The Nuts and Bolts of Business Notes

What Defines a Good Note?

Say Bill, the owner of a Laundromat, has just sold his small business for 100,000. He wants the buyer, Jane, to come in with an all-cash offer and/or be able to qualify for an SBA guaranteed loan. However, Jane isn't able to come up with either of the above and Bill ends up taking back the financing himself. So Bill creates a business note and becomes the "bank". After making a down payment, Jane gradually pays of the note through monthly installments. At first that may seem okay, but after a couple of years of receiving payments Bill decides to start another business and needs cash quickly.

Where is Bill going to find that cash? The best way for Bill, the note holder, to raise funds is to sell the remaining payments of the note. What's the note worth? That depends on the structure of the note. My aim today is to help brokers and sellers create a good business note by structuring it so that it's more attractive to prospective funding sources. The earlier note brokers assist sellers, business brokers or lawyers in the creation of a note, the better the opportunity to structure a good note.

The Players

There are four parties involved in the sale of a note. 1) the seller, Bill, who owns the note, 2) the buyer of the business, Jane, who makes monthly payments, 3) the new funding source who is willing to purchase the note from the seller if it meets certain criteria and 4) the note broker who assists the seller in finding a funding source.

What criteria does a funding source consider when buying a business note?

When considering the purchase of future note payments, the key objective of a business note funding source is to minimize the risk of default on the note. Before approving the purchase of a note, funding sources will look at the following criteria:

What defines a good note?

A cash down payment of at least 25 percent or more 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 25 percent, then the funding source will require that the difference be made up by additional principal payments on the business note. The funding source wants to see that the new owner of the business has at least a 25% equity investment in the business between the combination of cash down payment and payments made on the business note while operating the business.

Seasoning of at least two months

Funding sources want to see that at least two monthly payments have been made on the note by the new owner of the business. Part of the "due diligence" performed by the funding source is to interview the new owner to see if any problems exist that might lead to future problems making payments on the business note (called a "payor estoppel"). Funding sources generally wait until 60 days after the close of escrow or after the completion of two payments to do an estoppel this ensures that enough time has passed to clearly conclude that the buyer is happy with the business. In addition, the funding source will want to know if the new owner was "misled" by the seller of the business. For new owners of professional practices such as doctors or dentists, a minimum of six monthly payments will be required.

Buyer FICO of at least 625

The buyer of the business should have a credit score of at least 625. A higher score is required by the funding source when the value of future business note payments being purchased reaches above a certain level. Any "clouds" on the business buyer's credit history should have been resolved more than 12 months before the purchase of the business. Buyer credit after the purchase of the business should generally be "as agreed".

A personal guaranty is required

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 a business note if the buyer of the business defaults. Again, the funding source is looking for ways to lessen the likelihood of a default. Part of this comes in the form of a personal guaranty, which now is almost always required. If there is a default on the note, the funding source will require that the business buyer make the payments personally. This component should be the first thing to cross off the checklist if there's no PG, it maybe difficult to find a buyer for the note. The PG is a personal signature on the note or another document which guarantees the payments to be made by a corporation or partnership.

The maximum value of note payments being sold is 40,000 to 300,000

The maximum amount a funding source will buy in a single transaction is 40,000 to 300,000. The seller can create a business note for more than this maximum amount, but the funding source won't buy more than their maximum at one time. The funding source limits the exposure to risk by buying some, but not all, of the payments remaining. This is called a "partial" note purchase, when the period of sold payments is completed, any remaining payments will once again come to the seller. At this point the seller will have the option of selling future payments again.

A minimum cash flow of 1.25 times the debt service

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 ratio is usually calculated using the seller's financial records, such as tax records, because it's often difficult to obtain up-to-date financial info from the buyer.

A maximum term of 72 months

The term of the note should not be longer than 72 months with 60 months being preferred. You can create a business note for longer than the recommended period, but a funding source 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 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 and the circumstances involving the business can change over time.

Retail space lease term should always be shorter than the term of the note

For notes on businesses in the retail industry, the term of the lease should be at least as long as the term of the business note. If the buyer is unable to extend a short-term lease they may default on the remaining payments. This is not a concern for businesses which are in a non-strategic location.

No offsets

Neither the promissory note nor the purchase agreement should contain any "offset" statements which would allow the business buyer to deduct certain charges from the note payments. Such charges can include unresolved outstanding debt related to the business or to faulty equipment purchased as part of the business. If the promissory note or purchase agreement does contain "offset", then the funding source will require more seasoning to see if there have been any events that would activate the "offset" provision.

The note should be in first lien position

If there's a default and the note is in second position, the lien holder may have a difficult time recovering their investment. The purchase of second position notes is possible only when the cash flow of the business can easily support the payments of the first and second liens combined.

No balloon or lump sum payments

The note should be fully amortized over its term. There cannot be a balloon at the end because there's probably no way to refinance the balloon at the end of the note term. If a bank wasn't willing to finance the original transaction, it's unlikely that they would be willing to finance the balloon at a later date. However, some funding sources may accept a balloon if it can be amortized within 24 months using the same monthly payment used to pay the note. Other funders may buy payments up to a few months before the end of the note term, but leave the balloon for the seller or note holder. Equal-level monthly payments are preferable to large lump sum payments which may be difficult for the buyer to meet.

The buyer should have relevant business experience

The funding source 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 professional practice. The assumption is that experienced operators have a better chance of succeeding than someone without prior experience.

Factors affecting the discount amount

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 the interest rate on the original business note and the yield required by the funding source when buying 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 same goes for the term of the note. The shorter the term, the less of a discount is required to provide the funding source with an acceptable yield o the note purchase.

Mastering Due Diligence

The deal is not done until the paper work, or due diligence, is done. There are stories where people documented the sale of a business on a napkin or restaurant place mat. Unless you're an energy trader at Enron, that won't be adequate. I recommend having the seller contact a lawyer to produce official documentation of the transaction. There are four main documents that should be produced, shown below:

• A Chattel Security Agreement or Chattel Mortgage lists 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 receive 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.
• A UCC-1 Financing Statement shows that the seller is holding a "perfected" lien on the business. It's filed with the county government and is part of the public record. If there's 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.

If a business also includes real estate that is being sold at the same time, that RE should be handled in a separate transaction with a separate Promissory Note and Deed of Trust. Funding sources who buy RE secured notes pay higher prices because of the stronger collateral offered.

I do not recommend simultaneous funding. Funding sources like to see at least two months of seasoning to get a feel for how well the new owner is managing the business and its cash flows. Go back to the seasoning portion of this paper for more detail.

Parting thoughts

Although these criteria are paramount to creating an attractive note, a lot of opportunity for note brokers rides on timing. The earlier the note broker is involved in the creation of the note, the better. The earlier note brokers provide assistance to sellers in the creation process, the more likely they are to structure good notes that can be sold to funding sources later on.

The criteria outlined in this presentation are recommended guidelines only. A business note can be structured differently than the ways mentioned above, especially if the seller does not anticipate selling future note payments. However, if the seller is entertaining the possibility of selling future note payments, then I highly recommend these criteria in order to create an attractive note.

SFS criteria matrix

The table on the following page summarizes the criteria covered in this paper that will make a business note more attractive to a prospective funding source like SFS.