A number of our recent clients have been first time buyers financing the deal with an SBA loan. They've all had questions around seller financing, so here are some thoughts. Let me know if this is helpful, and I'll post on other topics in the upcoming months. Feel free to suggest a topic!

In most smaller SBA-related deals, there is a gap between the purchase price, the buyer’s cash, and the amount a lender is willing to lend. Seller financing—money that the seller lends to the buyer at closing—is a means to bridge that gap. This is accomplished by the buyer signing a seller note, promising to pay back the loan over several years. It is not unusual for a seller to loan a buyer upwards of ten percent.
Why a seller note? Depending on the circumstances, the buyer may have other options, such as a 401(k) loan. But usually, a seller note is somewhere in the mix. The lender may require it. And the buyer may want it. After all, the seller, as the current owner, is the lifeblood of the business. He or she holds relationships with material customers and suppliers, and generally understands what makes the business tick. Transitioning to a new owner is, therefore, inherently risky. The magic that made the business work may not cross over.
By financing part of the deal, the seller puts skin in the game and sets the lender’s and buyer’s minds somewhat at rest. It gives the seller a reason to work towards a successful transition. The buyer is more likely to repay the lender’s loan and the seller note, if everything works out.
Personal Guarantees But small businesses fail for a host of reasons. The buyer could run headfirst into an economic downturn or some other unforeseen event. And in that situation, the seller will still want to get paid. Yet the lender will almost certainly take priority, meaning, in the event the business fails, the lender will take whatever valuable assets remain. To make matters worse, the seller note is likely on standby. So prior to the business failing, the Buyer may have been making at most interest only payments.
Given these risks, it is commonplace for the buyer to provide the seller with a personal guarantee. In doing so, the buyer is giving the seller the right to sue the buyer as an individual in the event of a default (normally, the legal buyer is an entity such as a limited liability company). If the business fails before the note is paid, the lender will suck up the valuable assets, but at least the seller can go after the buyer personally to try and recoup.
Of course, the buyer will want to resist a personal guarantee. First, if the buyer intends to rely on seller financing to get the seller to put skin in the game, a personal guarantee somewhat ruins that intent. Second, if the business fails, the buyer is already having a bad day. The buyer will not want to compound that misery by giving the seller the right to pursue him or her personally.
But again, it is commonplace for the buyer to provide a personal guarantee. Without it, the seller may just refuse to lend the money. And besides, even with a personal guarantee, the seller will still want the transition to succeed. Pursuing the buyer personally may accomplish little more than pushing the buyer into personal bankruptcy. It will also cost the seller substantial legal fees.

Earnouts vis-à-vis Personal Guarantees Some buyers still push back hard against personal guarantees. This reaction is understandable, particularly when the target business is heavily dependent on the seller’s guiding hand. But ultimately, all it likely accomplishes is increased friction between the buyer and the seller, making negotiating other issues more difficult. And, for the reason stated above, it may also jeopardize the deal by making the seller apprehensive about lending money.
Instead of pushing back against the personal guarantee, buyers have another option. They can negotiate an earnout—a mechanism by which the buyer withholds part of the purchase price depending on the attainment of certain post-closing goals, such as future levels of profitability. The lender won’t permit the earnout to come from the loan; instead, it will have to come from the seller’s note being automatically forgiven if post-closing goals are not met (the buyer repaying the seller less versus the buyer owing the seller less).
By having this conversation up front, the buyer can signal that he or she wants the seller to take some responsibility for the success of the business post close, and, importantly, ward off last minute deal breakers over personal guarantees. But buyers must do this early, preferably at the letter of intent stage. A seller will not want to have an earn-out conversation while negotiating the purchase agreement (let alone days before closing). It is too material of a term. Buyers must think about any proposed earnout in advance.