A business note, known more specifically as a seller carryback business note, is created when the seller of the business “carries” the financing for the buyer and a note is created. Frequently, banks and similar lending institutions are hesitant to loan money to new business owners who have minimal track records and where hard assets make up a small percentage of the total purchase price.
If, instead, the seller of the business uses owner financing, he or she can later sell the note to one of the several promissory note buyers in the country. These investors, like private mortgage buyers who are in the business of buying mortgage notes, are looking for a good rate of return with minimal risk.
As the number of small businesses in the U.S. increases, it has naturally followed that a higher number of businesses are sold at some point. Although specific market research on business notes is hard to come by, surveys of business brokers have shown that 75% of small to medium-size business sales require the creation of a business note (seller financing). It had been estimated that up to $75 billion in business notes are newly created each year (as of the date of this writing). When you figure that there are 2-3 times that amount already existing at any one point, you can consider the market size of business notes to be valued at 200-300 billion dollars. Depending on the economic policies and interest movements that influence the tightening of credit by banks, the business note market could easily increase even more dramatically in the coming year or two.
Naturally, there are criteria that should be met in order for a business promissory note to be purchased. The most stringent of these is that usually only 1st Position Liens are eligible. In addition, we prefer to see most of the following elements:
- business has been and continues to be profitable, and has evidence of operating cash flow
- buyer has good credit, which generally means a FICO score of at least 625
- the buyer put down at least 25% of the purchase price in cash (ensures that the buyer is truly committed and able to weather down cycles)
- the principal owners have made a personal guarantee on the note
- the note has been “seasoned” at least two months (to show that the buyer is happy with the purchase)
- the note should have a face value of at least $20,000
The strength and mix of these factors determine whether the note can be purchased and the yield required by the investor. One option if the seller does not want to sell the entire note or if the note buyer cannot purchase all of it is to do a “partial”. As implied by the name, a partial is the purchase of some of the payments.
As an example, if a business was purchased for $250,000 and the buyer offered a down payment of $100,000, that would leave $150,000 to be seller financed. Let’s say that the seller only needed $50,000 for another business venture. The investor might offer to pay the seller $50,000 in exchange for the right to collect the first two years of payments. The investor takes assignment of the note and then re-assigns it to the seller after two years. Naturally, this is all detailed in a legal agreement.
In summary, selling a business note is an excellent way for the former owner of a business to get his cash out of the business. Whether the reason for selling the note is that the seller would have preferred all cash all along, that he now has large debts to pay, or that he has the opportunity to pursue other investments, the sale of a business note is a tool of which you should always be aware.