How To Create A Business Note That Is More Attractive
By Thomas` | November 29, 2008
How To Create A Business Note That Is More Attractive To A
Note Investor
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:
buyers down payment number of payments made on the note
(also known as seasoning) buyers 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 buyers 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 wont 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
Buyers 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
Buyers 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 wont
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.
http://www.peacockcapital.com
info@peacockcapital.com
Topics: Investing |
« Discovering The Truth About Using Abdominal Burners And The Real Secrets To Losing Weight Fast | Home | Basic Treatments For Sciattica Pain »
