allowing the seller to stay up to date and offer to return to the operation on a consulting basis if the business does eventually underperform.
In rare instances, where the size of the VTB loan is significant (>25% of the transaction), the seller may also be able to negotiate a leverage covenant therefore limiting the new buyer from taking on more debt and adding more risk to the balance sheet post-close. Covenant breaches can be enforced by accelerating the loan repayments if the new buyer does not comply. Should the new buyer take on more debt, the seller will then receive additional repayments sooner, therefore reducing their overall risk.
In most instances, a VTB loan is a cheaper alternative to bank financing. Whether the note is secured against a property or the goodwill of the business, rates of 3-7% are comparatively much cheaper than third-party alternative loans costing 10% or more. The downside to this cheaper rate is the shorter amortization. Most senior banks will amortize their loans over 5-7 years whereas VTB loans amortize between 2-4 years meaning that the money costs less to borrow but must be paid back quicker. This is important to note because, the quicker the amortization, the less a senior bank is willing to lend on a transaction. Our recommendation to buyers is to try to negotiate an interest-only period ensuring that the business’ cash flow is not burdened by a short-term amortization.
The other pivotal component is security. In most automotive dealership transactions, the seller wants to secure the VTB against the property which poses a challenge. The higher the VTB loan, the less is available for the primary financial institution to secure against the property; in other words, the less the buyer can borrow. In other industries, securing against the business is enough for the seller, however in the automotive sector, goodwill security is usually not sufficient for the seller, hence the back-and-forth negotiation usually occurring during VTB security discussions. One common resolution we have experienced is taking partial security on the property with the rest supported by a pledge of shares and a charge on the business.
It is fairly common for parties to misunderstand the purpose of VTB financing. A stigma exists where Sellers will often associate a buyer suggesting VTB financing, with them not having the necessary funds to close a transaction and not being serious enough to get the deal done.
In reality, the primary reason why VTB financing arises is due to the strict lending guidelines banks force upon buyers resulting in a “gap”. We see this often in deals where the dealership is marginally profitable or in a break-even position but with strong upside. Banks lack the appetite to fund a significant amount of the asset base and require a high level of equity from the buyer on the working capital side resulting in little left for goodwill financing. Put simply, a VTB loan “bridges” the gap allowing the seller to realize their desired walk-away exit price while helping the buyer finance the gap outside of traditional banks. While there is a real risk involved with carrying a loan post-deal closing, with proper sell-side advice, your trusted advisor can easily vet and qualify the buyer to ensure that you, as the seller, are lending your money to the right person.
Lastly, we often see our successful sellers struggling to decide how to reinvest their proceeds from the sale, usually choosing to invest with a wealth management firm that charges them an annual fee of 1-1.5% on the money invested. If negotiated properly, a VTB loan is a great alternative to keep some of your proceeds invested post-sale at a 5-7% annual rate of return with NO management fees. The interest income received should not be viewed as a negative but rather as an investment alternative. Once again, structuring a VTB loan upfront in a secured manner is an integral part of why an advisor such as DSMA adds value to your transaction allowing you to enjoy a steady rate of return post-sale.
In summary, VTB loans are increasingly becoming a common component of dealership M&A transactions allowing buyers to finance the gap in their transactions while ensuring that sellers can reach their target exit number much more easily. While most dealers, today, may lack a clear understanding of the different structures of VTB financing and the levers that can be pulled, seeking proper professional advise by using an automotive M&A advisor allows sellers to control expectations and educates buyers on what is required to structure a VTB loan in a fair and competitive manner. DSMA has completed over 240 transactions with a number of these including a VTB component, our experience helps ensure that we structure your deal in the best way possible to maximize the amount of bank debt available and ensure the best price for you. Please reach out to any our team of professionals to learn more.