The following article
describes how to structure a business note that will be more attractive
to a note investor. This is an important consideration if there
is
any chance the business note holder will want to sell all or part of
the future business note payments before the business note has been
paid off. This article is directed at business owners who are planning
to
sell their business and become business note holders. This
article may be useful to business brokers and bankers in
assisting their clients in structuring a business note when other forms
of financing cannot be used.
Title: 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.
� 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.
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