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You are selling your small business (business value under $1 million for this article).
You would like the buyer of your business to come in with an all-cash offer, or be
able to qualify for an SBA guaranteed loan. However, in many cases the owner of the
business ends up taking back the financing because the buyer is not able to make
an all-cash offer or does not qualify for an SBA guaranteed loan. So you create a
"business note" and you now become the "bank". At first that may seem okay, but
after a couple of years of receiving payments you may decide you want to get back
into business and you need the cash that is tied up in your business note on which
you are receiving payments. So now you want to sell your business note to raise
cash for your next business venture. What is it worth? That will depend a lot on how
you structured the note.
The objective of this article is to help you structure the
note so that it is more attractive to a prospective business note buyer.
Assumption: This article discusses the structure of a note that includes only the
business assets of a business. If a business also includes real estate that is being
sold at the same time as the business, that real estate should be sold in a
transaction that is financed separately from the business assets. This allows each to
be valued and financed in the most optimum manner. For example, it may be
possible to finance the real estate with a lower down payment, for a longer term,
with a lower interest rate, and without a personal guarantee.
The objective of a business note buyer or investor when buying future business note
payments is to minimize the risk of a default on the note. Therefore, they look for
specific things when evaluating the purchase of future payments from your business
note. Those include the following:
buyer's down payment
number of payments made on the note (also known as "seasoning")
buyer's credit history
personal guarantee of the buyer
total amount of payments being sold
cash flow of the business and past profitability
length of term of the note
payment amount
offsets
lien position of the note
amortization of the note
experience of the buyer with the type of business purchased
interest rate on the business note
documentation of the business sale
Unlike the purchase of a piece of real estate, the tangible assets of a small business
may not be adequate to cover the amount due on the business note if the buyer of
the business defaults. Therefore, the business note buyer is looking for ways to
lessen the likelihood of a default. If there is a default on the note, the business note
buyer will require that the business buyer follow through on their personal
guarantee which secures the business note.
A cash down payment of at least 33 percent should be made by the business buyer.
This down payment should not come from borrowed funds. The reason for requiring
such a large down payment is to make it less attractive for the buyer to "walk away"
from the business if they encounter problems. If they have a significant amount of
their own money invested in the business, they may think twice about walking away
from the business when things get tough.
If the down payment was less than 33 percent, then the business note buyer will
require that the difference be made up by additional payments on the business
note. The business note buyer wants to see that the new owner of the business has
at least a one-third equity investment in the business between the combination of
cash down payment and payments made on the business note while operating the
business.
Business note buyers want to see that at least two monthly payments have been
made on the note by the new owner of the business. For new owners of professional
practices such as doctors or dentists, a larger number of paid monthly payments
will be required. This serves a couple of purposes. It should show that the new
owner is generating cash flow from the business. It also allows the new owner to see
if the business is meeting their expectations. As part of the "due diligence"
performed by the business note buyer, they will interview the new owner to see if
any problems exist that might lead to future problems making payments on the
business note. They will want to know if the new owner was "mislead" by the seller
of the business.
The buyer of the business should have a credit score of at least 600. A higher score
is required by the business note buyer when the value of future business note
payments being purchased reaches a certain level. Any "clouds" on the business
buyer's credit history should not be current. These should have been resolved
before purchase of the business.
The business note must be personally guaranteed by the buyer. It cannot be
guaranteed by the company buying your business. Specifically, it cannot be
guaranteed by a person signing on behalf of the company. If there is a default, the
business note buyer will be coming after the personal assets of the individual(s)
making the personal guarantee. A personal financial statement for the buyer should
be obtained to verify that they have the necessary assets should it be necessary to
fulfill the personal guarantee.
The maximum amount a business note buyer will buy in a single transaction is
between $300,000 and $450,000. You can create a business note for more than this
maximum amount, but the business note buyer won't buy more than their
maximum at one time. This means when the period is completed for which
payments have been sold any remaining payments will once again come to you. At
this point you will have the option of selling future payments again, if you want to.
The cash flow of the business must be adequate to service the note and provide
additional cash for the new owner to live on. The cash flow should be at least 1.25
times the amount required to service the note. The business should have been in
the same location for at least 3 years (4 years for restaurants and bars), and it
should have been profitable over that time.
The term of the note should not be longer than 72 months with 36 to 60 months
being preferred. You can create a business note for longer than the recommended
period, but a business note buyer will only buy the number of payments with which
they are comfortable. The objective is to minimize the risk to the note buyer. The
longer the term, the greater the likelihood that something will go wrong. The note
buyer is looking to minimize their risk because the note is not fully secured by the
assets of the business.
A key item related to the term of the note is the term of the lease of the space in
which the business operates. In order to avoid a major disruption to the business
due to a problem renewing the lease, the term of the lease should be at least as
long as the term of the business note.
The business note must be in first lien position. The business note cannot be a
second position lien behind a bank loan. If there is a default, the second position
lien holder may have a difficult time recovering their investment.
The business note should be fully amortized over its term. There cannot be a
balloon at the end because there is probably no way to refinance the balloon at the
end of the note term. If a bank was not willing to finance the original transaction, it
is unlikely that they would be willing to finance the balloon at a later date.(Notes:
Some business note buyers may accept a balloon if it can be amortized within 24
months using the same monthly payment used to pay the note. Other business note
buyers may buy payments up to a few months before the end of the note term, but
leave the balloon for the business note holder.)
The business note buyer wants to see that the new owner of the business has prior
experience running the type of business being purchased. This is especially
important for the purchase of a "high-tech" business or a professional practice. The
assumption is that someone with experience in the type of business has a better
chance of succeeding than someone without prior experience.
One of the biggest factors contributing to the discount that the seller will have to
take when selling the future payments is the difference between interest rate on the
original business note, and the yield required on their investment by the business
note buyer when they buy the future note payments. Therefore, the interest rate on
the business note should be set as high as possible while still allowing a monthly
payment that can be covered by the cash flow of the business for the term of the
note.
The deal is not done until the paper work is done. There are stories where people
documented the sale of a business on a napkin or restaurant place mat. That will
not be adequate if you have any thought of selling your business note in the future.
There are four main documents that should be produced. It is recommended that a
lawyer be used to help properly prepare these documents. The documents are listed
below.
UCC-1
chattel security agreement or chattel mortgage
promissory note
purchase agreement
The UCC-1 documents that the seller is holding a "perfected" lien on the business.
This document is filed with county government and is part of the public record. If
there is a default, this document indicates that the business seller will be first (after
tax liens) to receive proceeds from the sale of any business assets.
The "chattel security agreement" is a list of the tangible assets of the business. This
will usually be the furniture, fixtures, and equipment that are the tangible assets of
the business. The intangible assets are things like a loyal customer base that can be
lost if the new ownership does not provide the service received from the previous
ownership. The chattel security agreement does not become part of the public
record, but is necessary to document what the tangible assets were at the time of
the business sale.
If any vehicles are part of the security for the business, the title of the vehicles
should indicate that you are the owner of the vehicles so that the new business
owner cannot sell these vehicles without your knowledge.
The promissory note documents the details of the sale like value of the note at the
time of sale, the term of the note, the monthly payment, the interest rate, and any
other special terms such as late payment fees.
The purchase agreement ties the whole transaction together. It may contain
information that is not specifically contained on the other documents such as
provisions to provide periodic financial statements to the seller which could then be
made available to a prospective note buyer for evaluation.
The promissory note or the purchase agreement should not contain any "offset"
statements which would allow the business buyer to deduct from payments made
on the note due to problems running the business or problems with equipment
purchased as part of the business. If the promissory note or purchase agreement
does contain "offsets", then the business note buyer will require at least 6 months
of seasoning to see if there have been any events that would activate the "offset"
provisions.
The following table summarizes the factors contributing to a business note that will
be more attractive to a prospective note investor.
Note Factor
Preferred Value for Note Factor
Buyer's Down Payment
At least 33% in cash that was not borrowed
Minimum Number of Payments Already Made (Seasoning)
2 monthly payments (more are preferred and more are required for professional
practices) by the new owner
Buyer's Credit History
Buyer must have a credit score of at least 600 with no recent "clouds" on credit
history
Personal Guarantee
Personal guarantee required (cannot be a person signing on behalf of corporation or
partnership)
Total Amount of Payments Being Sold
Maximum is $300,000 to $450,000 in a single transaction (note can be created for
more than this amount, but the maximum that can be sold at one time is $300,000
to $450,000)
Cash Flow of the Business
Cash flow should be at least 1.25 times the amount of the monthly payment on the
business note.
Length of Term of the Note
72 months maximum but 36 to 60 months is preferred (Note can be created for a
longer term but business note buyer won't buy the payments beyond a certain
point.)
Lien Position of the Note
First lien position only
Amortization of the Note
Note must be fully amortized within the note term
Experience of the Buyer
The buyer should have prior experience in the type of business being purchased.
Interest Rate
As high as possible such that cash flow can support the required payment for the
term of the note.
Documentation For Sale
UCC-1
Chattel Security Agreement
Promissory Note
Purchase Agreement
Real Estate
Real estate that is part of the business should be sold in a separate transaction from
the business assets
Of course, a business note can be structured other than recommended above,
especially if the seller does not anticipate selling future note payments. However, if
the seller has any thought that they might want to sell future note payments, then
the seller should follow the above recommendations as much as possible.
If you have an existing business note or are in the process of creating one as part of
the sale of a business, and you are thinking about selling some or all of your future
payments on that note, then we can help you determine what an investor would be
willing to pay for those payments. Please contact us today for a free, no obligation
quote on the sale of your future business note payments.
Afra AmirSanjari is the Principal for Peacock Capital. Peacock Capital specializes in solving the cash flow challenges of Small/Medium Businesses, Government Vendors and Individuals with innovative financial solutions by providing a network for securing operating capital.
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