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 beable to qualify for an SBA guaranteed loan. However, in many cases the owner of thebusiness ends up taking back the financing because the buyer is not able to makean 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, butafter a couple of years of receiving payments you may decide you want to get backinto business and you need the cash that is tied up in your business note on whichyou are receiving payments. So now you want to sell your business note to raisecash for your next business venture. What is it worth? That will depend a lot on howyou structured the note.
The objective of this article is to help you structure thenote so that it is more attractive to a prospective business note buyer.
Assumption: This article discusses the structure of a note that includes only thebusiness assets of a business. If a business also includes real estate that is beingsold at the same time as the business, that real estate should be sold in atransaction that is financed separately from the business assets. This allows each tobe valued and financed in the most optimum manner. For example, it may bepossible 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 notepayments is to minimize the risk of a default on the note. Therefore, they look forspecific things when evaluating the purchase of future payments from your businessnote. 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 businessmay not be adequate to cover the amount due on the business note if the buyer ofthe business defaults. Therefore, the business note buyer is looking for ways tolessen the likelihood of a default. If there is a default on the note, the business notebuyer will require that the business buyer follow through on their personalguarantee 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 requiringsuch 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 oftheir own money invested in the business, they may think twice about walking awayfrom the business when things get tough.
If the down payment was less than 33 percent, then the business note buyer willrequire that the difference be made up by additional payments on the businessnote. The business note buyer wants to see that the new owner of the business hasat least a one-third equity investment in the business between the combination ofcash down payment and payments made on the business note while operating thebusiness.
Business note buyers want to see that at least two monthly payments have beenmade on the note by the new owner of the business. For new owners of professionalpractices such as doctors or dentists, a larger number of paid monthly paymentswill be required. This serves a couple of purposes. It should show that the newowner is generating cash flow from the business. It also allows the new owner to seeif 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 ifany problems exist that might lead to future problems making payments on thebusiness note. They will want to know if the new owner was "mislead" by the sellerof the business.
The buyer of the business should have a credit score of at least 600. A higher scoreis required by the business note buyer when the value of future business notepayments being purchased reaches a certain level. Any "clouds" on the businessbuyer's credit history should not be current. These should have been resolvedbefore purchase of the business.
The business note must be personally guaranteed by the buyer. It cannot beguaranteed by the company buying your business. Specifically, it cannot beguaranteed by a person signing on behalf of the company. If there is a default, thebusiness note buyer will be coming after the personal assets of the individual(s)making the personal guarantee. A personal financial statement for the buyer shouldbe obtained to verify that they have the necessary assets should it be necessary tofulfill the personal guarantee.
The maximum amount a business note buyer will buy in a single transaction isbetween $300,000 and $450,000. You can create a business note for more than thismaximum amount, but the business note buyer won't buy more than theirmaximum at one time. This means when the period is completed for whichpayments have been sold any remaining payments will once again come to you. Atthis 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 provideadditional cash for the new owner to live on. The cash flow should be at least 1.25times the amount required to service the note. The business should have been inthe same location for at least 3 years (4 years for restaurants and bars), and itshould have been profitable over that time.
The term of the note should not be longer than 72 months with 36 to 60 monthsbeing preferred. You can create a business note for longer than the recommendedperiod, but a business note buyer will only buy the number of payments with whichthey are comfortable. The objective is to minimize the risk to the note buyer. Thelonger the term, the greater the likelihood that something will go wrong. The notebuyer is looking to minimize their risk because the note is not fully secured by theassets of the business.
A key item related to the term of the note is the term of the lease of the space inwhich the business operates. In order to avoid a major disruption to the businessdue to a problem renewing the lease, the term of the lease should be at least aslong as the term of the business note.
The business note must be in first lien position. The business note cannot be asecond position lien behind a bank loan. If there is a default, the second positionlien holder may have a difficult time recovering their investment.
The business note should be fully amortized over its term. There cannot be aballoon at the end because there is probably no way to refinance the balloon at theend of the note term. If a bank was not willing to finance the original transaction, itis 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 24months using the same monthly payment used to pay the note. Other business notebuyers may buy payments up to a few months before the end of the note term, butleave the balloon for the business note holder.)
The business note buyer wants to see that the new owner of the business has priorexperience running the type of business being purchased. This is especiallyimportant for the purchase of a "high-tech" business or a professional practice. Theassumption is that someone with experience in the type of business has a betterchance of succeeding than someone without prior experience.
One of the biggest factors contributing to the discount that the seller will have totake when selling the future payments is the difference between interest rate on theoriginal business note, and the yield required on their investment by the businessnote buyer when they buy the future note payments. Therefore, the interest rate onthe business note should be set as high as possible while still allowing a monthlypayment that can be covered by the cash flow of the business for the term of thenote.
The deal is not done until the paper work is done. There are stories where peopledocumented the sale of a business on a napkin or restaurant place mat. That willnot 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 alawyer be used to help properly prepare these documents. The documents are listedbelow.
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. Ifthere is a default, this document indicates that the business seller will be first (aftertax 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. Thiswill usually be the furniture, fixtures, and equipment that are the tangible assets ofthe business. The intangible assets are things like a loyal customer base that can belost if the new ownership does not provide the service received from the previousownership. The chattel security agreement does not become part of the publicrecord, but is necessary to document what the tangible assets were at the time ofthe business sale.
If any vehicles are part of the security for the business, the title of the vehiclesshould indicate that you are the owner of the vehicles so that the new businessowner cannot sell these vehicles without your knowledge.
The promissory note documents the details of the sale like value of the note at thetime of sale, the term of the note, the monthly payment, the interest rate, and anyother special terms such as late payment fees.
The purchase agreement ties the whole transaction together. It may containinformation that is not specifically contained on the other documents such asprovisions to provide periodic financial statements to the seller which could then bemade 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 madeon the note due to problems running the business or problems with equipmentpurchased as part of the business. If the promissory note or purchase agreementdoes contain "offsets", then the business note buyer will require at least 6 monthsof 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 willbe 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 professionalpractices) by the new owner
Buyer's Credit History
Buyer must have a credit score of at least 600 with no recent "clouds" on credithistory
Personal Guarantee
Personal guarantee required (cannot be a person signing on behalf of corporation orpartnership)
Total Amount of Payments Being Sold
Maximum is $300,000 to $450,000 in a single transaction (note can be created formore than this amount, but the maximum that can be sold at one time is $300,000to $450,000)
Cash Flow of the Business
Cash flow should be at least 1.25 times the amount of the monthly payment on thebusiness note.
Length of Term of the Note
72 months maximum but 36 to 60 months is preferred (Note can be created for alonger term but business note buyer won't buy the payments beyond a certainpoint.)
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 theterm 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 fromthe 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, ifthe seller has any thought that they might want to sell future note payments, thenthe 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 ofthe sale of a business, and you are thinking about selling some or all of your futurepayments on that note, then we can help you determine what an investor would bewilling to pay for those payments. Please contact us today for a free, no obligationquote on the sale of your future business note payments.
Afra AmirSanjari is the Principal for Peacock Capital. Peacock Capital specializes insolving the cash flow challenges of Small/Medium Businesses, Government Vendorsand Individuals with innovative financial solutions by providing a network forsecuring operating capital.
http://www.peacockcapital.com
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