A personal guarantee in a business sale is essentially a promise made by the buyer to the lender that they will pay back the loan - and if they don’t, they will pay. Literally.
For buyers and sellers, it is important to know how a personal guarantee factors into a business sale.
If you are a buyer, it means you are giving the lender permission to go after your personal assets if you default on the loan.
If you are a seller, a personal guarantee from the buyer can ensure that you will receive payment for your business even if they default.
To help buyers and sellers understand just how this works, we will cover what a personal guarantee is, how it works, and how it will affect them in the sale of a business.
Let’s hop in.
The Purpose of a Personal Guarantee
A personal guarantee provides the lender with financial protection if the recipient of the loan defaults (fails to pay). Because of this, most business loans will require a buyer to provide a personal guarantee.
If a buyer signs a personal guarantee, they can be held accountable for covering a portion or the whole amount of the loan with their personal assets if they default. That’s where the two types of personal guarantees come into play - limited guarantees and unlimited guarantees.
Two Types of Personal Guarantees
Lenders prefer unlimited guarantees while buyers prefer limited guarantees. A limited personal guarantee is a guarantee on a percentage of the loan. An unlimited personal guarantee is a guarantee on the full amount of the loan.
1. Limited Personal Guarantee
To illustrate how a limited guarantee works, say you purchase a business and receive a loan of $5 million with a limited personal guarantee of 20%. The amount you would be responsible for in the case that you default on the loan is $5 million x .20 which equals $1 million.
Your personal assets consist of:
- A house worth $1,000,000
- A boat worth $200,000
- A truck worth $80,000
- A sports car worth $100,000
- A checking account with $100,000
Even though you have well over $1 million in assets and available cash, the lender can only seize up to $1 million (20% of the loan) since it is a limited guarantee.
2. Unlimited Personal Guarantee
Now picture the same scenario, but with an unlimited personal guarantee. You purchase a business and get a loan of $5 million with an unlimited personal guarantee. You would be responsible for the whole $5 million if you were to default on your loan.
You would have the same assets as you did in the example for the limited guarantee:
- A $1,000,000 house
- A $200,000 boat
- A $80,000 truck
- A $100,000 sports car
- $100,000 in your checking account
In the instance of an unlimited personal guarantee, the lender can seize everything you have - cash and assets - if you default on your loan.
SBA Loan Process and Personal Guarantees
The SBA 7(a) loan program is one of the most common ways individual buyers will receive a loan to purchase a business. SBA standard operating procedures include personal guarantees as part of the loan agreement to protect SBA lenders.
Depending on the SBA lender, buyers may need to sign an unlimited or limited personal guarantee. If the buyer has a business partner who has 20% or more ownership in the business, they will also need to sign a personal guarantee on the loan.
If the SBA 7(a) loan includes a portion of seller financing either as a seller carry or a seller note, the personal guarantee also helps protect the amount that the seller has seller-financed to the buyer.
However, it is key to note that the SBA 7(a) lender will always be in 1st lien position and the seller in 2nd lien position. This means that if the buyer does default on the loan, the lender is the first to get paid and the seller is the second to get paid.
"If you receive an SBA loan with a personal guarantee and you declare personal bankruptcy, you will not be relieved of the obligation of the loan. Just like the IRS, the SBA is a government department and goes past bankruptcy.
When you default on an SBA loan, you can discuss an “Offer in compromise” with the SBA for a lower amount or payment plan moving forward. If you agreed on an “offer in compromise,” you will not be able to secure any government-backed financing moving forward. Alternatively, if you pay the funds back in full, you will again become eligible to apply for government-backed financing."
Steve Mariani, President
Diamond Financial Services
When Does a Personal Guarantee Come up in a Business Sale?
A personal guarantee will be included as part of the loan process in a business sale. The loan process will occur around the same time as the buyer and seller are going through due diligence together.
The lender will have a section of the loan where they require the buyer to sign the personal guarantee, which will also explain the buyer’s responsibility in the guarantee and its guidelines.
Understand How Personal Guarantees Affect Business Sales
When you know how personal guarantees affect business sales, you can be better prepared for what to expect as a seller and as a buyer.
As a buyer, you will know that you have to be confident in the business you are purchasing and your ability to run it. If you are unfamiliar with the SBA 7(a) process, read our blog “How to Buy a Business Using the SBA 7(a) Loan Program (With Example).”
As a seller who offers seller financing to a buyer, you can find assurance in knowing the personal guarantee is designed to protect the amount you seller finance. Learn what seller financing is in our blog “What is Seller Financing?”
We walk business owners and their buyers through the process of business sales every day. Give us a call to speak about selling or buying a business today.
Know Your Company's Worth
Prepare to sell by determining the value of your business.
Subscribe To
THE MIDSTREET BLOG
