A vendor loan note is a second layer of leverage that the seller provides: the arithmetic of what it adds to the sponsor's return, where it starts to hurt, and what it costs the seller.
A vendor loan note replaces part of the sponsor's equity with subordinated debt from the seller, so it raises the equity IRR whenever the deal earns more than the note's rate and lowers it whenever it earns less. On an illustrative 450.0 buyout, a 50.0 note at 8 per cent PIK cuts the equity cheque from 200.0 to 150.0 and lifts the five-year IRR from 14.3 to 16.1 per cent at a 9.0x exit. Below a 7.40x exit, the same note lowers the sponsor's IRR, and at every exit it reduces the profit in money.
Worked in full in The Buyout Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Vendor financing, also called a vendor loan or seller note, appears when the banks will lend no more and the sponsor will not pay more equity: the seller leaves part of the price in the business and is repaid at exit. It is one more layer of leverage, and it behaves exactly like one.
| Input | Value |
|---|---|
| Entry EBITDA and multiple | 50.0 at 9.0x |
| Enterprise value | 450.0 |
| Fees and cash to balance sheet | 15.0 + 10.0 |
| Bank debt at closing (5.5x) | 275.0 |
| Vendor loan note | 50.0 |
| Note rate, compounding, no cash interest | 8% |
| Exit EBITDA after five years, exit multiple | 60.0 at 9.0x |
| Net bank debt at exit | 150.0 |
Because the note pays no cash interest, it does not slow the repayment of bank debt: net debt at exit is the same 150.0 with or without it. That keeps the comparison clean.
Step 1: sources and uses. Uses are 450.0 + 15.0 + 10.0 = 475.0. Without the note, equity balances it at 475.0 − 275.0 = 200.0. With it, equity falls to 150.0, and total leverage at closing goes from 5.5x to 6.5x EBITDA. The note is 11.1 per cent of the price.
Step 2: what the note costs at exit.
Note at exit = 50.0 × 1.085 = 50.0 × 1.4693 = 73.5
Exit equity before the note = 60.0 × 9.0 − 150.0 = 540.0 − 150.0 = 390.0
Exit equity after the note = 390.0 − 73.5 = 316.5
In Excel: =ExitEquity-VLN*(1+Rate)^Years, then =(EquityOut/EquityIn)^(1/Years)-1 for the IRR on a single exit.
Step 3: returns.
| Structure | Equity in | Equity out | Gain | MOIC | IRR |
|---|---|---|---|---|---|
| No vendor note | 200.0 | 390.0 | 190.0 | 1.95x | 14.3% |
| 50.0 note at 8% | 150.0 | 316.5 | 166.5 | 2.11x | 16.1% |
The note adds 1.8 points of IRR and 0.16x of multiple, while reducing the sponsor's profit in money from 190.0 to 166.5. That is the usual trade of leverage: a better rate of return on less capital. The gain exists only because the 8 per cent the seller charges is below the 14.3 per cent the equity earns without it. Set the note's rate equal to that 14.3 per cent and it changes nothing.
| Note rate | Note at exit | Equity out | MOIC | IRR |
|---|---|---|---|---|
| 0.0% | 50.0 | 340.0 | 2.27x | 17.8% |
| 6.0% | 66.9 | 323.1 | 2.15x | 16.6% |
| 8.0% | 73.5 | 316.5 | 2.11x | 16.1% |
| 10.0% | 80.5 | 309.5 | 2.06x | 15.6% |
| 12.0% | 88.1 | 301.9 | 2.01x | 15.0% |
| 14.3% | 97.5 | 292.5 | 1.95x | 14.3% |
| 16.0% | 105.0 | 285.0 | 1.90x | 13.7% |
| Exit multiple | Exit equity | No note | IRR | With note | IRR |
|---|---|---|---|---|---|
| 6.5x | 240.0 | 1.20x | 3.7% | 1.11x | 2.1% |
| 7.5x | 300.0 | 1.50x | 8.4% | 1.51x | 8.6% |
| 8.0x | 330.0 | 1.65x | 10.5% | 1.71x | 11.3% |
| 9.0x | 390.0 | 1.95x | 14.3% | 2.11x | 16.1% |
| 10.0x | 450.0 | 2.25x | 17.6% | 2.51x | 20.2% |
The note is neutral when the equity without it earns exactly 8 per cent: exit equity of 200.0 × 1.085 = 293.9, an enterprise value of 443.9, or 7.40x EBITDA. Above that it helps, below it hurts, and the spread widens in both directions. It is the same asymmetry that bank debt creates, measured in how much of an LBO's return comes from leverage.
A note at 8 per cent on a subordinated, illiquid claim behind 5.5x of bank debt is cheap money. If the seller would demand 12 per cent for that risk, the note is worth:
PV = 73.5 ÷ 1.125 = 41.7
The seller has given up 8.3 of value, 1.8 per cent of the price. The headline stays at 9.0x, but the price actually paid is 441.7, or 8.83x.
That is often the real function of a vendor note: it lets both sides announce the seller's price while the buyer pays less. Read it as a price concession as well as a financing.
Comparing the two structures on the multiple alone, or calling the note "free" because it pays no cash coupon. Interest that rolls up is still interest: at 8 per cent the 50.0 becomes 73.5, and it comes out of the equity at exit before the sponsor sees anything. Model the rolled-up balance, not the face value, and check the IRR at a low exit as well as the base case.
Check also how the note ranks. Bank lenders will usually require it to be subordinated and to receive no cash until they are repaid, which is what makes it behave like equity in a bad year and like cheap debt in a good one.
A vendor loan note is leverage provided by the seller. At 8 per cent against a deal earning 14.3 it adds 1.8 points of IRR; below a 7.40x exit it subtracts. The full sources and uses and exit waterfall of a buyout of this size are in the free workbook for this case.
Legally it is debt, usually subordinated to the bank lenders and with interest rolled up rather than paid in cash. Economically, for the sponsor it behaves like cheap leverage: in the illustrative case 50.0 at 8 per cent compounds to 73.5 at exit and the sponsor keeps everything above that, lifting its IRR from 14.3 to 16.1 per cent.
To bridge a price gap or to get a deal financed when banks will lend no more. The cost is real: a note at 8 per cent that the seller would value at 12 per cent is worth 41.7 today, not 50.0, so the seller has quietly cut the price by 8.3, from 9.0x to 8.83x EBITDA.
When the equity returns less than the note's rate. The note is neutral when the unlevered equity IRR equals the note's 8 per cent, which in the illustrative case is an exit at 7.40x EBITDA. At 6.5x the IRR falls from 3.7 to 2.1 per cent because of the note.
This article is one calculation from The Buyout Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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