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.