Over the years, many kinds of cash flows and income streams have been introduced to cash flow brokers as another way to earn income. In our opinion, the fastest-growing segment of the industry is brokering, buying and selling business notes. They also come with the biggest surprise for the note holder: the discount.
What makes a business note
A “true” business note is created when someone sells a business and no real estate is involved as security. (There are transactions that include real estate, but that’s a topic for another lesson.) The seller sells the right to operate the business, to keep using the company name if the buyer wants to, and to benefit from the steady clientele the previous owner built up over the years.
All of these come into play when an investor reviews a business note. Because there is no real estate as security, every business note carries a risk that directly drives the yield the investor wants.
“No risk, no reward” and “No pain, no gain” both fit the business note arena. With no real estate and usually few tangible assets to foreclose on, business notes are viewed as very risky. At the time of writing, market yields typically ran in the 20% range and higher, depending on the deal.
Why investors want a personal guarantee
When you buy a business note, you are really counting on the creditworthiness of the payor. So most investors won’t buy a business note unless it is personally guaranteed, meaning it carries the personal signature of one or more creditworthy individuals.
Imagine the smoke screen a corporation can throw up if it defaults. That’s why most investors look for an individual’s promise to pay, and that individual needs a top-notch credit history.
Will investors ever buy a note guaranteed only by a corporation? Under the right circumstances, yes: high equity, good seasoning, a strong company payor with a strong D&B rating, and so on. But with business notes, we’d much rather see a personal signature.
Why the down payment matters so much
Because there is little security behind these notes, the buyer’s equity is a crucial part of any investor’s review. Typically a down payment of 25% or more is needed for the note to be salable.
There are always exceptions. But we want to see that the buyer is truly committed to making the business a success. A buyer with 30% to 40% down will do everything he can when times get lean. Compare that with a buyer who put 10% down and then discovered that being your own boss doesn’t mean arriving at 10 a.m. and leaving at 3 p.m., two or three days a week.
Explaining the discount to a note holder
Any note that requires a high yield to the investor usually ends up with a large discount. Business note holders are by far the most motivated note sellers, but they are rarely ready for what a yield in the 20% range does to the price of their note in the secondary market.
Have you noticed that most note sellers, whatever kind of note they hold, have a 10% discount firmly fixed in their minds? I’m convinced all the note holders in the world got on a conference call and agreed that 10% is the number.
The problem is that investors don’t approach notes from the discount, but from the yield. The two are directly related. But the discount also depends on many other factors, such as the note’s interest rate, its seasoning, the equity and, more than anything else, the number of payments being purchased.
Offer a partial instead of a full purchase
We have had the greatest success showing clients the benefits of a partial purchase over a full one. The note holder takes out just the cash he needs now and keeps the income from all the payments still to come.
The client can also go back to the same income stream later and repeat the process if he needs more cash. That will always be a more attractive option for your clients.
