Seller Carryback Business Notes: The Good, the Bad, and the Ugly

By Jim Bashaw

A “Seller Carryback Business Note,” as you probably already know, is a promissory note held by a seller, which represents that portion of the sale of a business that was not paid for in cash. It is the buyer’s promise to pay the remaining sale price over an agreed term.

One year ago, we presented information regarding the “marketability” or “salability” of such notes in the Connections Magazine 1998 May/June issue. The underwriting criteria for such notes to be salable was presented. These notes have varying degrees of value depending on many factors. An analysis of these notes can best be characterized as: The good, the bad, and the ugly.

The purpose of this presentation is to show the difference between these classifications. We will examine these differences in the reverse order so as not to end our examination on an “ugly note.” You will easily see the dos and don’ts that should be considered in preparing such notes or attempting to buy or sell them.

The Ugly note is usually created when a business is sold in haste or by a quick sale, either of which puts the seller at distinct disadvantages. Legitimate reasons can include sudden illness of the owner, death in the family, wanting to retire, not wanting to maintain profitability or because someone or some company has convinced the seller to sell to them quickly. The last reason shown is the most dangerous to the seller. The price for the sale of the business and the terms are always established quickly and never involve a 100% cash sale. The down payment is always small (instead of at least 30% of the selling price). The seller must take back a note usually for a longer term than he/she wants (normal term is three to five years depending on the size of the note) and at an interest rate that is too low or too high (the norm is 8%, except for large sales). Some notes call for high interest to satisfy the seller, usually suggested by the buyer. Why? Because the buyer already knows that he/she will never pay off the note anyway.

The ugliest part of this whole scenario is that the seller failed to perform proper “due diligence” on the buyer. Therefore, the seller stands to lose the majority of his sales price. This can be caused by the inexperience of the buyer who subsequently fails. Or, the buyer may plan failure by diverting the assets of the business to another business and disappear.

Conversely, let the buyer beware, because the seller can play the same game. The seller puts up the business for a quick sale to unsuspecting buyers who have some cash. The seller also prepares the business note which probably will have an interest rate and term that is probably unrealistic and which the seller knows the business cannot support. The seller knows that the business will be returned when the buyer fails to make it profitable. The buyer loses his/her investment and hard work and the seller gets ready to sell the business again. The ugly shows up here because the buyer did not perform “due diligence” on the seller or the business.

Ugly notes can easily be spotted by note buyers for the reasons stated and because the sale is never fully documented. These notes are not saleable.

The Bad notes are usually created unknowingly. By bad notes we mean, “not in the best interest of the seller” or anyone behind the seller such as an heir or subsequent note buyer. While ugly notes have just a few reasons for being classified as such, bad notes can exist for a very wide variety of reasons. Some of the reasons include (but are certainly not limited to):

  • Lack of 30% down payment.
  • A term beyond five years.
  • Incomplete documentation.
  • A company note not guaranteed personally by the principal(s).
  • Buyer’s lack of experience in the industry of the subject business
  • High turnover in this type of business.
  • Collateral includes good will that is an excessive percentage of the sale price.
  • Second lien notes, except where the buyer pledges his/her assets for additional collateral for the first position note to a lender together with substantial cash to 50% of the selling price.

With better planning, good notes can be created when one knows the pitfalls that cause a note to be considered bad.

The Good notes are notes that are created with proper planning, adequate due diligence and the following criteria. The price of the business should be determined by not only the seller, but by an appraisal from a qualified broker in the business. The sale must include a minimum of 30% down payment. The buyer must have very good credit and adequate additional liquid assets available after the purchase. An attorney should be involved and he/she must produce the proper documentation for the benefit of the buyer and the seller to meet all governmental regulations. The business must have been profitable for the last several years and continue to remain profitable with no signs of deterioration. They must be first liens. Good notes can be sold at up to 75% to 80% of their present balance. Typically, partial purchases are made. Example: the note buyer will offer to buy the next 48 payments of the 65 to 68 payments remaining. The 48 payments are bought at a discount and the 18 to 20 payments are paid to the seller in full on their due dates. This process limits the net discount sustained by the seller. Note sales take approximately four weeks if the documentation is proper and complete.

Due Diligence: I can not say enough about the importance of due diligence. Many buyers and sellers (especially in small business sales) take each other’s word regarding their backgrounds, resumes and even financial information. This is very short-sighted. Buyers need to know as much as they can about the business they are about to purchase and its owner before making their investment. Likewise, the seller needs to know that the proposed buyers are honest and are a good match for the business being sold to them. The seller is also granting credit to perfect strangers.

In the early stages of negotiation, the buyer and the seller should give each other the name of their respective banks and bankers that are most familiar with them. Each should have their own banker inquire of the other regarding satisfactory banking practices, account balances and the availability of funds to close on the part of the buyer. This procedure, when completed, will either establish a comfort level for each to proceed or it will cause an end to negotiations.

In addition to the above, the best way for a buyer and seller to perform due diligence is to hire a private investigation company. They are in the yellow pages. They are expert at providing civil and criminal background checks. This process should begin after the terms of sale of a business are agreed. There should be a contingency of the sale and it should be completed before closing. “Individual” background checks can be completed quickly in a cost range from $100 to $500 approximately. “Corporate” background checks can cost from $100 (sole owner) up to $2,000 approximately depending on the number of principals in the corporation. Buyer and seller should provide each other with a copy of their respective credit reports (if available), a copy of their driver’s license and a signed, dated and social security number insertion on an “Authorization to Release Information” form shown herein (see figure A). The form is self-explanatory. The first meeting with any investigation company is usually free of charge. That is when you decide the extent of the investigation you wish.

Background check reports will give both the buyer and the seller the comfort level they need to consummate the sale of the business.

A great deal of “trust” on both sides is required in any transaction that involves providing cash and a “promise to pay” in exchange for an unknown future.

[From Connection Magazine – May 1999]

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