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A personal guarantee may be necessary when securing financing. Here's what you should know.
When applying for a business loan, line of credit, equipment financing or business credit card, many business owners are surprised to learn that a personal guarantee is required to secure the financing.
There is nothing inherently wrong with issuing a guarantee ― it is a standard for most business financing ― but you should have a clear understanding of the possible consequences of personal liability on business debts.
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A personal guarantee is a business loan term you may encounter when seeking financing. According to Sean Messier, former associate editor at Credit Card Insider, a personal guarantee is a contractual stipulation in which you acknowledge that you’re personally liable for a debt if your business can’t repay it.
“Personal guarantees are used to mitigate risk on behalf of lenders,” Messier explained. “Without a personal guarantee, if a business were to fail, then the bank wouldn’t have much leverage to collect the money it initially lent.”
Typically, business loan amounts are high, incurring more risks for lenders. “In most cases, lending a huge pile of cash without a personal guarantee would simply be a bad business decision on the lender’s part,” Messier noted.
A personal guarantee is as enforceable as any other legal agreement. While enforceability depends on the guarantee’s wording, the lender likely covered all of its bases when putting together the standard text of the document, according to Gaurav Sharma, a former banker and founder of Bankers By Day.
Banks take on significant risks when issuing loans, lines of credit and other business financing. They must ensure the borrower is serious about the business and willing to risk their financial future on it. Requiring a personal guarantee is a way to share this risk with the borrower.
Business owners agree to personal guarantees because they’re frequently required to secure necessary financing. But while often necessary, agreeing to a personal guarantee is a calculated risk for borrowers. “If you don’t trust that your business can foot the bill and you’re not prepared to cover it yourself in the event of business failure, you should consider looking for funding elsewhere,” Messier advised.
Here are the two greatest risks of signing a personal guarantee.
According to Zach Reece, a small business owner and former certified public accountant, you can get rid of personal guarantees only if you sell your business and are released from the guarantee or file for bankruptcy. However, the bankruptcy angle has a catch: You must file for personal bankruptcy, as opposed to business bankruptcy.
If a business files for bankruptcy, “it does not eliminate the personal guarantee unless the business is a sole proprietorship,” explained Randall Yates, CEO of The Lenders Network.
You risk your financial security when you offer a personal guarantee, warned Sherry Mae, chief marketing officer at Tankarium. When you fail to comply with the loan contract’s agreement, you are liable personally for the repayment by offering properties and other nonmonetary assets as payment.
Reece echoed this warning, saying that the need for a personal guarantee typically is a sign of low or nonexistent credit history. The lender is trying to ensure it’s as protected as possible if you can’t repay the loan. If that happens, you could be sued and your personal assets could be seized.
When providing financing to a business, most lenders want the business and its owners to be financially stable and have strong personal and business credit scores. The stronger the credit, the better the chance of successful approval and better pricing on most financing. However, even the best business loans may also require a personal guarantee.
Sharma noted that for some businesses, offering a personal guarantee is the only way to get access to a loan and is considered standard practice. For instance, the United States Small Business Administration requires a personal guarantor on all its loans and has minimum credit score requirements.
Here are a couple of reasons why it makes sense for lenders to require a personal guarantee.
Lenders want to know you’re committed to repaying the loan and that you are a responsible business owner personally invested in the company.
“Think of it from the bank’s perspective: The owner has far more information about the business than the bank [does],” said Jim Pendergast, senior vice president and general manager at altLINE. “If [they are] not willing to back it unconditionally, then why should the bank risk its capital?”
If you fail to make your payments or default on the business loan, the lender doesn’t have to absorb the remaining balance if you’ve signed a personal guarantee. Instead, the lender can go after the borrower’s personal assets.
When reviewing a loan applicant, most lenders look at revenue to judge whether a personal guarantee is required. If you are a small or midsize business with revenue under $25 million a year, you’ll likely be required to sign a personal guarantee. Lenders also review your business credit scores and personal credit FICO scores and analyze them for risk.
When you offer a personal guarantee, you put your personal finances, credit and company credit on the line. A business loan’s impact on your credit will depend on repayment management and your outstanding debt. Here are some potential scenarios to watch for:
Defaulting on a business loan and missing payments will also significantly harm the business. If you haven’t separated company finances from personal finances and didn’t build company credit profiles, your business credit reports will be bare. They’ll identify you as a high-risk borrower and you’ll be more susceptible to damaged credit. Any negative information about bare profiles will wreak havoc on your scores.
Unfortunately, situations like this are common. If the business were to fail, you would be left with crippling debt and critically damaged credit.
Before offering a personal guarantee, it’s important to speak with an attorney to ensure you understand the differences between unlimited personal guarantees and limited personal guarantees. Here is some basic information about each type:
With an unlimited personal guarantee, you authorize the lender to collect 100 percent of the loan amount and usually any legal fees that arise from your failure to pay. In other words, the lender could collect on personal assets, such as your home, vacation homes, savings accounts, cars and retirement funds. However, many states have homestead laws in place that may keep your primary home and retirement accounts off-limits to most creditors.
Pendergast offered an example of an unlimited personal guarantee. “Say two people own a business, Greg and Gertie,” Pendergast said. “They take out a business loan for $100,000 with an unlimited personal guarantee. The business goes under and Greg does the unthinkable and splits town. Gertie now has to pay the whole loan herself.”
With a limited personal guarantee, the borrower and the lender agree on a set limit. If you were to default on a loan, you would only be responsible for that predetermined liability. In most cases, a limited guarantee is used when multiple executives with 20 percent or more stake in the company are personally signing for the loan.
Before signing on the dotted line, ensure you know what will happen if you sell your portion of the business. Your business model will not supersede your liability on the loan. In other words, setting up a limited liability company to limit personal liability does not protect you from liability in an unlimited personal guarantee.
Pendergast also gave an example of a limited personal guarantee. Consider the same scenario from the previous example.
“Gertie and Greg would split the responsibility for the loan,” Pendergast explained. “In this case, say they agreed to 50 percent each. Then, if the business goes under and Greg splits town, Gertie is only stuck paying back $50,000 and not the whole $100,000.”
Jennifer Dublino contributed to this article. Source interviews were conducted for a previous version of this article.