Selling a business and taking back a promissory note is common practice. However, finding investors to buy a business note without real estate as collateral is a bit more challenging. Fortunately there is Security Financial Services (SFS), a third generation company that specializes in buying business notes!
We interviewed Marc Rouda, Senior Vice President, for our Note Buyer’s Directory to learn about their business note programs, pricing, and updated investment criteria.
What type of notes does Security Financial Services purchase?
Marc Rouda: Security Financial is an institutional investor that purchases seller-financed business notes. We don’t purchase real estate Notes, factoring contracts, or any other types of cash flows.
What is unique about your company?
We were one of the first companies to invest in business notes in the mid 1990’s, so our team has the know-how to guide brokers to fast closings. But what makes us unique is our ability to offer very competitive bids – our cost of money is low because we use a mix of our own equity and very reasonably priced unsecured lines of credit.
Are you a principal buyer? Private Investor?
We are a principal buyer. We use our own funds to buy notes – we don’t depend on outside investors to fund our portfolio, so our funding decisions are made in house. This allows us to offer a more seamless underwriting process and fund more quickly.
Why are the seller-financed Business Notes an attractive cash flow?
I’ll answer this in two parts. First, we’re very excited to be in this space because the current macroeconomic environment has led to the creation of more seller financed Business Notes than ever before. As banks continue to exit small business lending, seller financing has become an integral part of small business sales. According to Bizbuysell.com, the web’s “largest business for sale marketplace” (bringing buyers and sellers of small business together), roughly 90% of small business sales involve owner financing of some sort. Second, this is an attractive cash flow product for brokers because there’s much less broker competition compared to RE Notes, factoring, or other cash flows.
How many Business Notes are created per year?
We haven’t done any formal market sizing analysis, but according to the SBA there are roughly 5 million small businesses in the U.S. With annual turnover of 10%, that’s roughly 500,000 small businesses that are sold every year. Next, let’s assume, using a more conservative estimate (compared to Bizbuysell.com), that only 50% of those sales involve seller-financing. That’s 250,000 business notes, but probably only 10% to 15% meet our investment criteria. So, we believe roughly 25,000 to 30,000 qualified business notes are created every year – a huge opportunity for both note brokers and for investors.
What are the keys to successfully brokering Business Notes?
There are two types of brokers. The first usually doesn’t take the time to 1) understand what makes a note attractive to investors and 2) create a network of contacts which can provide leads. The second and more professional type of broker is familiar with our underwriting criteria and doesn’t waste any time on notes that are clearly weak. This broker also understands the value of regular marketing campaigns. In addition, the most successful brokers have realistic expectations and good rapport with the seller. This type of broker is aware that finding worthwhile notes requires persistence and patience and has developed the ability to anticipate the seller’s needs.
What should brokers not do?
Sometimes brokers don’t bother to understand even the basic elements of the note before submitting. They shouldn’t submit a questionable note and just hope that an investor bids. We encourage brokers to always review the investor’s underwriting requirements beforehand. Also, brokers should never withhold key information from an investor to try to force the deal through.
Can you briefly summarize the key underwriting criteria?
Before answering this question, I want to mention that our appetite for Business Notes has increased and we’ve liberalized our underwriting criteria. There are several criteria, but these are the most important: a down payment of at least 20% (previously we required a 30% minimum d.p.), we require only 1 month of seasoning (vs. 3 months previously), solid payor credit, confirmation that the payor provided a personal guaranty, and positive business cash flow as shown on the seller’s most recent financials. We’ll be sending out more information about our revised underwriting criteria shortly. (Update: Click Here to download the current Business Note Buying Criteria in PDF format)
Which of the criteria you mentioned above is the most important?
The business’ cash flow is the single most important component because Business Notes are secured by assets (such as vehicles or equipment) that are usually worth only a fraction of the Note balance. If the business fails, the Investor would be left with very little collateral and would likely face a total writeoff. Examining the business’ cash flow and determining if the business can continue to comfortably make the monthly Note payments is paramount.
What happens if the business’ cash flow doesn’t cover the monthly payments?
Even though cash flow is the most important factor, it’s still part of a larger picture. Investors will still buy a Note with slightly insufficient cash flow if the payor’s payment history and personal credit score are excellent.
How long is the underwriting process?
I can’t speak for other investors, but our underwriting process (which begins when the seller accepts the broker’s quote) takes 10 to 15 business days. We rely on brokers not only to clearly communicate which documents we need to review but also to encourage the seller to provide these documents quickly. In instances where the seller is motivated and we receive a full loan file rapidly, deals can be closed in as quickly as 5 business days.
Where can brokers find Business Notes?
The most reliable sources: business brokers (who are aware of a Note that has already been created), attorneys (who drew up the business sale documents), escrow companies (who handled escrow for the business sale), servicing companies, franchisors, local SBA loan officers, and, last but not least, Note holders directly (we’re told postcards by mail work well). Less reliable sources: business brokers who will only focus on unclosed sales transactions and searching UCC financing statements. The best brokers are proactive and stay in regular contact with their targets not only by email but by direct mail as well. We’ve also learned that brokers who have embraced search engine marketing (SEM) are seeing better results than those who don’t pursue online advertising campaigns.
What kind of yields do business note investors require?
Yields in the industry vary widely, but we gather that most fall into in the 14% to 25+% range. As I mentioned earlier, we’re making an aggressive push to increase the number of Note purchases and have reduced our yield requirements – our yields now range from 14% to 17%. This is not only lower than the industry average but is also lower than the 16% to 19% range we were using not so long ago. The yield requirement depends on several factors, such as the face rate, the duration, payment history, and if a personal guaranty exists, among others. For the uninitiated, this means that a Note with strong attributes represents a lower default risk and therefore we will quote on the lower end of the yield range.
How should pricing be conveyed to the Note seller?
One recommendation I would make: because sellers are often discount-phobic, brokers should communicate a quote as a percentage of the balance of the Note. A quote of 85 cents on the dollar sounds a lot better than a 15% discount. Our pricing, as mentioned above, allows a seller to receive as much as 90 cents on the dollar net of broker fees.
What business types are the most attractive?
There are certain business types that underperform compared to other business types, but that doesn’t mean that we’ll automatically turn down a Note secured by a less-than-desirable business type. That said, the following are examples of better business types: retail/storefront, bars, liquor stores, restaurants (especially franchises), and laundromats. In other words, businesses that have relatively small average transaction amounts and the ability to weather a downturn in the economy. Business types are a factor in the underwriting process, but not anywhere as important as the key criteria I mentioned previously.
What areas of the nation do investors prefer?
We buy notes nationwide.
Do you buy partials?
Yes, investors often buy partials in instances where the note term is particularly long or to reduce exposure to a high-risk Note. SFS quotes partials if the term significantly exceeds our cap of 72 months or if the note balance is over $400,000. Partials also work when a seller doesn’t want to cash out the whole note.
Do investors buy non-performing Business Notes?
We don’t know of any who do. We do, however, purchase re-performing notes with 12-18 months of seasoning since the modification.
How can brokers submit a Business Note?
Brokers can fill out a Business Note worksheet online at www.secfin.com. Or, if they prefer, they can call us at 800-982-5945.
Click Here To Download a Business Note Worksheet in PDF format.