Business Note Basics

Written by Jeffrey R. Armstrong – President/Owner of Armstrong Capital

Your favorite Master Note Buyer – Straightforward, Honest, Fair…

How and When a Business Seller Should Take Back a Note

When a business owner makes the decision to sell their business there are many factors that they need to think about.  They would need to consider factors such as whether or not their particular business is appealing to someone looking to buy a business, is their business a niche type of business or a common business, what type of buyer they are looking for and of course what the value of their business might be.  Other considerations might include whether their business is easily financed for a buyer through traditional lending sources, whether they need an all cash buyer and whether or not to offer seller financing to potential buyers.  Yes, that is a real consideration when selling a business.  The seller of a business needs to consider financing the business for the buyers that may show an interest in purchasing the business.

First, let’s think about where a buyer of a business might go to obtain financing to purchase a business.  A bank?  A mortgage company?  A traditional lender?  What do those types of institutions usually require when they give a loan? The answer is collateral.  Most businesses do not have a lot of collateral associated with their business.  For example let’s look at a pizza restaurant.  A business like a pizza restaurant usually doesn’t own the building it is in.  They are usually renting or leasing their business space so there is no property as collateral.  A pizza restaurant might have some tables and chairs, a cash register, a large refrigerator, several pizza ovens, maybe a freezer, eating and cooking utensils, cardboard pizza boxes, pots and pans, some pepperoni and some cheese.  Those items of collateral may only comprise 10%-30% of the value of the business.  Among other things, the main value is in the intangibles such as the clientele that has been built up over the years, the restaurants reputation, the cleanliness and the location of the business itself.

Most of the value of the pizza restaurant is in these intangibles and this is what we call Blue Sky or Goodwill. A bank, mortgage company or traditional lender can’t take a picture of goodwill, they can’t hold it in their hands and it is very difficult to appraise.  Thus a buyer of a business, no matter how good their personal credit, might still not be able to get a loan to purchase the business. In addition to that there are very few buyers that will buy a business for all cash.  That’s where the seller financing comes in.

Did you know that over 75% or more of businesses sold are sold with some form of seller financing?  It’s true.  But if an individual that is selling a business has never done it (carry back a note) before they may structure the sale, the note or both improperly.  An improperly structured transaction can make the note that they carry back very unappealing and even worthless to investors that purchase these types of seller financed business notes.

Let’s be clear on what we are talking about here.  We are NOT talking about providing financing, originating, making, or funding loans to businesses.  We are talking about notes that are created to facilitate the sale of a business (in real estate it is called a Purchase Money Mortgage).  We are talking about the seller of the business carrying back a portion of the purchase price less the cash down payment and receiving payments over time. When a note is carried back from the sale of a business, we call this a business note, and when a business note is structured properly it can then be sold for a lump sum of cash.

Unlike notes secured by real estate, notes secured by businesses have some minimum requirements.  If a business note does not AT LEAST meet the following requirements, you will have a tough time selling it if you want or need cash in the future.   As of the writing of this article, the suggestions for a properly structured business note and sale are as follows:

– Minimum of 30% CASH Down Payment

– 12% Interest Rate or higher

– Fully Amortized with No Balloons

– Minimum 625 Buyer Credit Score

– Personally Signed for / Guaranteed

– Minimum 3 Months of Seasoning before you can sell the note

To start with you want to get at least a 30% cash down payment or more, the larger the down payment the better, 50% is great!  You want the buyers to have something substantial to lose if they default.  Do not accept a 1965 mint condition convertible mustang for the down payment or 20 acres in the middle of the Mojave Desert either.  You want cold hard cash down payment out of the buyers’ pocket and definitely not borrowed from anyone.  If they borrow the down payment it is not theirs and they would lose nothing if they stopped making payments.  If they don’t have it, wait for another buyer.

You want to charge a higher interest rate.  We suggest 12% or higher at the moment.  Look, they can’t go to a bank to get a loan to give you 100% of the purchase price of the business, they don’t have 100% cash to buy the business outright so you are doing them a favor by carrying the note so they can purchase your business. If they don’t like it, let them get the money elsewhere, if they can, and give you all of your money.

You want to fully amortize your note and have no balloons due in the future.  We suggest fully amortized for about 6 years.  If you amortize the note for a period of years but give it a balloon (make it all due and payable) earlier ask yourself this: where is the buyer going to go to refinance you in the future to pay off the balloon?  We already covered that, no where.  That is why you are carrying the financing in the first place, right? So don’t put yourself in the position later on down the road of having to extend the loan and carry it longer than you wanted to just because the buyer can’t pay you off.  Make the note fully amortized and that issue will not arise.

Make sure you look at the buyer’s credit.  The lower the buyers credit score the more likely they will not continue to make payments and eventually default on your note. A 625 credit score is the minimum it can be to sell your note late in the future.  Try to find a buyer with a credit score of above 700 and you should be in a good position to keep receiving the payments through the term of the note as well as having a more valuable business note.

As a individual holding a business note you want to make sure that when you sell the business and carry back the note that the buyer of the business signs for the note individually or at a minimum gives a personal guarantee.  We often see that a business is purchased, a seller will carry back the note and the note is signed by a corporate officer and purchased by a corporation without also getting a personal guarantee.  This is a crucial mistake.  Often the buyers will create a corporation for the sole purpose of buying the business.  If the business doesn’t work out for them, they stop making payments and the note goes into default.  The business owner then tries to go after the corporation for repayment and discovers that the corporation is just a shell with no other assets or collateral to take for repayment of the note.  Then the business note holder loses the possibility of ever getting anything out of his note.  A business can be sold to a corporation, but as an additional way to protect your interest as the seller of the business and business note holder, make sure the note is also signed for individually or there is at least a personal guarantee by the officer(s) of the corporation.

Once you have properly sold your business and created the note you then have an asset that can be sold for cash.  You can sell all of it or most often a portion of the note to get the cash you want or need at the moment.  When that moment arises investors in business notes want to see at least 3 months of seasoning (preferably 6-12 months).  A business note investor wants to see that the buyer of the business can keep the business operating and make the payments on time for at least 3 months.  Keep an accurate and well documented payment record when you are collecting the payments on your business note just in case you might want to sell it in the future.

A business note is a note that is created to facilitate the sale of a business when the buyer of the business is unable to obtain financing for the purchase elsewhere.  When properly constructed a business note can be sold for a lump sum of cash in the future.  With the above suggestions you are now much more informed as to how to structure the sale of your business as well as the terms of the seller financed business note so that if you have a need for cash in the future you will have the most valuable business note possible.  Stay positive never stop until you succeed.

Remember, success demands action! Keep on marketing, it’s going to work! TWITA! (That’s What I’m Talking About!)