Learn All About Business NotesBusiness Notes: What Are They?It’s official. There is no doubt about it: small business is king…and so are business notes. Small businesses have exploded across the country in the last 10 years. According to the Small Business Administration, in 2005, small businesses (500 employees or less) employed 58.6 million or 50.4% of non-farm, private sector workers. (Large firms employed 57.7 million or 49.6%). Even more astoundingly: small firms create 60 to 80 % of net new jobs. And there is no end in sight, even with the current economic downturn. This mushrooming growth of small businesses means an explosive growth of small business owners. As the number of small business owners grow, so grows the sale of small businesses. When many small business owners sell their business, they find it necessary to seller-finance a portion of the sale by carrying- back a note (…most times, a note they would rather not have). (NOTE: The terms "business notes", "cash notes", "cash flow notes", "cashflow notes", "business cash flow notes", and "notes" are used interchangeably throughout this page.)
How Do Business Notes Work?The concept of a small business note is not complicated. Business finance notes are created when small business owners provide owner-financing to their buyers. These seller-financed business notes, also known as seller carry-back business notes, are almost identical to owner-financed mortgage notes, except that they are notes created from the sale of a business instead of a home or property. Essentially, it is a promissory note secured by a business. A true business note includes any inventory and equipment that belongs to the business, but does not include real estate property. The note obligates the individual seeking to purchase the business (the buyer) to make agreed-upon payments for a specified amount of time to the individual selling the business (the seller). (NOTE: A business sold with real estate is considered by some investors as a commercial real estate note and by others as an owner-financed mortgage note.) The buyer (also known as the “payor”) would normally give the seller a cash down payment (the larger the better!) and then make payments to the seller in regularly-structured increments. Note payments are most often made on a monthly basis, but they can also be quarterly, annual and/or balloon type payments. (NOTE: As with many other types of transactions, the larger the down payment, the more “vested” the buyer is in ensuring the business’ continued success, and, therefore, his or her ability to pay down the note. Additionally, in most cases, the larger the payment, the lower the interest rate the seller will probably charge. The larger down payment reduces the risk to the seller that the buyer will default.) For example: a small business owner has a Laundromat for sale. His asking price is $100,000. Of course, he wants an all-cash sale (…in other words, he wants the buyer to provide him $100,000 cash, either the buyer’s own money, an SBA loan, from a bank loan, etc). However, the seller realizes this will probably not happen. Instead, he gets a buyer who has $30,000 cash as down payment and requests that he, the seller, carry-back the remaining $70,000 in the form of the “business cash flow” note. So, in order to complete the sale, the seller accepts the $30,000 cash and creates a cash flow note for the payment of the remaining $70,000, at an agreed-upon interest rate over a certain period of time, normally five to seven years (i.e., $70,000 at 11% interest for five years, etc). In the above example, the seller wanted all cash. However, as with most small business sales, the seller found it necessary to seller-finance much of the purchase price (in this example, $70,000). Though he would have preferred all cash, in order to sell his business, he had to “take back” a note he did not want. Like most business owners, this seller is probably not aware that he can readily sell the cash flow note he just created. There is a network of people in the cash flow industry who are in the business of buying and selling business cash flow notes like his.
The Importance of Business NotesUnfortunately, the example detailed above is far too common in the sale of small businesses. Because of their relatively high failure rates, the banking industry considers providing small business capital as high risk venture. Therefore, the vast majority of banks are wary of financing small business sales. This has led to an uptake in business owners providing seller carry-backs or private loans in order to complete the sale. In the above example, the business seller (the new note holder) is faced with two options: a) hold the note for five years and collect small monthly payments; or b) find a network of persons in cash flow businesses who will purchase the note for a lump sum amount of money (normally, somewhat less than the note’s $70,000 face value). The process of liquidating the note highlights the value of winning cash flow business. Without this secondary market being in place, the note holder would have no option but to retain the note for the full five year period.
What Happens Should The Buyer Default?Assuming a properly recorded business note (i.e., UCC-1 Financing Statement and other required documentation), if the buyer defaults on his obligation to repay, the seller has the business, plus the assets to go after in order to recoup his/her loss. Most sellers would rather not have to go through this. Remember, they sold their businesses in the first place in order to concentrate on other interests in their lives. They would prefer that the buyer continue to pay on the note as promised. However, the ability to go after the buyer to recoup the business and its assets in cases of buyer default is an added benefit to the seller. Business Notes Are Important…Why?There are an estimated 20,000,000 small businesses in America. Each year, approximately 10% (or 2,000,000) are sold. Half of these (1,000,000) are sold with some amount of seller financing. That means annually, 1 million business notes are created. It is estimated that $500 Million worth of these business notes are presently in existence. The importance of this is that in order for the small business ownership economy to continue functioning properly, many of these seller carry-back notes must be sold. Those who work in the business notes arena offer a very valuable service to our economy by transacting these notes. They connect note owners with investors who wish to buy them. Without this process occurring in the secondary market, many businesses would not change hands as often. This situation occurs because obtaining financing for small businesses is difficult. Because of traditional lenders’ tight restrictions, most potential buyers are not able to purchase a business unless they have all cash. This all changed when business sellers realized they could sell their discounted notes for cash soon after selling their businesses. This has made business note brokering one of the most profitable segments of the cash flow industry to work in. To be sure, there are times when the seller is content to receive note payments over a number of years. However, as is often the case, they would prefer an immediate lump sum payment instead of collecting small payments over time. The person holding the note, however, does not want to wait that long to receive all their money, so they look for someone to buy all or part of their business note. The types of businesses which can benefit from note sales vary widely. They range from dry cleaners, hair and nail salons, auto repair shops, printers, medical & dental practices, restaurants and bars, mini-markets, and convenience stores to manufacturing companies, various service establishments, pest control companies, mail and packaging centers, building maintenance services, and many others . . .
The Reason For Business NotesAs noted above, these seller-financed cash flow notes have become essential to selling small businesses. When it comes to financing the buying or selling of a smallbusiness, the perception of risk is magnified for anyone making a loan for purchasing the business. In fact, it is significantly more difficult to get a bank loan for the purchase of a small business than it is to get a loan for the purchase of a home. They historically have a high failure rate, and often do not have enough collateral to satisfy a bank loan. Typically, in a "true" business sale (no real estate involved), less than 25% of the sales price is against any hard, tangible assets such as furniture, fixtures, equipment, inventory, and chattels. Should the business fail or the new owner stop making monthly payments, there are precious little assets that can be foreclosed upon. In other words, there are few collateral assets because the balance of the purchase price is generally based upon the income or revenue the business has generated (or sometimes, what it is expected to generate in the future).
When small businesses are sold, any number of factors may come into play which adversely affects the business’ success: a) initial income projections may prove incorrect as market forces change, causing the business to have a lower than expected cash flow; b) the new owner may not have the same skills in running the small business as the seller did, therefore, the business’ cash flow is less than expected; c) the business may have suffered a catastrophic loss such as from a fire, or some other natural disaster; d) key employees may have left the business, etc. Because of the tenuous nature of small business success, banks and other traditional lending institutions are most times unwilling to fund these sales.
Against this backdrop of traditional lending institutions' unwillingness to fund small business sales is the issue of potential buyers not having enough cash to purchase the business outright. Every business seller wants one thing at closing: CASH. For business owners/sellers, the potential buyer with cash in hand is worth his or her weight in gold. However, just about every small business seller will tell you that this rarely, if ever, happens.
The Secondary Market For Small Business NotesSome figures suggest that nine of every 10 prospective buyers have asked the small business seller to finance a part of the sales price (carry some of the financing). Between limited available financing and limited buyers with cash, often a seller's only option is to extend financing and, in effect, become the bank! In order to complete the sale, most sellers agree to do this. As a result, there is an estimated $500 Billion of private business notes stagnating in sellers' hands - sellers who need cash flow for new small business ventures or other business and personal activities. The cash flow note market is huge and has created an equally large cash flow note business opportunity for those entering that cash flow industry. The private cash flow marketplace offers an alternative "financing" arm for these business note holders. Certainly, not every business note will be marketable, given the high risk of many of these cash flow notes. But the opportunity is there for many of these small business sellers to convert these cash flow notes to meet their cash needs. Many, if not most, of these owner-financed business notes have a cash value which investors would pay a lump sum of cash to obtain. To meet financial objectives, many note holders choose to sell their business notes. In some cases, they choose to sell all the remaining payments. In other cases, they may sell just enough payments to meet their particular financial need. The process of selling a business note, like most other cash flows, is relatively simple. The most vexing issues most note sellers face are: a) finding a business note broker whom they can trust to get the paperwork done; and b) finding a buyer who will give them top dollar for their note. (NOTE: Note sellers should not worry about their business' buyer (the payer). When they sell their note, the sale does not affect the original buyer at all. The original note contract terms remain the same.)
Why Do Business Note Holders Sell Their Notes?There are a number of reasons why business note holders offer their cash flow notes for sale. Listed below are several of the more common reasons:
- Buy a new business - Raise cash - Finance a new business venture or project - Retire after many years of hard work - Pay for a medical emergency - Cover the long term care of a loved one - Enhance investment portfolio - Attractive investment opportunity - Purchase real estate, home, car, boat or plane - Pay Bills - Eliminate Financial Obligations - Fund the education of children and grandchildren - Donate to favorite charity or cause - Take a vacation of a lifetime - Eliminate the hassle and worry of collecting payments
What is Involved in the Sale of a Business Note?When a business note holder wants to sell (or liquidate) a cash flow note, investors attempting to buy the note will need an accurate assessment and assignment of the security instrument, the UCC-1 Financing Statement, take an endorsement of the promissory note and process several other pertinent documents. This finalizes the note sale and transfers ownership to the investor while the seller gets a lump sum of cash he is owed. When purchasing a cash note, the business note investor looks at the payer’s credit rating and his ability to pay, and he also takes into consideration the type business and its ability to be profitable. This is a critically important point because the note buyer will not have property, like real estate, to foreclose on. If the business fails, there will not be much to go after, except the assets associated with the business (inventory, fixtures, etc). Although, assuming the promissory note is personally guaranteed, the investor’s risk will not be as great because the payer is still liable for payment (…good notes will be personally guaranteed). Business note investors are looking to make a higher yield on this type of transaction because of the obvious
greater risk and minimal security than a standard mortgage note would bring.
Typical Business Note Criteria- First position as lien holder - Substantial down payment- 20% -30% or more - Note terms – five - seven years or less - Profitability – shows profit after expenses - Interest rate – 11% or greater - Note must be personally guaranteed - Note fully amortized and in first position - Seasoning- at least three to five payments received on time - Payer Credit Rating – FICO Score of 650 or greater - Payer’s previous experience in the business
A note seller must understand the interplay between the different components. For instance, it is possible that having a good down payment can make up for less seasoning for some business note investors. For other investors, better seasoning and pay history can compensate for lower down payments. And still for others, a poor credit rating can be helped by good profitability and greater seasoning. In other words, if the cash flow note does not meet all of the standards outlined above, this does not mean it still can not be sold. However, a note’s value will be adversely affected, unless another factor can be used to compensate.
The Cost of Selling A Business NoteOne should have no illusions: Selling a business cash flow note can be expensive for the note holder, depending upon which note broker / investor he uses. The expense is not necessarily an out-of-pocket expense. Rather, it lies in the discount taken to purchase the note. Again, the factors which determine the value of a business note are outlined above. Also, key to a note’s value is the concept of “time value of money”. Using the earlier example where the Laundromat was sold for $100,000 ($30,000 down, $70,000 note over five years), the resulting note would not be worth its face value of $70,000 to an investor, even if all the factors above were met. This exits because money is worth more today than it will be in the future. And since the investor would have to wait five years to recoup his investment, he would not be willing to pay full face value for the note. He would offer to buy the note at a discount as just compensation for the time needed to recoup his investment. As an example, he might offer the note holder $60,000 for the $70,000 note. The $10,000 difference ($70,000 note face value - $60,000 purchase offer) would cover the five-year note period and the investor’s risk (i.e., possibility of payer default, slow pay by payer, business going bankrupt, etc).
Choosing A Business Notes BrokerIn order to best ensure that the note transaction experience is as smooth as possible and is most beneficial to all parties involved, most note holders enlist the aid of a business notes broker. While it is possible for the average business note holder to successfully transact a sale of note, relying upon the professional skills of a notes broker is usually best in most circumstances. These individuals successfully complete business notes buying and selling transactions as their chosen profession. The critical decision is which individual business note broker or firm to choose. Most professional business note brokers and firms are highly skilled at what they do. Business notes sellers should first concentrate on finding an individual or firm that they trust and with whom they have good rapport. The chosen note business broker or firm should have a wealth of potential investors from which to choose. Certain investors invest in particular types of cash flow notes. Having a number of these business note buyers to choose from increases the seller’s opportunity to receive the largest lump sum payment for his or her note. The broker should have already established the great working relationship with these investors. And perhaps most importantly, the broker should offer a free, no-obligation, and confidential note assessment and valuation service.
Time To Close A DealIt usually takes 3-4 weeks to close the more basis transactions. This, of course, depends upon how fast documents can be gathered. One should remember that some cash flow notes and their underlying businesses are more complicated than others. Therefore, the due diligence period for reconciling all of the documentation, inspections and fact-gathering may take upwards of another two weeks. So, unless there are some unusual complications, the longest time to deal closure should be 6-8 weeks. Paperwork Required to Sell a Business NotePromissory Note (Original): this document details the terms of the sale of the business between the seller and buyer. It generally records the seller’s promise to pay a specific sum of money over a period of time at a certain interest rate in order to purchase the business. Sales (or Asset) Purchase Agreement Security Agreement or Chattel Mortgage: this document is used to determine the collateral for securing the loan such as equipment, furnishings, fixtures, appliances, sale of inventory, etc. UCC – 1 (Financing Statement - recorded at the state and county): This document is filed to inform the public that specific assets have been put up as collateral. Information contained in this document is used to conduct background and credit checks. Lease Agreement and Assignment: Used when transferring a rental property lease from the seller to the buyer Tax Returns: At least the last two years Operating Licenses: such as Liquor License Accounting Records: Complete records Settlement/Closing Statement (and Escrow Instructions): Summarizes all fees and charges that both buyer and seller are responsible for at closing Business Insurance Policy Personal Guarantee: Also, most investors will insist upon a signed note personally guaranteeing payment, especially if corporately signed note. Franchise Agreement, if applicable Covenant Not to Compete (unless already shown in Purchase Agreement)
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