What are the pros and cons of seller financing for the buyer and the seller of a business?

BDC (the Business Development Bank of Canada) describes vendor financing as a form of business acquisition debt that lets the buyer hold back part of the purchase price as a debt to the vendor. The effects land differently on each side of the table. This page sets out the consequences that BDC and the Canada Revenue Agency (CRA) state, one side at a time, without recommending either choice. How a take-back is built is covered in seller financing explained.

What the buyer may gain

BDC says vendor financing reduces how much cash the buyer needs on hand to close, which leaves more liquidity for operations and unanticipated expenses. It also says the payment terms are usually less rigid than traditional bank financing, and that can mean no payments for several months or interest-only payments for a set period. BDC adds that having vendor financing in place can help a buyer secure bank loans they were unable to get without it.

What the buyer should weigh

BDC notes that under a vendor financing agreement the former owner has a vested interest in the company’s success after the sale. Ask what role the seller expects to keep. The buyer’s promise is also a debt. Under section 176(1) of the Bills of Exchange Act, a promissory note is an unconditional written promise, signed by the maker, to pay a sum certain in money on demand or at a fixed or determinable future time to a specified person, to that person’s order or to bearer. A buyer who signs one has put that promise in writing.

What the seller may gain and give up

BDC says that in almost all cases vendor financing is junior debt, subordinate to bank loans and other financing, and that the seller should understand this from the outset. On the tax side, the CRA says that when proceeds of a capital property are received over several years, a seller may be able to claim a reserve. Usually that lets the seller report a portion of the gain in the year the proceeds are received, based on the part not yet received.

The CRA says the maximum period over which most reserves can be claimed is generally four years, with a nine-year period provided for in some cases. The CRA also says that, generally, a reserve cannot be claimed in a tax year if the seller was not resident in Canada at the end of that year or at any time in the following year, was exempt from tax at either of those times, or sold the property to a corporation the seller controls in any way. Whether a reserve is available depends on the sale, so the seller’s accountant should confirm it against the CRA page before the terms are set.

What both sides should do early

BDC says the vendor’s own legal and financial teams should approve the terms, and that if they do not see the terms until closing, the whole deal could fall through. Show the draft terms to the seller’s advisers and the bank early. Ask the buyer’s lender how it will treat the ranking of the take-back.