Finding a Viable Business Note Borrower
If you have tried to create and sell business notes, you likely already understand how challenging it can be. So what makes a borrower viable when a person or company wants to create a valuable business note to sell on the secondary market, and more importantly, what is the business note buyer looking for?
- An average credit score: At least a 625 FICO middle-score or higher (which is a very average credit rating). As most note buyers would prefer to see a higher borrower credit rating, it is not mandatory to be higher than a 625 FICO middle-score. Keep in mind though, the higher the credit score, the higher the offer when you sell it. A 625 FICO score is the bare minimum when it comes to business loans, so the higher the better. Anything lower than 625 will most likely not be funded. Also, be sure to confirm the credit score yourself (via an attorney or business broker) and not solely rely on the borrower’s word. A little due diligence can go a long way.
- The ability to produce a down payment (not borrowed): A viable note borrower must be able to put down at least 30% hard, non-borrowed capital, or more, which will keep the loan’s LTV ratio down (which will off-set some risk to the buyer). Any less and the business seller will risk not being able to sell the debt-instrument for a full buy-out option (maybe a partial purchase). The more equity in the collateral, the more attractive the note is as an investment to a buyer.
These two above items are at the very top of the list of important characteristics when you’re looking to price and sell business notes for full purchase. If the credit score is below a 625 FICO middle-score or the borrower does not have the ability to put down at least 30% or more, the business note may not sell at all (as full-purchase).
Include a Personal Guarantee
A personal guarantee is included with a loan when the borrower is a corporate entity (LLC, etc) and not a private individual. If a business seller sells their small business to a corporate entity and does not ask the borrower to agree to a personal guarantee, this could negatively affect the loan’s value on the secondary market by thousands, if not tens of thousands of dollars. It is that important!
In the case of a loan default by a corporate borrower, the borrower can avoid repayment by dissolving the articles of organization or incorporation, depending on the entity’s business structure. Once the company is dissolved, in the eyes of the law, no one can legally be held accountable, thus the holder/seller is out their money. There is absolutely no recourse.
Also, in some cases, keep in mind that some business loans do not even have tangible collateral such as: a client list or shares in a company, etc. When it comes to repossessing this type of collateral in the case of default, it could become extremely tricky to accomplish. It is definitely not like repossessing a car or foreclosing on a property.
As the saying goes, it is like comparing apples and oranges. A simple way to avoid this costly mistake when selling to a corporate borrower, is to require and include a written personal guarantee by the borrower.
Loan Terms/Loan Amortization
When creating a seller carry-back business note with the intention of selling the loan to a note buyer, one must keep several things in mind when deciding the loan’s terms and structure:
- Stay away from interest-only structures and balloon payments of any kind (unless the seller does not mind a partial offer). Structuring a business note as an interest-only (I/O) structure with a balloon payment is a very risky proposition in today’s market, because the borrower would need to be approved for a traditional loan in order to satisfy the balloon payment at maturity. To a note investor, the bulk of the return on investment (ROI) arises from the balloon payment being paid in full and on time. Very few, if any, traditional lending institutions will fund these types of requests, which leaves the business seller stuck with a devalued asset.
- A typical note investor usually likes to be out of an investment within 3-5 years (depending on the note buyer’s risk tolerance and investment appetite). Creating a business loan with a 10, 15, 20 or 30-year full amortization loan structure will likely succumb to a much steeper discount when being priced for a partial purchase. That being said, if you go over a 5-year pay-back-period, you will NOT be able to sell the note for a full-purchase buy out. In order to maximize value, it is suggested to structure the loan as a fully amortized asset and keep the maturity date at 5 years or less. 3 to 4 years is a much safer bet for those sellers who require absolute maximum value. Anything above 10 years will take a bigger hit, due to a long wait for a return on investment (ROI).
- Always keep the loan’s interest rate at least 3% to 6% higher than what the primary lending market is charging. This means that the loan’s interest rate must reflect the risk that the small business seller is taking, by seller-financing the transaction in the first place. Keep the interest rate at least 9.5% to 12%, depending on the borrower’s credit score and down payment amount. If the borrower wants a 5% interest rate, let them go to a bank for the financing. Plus, a higher interest rate will protect the seller from a deeper discount when the buyer figures their yield into the equation. The higher the interest rate, the more shelter the business seller has from the note’s discount.
As every buyer is different, most buyers do like to see at least 3 to 12 months of seasoning before placing a bid on a note for sale. This particular item does tend to vary between buyers. For the most part, many buyers will most likely decline on a loan that has not been seasoned at all (simultaneous closing, etc.).
The seller may need to collect at least 3 payments before submitting the note for purchase. This way, there is some sort of visual indication of positive performance pertaining to the loan. We at AX have been involved in instances that allowed this item to be waived, due to a large down payment submitted by the borrower at origination (50% down or more).
Out of all of the above listed items, loan seasoning is truly a matter of an investor’s preference. It is mandatory with us at AX to have a business loan seasoned by at least 3-6 payments before we can buy it.
Payment Record Keeping
Payment record keeping is an extremely important item that must be practiced in order to prove that the privately held loan will be predictable as an invest. Record cleanliness is a characteristic that most if not all buyers would review during the pricing and underwriting of that asset.
It simply requires that the seller produce either canceled checks (proving payments collected), bank statements showing payments deposited/received (hard-copy or digital), or deposit slips (with bank stamp on them (showing proof of payments received).
This also goes for the down payment as well. If you cannot prove that money exchanged hands, you will have a tough time maximizing your profits when selling the business loan to an investor. Also, if you receive money orders from the borrower, simply make photocopies prior to cashing them. There is no need to make copies if you deposit the money orders into your bank account (as this will be reflected in the bank statements).
Documents and Closing
Executing the above mentioned suggestions will lay a strong foundation for engineering a high-value business loan that will successfully sell on the secondary market. Also, always use an attorney to draw up the closing documents (i.e. the actual note, the asset purchase agreement, and most importantly the security agreement).
If you’re looking to sell business notes or restructure a business note for resale, corners should never be cut. If they are, a seller should expect friction, delays, disappointment, and of course the possibility of getting stuck with the loan. Properly informing yourself (or your seller) on structuring a business loan for resale will make the difference between selling it or not.