When selling a business many sellers will consider owner financing a portion of the purchase price for the buyer. Unfortunately, collecting monthly payments on a business note can be it’s own risky business.
Here are three truths that both business owners and brokers should know before creating a seller financed business note for resale.
Business Note Truth #1 – Greater Default Risks
Considering almost half of businesses fail within the first three years of setup, it is easy to see why it pays to be careful. If the buyer stops making payments the collateral will be the assets of the business. These assets are generally personal property (rather than real estate) and are more likely to depreciate or go down in value.
Business Note Truth #2 – Limited Liquidity
Should the seller ever desire to sell the future note payments for cash there will be fewer investors for business notes than real estate notes. An investor is more likely to make a partial offer, wherein they buy only a portion of the remaining payments, rather than a full purchase. The yields are generally higher resulting in greater discounts, especially if the note interest rate is low.
Business Note Truth #3 – Restrictive Purchasing Guidelines
It pays to know what business note investors look for when purchasing a business note for cash. Even when a seller plans to hold the note they will want to protect themselves by following the guidelines. Here are the basic criteria established by most investors considering the purchase of a business note:
- 1st Position Lien
- Minimum Down Payment of 20-25% (a 30% equity to sale price is preferred)
- Down Payment made in certified funds and not borrowed
- Maximum Funding of 70% ITV (Investment to Value)
- Minimum of two monthly payments already made
- 12 months or more preferred
- Credit Score of 650 or higher
- No major derogatory trade lines (No 90-180+ days delinquent, foreclosure, repossession, bankruptcy, etc.)
- No decline in credit since purchase of business
- Prefer 60 months or less
- Maximum of 72 months
- No Balloon Payment preferred
- Business has positive cash flow
- 1.25 debt service coverage ratio preferred.
- Personal guarantee from a creditworthy individual
- Standard documents including Note, Security Agreement, and UCC-1 filing.
- Tax Returns on the business that substantiate profit and loss statements.
- Payment history current and verifiable
- Payer Interview indicating buyer is satisfied with business and comfortable making payments
- Motivation for selling the note is not a result of a deteriorating business
- Consideration of high risk businesses or geographic areas
By understanding these truths related to risk, liquidity, and purchasing guidelines, a business seller or broker can know how to best create a business note for resale.
Thanks, Tracy, for this great article.
Do you have any commendation on how much or what percentage (%) the seller note should be to the buyer when an SBA loan is involved?
For example, the business is selling for 2 million, the buyer is putting 30% down, they are asking for a 15% seller note and the rest will be SBA loan. I find the 15% is too much.
Excellent article Tracy.
Tracy Z says