The Marketability of Seller Carry Back Business Notes: Are They Valuable or Worthless?

By Jim Bashaw

One of the fastest growing segments in the financial arena today is the “Cash Flow Industry”. It deals exclusively in the brokering of cash streams created by debt instruments that can be sold in the market place. The industry has defined fifty seven different types of financial instruments that create cash streams that flow from a seller to a buyer on a periodic basis (usually monthly). They can be single instruments or a portfolio of instruments.

The most widely known instruments are mortgage notes. These are promissory notes that are collateralized by mortgages on real estate. The monthly payments create the payment stream. Almost all mortgage notes made to banks or other institutions are sold to a third party, at least once, as most home owners can attest.

In the late 1980’s, it was determined that a sizeable percentage of mortgage notes were held by individual sellers of real estate. These were either first or second mortgages and represented billions of dollars in debt instruments being created annually by individuals. It should be noted that real estate is an excellent collateral for promissory notes, primarily, because it does not move. It was also determined that there were buyers (institutional and private) interested in purchasing these privately held notes, either as individual notes or in portfolio. These instruments also included trust deeds and land sales contracts.

The “cash flow industry” was born when individuals with a business background in real estate, mortgage origination or insurance brokerage realized that a fee could be earned by bringing together a buyer and a seller of such notes. Using the theory of “The Time Value Of Money”, buyers will buy the notes for an amount somewhat lower than the principal balance remaining on the note(s). The difference between the remaining principal balance and the offered amount is known as the “yield” to the buyer. It is also referred to as the discount to the seller.

The purpose of this presentation is to provide current information regarding the sale of “Business Notes”. They are similar to mortgage notes in that they represent that portion of the selling price of a “business” t hat is not paid for in cash. These notes, known as “Seller Carryback Notes”, are made by the Buyer of a business and held by the Seller of the business. They are almost always collateralized by a combination of inventory, equipment, (sometimes, accounts receivable) and good will, not real estate. Although, these assets are valuable to the continued health of the business, they represent poor collateral for a promissory note.

Prior to the end of 1994, business carry back notes had no marketable value. The holder of the note was totally at risk for the percentage of the selling price that the carryback note represented. A very scary scenario. And it still exists today for those notes that do not conform to the underwriting criteria shown below.

However, in the past few years, a market has emerged for the purchase of seller carryback business notes. It is restrictive yet flexible. It is relatively unknown, except to a small group of knowledgeable brokers who deal in this area of cash flow every day. It is estimated that 75% to 80% of all small and medium size businesses sold each year involve seller carryback notes. This is due to the lack of bank or government backed financing available for a variety of business sectors. Also, buyers want to retain some of their cash for working capital or as a cushion. They also want the seller to be exposed financially in the event that the sale of the business was either overpriced or misrepresented. Conversely, sellers prefer to sell for cash in order to pay off existing debt, buy another business or make other investments.

Almost all notes above $20,000.00 are saleable if they meet certain criteria. Anyone who has sold a business or is planning to sell a business and has a carryback note or is planning to accept a carryback note should heed the following criteria for a saleable business note.

Underwriting Criteria for a Seller – Carryback Business Note:

  • At least 1/3 cash down payment and proof of same.
  • A minimum of four (4) months seasoning (some notes can be purchased either sooner or later depending on the down payment, term, business sector, etc.).
  • Good payer credit before and after the purchase of the business.
  • Prior experience of the payer/buyer.
  • Term of the note should not exceed seven years and be fully amortized.
  • Interest rate should not be excessively low or high.
  • Lease on the premises including options for renewal should exceed the term of the note.
  • Acceptable payer business bank account balances.
  • Personal guarantee of payer.
  • Credit check for government and private liens against seller.
  • Review of seller’s bank statements subsequent to the sale of business showing deposits of payer’s loan payments to the seller.

If the above criteria is not adhered to, the business carryback note is worthless in the market.

Yield Requirements (Buy Rates) of the note buyers have come down from 30% and above to less than 25% currently (some lower). Each note is evaluated on a case to case basis. Existing and planned future notes can be appraised for present or potential value usually within 48 hours of receiving certain information in accordance with the yield requirements above. Partial purchases are also available for larger notes.

Jim Bashaw has been a Florida licensed Mortgage Broker for seven years and has specialized in the brokering of notes for the past four years. He is currently Manager of Mortgage and Business Note Brokering at The Signature Funding Group, 101 N. Woodland Blvd, Deland, FL 32720. Call 800-266-6039.

[From Connection Magazine – May 1998]

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