Vendor finance, ranking and subordination in an acquisition

The structuring question, not the product question

What vendor finance is as a funding route, the three forms it takes and how each is treated for tax is covered in vendor and seller finance. This page is about the part that decides how much external money you can raise alongside it: where the seller sits in the queue, what document puts them there, and what a senior lender will accept before it agrees to share the deal with a second creditor.

The distinction matters because two deals with identical amounts of seller money can produce completely different answers from the same lender. One is read as the buyer's stake, sitting behind the bank and absorbing the first losses. The other is read as another loan competing for the same monthly cash. The difference is drafted, not negotiated.

Ranking, and what it actually decides

Ranking is the order in which people get paid, and it operates in two places that are easy to confuse.

In the bad case, ranking decides who recovers what from whatever is left. The senior lender takes its security and is paid first, which is what the word senior means. Whoever is behind it recovers from what remains, and in most failures there is nothing there. This is the ranking that gets talked about.

In the ordinary case, ranking decides who is allowed to be paid month by month while the business is trading normally, and this is the one that affects the deal. A senior lender that has sized a facility against the cash the business generates does not want another creditor drawing on the same cash on a schedule it cannot see or control. So the terms it imposes are about permitted payments, not just about enforcement.

The practical result is that a seller can be perfectly well ranked and still be paid on time every year, because their payments sit inside what the senior lender has permitted. What they cannot do is jump the queue when things go wrong, or take action that forces the issue.

The subordination deed, and what is in it

Ranking between two lenders is a contract, and in an SME acquisition it is usually a subordination deed or a deed of priority between the senior lender, the seller and the buying company. Where the second creditor is a commercial funder rather than the seller, the same job is done by an intercreditor deed, which is longer and harder fought.

The provisions that do the work are these.

The payment block. Deferred instalments may be paid on their agreed dates provided no default has occurred under the senior facility, and provided the covenants are being met with a stated margin. On a default, payments to the seller stop until the position is cured.
The standstill. If the seller is not paid, they may not take action for an agreed period, which gives the senior lender time to deal with the problem before anyone starts enforcing. Standstill periods are typically stated in months and are one of the most negotiated numbers in the document.
No security, or security ranking behind. Most senior lenders will not permit the seller to hold a charge over the trading company at all. Where any is permitted it ranks second, and it cannot be enforced independently.
No acceleration. The seller may not demand the whole deferred amount early while the senior facility is outstanding, whatever the loan note says on its face.
Turnover provisions. If the seller receives money they were not permitted to receive, they hold it for the senior lender and pay it over. This is the clause that makes the rest of it enforceable.
Interest treatment. Whether interest on the deferred amount may be paid in cash, or must be rolled up and paid only once the senior facility is clear.

A seller reading that list for the first time in the final fortnight tends to react badly, and reasonably so. It is a long way from "we agreed you would pay me over three years". Raise it early.

Equity or debt, and how the test is applied

Whether a lender counts the seller's money as part of the buyer's stake is the single most valuable thing to establish before the structure is fixed, because it changes what the deal can carry.

A deferral is far more likely to be counted in the buyer's favour where it is unsecured, formally subordinated by deed, carries no right to accelerate or enforce while the senior facility is outstanding, is payable only out of cash remaining after the senior lender has been paid, and runs for a term at least as long as the senior facility. Anything that lets the seller jump the queue, take security, or demand early repayment moves it back into the debt column, and the facility is sized as though there were two loans.

Note what is not on that list: the size of the deferral, and the interest rate on it. Those are commercial terms between buyer and seller. The classification is about control and ranking.

There is no published list of which lenders apply which test. It is individual credit policy, it moves, and the only reliable way to know is to have asked recently. That is the specific thing worth finding out before heads of terms rather than after.

What it does to the senior facility

Bringing a second creditor into a deal changes the senior facility in ways that are worth anticipating.

The covenants tighten. A debt service cover test will often be defined to include the deferred payments, so the business has to cover both out of the same cash. A gearing test may count the deferral as borrowing even where the lender has been willing to treat it as stake for sizing purposes, which is not a contradiction: those are two different questions asked at two different moments.

The documentation lengthens. A subordination deed is a three-party document, and all three have to agree it. It is not a formality and it is not something a solicitor can produce overnight when someone remembers it.

The permitted payments schedule becomes real. Once the deed is signed, the buyer cannot simply agree with the seller to pay early because it has been a good year. Doing it anyway is a breach of the senior facility, and the turnover provision means the money comes back.

How all of this sits alongside the other pieces of a structure, and the order lenders expect to see them presented in, is covered in stacking facilities.

The sequence that avoids the argument

Most of the trouble with seller money comes from doing things in the wrong order. The order that works looks like this.

Agree the commercial shape with the seller in principle, including how much is deferred and over what period, but not the fine terms.
Establish how a lender will treat that shape, and what it will require on ranking, before the heads of terms fix anything.
Write the ranking position into the heads of terms explicitly, so the seller knows from the start that subordination is a condition of the funding rather than a late demand from the bank.
Let the solicitors draft the deed alongside the sale agreement rather than after it.

What belongs in that heads of terms document, and what should deliberately be left out of it, is covered in heads of terms. How the amount and measurement of the deferral itself are settled is in deferred consideration and earn-outs.

What goes wrong

The subordination deed is left to the last week. Three parties, one of whom is emotionally invested in the business and has just been told they rank behind a bank. This is the single most common cause of a late stall in an SME acquisition.

The seller was promised security. A seller told early on that they can have a charge over the company, by someone who had not asked the lender, has been set up for a confrontation nobody needs.

The loan note and the deed contradict each other. The note says the seller may demand repayment on a default. The deed says they may not. The deed wins, and everyone finds out at the worst moment.

Nobody modelled the permitted payment test. A deferred instalment that can only be paid if the cover ratio is above a stated level is not a certainty, and a seller who assumed it was will treat the first missed payment as a breach of faith rather than as the deal working as drafted.

The deferral outlives the covenant headroom. Deferred payments that fall due in the same period as the heaviest capital repayments create a pinch point that looks fine in an annual forecast and is not fine in the month it happens.

Where it matters most

Seller money does the heaviest lifting in deals where the value is in relationships rather than assets. In accountancy practice purchases the staging is close to universal, and the ranking question comes up on almost every file. The same is true wherever a founder personally holds the customer base, which is most of HVAC and the trade services sectors.

Where seller money is not available and a gap remains, the alternatives are more expensive and bring a commercial lender into the same ranking conversation with far more teeth. That comparison is made honestly in mezzanine in an SME context. Terms that appear in a subordination deed and nowhere else are in the glossary.

Finding out how yours will be read

We know this market and we know specific people who fund these deals, so the useful thing we can do is tell you whether the deferral you have agreed will be read as stake or as debt before the structure is fixed and the solicitors are instructed.

Tell us what has been agreed with the seller and how the rest of the money is meant to work. We go to the lenders and brokers who fund deals of that shape, and we come back to you with who can fund it and what they will want to see.

We introduce buyers who are acquiring through a limited company or a NewCo. If you are buying personally, as a sole trader or as a partnership, we will point you to an authorised firm directly instead.