What are the risks of vendor loans and how can they be mitigated?

While vendor loans can unlock value and enable deals that might otherwise fall through, they also introduce a level of risk for the seller.

Understanding those risks is an important part of structuring a vendor loan. In this article, we explore the key risks involved, how they can be mitigated, and some practical examples of how vendor loans are used in real transactions.

For an introduction to vendor loans, you can read our first blog in our vendor loans series here. To find out more about how vendor loans can be structured, and their tax implications, you can read our second blog in the series here.

Why does repayment depend on the success of the business?

The most significant risk with a vendor loan is that repayment is typically dependent on the ongoing performance of the business.

Vendor loans are most commonly seen in Management Buyout (MBOs) and Employee Ownership Trust (EOT) transactions, where external funding has either been fully utilised or is not available. Unlike a sale to a trade or equity backed buyer, that would have their own means of cash generation. As such, the ability of the buyer to repay that loan is usually tied to the business generating sufficient cash flow.

This means the seller remains indirectly exposed to the company’s future performance even after they have stepped away from ownership.

If the business performs well, the loan is repaid as expected. However, if trading conditions deteriorate or the business struggles under new ownership, the repayment of the vendor loan may be delayed or at risk.

How can economic shocks affect vendor loans?

External events can have a significant impact on the ability of a business to repay a vendor loan.

In the past, these types of events were often described as “black swan” scenarios – unexpected shocks that were unlikely to occur. However, recent years have shown that economic disruption can happen more frequently than anticipated.

Examples include:

the impact of COVID-19, which disrupted supply chains and customer demand.
the economic uncertainty following Brexit.
wider global disruption linked to events such as the war in Ukraine, and more recently the war in Iran.

Even businesses that appeared stable at the time of sale can be affected by these kinds of events. For example, a business that completed an MBO shortly before the pandemic may have suddenly faced falling demand, rising costs, and supply chain challenges. In those circumstances, servicing a vendor loan becomes much more difficult.

This highlights the importance of considering risk carefully when structuring these arrangements.

What protections can vendors put in place?

Although risk cannot be eliminated entirely, there are several ways vendors can protect themselves when agreeing to a loan as part of a transaction.

One of the most important is ensuring the vendor loan agreement contains appropriate covenants and protections, similar to those used by banks.

These may include:

financial covenants, which monitor the performance of the business.
information rights, allowing the vendor to receive regular management accounts.
security over shares or key assets, where appropriate.
default provisions, outlining what happens if repayments are missed.

These measures do not give the vendor day-to-day control over the business, but they can provide early warning signs if performance begins to decline, at which point the vendor can have the right to exercise more direct control over the business.

Control is only needed when performance is not as expected, and the vendors outstanding loan is at risk. In practice, this allows the vendor to move from a passive role to a more active monitoring position if the situation requires it.

How can vendor loans be structured to reduce risk?

The structure of the loan itself can also help mitigate risk and align incentives between the seller and the buyer.

For example, the repayment period and interest rate can be designed to reflect the expected growth of the business. Early years may include lower interest or more flexible repayments to support the management team as they adjust to ownership.

Over time, the interest rate may increase, encouraging the business to refinance the vendor loan through traditional bank funding once it has established a track record under new ownership.

This type of structure helps balance the needs of both parties:

the business has time to stabilise and grow
the vendor has a clear path towards repayment

What do vendor loans look like in practice?

Vendor loans are often used in situations where there is a gap between the agreed value of a business and the funding available to complete the transaction.

For example, a business generating £1 million of EBITDA might be valued at around £5 million based on market multiples. However, lenders may only be willing to provide around £2 million of funding.

In this scenario, the transaction might be structured as follows:

£1 million funded from existing cash within the business
£2 million funded through bank lending
£2 million funded through a vendor loan

This structure allows the seller to receive a significant portion of the proceeds upfront while enabling the buyer to complete the transaction without overextending financially.

Similar structures are often used in MBOs where the management team may not have the capital to purchase the business outright but have the operational knowledge to run it successfully.

How can Price Bailey help?

Our team at Price Bailey can provide real value at each stage of selling your business, not only offering the benefit of our extensive sell-side experience, but also drawing on insights from our buy-side work to anticipate and address potential issues.

We also work closely with our tax specialists to ensure the structure of a transaction supports both the commercial outcome of the deal and the seller’s wider tax position.

We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.

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