Note Valuation and Valuation Essentials: A “Model” for Maximizing Value: Part Two
discount explained
To maximize the value of a financial instrument, such as a promissory note, its purpose and objectives must be well thought out; It should be well structured and well written. Ideally, it should be valued at face value, or its outstanding balance. The overall goal is to prevent flaws that cause an appraiser or buyer to lower your price or value, to discount your value. This value reduction factor is called “the discount” and the investor’s goal is to minimize it. Financially speaking, the discounts are painful.
Root Causes of Discounts
Ignorance, lack of planning and changes in financial market conditions are three of the main reasons that cause failures and errors that trigger the discount of the note. These discount drivers apply to all aspects of the promissory note creation process: conceptualizing the transaction, structuring it, and documenting it. Let’s examine how they apply to the creation and writing of the note itself and its accompanying file.
Essential Concepts for Appraisal and Valuation of Promissory Notes
There is a dangerous misunderstanding among some investors, lawyers, and CPAs; they feel that writing a note is a “no-brainer” — a “hit.” If you search the web you will find numerous offers of “free” promissory note forms that you can use to “do it yourself”. The implication is that almost anyone who can write can fill in the blanks on a grade form correctly, and that the final grade will be as “good as gold.” Truth be told, this is a serious misunderstanding of how many moving parts there are that need to be synchronized to maximize the fair market value of the note.
The complexities and pitfalls involved in creating an IOU are many and varied. Let’s explore and examine some of the most important ones.
legalities
Is the transaction that creates the promissory note legal? As examples, the following financial transactions may not be enforceable in a court of law: the borrower or lender is a minor, the borrower or lender is mentally incompetent, the borrower or lender is acting under duress, the borrower or lender they have a misunderstanding of the terms of the transaction, the legal description of the property is inaccurate. A non-demandable note will have a large discount.
Financial condition of the borrower
Many notes are created without determining and documenting the financial condition of the borrower. Additionally, many are created that do not have documentation showing the borrowers Social Security number, employment status and payment histories, credit scores, character references, etc. Having the financial data and accompanying supporting documents is essential; the lack of them causes a significant valuation discount.
collateral security
All promissory notes contain the borrower’s promise to repay the debt. These notes are called “unsecured” because they lack additional collateral. If the borrower is unable to make the payments, the note holder will suffer a loss.
If the note has a recorded lien on an asset (real estate mortgage) or pledge on an asset represented by a UCC-1 Statement, in addition to the borrower’s signature, it is called a “secured note.”
The collateral must be legally identified and legally encumbered in order to be attached to the note as a guarantee of reimbursement. Many banknotes that are considered “guaranteed banknotes” are in fact poorly insured, or not actually insured, due to wording defects and recording deficiencies.
Probably the most common mistake is not having documentation showing that a mortgage lien exists and, if so, its rank or priority. Many loan packages contain a copy of a mortgage or deed of trust, but there is no evidence that they have been recorded; and, if recorded, in what order or priority are they ranked; whether they registered in first, second or third position.
The lack of collateral and/or its rank or priority causes many, many discount situations.
Summary
In this article we have examined some of the flaws and errors that cause a discount to be applied to the fair market value of a promissory note. We focus on borrower information, the drafting of the promissory note itself, and obtaining and documenting collateral. In the next article we will continue to learn how to prevent a ticket from being discounted by examining some additional bugs and errors within the ticket file that are responsible for discounts.
Remember:
• We can also learn from our mistakes. But the cost of learning is not cheap.
• You must learn from the mistakes of others. You can’t live long enough to make them all yourself.
• Experience is the name we give our mistakes.