What is a Business Note?

A business note is similar to a real estate note except that the collateral is the actual business rather than real estate. Uh huh, so tell me again, what is a business note? When a business is sold, there are basically three ways to manage the financing. First, the buyer might pay all cash for the business. Second, and more common, the buyer puts some money in as a down payment and gets an SBA (Small Business Administration) loan or other bank loan. Third, and the focus of this article, the buyer puts in some of his or her own money as a down payment, and the seller and buyer of the business set up owner financing for the remainder. 

The business note is a legally binding agreement showing the amount of money that one party (the buyer) is promising to pay to the other (the seller). Among other things, the note shows the principal amount owed, the interest, the term of the note, provisions for default, etc.

Let’s try an example where Shelly Seller decides to sell her coffee shop to Bobby Buyer. Shelly leases the land and building where the building is located from another party, and thinks that the business and its assets are worth about $300,000. Bobby agrees to the price, but he does not have $300,000 available and cannot get a loan from his local bank, so seemingly has no way to buy the coffee shop. He does have $100,000 available to spend on the business. Shelly believes that Bobby would be a reliable payer and capable of managing the business, so she proposes an owner financing arrangement in which she sells to Bobby using the following figures:

Sales Price:                      $300,000
Down Payment:                $100,000
Original Note Amount:     $200,000 (sales price minus down payment)
Terms:                                6 years, 8% interest rate, monthly payments of $3506.65

Once the parties have agreed upon a price and the terms of the note, they would have an attorney create the documents showing exactly which assets are being sold, the security agreement showing the collateral for the business, and a business note showing the payment terms. The business note is sometimes called the promissory note or simply the note and shows the payment terms as well as what happens in case of a default by the payer. It is critical to make sure that the documents are prepared correctly in order to protect the interests of the seller and the buyer. Be aware that notes can be created for the sale of real estate, equipment, or other assets, but for the purposes of this article, we are only referring to those notes related to the sale of the entire business.

What is included in a business note?

While business notes can vary in length and details, the most essential items are:

1. The names of the seller and the buyer
2. The amount being financed, the interest rate, the term, when payments are due, and conditions that would trigger the default clause
3. Ways for a borrower to remedy a default
4. Often, the business note will include the collateral for the note
5. Conforming with state and national laws, including rules about usury rates.
6. Signatures from the borrower are essential to making the contract legally binding. It is best to have the signatures notarized.

In the example above, as is often the case, owner financing saved the sale and gave both the buyer and the seller what they wanted. Creating a note rather than having the payer get a bank loan is generally faster, cheaper (less upfront fees), and simpler. The note keeps the seller interested in the activities of the business and gives her a nice monthly payment with interest. Hopefully, Bobby will keep the business operating and profitable, and make on-time payments to Shelly.

Owner financing was an advantage to both parties in this situation. For the seller, she could get her asking price and expect more money from the interest that she is collecting on the note over the next six years. For the buyer, he is able to buy a business that he could otherwise not afford, and he probably saved a lot of hassle and expenses by not having to work with a bank.

Selling a business note

Once Bobby has made a few payments to Shelly, she may decide that she wants more cash now rather than waiting for a full six years. Perhaps she is starting a new business, needs to pay down some debts, or just wants to take a long vacation. Shelly could choose to contact a business note investor or broker like Seascape Capital about selling the note. Some of the things that Seascape will be looking for in pricing the note include the following:

1. A down payment of at least 20%. Although this 20% figure is not an absolute, the higher the down payment, the less risk for the business note buyer. In our example above, Bobby made a down payment of 33%, so that is excellent.
2. The business has been and continues to be profitable and will be viable long term. The buyer of the business note wants to feel confident that the buyer will be able to keep making their monthly payments on time.
3. The payer has personally guaranteed the note and has strong credit. Although the buyer has often purchased the business in the name of an LLC or other entity type, adding a personal guarantee makes the note safer. In the business note buying world, we define strong credit as a credit score that is at least in the high 600’s.
4. At least two on-time payments have been received from the buyer.
5. There are no other large liens or loans that are legally superior (higher) against the business. The business note buyer will want the note that they are buying to be in 1^st lien position.
6. The note is amortizing during the term and has either no balloon payment or a very small balloon payment at the end. If there is a large balloon at the end of the term, the business note buyer might only be willing to buy the monthly payments leading up to the balloon.
7. Were all of the documents prepared by an attorney or other expert, and is the business properly collateralized to protect the note holder?

The potential buyer of the business note will assess the risk of the note and provide a price to buy the note based on the perceived risks. These risks include the type of business, the location of the business, the payer’s credit, the terms and rate of the note, the profitability of the business, and the long-term viability of the business. The business note buyer may offer to buy all of the remaining payments or a subset of the payments. The latter is referred to as a partial. The business note investor will buy the note at a discount, meaning that they will pay less than the current balance of the note.

Using the example, the investor may offer Shelly a price of $175,000 for all of the remaining payments on the note. Alternatively, the partial offer may be to buy the next 36 payments (3 years) for a price of $106,000. The partial offer may be appealing to Shelly because she only needs $100,000 to start a new business, because she wants to keep part of the note, and/or due to deferred capital gains on the sale.  Regarding the latter point, she should speak with her accounting person to find out whether the partial would be advantageous to her tax situation.

After one to two years have passed, Shelly may be able to sell the rest of the note as long as the payments have been coming in on time to the note buyer. Alternatively, she can decide to wait until the 36 months has ended, and then the note would revert to her automatically.

In summary, owner financing and setting up a business note are viable tools for selling a business. The person who sold the business would later have the option of keeping the note and receiving the monthly payments or selling all or part of the note to get their cash faster. Both parties need to make sure that they have a complete understanding of the transaction and obtain outside help to create the note and the related documents.