Create Business Notes Cash Flows

You Can Create Business Notes...Saleable Ones!

You are thinking about selling your small business. You know you must create business notes to do this. Of course, you want an all-cash buyer or at least someone with a bank or SBA loan for your full asking price. Having accessed the learn-about-cash-flow.com site, as well as having read tons of stories about selling small businesses, you realize that small business owners, like yourself, normally end up taking back a portion of the financing. You have already figured out that your potential buyer will not have all cash. He or she, at best, will have a size-able down payment.

(NOTE: The term, “business note”, as used here, assumes that only business assets (i.e., inventory, fixtures, etc) are being sold and that no real estate is involved.)

So, you know that you will have to create a business note. In so doing, you will now become the bank. Being an avid learn-about-cash-flow.com reader, you know that this can be a temporary situation, if you take the right actions.

At this point in your life, you have plans other than continuing to run a business. Your intent is to sell the business lock, stock and barrel. But you know you must temporarily take back a note in order to sell it. You don’t mind collecting monthly payments for a while (to “season” the note). Eventually, however, you want to be able to sell the note. OR…you may even want the flexibility to start another business venture later on. In either case, you will need the cash - as much as possible - from this note.

With this in mind, you know you will need to create this business note to get the greatest value from it. In order to do this, you must make it as attractive as possible to prospective business note buyers and investors.

Proposed Business Note Structure Criteria

- A hefty down payment by the buyer (30% or greater is optimum)

_ The buyer’s credit history and FICO Score (at least 650; higher the better)

- The payer’s payment history (no “slow” or “no pays”) - A written, personal guarantee from the buyer

- The note’s length of term (the shorter the better)

- The note’s lien position (1st position)

- Note’s interest rate

- Note completely amortized (no balloon payment is better)

- Number of payments made on the note (at least 3-5 months of “seasoning”)

- Total amount of payments being sold (all or partial)

- Business cash flow (month-to-month profits is best)

- Business past profitability (uninterrupted string of success is best)

- Payment amount (is the business making enough money to cover the cost)

- Any "offsets"

- Payer’s experience in operating this type of business

- All business sale documentation in order

You understand that this is a long laundry-list of considerations. However, you also realize that unlike a mortgage note sale where there is property to foreclose against in the event of payer default, there is little such possibility with business notes. Because small businesses have so few tangible assets to cover the amount due in cases of payer default, the above listed factors take the place of tangible assets in insulating the note buyer’s investment.

1. The first key the investor is looking for is a hefty down payment. 30% or greater (the larger the better) is probably the minimum to make the note enticing. These funds should come from the buyer’s savings or investment. It should not be borrowed money. The reason for such a large down payment is to ensure the buyer has “skin in the game”. The possibility of losing these funds makes it rather painful for the buyer to “walk away” from the business should they encounter problems. Having that significant amount of their own money invested in the business, they will think twice about walking away when things get tough (…as sometimes it does).

The bottom line: Most investors want the buyer to have 30% (or preferably greater) equity in the business. Should the buyer not have quite 30% equity, he or she could make additional payments to make up the difference. Bottom line: tie buyer equity in at least 30% equity.

2. The buyer of the business should have a FICO Credit Score of at least 650. This is a critical consideration. Ensure you do not sell your business to someone who has suspect credit. This does not mean that the buyer has to have a perfect score, just one which shows a consistent ability to pay his debts. Also, ensure that any credit “dings” or bankruptcies have been settled or discharged and are in the buyer’s distant past. Again, his or her current credit record should show an ability and willingness to pay all bills.

3. This point is also critical: the buyer must personally guarantee the business note. A guarantor must be a person, not the company or other entity. Specifically, this means that even if a company is buying your business, you will want a principal within the company to personally guarantee the business note. The reason for this is: if there is a default, the business note investor will go after the guarantor’s personal assets. To complete this, ensure that the guarantor’s personal financial statement is included as part of the note’s documentation.

4. The optimum term of the note is 60 months (five years). The maximum it should be is 84 months (seven years). Remember, the shorter the period, the more saleable the note. A short time period reduces the likelihood that something will go wrong. In other words, a shorter period minimizes the note buyer’s risk do to the fact that the note is not fully secured by the business’ small amount of assets. While it is true that you can create a business note for longer than the recommended or maximum period, a business note investor will only buy the number of payments with which they are comfortable.

5. There is no getting around this: the business note must be in first lien position. The reason for this is that if the business note is in a second position behind a bank loan, in the case of a default, it is unlikely that the business note investor will recover any of his or her investment. (This leads back to the importance of the personal guarantee.)

6. The one factor which dictates more transactions than any other is the note’s interest rate. This rate determines the discount that the seller will have to take, and hence, the investor’s yield or profit potential. Remember, for a lump sum payment today, the note buyer must wait years to fully recoup his or her investment (…at a reasonable profit). Therefore, set the business note’s interest rate 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. 11% is the optimum interest rate many investors seek. It is fair to the business buyer and to the potential investor. Some may accept a lower interest rate if the totality of the packet is acceptable.

7. Also, you should amortize the note over its entire term. This means that there cannot be a balloon payment in the term. In all likelihood, the business buyer will not have cash on hand to pay off the balloon, nor will he or she be able 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. In the case where the balloon payment is necessary, be aware that many investors will buy the monthly payments up to a few months prior to the balloon payment. Still yet, 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. However, to make your note as sellable as possible, do not include a balloon payment.

8. Business note investors want to see at least 3-5 payments made by the buyer. Of course, this describes a routine small business, such as hair/nail salons, local maintenance companies, pest control companies, etc. However, professional practices, such as doctors, dentists, lawyers, chiropractics, financial consultants, etc., may well be different. They require a greater number of payments. The books should show that the new owner is generating cash flow from the business and that the business is meeting their expectations.

9. When you structure your note, determine ahead of time if you would ever want to sell all or just some (partial) of your note payments. This is a critical point. Your answer will drive how you structure your note.

10. The business cash flow must be adequate to pay the note, business expenses and provide business buyer with a living wage. This means that the cash flow should be at least 50% greater than the note’s payments. For example, if the monthly note payments are $6000, the business cash flow should be in the neighborhood of $9000 per month. This will provide enough money to service the note, meet business expenses and pay the business buyer. 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.

11. Be aware that normally the maximum amount a business note buyer will buy in a single transaction is between $300,000 and $500,000. It is important to note that as you create business notes to sell, it may be advantageous for you to consult with the potential note investor to determine his or her maximum transaction limit. That way, you will better position yourself to “presell” your note. If your note amount is greater than the investor’s maximum transaction limit, you can create a business note for more than this maximum amount. All probability is that the buyer will only buy up to his maximum transaction amount. Once those maximum payments have been met, the note will revert back to you. At that point, you can sell the remaining payments.

12. Prior experience: The business note buyer will want to ensure that the new business owner has prior experience running the type of business being purchased. This is especially true for professional practice or complicated, high tech business note purchases. The investor will assume that someone with experience in the type of business has a better chance of succeeding than someone without this experience.

13. Expect the business note investor to interview the new business owner to determine any possible problems that could cause business cash flow problems or payment issues. They will want to know if the new owner was “mislead” by the seller of the business.

14. An often overlooked, but key provision is the term of the lease of the space in which the business operates. Smart investors are likely to catch the fact that the lease will expire during the note pay back period. 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 business note’s.

15. Ensure you complete the sales packet in its entirety -that means all documents. Remember the old adage: The deal is not done until the paperwork is done. A simple handshake on important issues or scribbling critical points on a restaurant napkin will not suffice. If you wish to ensure yourself of a smooth transaction when you finally sell your business note, it is recommended that you use a lawyer properly prepare critical documents.

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 less-than-great credit rating can be helped by good profitability and greater seasoning. In other words, if a business 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.

If it is your expressed intent to sell your business note, you may better position yourself to do so if you “presell” your note. Again ,you can do this by consulting with a potential note investor to determine his or her notes specifications. That way, you will better position yourself to sell your note when the time comes.

Create Business Notes Structure Checklist

_____ Buyer’s down payment/business equity is 30% or greater (not borrowed)

_____ Buyer’s Credit History (FICO Score of at Least 650)

_____ Buyer has no recent “slow pays” or “no pays on credit report

_____ All buyer’s bankruptcies or judgments discharged/cleared for two years

_____ Buyer has experience operating this type business

_____ A written, personal guarantee from the buyer (personal, not corporate)

_____ Note’s length of term (less than 84 months; shorter the better)

_____ Note is less than $500,000

_____ Note’s lien position (1st position)

_____ Interest rate 11% or greater

_____ Note fully amortized

_____ Business is making enough money to cover all expenses

_____ Business cash flow at least 1.5 times the note’s monthly payment

_____ Business has great profitability; uninterrupted string of cash flow success

_____ Business location lease does not expire during the note’s term

_____ There are no business “offsets”

_____ All business vehicles are in the note holder’s name

_____ UCC-1 properly filed; “perfected” with note holder in 1st position

_____ All sales documentation is in order

_____ An attorney assisted in preparing and assessing note package; reviewed packet

_____ Note “seasoned” 3-5 months; at least six months for professional practices _____ Decision made to sell entire note or just partial

Create Business Notes Sales Documentation

- Promissory note

- Purchase agreement

- Chattel security agreement or chattel mortgage

For the investor, the UCC-1 is crucial. Filed as a public record at the county (and state), it documents that the seller is holding a “perfected” lien on the business. Should there be a default, the UCC-1 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. Though not a part of the public record, the chattel security agreement is necessary to document what the tangible assets were at the time of the business sale.

Does your business own any vehicles? If any are part of the security for the business, their titles should indicate that you are the owner so that the new business owner cannot sell them without your knowledge.

The promissory note documents the details of the sale. It includes such entries like the note’s value at the time of sale, the note’s term, monthly payment amount, 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 there are offsets, most business note buyers will require at least 6 months note seasoning to see if any offset has been activated.

It goes without saying that the information presented here is NOT meant in any way to replace, stand in for, represent or preclude you seeking and obtaining legal and financial consulting advice. In fact, we, at learn-about-cash-flow.com recommend you do so. We presented this information simply as pertinent, NON-LEGAL information so you can be better prepared to make the most money from the potential sale of your business note.

Conclusion: Create Your Business Note Today

Once more, if it is your expressed intent to sell your business note, you may better position yourself to do so if you “presell” your note. You can do this by consulting with a potential note investor beforehand to determine his or her notes specifications. That way, you will better position yourself to sell your note once you finally make the decision to do so.

(Final NOTE:Also, it goes without saying that the information presented here is NOT meant in any way to replace, stand in for, represent or preclude you seeking and obtaining legal and financial consulting advice. In fact, we, at learn-about-cash-flow.com recommend you do so. We presented this information simply as pertinent, NON-LEGAL information so you can be better prepared to make the most money from the potential sale of your business note.)

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