In a previous post, I talked about vendor financing. In this post, I am going to give a numerical example of how it may work from the point of view from a private equity firm. Let’s start with a few assumptions. 

• My private equity firm is interested in buying TPE Healthcare
• TPE Healthcare has FY09 EBIT of $10m
• Based on previous analysis, I decide that the highest multiple I will pay is 7x
• The owner of TPE Health care wants $85m for the business

So, the highest price I can pay (and justify to my investors) is 7x $10m, which is $70m. However, the owner (or vendor) wants $85m. In preliminary talks I explain the concept of vendor financing and that it may help to get the deal done. The vendor wants to retire and I think TPE Healthcare is a great business, so we really want to come to an agreement.

I start with the idea of paying $50m initially and $35m in three years. The total is $85m, which the vendor wants, but the deferred $35m is worth less when considering a dollar today is worth more than a dollar tomorrow (let’s assume we don’t have a deflating currency). Say I use a 20% discount rate as the opportunity cost of my funds. (So, I’m inferring that I think I can invest my money for 20% elsewhere if I had to.) Discounting the $35m back to today’s money results in a present value of 35/(1.2)^3 = $20.25m. So the real value of the proposed deal is $50m + $20.25m = $70.25m, which is close enough to the $70m limit that I hoped to pay.

If we agree on this structure, I’ll pay $50m upfront with a combination of equity and debt. Then in three years’ time, hopefully the business is performing much better, and I can decide to pay the $35m in either cash or completely with debt (since earnings should be much higher). The risk, of course, is that the business goes backward and I can’t afford the $35m. In this case, I’d have to call on equity from the fund, which would be a very bad outcome. So, there is certainly risk with vendor financing, but it’s important to remember that the present value of the deal is still $70m, which I was fine with paying (as long as I believe in my discount rate too).